The RBA will do something historically noteworthy this coming meeting, regardless of what they decide. Either they will deliver the first rate cut of the 2025 rate cutting cycle, or they will disappoint a market priced for cuts more severely than they ever have before. With the consumer side of the economy showing signs of strengthening following tax cuts and real wages rising, there are plenty of reasons to wait before delivering the rate cut, even if inflation has fallen materially. But the optics may not let the RBA wait. So does the RBA want a rate cut or a hard place?
The RBA meets next week for the first meeting in 2025, which is also the last meeting of the current board structure. The market is very convinced that there will be a rate cut, but several commentators (us included) are not quite so sure.
The underlying economy is doing fairly well and holding together nicely given the point in the cycle. Inflation has fallen materially, which is great news, but has come mostly on the back of falling goods prices, with services prices staying elevated. There are early signs that some of the stickiness is coming out of the picture with rent prices and building construction prices no longer rising as quickly. This will help lower inflation further over time. The impact of the Government’s electricity price measures is clouding the picture somewhat, but the overall story of inflation falling is both welcomed and undeniable.
The problem is that the falls have mostly been in goods prices. In 2012, goods prices dropped quickly and the RBA started cutting rates, but the services inflation never really fell, meaning that as goods prices returned to normal positive inflation across 2013 and into 2014 the overall CPI rate rose a little uncomfortably. There is a clear risk that the same plays out in coming years.
Furthermore, in the minutes from the December 2024 RBA meeting, the RBA pointed to two considerations which made it too early to lower rates then, even though inflation was looking more under control. These were that the economy was showing resilience, and that it wasn’t clear how restrictive rates currently really were. If anything, both of these concerns have intensified since.
The data on consumer spending has been strong while private sector credit is growing quickly (up 6.5% on the year). Meanwhile, the labour market is showing some signs of weakening but starting from an incredibly strong position. The unemployment rate is very low at only 4.0%.
It's also worth remembering that the RBA didn’t raise rates as quickly in 2022 and 2023 as they might have done. They choose a slightly lower peak to prevent punishing the labour market too much while inflation was brought under control. If the current cash rate was incredibly high and punishing then yes, the current performance of the inflation rate would justify a rate cut. The problem is that the current economy doesn’t look particularly badly punished. The unemployment rate is low, and people are borrowing more than they have done in years. That’s partly because although the cash rate is high, the current credit spreads are very low, meaning all-in borrowing costs are not high; partly because the RBA cash rate has been stable for over a year now, meaning that the worst-affected have had time to adjust; and partly because the RBA didn’t take the rate as high as it might have done.
From a purely economic perspective, it seems that the wisest course would be to wait for another month or two to see how the strength in consumption plays out before cutting rates. There’s very little downside as although many would appreciate a rate cut, the economy is holding together well. If inflation continues to drop and the labour market weakens, the RBA could cut rates in April or May and very little would be different. If the growth in household consumption is on an intensifying path, then cutting the cash rate and lowering mortgage rates will only add fuel to that fire. Hence, we see the reasons to wait.
Unfortunately, the RBA doesn’t always have the luxury of making a purely economic decision. The market pricing is currently suggesting an 88% chance of a rate cut. There is a Federal election looming. If the RBA bucks expectations now it could be seen as being highly political (even if it wasn’t) and would trigger a fairly large bout of market volatility. That’s quite a hit to credibility and the soft power of the RBA.
We looked at the data of rate decisions going back to 2003, which is the earliest time that individual decision prices can be easily extracted. Since then, the market has been exceptionally good at predicting rate cuts. Figure 2 shows the RBA pricing on the day before the decision on the horizontal axis and the actual outcome on the vertical axis. Both charts show the same data, but the right-hand chart is more zoomed in so the small distinctions can be seen.
Notice that if the pricing of the RBA was perfect, there would be a straight 45-degree line between implied moves and actual moves. The market is very accurate for all cuts and for the occasional 50bp hike. The right-hand side of Figure 2 shows that the market predicts small rate cuts very well also. The largest amount of rate cuts priced and not delivered was the 16% chance (4bp) priced and not delivered in September 2011. The current market pricing is 22bp, or an 88% chance of a rate cut. There is no example of anything similar in the history of RBA decisions.
Since the RBA probably does see a rate cut as likely in the medium-term, they may well decide that cutting rates now is actually the best outcome. Even if it’s slightly early based on a purely economic viewpoint, there is a strong case to be made that a rate cut should come in the not-too-distant future. If so, there’s not a lot of reason to fight the market and trigger a lot of volatility for no purpose. It lowers the confidence in the system overall and does damage too.
However, if the RBA does cut rates this month, it will be surprising in many ways. They will cut rates while the rate of Private Sector Credit usage is growing quickly, and the unemployment rate is exceptionally low. Both of these are not the normal background for a rate cut, which usually comes against a backdrop of a weakening economic environment.
It’s for that reason that although we expect the RBA to cut rates, we can’t quite shake the nagging feeling that they might just surprise the market and stay on hold. Either way, some history will be made in the February meeting of the RBA board, with either a first rate cut of the cycle or a very unusual contradiction between market pricing and the actual outcome.