Better than expected inflation figure triggers significant reaction

Inflation is reported to be at 2.9% on the headline rate and 2.7% on the underlying rate. This is less than expected and has been a cause for relief for the RBA.

The RBA have a target range of 2 to 3% inflation. The widespread expectation was that headline inflation would rise to about 3.2% for the quarter to March and that this would cause the central bank to raise interest rates from their current low to reduce inflation.

The relief is on two counts.
1. A rise in interest rates would cause lower discretionary income for households and reduce Consumption. Also it would reduce Investment by firms which are sensitive to the cost of borrowing. Both are components of Aggregate Demand.

2. The exchange rate would likely rise as interest rates rose (Australia already has very high interest rates compared to the other industrialised economies). This would make exports more expensive and imports cheaper and stifle the export led growth on which much relies.

The news led to a sharp fall in the value of the Aus$ (by around 0.75 cents against the US$). This was due to traders lowering their expectations on the possibility of a rate rise.

It is well worth looking at the ABS statistics which can be accessed in the links section (key data). 

The likelihood is that rates will stay on hold for the rest of the year. This is good as business and consumers like stability. It gives them confidence and they can plan their next moves.

It is, however, unlikely that even 3.2% inflation would be the cause of a rise in rates. The RBA knows that it takes two years for interest rate changes to work through the economy to reduce inflation. They will be looking at the longer term forces affecting inflation over those two years when deciding on interest rate changes. So rates may rise anyway!