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Aussie Dollar Stands to Benefit from Reserve Bank’s First Interest Hike in over 11 Years

The Reserve Bank of Australia (RBA) has followed the lead of the US Federal Reserve in raising interest rates to combat breakneck inflation, in a move that promises to lend support to the Aussie dollar.

On Tuesday the RBA announced that it would increase its cash rate target by 25 basis points to 0.35 per cent.

The cash rate had previously sat at a record low of 0.1 per cent since November 2020, when the RBA reduced it by 15 basis points to help the Australian economy weather the impacts of the COVID-19 pandemic.

The hike announced on Tuesday marks the first time in more than 11 years that the RBA has raised the cash rate target.

The latest increase was far stronger than expected, with a median forecast of 32 economists surveyed by Reuters previously anticipating a rise of 15 basis points.

The cash rate is the interest rate on unsecured overnight loans between banks, and serves as the risk-free benchmark rate for the Australian dollar.

By adjusting the cash rate, the RBA can influence the cost of borrowing throughout the economy, and thus levels of economic activity.

The RBA hopes to contain surging inflation by raising the rate, which will contain excessively rapid price gains by suppressing market demand.

The official inflation figure in Australia for the March quarter was 5.1% in annual terms – its highest level in over two decades, and well ahead of the general mandate of modern central banks to keep inflation at around 2% per annum.

RBA governor Philip Lowe said that the rise in inflation is expected to continue in the near term, as a result of global factors in tandem with domestic capacity constraints.

Lowe highlighted the RBA’s commitment to containing inflation in the Australian economy.

“The board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time,” said Lowe after the Tuesday announcement.

Lowe also said that the cash rate still had a long way to rise before it returned to normal levels more closely on par with rates of inflation.

“How quickly we get there, and if we do get there, will be determined by how events unfold,” he said.

For this reason, analysts expect a string of further rate hikes by the RBA in the near-future. Markets have priced in another rise in June, while half of the bets forecast an increase even larger than 25 basis point hike.

From the perspective of forex markets, interest rate hikes by the RBA should provide some support to the Aussie dollar by increasing the return on assets denominated in the Australian dollar.

The Australian dollar surged by over 1% against the US dollar after the RBA announced the rate hike, rising to 71.4.

The Australian dollar may find it difficult to sustain gains against the US dollar however, as the US Federal Reserve is expected to push through with further rate hikes of its own to combat severe inflation in North America.

This means that the US dollar asset will also deliver stronger yields, further increasing the appeal of the greenback to investors.