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Australia's Central Bank Is Confident on Economy, Eyes Markets

Australia's top central banker played down the threat of global market turmoil to the domestic economy on Friday, even as his institution acted to support a slumping currency and provide extra cash to the financial system.

Giving his semi-annual testimony on the economy before lawmakers, Reserve Bank of Australia (RBA) Governor Glenn Stevens said he had no regrets about last week's decision to raise interest rates to a decade high of 6.5%.

And, while the turmoil in financial markets bore careful watching, he doubted it would hurt the real economy. "At the moment the financial market volatility we're seeing really is a thing which is impacting most directly on financial institutions," Stevens said. "I don't think it's really had any great effect on your average everyday business."

The impact on financial institutions was clear in the money market where credit dried up, pushing rates higher for even the best-rated borrower. In response, the RBA added more cash than usual to the banking system and at rates lower than in the market.

The central bank also acted to provide desperately needed liquidity in the foreign exchange market by buying Australian dollars. The dollar had gone into near free-fall as investors bailed out of leveraged bets on high-yielding currencies.

Stevens said the amount bought had been small but the central bank stood ready to act from time to time when markets were disorderly. The Australian dollar dived as deep as 78.18 U.S. cents late in New York on Thursday, a loss of almost four cents in 24 hours.

The last time the RBA openly intervened to support the currency was 2001.

"It definitely helped in adding liquidity to the Aussie dollar at a time when it was gapping significantly," said Jo Masters, currency strategist at Macquarie Bank.

"The Aussie is now almost one cent higher than its overnight lows which shows their action helped restore some liquidity. Having said that, the Aussie is caught up in this entire tide of de-leveraging that is happening in global markets," she added.

Bordering On The Irrational

The central bank said an unexpected acceleration in inflation was behind last week's rate rise. Indeed, it followed the move by raising its forecast for core inflation to 3%, higher than expected and the very top of its 2% to 3% target range.

On Friday, Stevens repeated he was more concerned about the risk of inflation accelerating than that economic growth might slow, even given the losses suffered in markets.

Australia's S&P/ASX 200 Index fell as much as 5% on Thursday before steadying on Friday.

"The impression is of a central banker who believes the economic fundamentals driving the Australian economy are still sound and sees much of the market action of the past few weeks as an inevitable and desirable repricing of risk," said Michael Blythe, chief economist at Commonwealth Bank.

Yet it was also clear Stevens was less comfortable with the speed and extent of the market adjustment, which he said was "bordering on the irrational" at times. That led analysts to conclude there was less chance of another rise in interest rates in the near-term.

"While the Bank clearly retains a tightening bias, it is now firmly on hold as it assesses not only the impact of the latest hike but also the unfolding global credit crunch," said Tony Meer, chief economist at Deutsche Bank. "It will hunker down and do nothing until the dust settles and the outlook for the global economy, and so the local economy, becomes clearer," he added.

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