Federal Reserve’s inflation target fudge: what it means for Australians
Late last week, the chairman of the US central bank announced major changes to the way the US will be targeting inflation in coming years.
Instead of trying to keep inflation around 2 per cent by lowering or raising interest rates, Fed chairman Jerome Powell said the US central bank might let things run a bit hot for a while as the economy bounces back from coronavirus.
That means US interest rates are likely to stay around zero for years, even as the economy rebounds.
It sounds pretty wonkish, but the decision is going to have real-world effects on Australian households.
Some are already happening.
Higher Aussie dollar
The most obvious impact is on Australia’s dollar.
Since last week’s announcement, the Aussie has strengthened a fair bit, continuing its remarkable turnaround since its recent low of 55 US cents in late March.
Australia’s dollar is now worth 74 US cents — up by more than a third in just five months.
This is the first time the Aussie has been higher than 74 US cents since August 2018, and currency strategists think it will likely keep rising.
(As an interesting historical aside, since Australia’s dollar was floated in 1983, its long-term average has been 76.92 US cents.)
Sean Callow, a senior currency strategist at Westpac, says the dollar will likely be worth 75 US cents by the end of this year, and 80 US cents by the end of next year.
Joe Capurso, Commonwealth Bank’s head of international economics, says his team thinks the range for the dollar’s “fair value” is somewhere between 71 and 82 US cents, centring around 76.
Since the dollar is currently worth 74 US cents, that means it will probably strengthen a bit more. He thinks it will be worth 78 US cents by this time next year.
What does a stronger Australian dollar mean for households?
When Australia’s dollar strengthens, imports of consumer items become cheaper.
So if you’re looking to purchase goods from overseas, you’ll appreciate the rising dollar at the moment.
However, the COVID-19 lockdowns on international borders mean some of the traditional benefits of a rising dollar have disappeared.
Take overseas holidays.
In normal times, a stronger Aussie dollar is a good thing for Australians heading overseas because it increases their purchasing power in other countries.
But, since borders are closed, none of that matters — few people can head overseas anyway.
Conversely, in normal times, you can see a drop in foreign tourists coming to Australia when the Aussie dollar strengthens, but that doesn’t matter at the moment either.
Ray Attrill, NAB’s currency strategist, said the unusual circumstances of the COVID-19 lockdowns mean any volatility in the currency is “much less significant” than it might otherwise be.
“It will make Australian exports to other countries more expensive, and imports to Australia cheaper,” he said.
“But the ways where the currency tends to have a big impact is in areas like tourism and education, but with the borders shut, that’s an irrelevance at the moment.”
Interest rates and house prices
The US Federal Reserve’s decision to keep interest rates lower for longer to encourage inflation to lift above 2 per cent — and to remain above 2 per cent for years — also has implications for Australia’s Reserve Bank.
It means the RBA will have another reason to keep interest rates at historic lows.
RBA governor Philip Lowe has said repeatedly he will happily keep Australia’s official interest rate around 0.25 per cent for three years at least, possibly more.
The US Federal Reserve’s latest shift will just encourage the RBA to delay any decision to lift rates in Australia (lest any rate rise sees the Aussie dollar jump even higher still).
That means if you’re in the position where you have a steady income and you’re looking to buy a property, you’ll be facing an unusual period of certainty on interest rates.
“If it’s pushing out even further the day when the RBA raises rates then it will keep downward pressure on Australian mortgage rates,” Mr Calllow said.
“You’ll have a pretty high degree of confidence about what your mortgage payments are likely to be over the next years.
“You’ll have an unusual amount of confidence that you won’t be faced with a jump in mortgage rates for not just one or two years, but probably quite a bit longer.
“However, saving for a deposit would be another question.
“Although, saving is actually more a case of just spending less than your income — rather than saying, ‘Here’s my pot of money, watch the magic of compound interest, isn’t it fabulous.’ That really hasn’t been a case for a while.”
Share markets and super funds
The US Federal Reserve’s decision to allow inflation to run above 2 per cent in the future will add support to US equity prices and, because of the primacy of the US economy and currency, to many share markets around the world, including our own.
Why? Because in a low-interest rate world, it will encourage investors who are looking for returns to favour equity markets for dividends and potential capital growth, compared to the unattractively low returns from US bond and money markets.
The Fed is ensuring that companies that need to borrow at lower rates will be able to do so, which may see even more cheap, borrowed funds returned to shareholders through share buybacks or special dividends.
That extra support for US equities could also be directly beneficial for Australian superannuation funds with exposure to US shares.