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Austrlian dollar's slide lowers scope for rate cuts

SYDNEY - A runaway slide in the Australian dollar to seven-month lows risks stoking already high inflation and will give the central bank less room to cut rates aggressively as growth slows, analysts warn.

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The currency has tumbled 14 percent against the US dollar in the past month, partly as investors priced in the possibility of a rate cut as early as September.

The slide accelerated this week with the hapless currency falling as far as $0.8590 on Wednesday, far from a 25-year peak of $0.9851 hit last month. In trade-weighted terms, it has dropped 9 percent in less than a month.

So sharp has been the setback that analysts are worried it will lift the price of imported goods, notably oil, and add to inflation which is already at 17-year highs.

The Reserve Bank of Australia (RBA) had welcomed the strength of the local dollar over the past year as a counter to home-grown price pressures.

‘The speed of this fall will have made them sit up and take notice,’ said Brian Redican, a senior economist at Macquarie. ‘It won't prevent an initial rate cut, but it might well temper how fast and far they ease.’

The central bank has raised rates four times in the past year to slow demand and restrain inflation, but recent data has shown the economy slowing far more rapidly than expected.

Still, investors fully expect the central bank to cut its current 7.25 percent cash rate by 25 basis points at its next policy meeting on Sept. 2.

But talk of a half point easing has been tempered by the dollar's precipitous decline.

‘RBA has signaled that they are looking to lower official interest rates, but we continue to hold the view that the signals from the RBA remain less aggressive than those now priced into local markets,’ said Stephen Halmarick, co-head of economics and market analysis, at Citi.

‘Any further depreciation of the Aussie could be a concern in terms of its inflationary implications, especially if Australia's terms of trade continue to rise, as we expect,’ he added.

Australia's terms of trade -- prices its gets for exports in relation to what it pays for imports -- has surged by more than 40 percent in the past few years, and are expected to rise by a further 20 percent this year driven by strong demand from Asia.

Australia, which is a big exporter of natural resources, has seen the once-in-a-generation rally in commodity prices deliver a bonanza of higher profits, wages and tax receipts.

That was one reason annual core inflation climbed to a 17-year high of 4.4 percent last quarter, well above the central bank's target range of 2-3 percent.

TIDE TURNING

The central bank reacted to rising inflation by raising rates in February and March, which, along with firm commodity prices, provided the Aussie with a huge degree of support.

But that has given way as commodity prices fell from dizzy heights and the RBA turned dovish on monetary policy as the domestic economy slowed more sharply than first expected.

That led rate differentials between the United States and Australia to shrink to their lowest in a year. The yield spread between the two-year Australian and US government bonds has dropped to 337 basis points, from peaks above 500 last year.

This narrowing coincided with a major rebound in the US dollar, putting further pressure on the Australian currency.

‘We expect the US dollar to rise because we believe the US economy and interest rates are near their low point,’ said Joseph Capurso, currency strategist at Commonwealth Bank.

‘The US dollar was the first currency to fall and we believe it will be the first to recover. A resurgent US dollar will put downward pressure on the Aussie.’

All of which leaves the central bank in a tight spot, balancing a slowing economy with high inflation and a vulnerable currency.

‘We believe RBA officials will want to avoid an inflationary plunge in the Aussie dollar and that rules out a 50 basis point cut in September,’ said Helen Kevans, an economist at JPMorgan.