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Chief economist update: Vaccine optimism sparks AUD resurgence

The Australian dollar is back! Back above the US$0.73 level that is.

The Australian currency rose to around this level back in late-August/early-September after the US Federal Reserve announced a shift into a lower for longer strategy - suggesting that Australian interest rates would be at a premium over US rates going forward and enticing investors to buy the Aussie dollar to avail of the premium.

On August 27 at the Hole, the US Federal Reserve chair, Jerome Powell, virtually buried the Philips Curve - the inverse correlation between inflation and the unemployment rate - by announcing that the Fed was switching from a point target of 2% inflation.

The Fed said this was "to achieve inflation that averages 2% over time. Therefore, following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time."

There was also the swift recovery in China's economy that, in turn, also lifted commodity prices.

Good times! The AUD likes good times. Financial markets view the AUD as a risk currency; it's sold in times of heightened uncertainty and correlates positively with good tidings.

It's not surprising therefore for the AUD to weaken anew following the second wave in Europe and the reimposition of restrictions there - it dropped to a three-month low of US$0.7055 in mid-October.

Vaccine optimism has brought it back to life - above US$0.73 - and latest activity stats indicate that the Chinese economy continues to strengthen.

Industrial production grew by a better than expected 6.9% in the year to October, with 34 out of 41 major industry groups recording gains. Fixed asset investment accelerated to 1.8% from 0.8% in September; and, the annual growth in retail sales quickened to 4.3% in October from 3.3% in the previous month.

More importantly, Australia's containment of the second wave (notwithstanding fresh reports of infections in South Australia) has improved domestic economic outlook.

Reserve Bank of Australia (RBA) governor Philip Lowe thought as much.

In his address at the annual dinner of the Committee for Economic Development of Australia (CEDA), the governor declared that:

"It is certainly possible that the economy will do better than this baseline scenario."

"That baseline scenario is GDP growth of "5% next year and 4% over 2022...the unemployment rate "to rise further over coming months to a little below 8%" before gradually declining to "a little above 6% at the end of 2022.  And inflation, in underlying terms, is expected to be just 1% next year and 11/2% in 2022.

"The recent data have been better than expected and the easing of restrictions has lifted spirits. Further good news on a vaccine and rapid testing would also help. There is a lot of stimulus in the system, balance sheets are generally in good shape and governments are providing substantial incentives for firms to invest and employ people. So if we do get further good news on the health front, we could have a rapid rebound."

However, Lowe warned that "there is still considerable uncertainty about the outlook."

"...it is still possible that we experience further outbreaks. And the hoped-for medical advances may be delayed and could face production and distribution challenges slowing their rollout. This means that there are downside scenarios too," Lowe said.

These would put renewed downward pressure on the dollar-A. Then again, the RBA would be happier with a lower Australian dollar.

Read our full COVID-19 news coverage and analysis here.

Read more: US Federal ReservePhilip LoweReserve Bank of Australia
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