Tue May 20

RBA cuts interest rates, ready to respond again if the economy weakens further

Written by: John Hawkins, Senior Lecturer, Canberra School of Politics, Economics and Society, University of Canberra

The Reserve Bank of Australia cut the official interest rate ^[1] for the second time this year, as it lowered forecasts for Australian economic growth and pointed to increasing uncertainty in the world economy.

The bank lowered the cash rate target ^[2] by 0.25%, from 4.1% to 3.85%, saying inflation is expected to remain in the target band.

All the big four banks swiftly passed the cut on to households with mortgages. This will save a household with a $500,000 loan about $80 a month.

Announcing the cut, the Reserve Bank stressed ^[3] in its accompanying statement it stands ready to reduce rates again if the economic outlook deteriorates sharply.

The Board considered a severe downside scenario and noted that monetary policy is well placed to respond decisively to international developments if they were to have material implications for activity and inflation in Australia.

Inflation is back under control

The latest Consumer Price Index ^[4] showed that inflation remained around the middle of the Reserve Bank’s medium-term target band of 2-3%^[5] in the March quarter.

The Reserve Bank was also comforted by the underlying inflation measure called the “trimmed mean”. This measure excludes items with the largest price movements up or down.

The bank noted that it has returned to the 2–3% target band for the first time since 2021. This suggests inflation is not just temporarily low due to temporary factors such as the electricity price rebates.

In February, Reserve Bank Governor Michele Bullock conceded ^[7] the bank had arguably been “late raising interest rates on the way up”. It did not want to be late on the way down.

Perhaps Bullock is being unduly modest. The central bank looks to have judged well the extent of monetary tightening. It did not raise interest rates as much as its peers, but still got inflation back to the target.

Unemployment remains low

Last week, we got an update ^[8] on the strength of the labour market. Unemployment stayed at 4.1%. It has now been around 4% since late 2023, a remarkable achievement.

This is below the 4.5% the Reserve Bank had regarded ^[9] as the level consistent with steady inflation (in economic jargon, the NAIRU ^[10]). But neither prices nor wages ^[11] have accelerated.

Households and businesses may turn cautious

In its updated forecasts ^[12], the bank sees headline inflation dropping to 2.1% by mid-year but going back to 3.0% by the end of the year, as the electricity subsidies are removed. By mid-2027, it will be back near the middle of the 2-3% target.

Underlying inflation is forecast to stay around the middle of the target band throughout.

The Reserve Bank cut its forecast for gross domestic product (GDP) to 2.1% by December, down from its previous forecast of 2.4% made in February. It said:

Economic policy uncertainty has increased sharply alongside recent global developments, and this is expected to prompt some households to increase their precautionary savings and some businesses to postpone some investment decisions.

The unemployment rate is expected to increase to 4.3% by the end of the year and remain there through 2026.

Cost of living pressures look set to ease, as real household disposable income grows faster than population.

As the Reserve Bank governor told a media conference on Tuesday:

There’s now a new set of challenges facing the economy, but with inflation declining and the unemployment rate relatively low, we’re well positioned to deal with them. The board remains prepared to take further action if that is required.

Economic and policy ‘unpredictability’

The main uncertainty in the global economy is how the trade war instigated by US President Donald Trump will play out. According to one count ^[13], he has announced new or revised tariff policies about 50 times.

“The outlook for the global economy has deteriorated since the February statement. This is due to the adverse impact on global growth from higher tariffs and widespread economic and policy unpredictability,” the bank noted.

The US tariff pauses on the highest rates on China and most other nations are due to be in place for 90 days. But more measures may be announced before then.

This uncertainty is likely to be stifling trade, and even more so investment decisions by companies in the face of rapidly changing policies. And it will weaken the global economy.

In her press conference ^[14], Bullock said the board’s judgement was that “global trade developments will overall be disinflationary for Australia”. Not only is the global outlook weaker, but some goods no longer being sold to the US could be diverted to Australia.

Where will interest rates go from here?

The Reserve Bank’s updated forecasts ^[15] assume interest rates will fall further, to 3.4% by the end of the year.

But this is just a reflection of what financial markets are implying ^[16]. It is not necessarily what the bank itself expects to do. It is certainty not a promise of what they will do.

But the Reserve Bank still regards its stance as “restrictive”, or weighing on growth. So if it continues to believe inflation will stay within the target band, or the global outlook deteriorates, it will cut rates further.