Managing inflation: why exchange rates, not just the cash rate, are important

Dr Siddharth Shirodkar, IBA Principal Economist & Sharna Meinertz, proud Noongar woman and IBA Head of Investor Relations

Inflation, interest rates and exchange rates. These three ideas create a deadly part of doing business and investing money.

We have previously yarned about how the Reserve Bank of Australia (RBA) sets the cash rate (Australia’s main interest rate) to manage inflation. However, what about the exchange rate? Is it important too?

It starts with investment.

Australia only makes up around 1-2% of the world economy. The market for investment is global. Where an investor chooses to put their money has huge implications for countries, particularly countries like Australia, where we rely on foreign investment to fund a lot of our housing, businesses and infrastructure.

Because of international investment flows, decisions on interest rates in the US can have implications for Australia – and our inflation – without the RBA needing to do anything.

That’s where the exchange rate plays a critical role.

The US Federal Reserve (arguably the world’s most powerful central bank, known as the ‘Fed’) recently announced an interest rate cut of 0.5%. This marks the start of a major interest rate easing cycle, after the joint efforts of central banks around the world have broken the back of the global inflation challenge.

Following this announcement, many US investors looked to invest overseas. They see Australia as a safe and secure place to invest.

Importantly, as the RBA has not yet lowered the cash rate here, US investors will receive a higher risk-adjusted return on Australian investments, which is good news for our investments.

When foreigners invest in Australia, they will need Australian dollars, so they look to buy them on the international currency market. That’s why the Australian exchange rate grew by 2% to 68.8 US cents following the Fed’s announcement of a rate cut and has remained steady at that level for several days. [1]

An exchange rate rise benefits Australians as it lowers the price of imports. Australia needs imports from the rest of the world to sustain our way of life. You only have to look in a local shop to know how much is made locally.

A rising exchange rate lowers import prices. That puts downward pressure on Australian inflation. That’s because if our dollar is worth more against other currencies, then we can buy from overseas for cheaper, which directly reduces our prices and therefore inflation.

But because we are a massive exporter, an exchange rate rise also hurts our international competitiveness. The exchange rate rise makes many of our products and services more expensive, so we have fewer tourists coming in, and sell fewer agricultural and manufacturing products.? ?

With fewer exports, Australian companies earn less revenue. This reduces earning, leading to job cuts in some industries, which in turn reduces overall Australian consumer spending. Consequently, overall demand in Australia decreases, which puts further downward pressure on inflation – but at the cost of jobs and the economy.

So, while setting the cash rate in Australia is critical for managing inflation, it’s also important to recognise the impact of a rising exchange rate on curbing inflation and on the economy.

It means Australia’s inflation may fall faster than many currently think. That could bring some additional cost-of-living relief to Australian households.

You might already know that IBA provides home loans and business finance, but did you know IBA has developed a range of managed fund options that enable First Nations organisations to invest in a diversified portfolio with the objective of outperforming inflation? This means that the money they earn today can have the potential for greater purchasing power in the future.

To find out more about investing with IBA, visit IBA.gov.au. If you are interested in wholesale investing with IBA, visit IBAFunds.com.au, which includes information about the Indigenous Prosperity Funds (IPF) and the Indigenous Real Estate Investment Trust (I-REIT).

Legal Disclaimer

The information contained in this material is general in nature and not tailored to your particular circumstances, objectives or needs. If you are eligible and decide to apply for products or services from IBA you should obtain independent financial and legal advice before signing any documentation or making any significant financial decisions and you should rely upon your own independent advice and inquiries. While IBA has no reason to believe that the information in this material is inaccurate, the truth or accuracy of that information cannot be warranted or guaranteed and may have changed since it was prepared. IBA takes no responsibility for any damage or loss suffered by you in relying on the information in this material.

[1] As of 4pm AET, 25 September 2024.