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Australian dollar drops as RBA cuts inflation forecasts

Australian dollar drops as RBA cuts inflation forecasts

CommBank currency analysts are keeping their Aussie dollar year-end forecast at US78 cents despite recent volatility after the Reserve Bank cut its inflation forecasts.

The Australian dollar (AUD) slipped below US74 cents after the Reserve Bank of Australia (RBA) lowered its inflation forecasts, increasing speculation of another cash rate cut in coming months.

The RBA said in its Statement on Monetary Policy (SMP) that it expects both underlying and headline inflation to be 1-2% a year over 2016, below their target band of 2-3%.

"This is a big downward revision and indicates that the incredibly soft Q1 inflation report took the Bank by surprise," CommBank economists said in a note.

The RBA cut the official cash rate (OCR) by 25 basis points to a record low 1.75% at its board meeting this month.

After that meeting last Tuesday, Governor Glenn Stevens said in a statement that the decision to cut the cash rate was because "inflationary pressures are lower than expected”.

The Consumer Price Index (CPI) – the main measure of inflation in Australia – fell by 0.2% in the March quarter, below expectations for a rise of 0.3%.

The cash rate had been the same since last May when it was cut to 2%.

"Today’s SMP makes it crystal clear that the decision to ease policy came purely down to the Bank’s concerns about entrenched low inflation and deflation risks," CommBank said, noting that growth and labour market trends didn’t signal that more rate cuts were either required or forthcoming.

"We have the RBA cutting rates again in 2016 and August looks the most likely month following the next update on inflation," they said.

CommBank currency and rates strategist Richard Grace added that lower inflation "is actually supportive of currency strength, not currency weakness" and "an improving Australian economy, a narrowing current account deficit and higher terms of trade will also support AUD".

Grace agreed that the RBA's cash rate cut to 1.75% had "put some downward pressure on AUD/USD", but he noted that international experience suggested incremental reductions in interest rates don't have a long-lasting impact on the exchange rate.

The Reserve Bank of New Zealand has cut the OCR by 125 basis points since June 2015 and the NZD/USD is less than 3% lower, Grace said in a note.

The New Zealand dollar has lifted against the greenback by more than 12% "despite two recent 25 basis point rate cuts and more than another 25 basis points of rate cuts priced into the New Zealand rates market".

As a result, Grace and his CommBank currency strategy team are sticking with previously reported AUD/USD forecasts of US75 cents by end-June and US78 cents by year-end.

This article is intended to provide general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice.