Inflation News in Australia: Its Effects on Exchange Rates and Interest Rates

Abstract

This paper investigates the effects of the Australian quarterly inflation news on $A exchange rates and interest rates for the period June Quarter 1984/85 to December Quarter 1992193. The results indicate that the Australian dollar depreciated and interest rates rose as a result of an announcement of a higher than expected Consumer Price Index inflation before April 1988, and the dollar appreciated and interest rates rose thereafter. This difference in market response to the news is due to the different market perceptions regarding the role of monetary policy by the Reserve Bank of Australia (RBA). Prior to April 1988, an unexpected inflation caused markets to expect further future inflation and caused a rise in the risk premium on domestic assets. Post April 1988, an unexpected inflation was regarded as a signal for an impending tight monetary response by the RBA. The evidence is consistent with the belief that market participants had the Portfolio Balance Model of exchange rate determination in mind when they responded to the inflation news.