To cut or not to cut? The pros and cons facing the RBA

Reserve Bank governor Michele Bullock and the rest of the board may not sit down at their February meeting with an actual list of the pros and cons of an interest rate cut – but they will mentally work through one as they make one of their most important decisions in years.

While financial markets put the chance of a rate cut at better than 90 per cent, and most economists now believe the RBA will reduce rates for the first time since November 2020, Bullock and the bank still have to weigh up the risks and rewards of such a move.

Reserve Bank governor Michele Bullock and the rest of the bank board face one of their biggest decisions in February.Credit: Louie Douvis

The pros

The most important item in the pro column for a rate cut is this week’s inflation figures.

Headline inflation fell to a near four-year low of 2.4 per cent. Quarterly inflation was just 0.2 per cent, after a similarly small result in the September quarter. Underlying inflation was also subdued at 0.5 per cent (although it is at 3.2 per cent over the past year).

It won’t be just the overall rate of inflation giving the RBA confidence that it can finally give mortgage holders and small businesses some relief. The breadth of inflation is easing.

Annual inflation peaked at 7.8 per cent in the December quarter of 2022. Of all the goods and services tracked by the bureau, the prices of 30 were growing at more than 10 per cent at that point.

They included oils and fats (driven up by the war in Ukraine and drought in key olive-growing regions), which had soared by 20.8 per cent. The cost of milk was growing at 17.9 per cent, buying a pet had become 19 per cent more expensive, while the prices of domestic holidays had soared by 19.8 per cent.

The most recent figures showed just four areas of significant price pressure: lamb (17.3 per cent) and eggs (11.2 per cent) have jumped due to a sharp reduction in supply, tobacco prices are up 12.2 per cent because of government taxes, while insurance is up by 11 per cent (although it peaked at 16.4 per cent early last year).

On Thursday, National Australia Bank became the last of the Big Four banks to expect the RBA will slice the cash rate from 4.35 per cent to 4.1 per cent on February 18.

NAB chief economist Alan Oster, who had been tipping a May rate cut, noted one factor was the softer outlook for inflation in the housing sector.

Dwelling construction costs are the single largest element of the basket of goods and services measured for inflation, making up 8 per cent of the consumer price index.

In late 2022, new dwelling inflation was running at 17.8 per cent as low interest rates, pent-up demand, worker shortages, supply chain disruption and government stimulus delivered a perfect price storm.

In the final three months of 2024, however, inflation in this sector fell by 0.2 per cent, with the annual rate down to 2.9 per cent. The monthly measure of inflation, which was also released this week, showed the inflation rate for new dwellings tumbling to just 2.3 per cent.

Other points on the pro list include the broader state of the economy.

While the jobs market is still super tight, wage growth is actually slowing.

The bank believes a jobless rate of 4.5 per cent is around the level needed to ensure pay rises don’t add to inflation. That figure now appears too high, with inflation falling over the past year despite 440,000 jobs being created.

And the overall economy is barely growing. Australian GDP has expanded just 0.8 per cent over the past year, while in per-capita terms it has contracted by a recession-like 1.5 per cent.

The Reserve Bank will know a rate cut could affect the property market.Credit: Peter Rae

The cons

While there are plenty of points on the pros list for a rate cut, the cons list is almost as solid.

At the top remains the job market. It is still strong and an early rate cut could make it even tighter, feeding into the RBA’s fear of a wage breakout that would add to inflation pressures.

Oster noted there could be merit in the bank waiting for more economic data. In the two days after the February 18 meeting, the latest wage figures and jobs data will be released. The national accounts will come a fortnight later.

Westpac chief economist Luci Ellis says the future direction of interest rates will depend on inflation continuing to ease.Credit: Janie Barrett

While the inflation figures are clearly better than even the Reserve Bank had expected, they are still being affected by various government subsidies including for electricity and rents.

The bank excludes the subsidies from its inflation measures, but it’s difficult to discern the broader way these subsidies are playing out across the economy and on any price pressures.

Westpac chief economist Luci Ellis says much depends on the interaction between existing inflation pressures and the jobs market.

“All of this depends on whether inflation continues to come down as expected and if the labour market continues to ease a little bit from here,” she said.

That feeds into what a rate cut might do to the nation’s property market.

Though the RBA does not target the housing sector, interest rates absolutely matter to prices and the ability of buyers to get into the market.

A quarter of a percentage point rate cut would deliver a $100-a-month saving to someone with a $600,000 mortgage. That’s money that could flow back into the economy, or enable potential buyers to bid up prices for a new home.

Another point on the cons list is the RBA board.

Ten days after the February 18 meeting, the Reserve Bank’s new monetary policy committee, with newcomers Renee Fry-McKibbin and Marnie Baker, will take over control of interest rates.

It’s not a make-or-break situation, but tying the new body to the monetary policy direction of the old board cannot simply be dismissed.

Cut through the noise of federal politics with news, views and expert analysis. Subscribers can sign up to our weekly Inside Politics newsletter.