The Reserve Bank of Australia is on the horns of a dilemma: The Aussie dollar sank to a 12-year low of 57.99 U.S. cents on June 16, as the Asia crisis began to throttle the economy. The RBA may need to hike interest rates to support the dollar and thwart a round of import-led inflation, but higher rates could turn an economic slowdown into a recession. What will the central bank do?

The odds are nothing, for now--especially as the growth outlook weakens. Economists are cutting their growth forecasts to 2% for the year ending June, 1999, calling the government's 3% projection too optimistic. First-quarter real GDP grew strongly, up 4.9% from a year ago, but a huge unintended buildup of inventories accounted for all of the quarter's strength. Exports fell sharply, and private domestic demand stagnated. Asia accounts for 60% of Australian exports, and one-third of the total goes to Japan and Korea--both in recession.

The domestic economy is also set to weaken. Given that capital spending plans and retail sales are softening, the coming inventory correction is expected to last through yearend. Employment is down in four of the past five months, and the jobless rate, at 8.1% in May, is likely to rise. May business confidence was the lowest since the early-1990s recession, and June consumer confidence was the lowest in three years.

But the RBA is also concerned that the currency's 20% plunge vs. the U.S. dollar since late 1997 will lift inflation above its 2%-to-3% target range. The Aussie dollar strengthened to above 59 U.S. cents on June 17, but its problems go beyond the Asian crisis to the country's heavy dependence on foreign capital. The RBA projects the 1998 current account deficit will reach a huge 6% of GDP, the highest since the mid-1980s.

Still, the dollar is holding its value relative to Asian currencies, and import inflation also will be restrained by weaker world commodity prices and softer domestic demand. Besides, the weaker currency will be stimulative for Australia's slowing economy.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE