Trick or treat? Inflation spooks RBA, longer wait for cash rate cuts
It will likely take more than one quarter to undo the shock of the September quarter CPI. Two cash rate cuts expected, in May and August; a later start would induce additional easing.
- As flagged earlier in the week, the RBA is now expected to keep the cash rate on hold in November and December. A February cut is also unlikely unless the labour market deteriorates in the near term by more than we expect.
- Monetary policy is still somewhat restrictive, so some further cuts to the cash rate next year are warranted. Our revised inflation forecast starts higher than previously but still goes below the midpoint of the RBA’s 2–3% target range, troughing at 2.3%. Without further rate cuts, inflation would fall further than this. We therefore expect two more 25bp cuts; the earliest likely date for the first of these cuts is now May (to 3.35%), followed by August (to 3.1%). If the RBA instead waits beyond May to start cutting, we anticipate an additional cut late 2026 to a trough of 2.85%.
- Our revised outlook incorporates the stronger starting point for consumption flagged in the October Market Outlook and our revamped Card Tracker data. Without further rate cuts, though, we anticipate this consumer recovery would fade quickly. A slightly weaker starting point for the labour market also sees the peak for the unemployment revised up to 4.6% late next year.
As we flagged earlier this week, the release of higher-than-expected inflation data will have spooked the RBA and taken a cash rate cut off the table for November. We never expected a follow-up cut in December, noting the RBA Monetary Policy Board’s (MPB) preference for caution.
There is a pathway to a February rate cut, but only if the labour market deteriorates more than expected in the next couple of months, and the emerging consumer recovery falters quickly. This is not our expectation. Although we expect the December quarter inflation data to be a lot less scary than the September quarter, we think it will take more than one quarter of data to convince the RBA that the inflation trend is still consistent with target beyond the short term. This is particularly so given that a couple of CPI categories, including home-building prices and AV-related services, do look to be seeing a sustained pick-up.
Our base-case expectation is therefore now that the RBA does not cut the cash rate until May 2026, to 3.35%. A further 25bp cut to 3.1% in August is also expected.
Monetary policy is still somewhat restrictive. Further cuts to the cash rate next year are therefore warranted given that underlying inflation will remain within the band and be heading down in coming quarters. We concur with the RBA that it is not sensible to be too precise about where the ‘neutral rate’ is at any point in time. That said, a 50bp adjustment to the cash rate from here can be reasonably seen as removing the remaining restrictiveness of policy.
The higher starting point for trimmed mean inflation lifts the inflation outlook in the near term. But with interest rates a bit higher for longer and the gradual softening in the labour market already underway, there is downward pressure on inflation further out. (We are looking to see whether the RBA’s revised forecasts next week incorporate this point and have a downward slope, or whether the flat profiles of the previous three forecast rounds are still favoured.)
Our revised forecasts, also published today, still show trimmed mean inflation drifting below the midpoint of the RBA’s 2–3% target range, troughing at 2.3% late in 2026. If things turn out as our forecasts imply, the RBA’s forecasts will also be revised down over time, if they do not already show a similar low point next week. That in turn would drive a decision to remove the current restrictive stance of monetary policy to avoid inflation going below the bottom of the target.
We had already revised up our near-term forecast for consumption in light of stronger internal data on spending. These data, as shown in our revamped Card Tracker, suggest that the consumer recovery is now on a firmer footing. We believe that the bounce-back in national accounts measures of consumption will be another factor keeping the RBA on hold for longer.
Our internal data also show, however, that the pick-up in spending is concentrated among mortgagors, that is, people with mortgage debt. Renters and people who do not pay either rent or mortgage repayments have not increased their spending to the same extent. This leads us to suspect that there is a risk that this recovery is a relief rally, contingent on the cash rate cuts that have been seen so far. If rates were to remain on hold from here, that recovery would falter and fade out over 2026, especially given that jobs growth has slowed and the unemployment rate has drifted up marginally. The sizeable impulse coming from the Stage 3 tax cuts (more than $20bn a year) will also be fading.
We also expect that the slightly weaker starting point for the labour market and later date for cash rate cuts implies a softer outlook for employment. We have revised up the peak for the unemployment rate to 4.6%, late in 2026. The RBA has repeatedly stated (correctly) that it does not mechanically map its assessment of ‘full employment’ to a particular level of the unemployment rate. That said, it is clear from the RBA’s internal analysis released under Freedom of Information law that it would not consider the labour market to be ‘a little tight’ at that level. Assuming the RBA does indeed cut the cash rate on the expected timetable, some recovery from that point is expected over 2027.
Given the RBA’s determination to reach the exact midpoint of its 2–3% target range, it is possible that even two quarters of more moderate inflation relative to the September quarter outcome will not be enough to convince the MPB that further rate cuts are needed. The bias to stay on hold will be strong given the uplift in consumer spending and the brisk recovery in housing prices. As noted earlier in the week, we therefore contemplate an alternative scenario where the cuts to the cash rate do not start until August (or even later). This would see further easing in both the labour market and the inflation outlook, and a larger eventual policy response needed by the RBA. A third cut would take the cash rate to 2.85%, a level that is probably mildly supportive and would help return inflation to the target midpoint from below.
There is also a more hawkish case that could be made for the rates outlook, but it would require developments that we do not think are that likely. Firstly, it would require the consumer recovery to accelerate in the face of ongoing (slightly) restrictive monetary policy and a softening labour market. Unless household income growth also improves, real consumer spending power will be constrained and the recovery would falter, much as we saw earlier this year. Secondly, it would imply that Australia is facing renewed ongoing domestic inflation pressures, either because interest rates at current levels are actually stimulatory, or because the labour market is tighter than we believe. We do not think the data support either interpretation, noting among other indicators of domestic financial conditions that household credit is not rising faster than household income, and that wages growth has not been surprising on the upside.
Our base case therefore moves to two cash rate cuts, in May and August, with a decent chance of a later timing and larger number of cuts if the RBA has been so spooked by this week’s inflation data that it delays even further.
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