The Reserve Bank’s Influence on Australia Exchange Rates
Expert reviewed • 21 July 2024 • 9 minute read
What is the Reserve Bank of Australia's Influence on Exchange Rates?
The Reserve Bank of Australia (RBA) has a significant influence on the country's exchange rate (ER). This mainly occurs through policy-making decisions such as the manipulation of monetary policy. The following methods describe the impact and effect of the RBA on Australia's exchange rate.
How is Monetary Policy Used to Manipulate the Australian ER?
The primary tool used by the RBA is monetary policy. Although it is usually used to manipulate interest rates, the RBA can alter Australia's exchange rate intentionally or unintentionally through the interest rate channel. By adjusting the cash rate, which is the overnight money market interest rate, the RBA influences economic activity and inflation. This in turn will result in changes in the exchange rate. When the RBA raises interest rates, it generally leads to an appreciation of the AUD as higher rates provide better returns on investments denominated in AUD. Conversely, lowering interest rates can lead to depreciation due to reduced investment attractiveness.
For example, in May 2022, the RBA increased the cash rate by 25 basis points from 0.10% to 0.35%, marking the first rate hike in over a decade. This move was aimed at addressing rising inflation. On the day of the announcement, May 3, 2022, the Australian dollar experienced an appreciation against the US dollar.
- Pre-announcement Exchange Rate (May 2, 2022): AUD/USD was approximately 0.7040.
- Post-announcement Exchange Rate (May 3, 2022): AUD/USD rose to approximately 0.7090, reflecting an increase of around 0.7% on the day.
Additionally, the RBA can use other monetary policy tools such as manipulating economic expectations to influence the exchange rate. Otherwise known as 'forward guidance', the RBA expresses its future monetary policy intentions to influence the expectations of financial markets, businesses, and households.
How is Foreign Exchange Intervention Used to Manipulate the Australian ER?
Although not a frequent practice, the RBA can directly intervene in the foreign exchange market to influence the AUD's value. This usually involves selling AUD when it is undesirably strong and buying AUD when it is weak to stabilise and achieve desired economic outcomes.
The Advantages of Direct Intervention:
- Stabilising effect: Direct intervention can help stabilise the foreign exchange market during periods of excessive volatility.
Disadvantages of Direct Intervention:
- Limited effectiveness: The effectiveness of direct intervention can be limited, particularly if the size of the intervention is insufficient to counter market forces.
- Potential for loss: Direct intervention exposes the RBA to potential financial losses if the currency moves against the direction of the intervention.
As such, due to its limited effectiveness, the RBA does not intervene often in foreign exchange markets. This is shown in the following graph:
As shown in the graph, over the last half decade, the RBA has only intervened in foreign exchange markets 4 times. Additionally, these were only done in times of significantly detrimental economic activity. For example, the RBA intervened during 2019, to stop deflation as a result of COVID-19. Additionally, they intervened again in 2022 to combat high inflation rates of 7.8%, hence depreciating the value of AUD.
What is the Effectiveness of the RBA's Influence?
The effectiveness of the RBA's influence on exchange rates depends on the following factors:
- Credibility: The RBA's ability to influence exchange rates is enhanced by its credibility in managing monetary policy and maintaining financial stability. A credible central bank can shape market expectations and behaviour more effectively as it is more trusted by all in the economy.
- Consistency with fundamentals: The RBA's actions are more likely to be effective when they are consistent with underlying economic fundamentals, such as limiting inflation and stabilising economic growth. If the RBA's actions are seen as diverging from fundamental economic objectives, their impact on exchange rates may be limited.
- Market sentiment: The RBA's influence on exchange rates can be affected by overall market sentiment and global economic conditions. During periods of heightened risk aversion or global economic uncertainty, the RBA's ability to steer the currency may be diminished.