The case for an RBA rate cut

Next week brings this year’s first Monetary Policy Meeting of the RBA Board. As highlighted last week, it’s also the last time the Board will meet under the existing arrangements, with the RBA’s new dual board structure taking effect from March this year. And according to market pricing, next week will also see the RBA deliver the first cut to the cash rate target since 2020.

At the time of writing, one market indicator was estimating the probability that the Board would announce a rate cut on 18 February at 90 per cent. That was down slightly from the 95 per cent probability it had been assigning for well over a week before that, with the slight dip in confidence likely coming in response to an unexpected increase in US consumer price inflation in January. Other market indicators have been telling a similar story and despite the US inflation related wobble, there remains an almost overwhelming consensus that rates will come down next week, to the extent that a decision by Martin Place to hold policy unchanged would now represent something of a shock.

The last time the RBA changed the cash rate target was in November 2023, when a 25bp rate hike took the rate to its current level of 4.35 per cent. That was the 13^th and last rate increase of the current cycle, which began with a 25bp hike in May 2022. After that, the RBA Board left the cash rate unchanged for nine consecutive meetings. The last time that the RBA delivered a rate cut was back in November 2020, when a 15bp reduction took the cash rate down to a record low of just 0.1 per cent in response to the economic fallout associated with the COVID-19 pandemic.

We dig into the case for a rate cut next week below, focusing the debate on conflicting messages coming from inflation numbers on the one hand and the labour market on the other. On this basis, we judge that there is a good case for a rate cut and continue to expect that the RBA will deliver one. But we also reckon the case is closer than market pricing currently implies – it looks more like a 60-40 call than a 90-10 one.

We also crunch the numbers on President Trump’s latest proposed tariffs on aluminium and steel and review this week’s Australian data releases including new numbers on business and consumer confidence. This week’s linkage roundup includes debate summaries on the future of economics teaching, on how to understand international economics and trade imbalances and the flaws of Bidenomics.

Inflation slows faster than RBA expected

In the last weekly update of 2024, and in the aftermath of the December 2024 RBA Board meeting, we noted that ‘the Board sounded rather more dovish than it had after previous meetings. With the economy stuck in a per capita recession and private sector activity stagnating, Australia’s central bank finally effectively admitted that the next move in the cash rate would be down… It also sounded more open-minded on the timing of any move, prompting financial markets to reconsider the chance of a February 2025 rate cut after having recently all but ruled it out’. Readers might recall that back in June last year we had pushed back our best guest as to the likely timing of a first rate cut to February this year. And then held on to that call despite some wobbles towards the end of last year, when markets had retreated to a mid-2025 rate cut call.

The main reason the consensus now expects the RBA to ease policy next week is that inflation has slowed faster than the RBA had previously expected. In the November 2024 Statement on Monetary Policy (SMP), RBA staff had forecast that headline consumer price inflation would ease to 2.6 per cent in the final quarter of last year, while trimmed mean inflation was expected to run at 3.4 per cent. (Note also that both of those forecasts represented modest downgrades from the August 2024 SMP, which had projected rates of three and 3.5 per cent, respectively.) Then the actual December quarter Consumer Price Index (CPI) release showed progress, with disinflation running ahead of the RBA’s projections as headline inflation fell to 2.4 per cent. (This was due in significant part to a combination of lower automotive fuel prices due to lower global oil prices and lower electricity prices reflecting government cost-of-living relief.) Underlying inflation also eased to 3.2 per cent (in the December quarter the trimmed mean reading excluded price falls in both electricity and automotive fuel).

That means the rate of headline CPI inflation has now fallen from a peak of 7.8 per cent in the December quarter 2022 to be back in the (lower half) of the RBA’s target band, while underlying inflation has eased from 6.8 per cent to just above the top of the band. The headline rate is now at its lowest since the March quarter 2021 and has been inside the RBA’s target band in both the September and December quarters of last year, while the underlying rate of inflation has fallen to its lowest rate since the December quarter of 2021.

Labour market stronger than anticipated

Set against this better-than-expected progress with disinflation, however, has been a more robust than anticipated Australian labour market. The November 2024 SMP predicted the unemployment rate would average 4.3 per cent in the December quarter of last year. Instead, after the unemployment rate printed at four per cent in the final month of last year, the quarterly average unemployment rate likewise came in at a below-forecast four per cent.

The challenge this raises for the case for a rate cut is that in both the August and November SMPs the RBA had indicated it thought there was excess demand in the labour market (that is, that the unemployment rate was too low). Going by November 2024 forecasts, the RBA’s view was that the ‘full employment’ rate (the rate of unemployment consistent with inflation sustainably back at target) was around 4.5 per cent. Market estimates of the closely-related concept of the Non-accelerating Inflation Rate of Unemployment (or NAIRU) have been around 4.25 per cent – a bit lower than the RBA number but still above the current unemployment rate. (We spent a bit of time on this debate last year – readers can find an overview discussion here).

So, if the unemployment rate is still too low to be consistent with inflation returning sustainably to target, doesn’t that rule out a rate cut next week? Not necessarily. One important qualification to this argument is uncertainty around estimates of the full employment rate of unemployment and/or the NAIRU. It could well be that the relevant rate of unemployment is now lower than the RBA previously thought – that is, closer to four per cent than 4.5 per cent.

Related, the RBA has said that in practice it does not think its concept of full employment can be captured by a single metric such as the unemployment rate. In the Minutes to the December 2024 RBA meeting, for example, the discussion also notes that employment growth in the market sector was weak and that hiring intentions in the private sector were below average, with overall labour market strength reflecting employment growth in the non-market sector.  The labour market has also been adjusting in ways that do not involve a rise in joblessness – for example, via changes in vacancy rates.

A third point is that the RBA cares about the implications of labour market tightness for wage growth and for growth in unit labour costs, which in turn influence inflation outcomes. The ABS will only release the December quarter 2024 Wage Price Index (WPI) on 19 February this year, but the September quarter 2024 WPI release showed annual wage growth had slowed to 3.5 per cent, down from a peak of 4.3 per cent in the December quarter 2023. That was already close to the 3.4 per cent WPI forecast in the November SMP. And in the December 2024 Minutes the discussion noted that this slowdown in wage growth had happened faster than the RBA had expected. That said, the Minutes also reported that the Board remained concerned about the implications of weak productivity growth for unit labour costs.

Fourth, developments in the labour market including in the unemployment rate are typically seen as lagging, not leading, economic indicators.

Economic activity weak, but shows signs of recovery

While much of the debate over the case for a rate cut can be cast in terms of the difference between the signals from the latest inflation and labour market readings, there are obviously other considerations in play. Economic activity as captured by GDP growth has been running a little softer than the RBA has expected and as at the September quarter of last year, the Australian economy remained locked in a per capita recession with private sector activity stagnating and growth reliant on a mix of population growth and public sector spending. Set against that, recent monthly readings have delivered some modest signs of a recovery in household spending. For example, the December 2024 monthly retail turnover numbers and the December quarter volume figures both surprised to the upside, with the quarterly rise in volumes the strongest result since the March quarter of 2022. The data also reported a first per capita increase since the June quarter 2022.

RBA should cut next week

Pull all that together and there is a good case for an RBA rate cut next week. After having held on to it for more than half a year now – a 25bp reduction in the cash rate target remains our call. Still, running through the previous analysis does suggest it is not quite the slam dunk case that market pricing currently implies.

More Trump tariffs – This time on steel and aluminium

On 10 February this year, President Trump announced 25 per cent tariffs on all imports of steel and aluminium into the United States. According to the White House, the President is exercising his authority under Section 232 of the Trade Expansion Act (1962) to adjust imports to protect US national security. During the previous Trump administration, in 2018, the United States imposed 25 per cent tariffs on steel and 10 per cent tariffs on aluminium, although Washington also negotiated a series of opt outs and exemptions with various partners, including Australia. This time, the US President has pledged there will be no exemptions (although Prime Minister Albanese has been trying) and the tariffs are due to take effect on 12 March.

Last week’s note considered the bigger picture on tariffs and trade wars, so this time we’ll stick to a look at the narrow implications of the latest announcement for the Australian economy, assuming no exemption is forthcoming and the measures go ahead as threatened. The bottom line is that while there could be significant consequences for individual exporters, the direct impact on the Australian economy overall would be quite modest, given the small share of Australian trade involved.

According to monthly ABS data on merchandise (goods) exports, in 2024 Australia sold $23.8 billion of goods into the US market out of a total of $517.9 billion merchandise exports. So, all exports to the United States (not just steel and aluminium) accounted for about 4.6 per cent of total merchandise exports last year, and of course a smaller share of total exports (of goods and services).

The same data suggest that Australia’s total exports of aluminium (SITC 684) in 2024 were worth around $5.7 billion, while exports of iron and steel (SITC 671-679) were worth a further $1.3 billion, giving a combined total of around $7 billion. That was equivalent to around 1.4 per cent of total goods exports. Narrow that down to exports to the United States and the numbers suggest around $0.3 billion of aluminium exports and $0.4 billion of iron and steel exports for a combined total of close to $0.8 billion. That adds up to just 0.1 per cent of total merchandise exports last year.

What happened on the Australian data front this week?

The Westpac-Melbourne Institute Consumer Sentiment Index was little changed in February 2025, edging up just 0.1 per cent from the January result to an index reading of 92.2. By subcomponent, the ‘family finances vs a year ago’ subindex fell 3.4 per cent in February, which Westpac suggested could reflect a larger than normal ‘hangover’ from the Christmas-New Year period or could signal waning impetus from last year’s tax cuts and other fiscal support. On the other hand, the ‘family finances, next 12 months’ subindex edged up 0.6 per cent and remains close to three-year highs, which Westpac attributed to growing consumer confidence about the prospect of rate cuts from Australia’s central bank. The Westpac-Melbourne Institute Mortgage Rate Expectations Index fell in February to its second lowest reading in the 15-year history of the series. Overall, Westpac characterised the message from this month’s survey readings as consistent with a ‘cautiously pessimistic’ consumer mood, consistent with still-stretched family finances.

The ANZ-Roy Morgan Australian Consumer Confidence Index fell 1.8 points to an index reading of 86.7 points for the week ending 9 February 2025, retreating slightly from the previous week’s 32-month high. Most subindices fell over the week (the one exception was ‘future financial conditions’ which crept higher). Weekly inflation expectations nudged up to 4.7 per cent, a 0.1 percentage point increase.

The January 2025 NAB Monthly Business Survey reported that business conditions eased over last month, falling three points to +3 index points and below the long-term average of +7 index points. By subindex, trading conditions eased from +10 to +6 index points and profitability fell from +4 to -2 index points, while employment rose from +4 to +5 points. In contrast, business confidence improved by six points to a reading of +4 index points – just below the series long-term average of +6 index points. In terms of other forward-looking indicators, the forward orders index declined from -2 to -3 index points and Capex fell from +11 to +4. And the reported rate of capacity utilisation dropped from 82.7 per cent in December to 82 per cent in January. The message on cost pressures was mixed. Purchase cost growth slowed from 1.4 to 1.1 per cent (quarterly equivalent terms) while labour cost growth accelerated from 1.4 per cent to 1.8 per cent. Final product price growth was unchanged from December at 0.8 per cent, while retail price growth edged up from 0.7 to 0.9 per cent.

The ABS said that in December 2024 its Monthly Business Turnover Indicator showed a 0.4 per cent monthly rise in the 13-industry aggregate, with gains in seven of the 13 published industries. On an annual basis, the indicator was up 3.3 per cent with rises in 11 of the 13 industries. The Bureau highlighted a 12.9 per cent monthly jump in turnover in electricity, gas, water and waste services, which it attributed to the combined impact of coal power plant outages and elevated temperatures on the east coast leading to increased pressure on the electricity supply.

In the December quarter 2024, the total number of new loan commitments for dwellings fell 0.4 per cent over the month (seasonally adjusted) to 132,082. That was up 7.2 per cent on the number in the December quarter 2023. The ABS reported that the number of new loans made to owner occupiers was up 2.2 per cent month-on-month and up four per cent year-on-year, at 83,206. At 48,876, the number of investor loans was down 4.5 per cent over the month but still 13.2 per cent higher in annual terms.

According to the ABS, as of 30 June 2024 there were 2,662,998 actively trading businesses in the Australian economy. Across 2023-24 the number of businesses rose by 73, 125 (2.8 per cent) which reflected a 16.8 per cent entry rate and a 14 per cent exit rate. Growth in business numbers was led by Transport, Postal and Warehousing (up 8.5 per cent), Health Care and Social Assistance (7.7 per cent) and Financial and Insurance Services (4.8 per cent) industries. The largest falls in business numbers were in the Agriculture, Forestry and Fishing (down 1.3 per cent) and Retail Trade (down 0.2 per cent) industries.

Other things to note . . .

• In the AFR, Warren Hogan argues that the RBA should not cut rates next week.
• The e61 Institute reckons an alternative measure of underlying inflation suggests that Australian inflation is already sustainably within the RBA’s target range.
• Monash University’s latest Transforming Australia report.
• Economics debate #1 - The teaching of economics. The January 2025 edition of the RBA Bulletin included a piece asking Where have all the Economics Students gone? The authors noted that ‘the size and diversity of the economics student population has declined sharply since the early 1990s, raising concerns about economic literacy in society and the long-term health of the economics discipline’. They reported both a low interest in economics among high school students and a low conversion rate from this interest to university enrolment. This prompted a column from SMH Economics Editor Ross Gittins arguing amongst other things that the solution was to drop the obsession with maths and pay more attention to the real world. Economics professor Richard Holden took exception to the Gittins column and in a piece for the AFR argued that economics has become more, not less, focused on real world problems. Subsequently, another AFR columnist, John Roskam, has argued that  Gittins didn’t go far enough.
• The WSJ looks at the idea of reciprocal tariffs. According to the report, the idea may replace previous talk of universal tariffs. The measures could go beyond simply matching other countries’ tariffs to also include taxes (including value added taxes) on US companies, government subsidies, or regulations.
• Also from the WSJ, China is building an economic fortress to withstand US economic pressure, albeit at a significant cost. And the Economist magazine considers how China is weaponizing its supply chains.
• Economics debate #2 - China, tariffs, trade and international macro. Back in December last year, Michael Pettis wrote a piece for the FT arguing that tariffs were a misunderstood policy tool and that if someone wanted to understand their economic impact, they’d do better to ask economic historians than economists, because not enough of the latter were ‘willing to engage in a serious discussion on tariffs’. That (and other elements of Pettis’s work) prompted critical responses from Tyler Cowen and Paul Krugman among others. Last week, the FT posted a Q&A with Pettis in which he defended his position, prompting further commentary from Cowen.
• Richard Baldwin makes the case for Mutually Assured Destruction (MAD) trade policy in response to tariff threats (LinkedIn).
• A new BIS Bulletin on the macroeconomic impact of extreme weather events.
• Some economic futurology from the FT as Daron Acemoglu tells a story of US decline as seen from 2050 drawing on his work on the importance of institutions.
• Economics debate #3 – Jason Furman has an essay in Foreign Affairs on The Post-Neoliberal Delusion and the Tragedy of Bidenomics. Noah Smith reckons some of the criticism is fair but also has some disagreements.
• On Infrastructure power.
• Are corporate climate commitments empty posturing or can they have a real impact on decarbonisation?
• Explaining globalisation’s post-GFC stall in terms of uncertainty and automation: according to the authors, high uncertainty leads to more reshoring, but only in highly robotised industries.
• The ABC’s Insiders podcast with a quick look at the background to the story on US-Australia Aluminium tariffs.
• The FT’s economics podcast asks, is innovation is slowing down?