The TWI and monetary policy tightness

One of the better guides to whether Australian monetary policy is actually tight is the trade-weighted Australian dollar.

The TWI summarises the value of the Australian dollar against the currencies of our major trading partners. For a small open economy like Australia, the exchange rate is one of the most important channels through which monetary policy affects inflation.

A higher dollar makes imports cheaper. It also makes Australian production relatively more expensive, weakening export demand and increasing competition from imports. Both reduce inflation.

But the exchange rate responds to Australian interest rates relative to rates elsewhere, not simply to the cash rate.

The post-COVID tightening illustrates this well.

The RBA raised the cash rate from 0.1% to 4.35%. But other central banks tightened too, often faster and further. Australia eventually had lower policy rates than many comparable economies.

Despite 425 basis points of RBA tightening, the TWI barely moved. It was around 63 before tightening began and around 63 at the end of 2023.

The mortgage channel tightened dramatically. The exchange-rate channel did surprisingly little.

Compare that with 2026.

The RBA began raising rates while most other major central banks were on hold. Australian rates rose relative to foreign rates and the TWI surged from around 62 to above 67. The stronger dollar pushed down imported consumption-goods prices.

Now the world is moving again. The ECB and RBNZ began raising rates mid-year. The Fed raised in September and the ECB raised again. The RBA also raised rates at the end of September, but the TWI has fallen from its May peak of 67.3 to around 64.8.

Australia does not set monetary policy in isolation. A 4.6% cash rate does not have a fixed degree of restrictiveness independent of rates elsewhere.

Commodity prices and risk appetite move the TWI too, so it is a guide rather than a gauge. The cash rate tells us what the RBA has done. The TWI helps tell us how tight monetary policy actually is.