The Australian dollar has depreciated against the US dollar recently, as have many other currencies. This should not have material implications for interest rate decisions.
Markets are generally thin over the Christmas period, which means there are often big moves in market pricing over the period. This summer was no exception. The US dollar strengthened against most currencies, including the Australian dollar, with the AUD/USD exchange rate briefly falling below US62c earlier in the month.
An exchange rate depreciation does tend to raise the local-currency prices of imported goods and services. If you are about to embark on a trip to the United States or have a USD-denominated contract to purchase goods or services, you will definitely feel the difference. Because of this, some observers have been asking if the recent depreciation could lift the inflation outlook enough to induce the RBA Board to delay cutting the cash rate, relative to what it would otherwise have done.
A closer look at the data, however, suggests that the effect on inflation trends will be small. There are a few reasons for this.
First, the depreciation needs to be sustained to affect inflation materially. Most importers and other users of foreign currency hedge at least some of their exposure. If an exchange rate move is short-lived, prices actually paid in Australia might not move much.
Second, the USD is not the only relevant currency for the Australian economic outlook. The RBA Board has previously highlighted that they view the trade-weighted index (TWI), not the bilateral exchange rate against the US dollar, as the relevant measure for assessing trends in imported inflation, and the RBA publishes such a TWI daily. The USD only has an 8.7% weight in this index, while China’s weight is just under 30%. Other Asian trading partners such as Japan and South Korea also figure more prominently than the US dollar. Taking the broader view afforded by the TWI, recent currency movements look much less stark. The Australian dollar has depreciated by nearly 10% against the US dollar since its brief peak around the end of September. Against the trade-weighted index, though, it is down less than 4% over the same period. The TWI is currently at roughly the same level as it was for most of the second half of 2023.
Third, while the landed price of imported goods does move closely with the (import-weighted) exchange rate, the relationship with the prices of imported items in the CPI is much more diffuse. (This is known as ‘second-stage pass-through’, as opposed to the ‘first-stage pass-through’ from global prices to landed import prices in Australia – see Graph 2 in this RBA Bulletin article.) The usual rule of thumb coming from the RBA’s own estimates is that a 10% sustained depreciation typically results in an increase in the level of the overall CPI of about 1%. Actual results can vary, though: for example, retail price inflation was lower in the 2010s than implied by movements in import prices, as the domestic retail landscape evolved.
Finally, it matters why the exchange rate depreciated. Much of the recent depreciation of the AUD was a response to shifting market views about the US rates outlook, following the December meeting of the Federal Reserve. However, it was also partly a response to a more negative outlook for the Chinese economy. The AUD is often seen as a proxy that traders use to express their views on China, given our tight trade relationship and deep, liquid FX market.
To the extent that the outlook in China has genuinely worsened, the exchange rate depreciation both implies a positive impulse to inflation and reflects an offsetting negative real-economy shock. The net effect on the domestic economy might not be inflationary at all in these circumstances. If on the other hand, market participants are being overly pessimistic about China, we would expect to see exchange rates evolve as people update their views.
It is also worth noting that China’s economic headwinds are also showing up as very weak inflation there, relative to Australia and most advanced-economy peers. Some other east Asian economies have also seen lower inflation rates lately than those prevailing in Australia, including some with material weights in the TWI.
Adjusted for relative inflation rates, the trade-weighted index was therefore in fact appreciating over most of this year; it is this ‘real TWI’ that the RBA uses in many of its models for forecasting domestic growth. While the RBA has only published its real TWI up to the September quarter – reflecting a lack of published inflation data for many countries – we can make some reasonable assumptions to ‘near-cast’ the real TWI for the December quarter. This shows a depreciation of only around 1.7% in the quarter.
The main reason for the smaller decline is that these indices are calculated using quarterly averages of daily exchange rates, which show a less extreme decline than the point-to-point change. The depreciation between the September quarter average and December quarter average was just 1.6% for the nominal TWI and 2.6% for the bilateral rate against the US dollar. If exchange rates hold at their current levels for the rest of the March quarter 2025, we will see a further 2% quarterly depreciation in the TWI and 4½% against the US dollar on this quarterly-average basis. The real TWI would also depreciate by a further 2% in the March quarter. This would take the series back to roughly where it was at the beginning of 2024.
Again, this estimate for the real TWI requires a few assumptions about inflation outcomes in the March quarter. We use our own forecasts for the Australian side of the relative price as well as for New Zealand. For other countries, we used some simple extrapolation and/or time series models. (We are also using forecasts of headline inflation, while the RBA series uses core inflation where available. In addition, we are ignoring the implications of the forthcoming change in TWI weights, which will affect the March quarter calculation slightly.)
These considerations are part of the reason why the RBA uses measures such as trimmed mean inflation as their best estimate of the near-term trend in inflation, even though headline inflation is what people actually experience. Short-term volatility in the exchange rate – and thus petrol and other imported prices – is not enough to tip the balance for the RBA’s decisions. Domestic inflation pressures, and the outlook for the labour market, continue to be more important factors influencing the monetary policy outlook.
