The Reserve Bank of Australia has operated under a flexible inflation targeting framework since the early 1990s, aiming to keep inflation between 2-3% over the medium term. This framework has served Australia reasonably well, but periodic reviews consider whether adjustments are needed.

The current review, examining whether the framework remains optimal in a changing global economic environment, has implications for monetary policy and the Australian dollar.

The Current Framework

The RBA’s mandate is to target inflation at 2-3% on average over time, while also considering employment and economic stability. This is “flexible” inflation targeting - the RBA doesn’t respond mechanically to every deviation from the band, but considers broader economic conditions.

This framework gives the RBA discretion to look through temporary price shocks (like pandemic-related supply disruptions or commodity price spikes) while still anchoring long-term inflation expectations.

The question being examined is whether this framework, designed in the 1990s, needs updating for current economic realities.

Potential Framework Changes

Several modifications are under discussion, though nothing has been formally proposed:

Average inflation targeting: Rather than aiming for 2-3% at all times, target 2.5% average inflation over economic cycles. This would allow inflation to run above target during recoveries to offset periods below target during downturns.

Price level targeting: Rather than targeting inflation rate, target a price level path. If inflation undershoots the target, policy would aim to make up for it with above-target inflation later.

Dual mandate formalization: Explicitly equal weighting of inflation and unemployment targets, similar to the US Federal Reserve’s approach.

Flexible average inflation targeting: Combining average inflation targeting with flexibility to respond to economic conditions.

The AUD Implications

Changes to the inflation targeting framework would affect the Australian dollar through several channels.

If the framework becomes more accommodative (allowing higher inflation for longer), this could lead to lower interest rates on average. Lower rates typically weaken the currency, all else equal.

But the effect depends on how the change affects inflation expectations. If credibility is maintained and inflation expectations remain anchored, currency impact might be minimal. If the change is perceived as weakening inflation discipline, AUD could face pressure.

The International Context

Australia wouldn’t be alone in updating inflation frameworks. The US Federal Reserve moved to flexible average inflation targeting in 2020. The Bank of Canada and Reserve Bank of New Zealand have examined their frameworks recently.

This international context matters for currency markets. If major central banks are all adjusting frameworks in similar directions, relative currency impacts may be limited. The AUD would be affected more by how Australia’s framework changes compare to peers.

Interest Rate Differential Effects

Changes that lead to systematically different RBA policy rates compared to the Fed, ECB, or Bank of Japan would affect interest rate differentials that drive currency flows.

If Australia adopted more accommodative framework while other central banks maintained current approaches, AUD could weaken as interest rate differentials narrow. If Australia maintained tighter framework than peers, the opposite could occur.

Currency markets care less about the specific framework than about where policy rates end up relative to other countries.

Inflation Expectations and Currency

Currency markets price in expected inflation differentials between countries. If framework changes lead to higher expected Australian inflation relative to trading partners, this would typically weaken AUD to offset the inflation differential.

But if the framework change improves economic outcomes (more stable growth and employment) while maintaining inflation discipline, this could support AUD through improved fundamentals.

The Credibility Question

The RBA has strong credibility built over decades of effective inflation control. Any framework change needs to maintain this credibility, as loss of confidence in the central bank’s commitment to price stability could trigger currency weakness.

Markets will scrutinize any proposed changes for signs of weakened inflation discipline. Clear communication about how the new framework maintains price stability will be critical.

Potential Scenarios

Scenario 1: Average inflation targeting with maintained credibility Modest framework adjustment allowing temporary above-target inflation to offset past undershooting. If communicated clearly and credibility maintained, minimal lasting AUD impact. Near-term volatility possible during adjustment.

Scenario 2: Dual mandate with increased accommodation More explicit employment focus leading to looser policy on average. This could weaken AUD, particularly if it leads to lower rates than trading partners.

Scenario 3: Framework unchanged Review concludes current framework remains appropriate. Minimal currency impact from the framework itself, though markets might interpret this as relatively hawkish compared to central banks that have modernized frameworks.

Scenario 4: Price level targeting More complex framework requiring making up for past inflation misses. Could create more volatile policy path, leading to increased AUD volatility. Net direction depends on implementation details.

What Currency Traders Are Watching

The market is currently pricing minimal probability of major framework changes. But traders are monitoring:

• RBA communications about the review
• Comparative framework changes at other central banks
• Whether framework changes affect near-term policy decisions
• How any changes affect rate expectations versus other currencies

The AUD response will depend heavily on how framework changes affect relative monetary policy positions.

The Commodity Currency Factor

Australia’s status as commodity exporter creates additional complexity. Framework changes that lead to more stable domestic growth might support commodity demand and AUD. Changes that prioritize inflation control over growth could have opposite effect.

The interaction between monetary framework, economic growth, and commodity prices matters more for AUD than for currencies of countries with different economic structures.

Practical Implications for AUD Outlook

For AUD forecasting, the framework review matters less than:

• Actual policy decisions in response to economic conditions
• Interest rate differentials versus major currencies
• Commodity price movements
• Global risk sentiment

Framework changes affect these factors indirectly rather than driving AUD directly. The framework is plumbing - important for how policy operates, but not the primary driver of currency movements day to day.

Looking Ahead

Any framework changes would likely be introduced gradually with extensive communication. The RBA has incentive to avoid market disruption or credibility damage.

Most likely outcome is evolutionary change rather than revolutionary shift. Adjustments to make framework more robust in low-inflation environment, while maintaining core inflation discipline.

For AUD, this probably means framework review is background noise rather than major driver. Economic data, policy decisions in response to that data, and relative positioning versus other central banks matter more.

But if the review were to produce surprising recommendations that substantially change policy approach, AUD volatility could increase around announcement and implementation.

The Bottom Line

Inflation targeting framework reviews are important for monetary policy operation but typically don’t drive major currency moves unless they signal significant policy shift.

For the AUD, watch how any framework changes affect:

• RBA rate decisions relative to other central banks
• Inflation expectations relative to trading partners
• RBA credibility and policy clarity
• Australian economic outcomes under new framework

The framework is means to an end. Currency markets care about the end - inflation outcomes, interest rates, economic growth - more than the specific framework achieving them.

Changes that maintain credibility while improving policy effectiveness would be neutral to slightly positive for AUD. Changes that weaken inflation discipline or reduce policy clarity could weaken the currency.

Most likely, any framework evolution will be measured and well-communicated, minimizing currency disruption. But it’s worth monitoring as part of broader AUD analysis.