Latest Inflation Data is Encouraging for Cash Rate Reductions

Key points:

• The Q4 CPI came in better than forecasted, increasing the Board’s confidence that inflation is on track to return to target.
• As a result, a 25bp interest rate cut at the February Board Meeting is now likely.
• Markets are already pricing around 90bps of rate cuts over 2025, which seems reasonable.
• Longer-term borrowing rates will continue to be influenced by US bond market developments.

 

Australian inflation (finally) doing better than RBA forecasts

For the first time in years, the trimmed mean CPI came in better than expected at 0.5% q/q and 3.2% y/y in Q4. Furthermore, the trimmed mean from the December monthly CPI also slowed to 2.7% y/y, reinforcing signs of easing inflation.

While cost-of-living support has helped reduce headline and core inflation, the sub-componentry within both the quarterly and monthly measures provided further encouragement that price rises are broadly slowing. Key categories such as insurance, food, new housing costs, electricity and rents are all showing slowing trends after previous very strong rises over the COVID-19 period.

 

Increased confidence in lower inflation paves the way for interest rate cuts

With inflation easing more than expected in Q4, the RBA is now in a stronger position to revise down its inflation forecasts for the first time in some years. This meets the Board’s requirement for increased confidence that inflation will return to the midpoint of the 2-3% target by the second half of 2026. If anything, it’s now looking more likely that this will happen a bit earlier than H2 2026. This means the Board can begin to reduce the degree of restriction placed on the economy by reducing the cash rate by 25bps at the February board meeting.

Labor market indicators, including SEEK job ads and business capacity utilisation surveys, appear consistent with a slow rise in the unemployment rate and thus a moderate interest rate cutting cycle of 50-100bps by the RBA. Should population growth slow as the government forecasts, cuts towards the top end of that range are likely over 2025, with the market currently pricing around 90bps of cuts.

Longer-term borrowing costs will be influenced by both RBA interest rate reductions and developments in longer-term US interest rates. Recently, US long-term rates have edged higher due to uncertainty around the inflationary impact of a new Trump administration’s policies on tariffs, immigration, fiscal spending, and regulation. As a result, the US interest rate market is now factoring less than the further 50bps of cuts Fed officials previously predicted for 2025.

 

What this means for your business

• Lower Australian interest rates will be welcome news for households and businesses alike. A rate cut should support consumer spending and ease interest burdens for mortgage holders and business borrowers.
• With the US market now expecting fewer interest rate reductions than in Australia and the US tech sector retaining its strength, there will likely remain downward pressure on the AUD/USD exchange rate as covered in last month’s economic update.
• Slower population growth is expected to be a drag on growth even as interest rates are reduced and the Trump Administration’s policies will remain a major uncertainty for many businesses, especially for manufacturing and those impacted by supply chain uncertainties.  Hopefully by the next update, there will be more clarity on tariff policy. While the extent of the changes is very important, so to will be the duration.

 

Author: Ivan Colhoun  Consulting Economist for Bank of Sydney Bachelor of Economics (Hons) Ivan is a highly experienced chief economist and keynote speaker on the Australian economy and financial markets. His career has included leadership roles within financial and professional service organisations, as well as the Reserve Bank of Australia.