The Reserve Bank of Australia (RBA) has not ruled out the possibility of raising interest rates again, despite recent indications that cuts could be on the horizon in 2025. In a speech titled Shedding Light on Uncertainty: Using Scenarios in Forecasting and Policy, the RBA’s chief economist Sarah Hunter underscored the complexity of forecasting and the need for flexibility in monetary policy.
While the RBA has recently pivoted towards a dovish stance, signaling potential rate cuts next year, recent economic surprises—such as stronger-than-expected labor market data—suggest the bank remains prepared to adjust its approach if new developments arise.
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The Challenge of Uncertainty in Monetary Policy
Dr. Hunter’s speech, delivered in Adelaide, highlighted the inherent uncertainty in economic forecasting and its impact on policymaking:
“The future is uncertain, and the forecasts will usually be wrong in various ways. Yet, monetary policy operates with a lag, requiring the board to think ahead when setting the cash rate target.”
She emphasized the importance of scenario analysis in preparing for deviations from baseline forecasts. By exploring alternative economic paths, the RBA aims to maintain flexibility in responding to unexpected developments.
Key Risks: Household Spending and China’s Economy
Dr. Hunter identified two major uncertainties influencing the RBA’s outlook:
- Household Income Growth and Spending:
- Real household income is expected to rise due to stage 3 tax cuts, but consumer behavior in response to this boost remains unpredictable.
- A stronger-than-expected surge in spending could fuel inflation, requiring tighter monetary policy.
- China’s Fiscal Stimulus:
- As Australia’s largest trading partner, China’s economic trajectory significantly impacts domestic monetary policy.
- Unexpectedly robust Chinese fiscal spending could drive global demand, influencing Australian inflation and growth forecasts.
Both scenarios could push inflation off its target trajectory of 2.5% by 2026, necessitating adjustments in interest rate policy.
Interest Rate Cuts? Not So Fast
Although financial markets initially anticipated an interest rate cut as early as February, recent data complicates this narrative.
Labor Market Resilience
November’s unemployment rate fell to 3.9%, defying expectations of a rise to 4.5%. With 36,000 jobs created and fewer people unemployed, the labor market appears more robust than forecasted, potentially delaying rate cuts.
This surprise prompted economists like Betashares’ David Bassanese to revise expectations. In a note titled Bye-bye February Rate Cut, Bassanese cautioned:
“The December quarter CPI report in late January will now need to be very low for the RBA to consider a rate cut as early as February.”
Instead, he predicts the first cut may be delayed until May 2025, after the federal election.
Inflation Still a Wildcard
The RBA remains focused on inflation as a critical driver of its decisions. While inflation is trending downward, the strong labor market and resilient household spending could reignite price pressures.
Scenarios That Could Trigger a Rate Hike
Dr. Hunter acknowledged that while the RBA has pivoted towards rate cuts, it is equally prepared to raise rates if strong-demand scenarios materialize. In such cases, inflation would remain above the 2.5% target, requiring tighter monetary policy to restore balance.
However, she clarified that these scenarios are theoretical and not specific policy considerations currently under review by the board.
Why Forecasts Matter Despite Their Flaws
Critics often question the reliance on forecasts that frequently miss the mark. Dr. Hunter defended the practice, citing its necessity in a forward-looking approach to monetary policy:
“Thinking through ways in which actual outcomes might deviate from the forecast is invaluable. Monetary policy decisions made today will only take effect in the real economy after a lag.”
The Road Ahead: Balancing Flexibility and Stability
The RBA faces a delicate balancing act as it navigates an uncertain economic environment. With households and China as key variables, policymakers must remain flexible to adapt to changing conditions.
The next critical data point will be the December quarter Consumer Price Index (CPI) report in late January. A lower-than-expected CPI could revive hopes for an earlier rate cut, but until then, the RBA’s course remains contingent on new developments.
For now, the message is clear: nothing is off the table. Whether it’s a rate cut, a prolonged pause, or even a rate hike, the RBA is prepared to act in response to shifting economic dynamics.
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