New Inflation Data Point to an RBA Cut

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Punchline: The Reserve Bank of Australia surprised markets by holding rates steady in July, but the decision seems more understandable in hindsight given the limited CPI data available at the time. Since then, inflation has clearly moved within target and growth remains weak. A 25-basis-point cut on 12 August now looks likely. My simple model of past RBA behaviour points in the same direction.

At its July meeting, the Reserve Bank of Australia (RBA) surprised markets by leaving interest rates unchanged. I was curious whether that reflected stubborn inflation, as in several other economies, most notably the United States, and therefore decided to take a closer look at inflation and monetary policy in Australia.

This is the first time I have done that, so I make no claim to expertise. But the pattern of inflation and monetary policy in Australia looks broadly familiar from my work on the euro area, Sweden and Switzerland.

In these economies inflation pressures eased in the early months of the pandemic in 2020. Then, from 2021, inflation began to rise, peaked in 2022 or early 2023, and has since declined. In most advanced economies, central banks are now cautiously pivoting from tightening to easing.

Source: ABS.

Inflation and the July Decision

Similarly, the quarterly CPI inflation rate in Australia peaked at 7.8 percent in the December quarter of 2022 and has since dropped sharply. By the June quarter of this year, it had fallen to 2.1 percent. More importantly, quarterly trimmed mean inflation, which is the RBA’s preferred measure, also moved lower, from 6.8 percent in late 2022 to 2.7 percent in the second quarter of 2025.

Monthly data tell a similar story. From a peak of 8.4 percent in December 2022, annual inflation fell to 1.9 percent in June this year.

But the readings for June and the second quarter were not available when the RBA met on 8 July. What was available were data from the first quarter of 2025, according to which headline inflation stood at 2.4 percent and trimmed mean inflation at 2.9 percent. While that placed inflation within the two to three percent target band, exactly where was unclear since the data releases were arguably already out of date.

The release of soft inflation data for May led markets to expect a July rate cut. Nevertheless, the RBA kept the cash rate at 3.85 percent, surprising many forecasters. It explained that while inflation in May was encouraging, the monthly data do not offer a firm basis for a cut. The RBA consequently decided to wait for the second-quarter data to be released at the end of July.

That data is now available. It shows inflation clearly within the target band. This has strengthened expectations that the RBA will reduce the policy rate at its next meeting on 12 August.

The broader economic context also supports a rate cut. Growth has slowed, and signs of labour market softening have begun to appear. Quarterly real GDP rose by just 0.2 percent in the first quarter of 2025 and has averaged only 0.25 percent since late 2023, pointing to weaker domestic demand and rising economic slack. The unemployment rate has followed suit, drifting up from a low of 3.4 percent in July 2022 to 4.3 percent in June.

Finally, the international outlook adds to the case for easing. Trade tensions have increased, especially after the announcements of new United States tariffs. That raises downside risks for global growth and commodity demand, both of which are important for Australia.

Most observers now expect the RBA to cut the cash rate by 25 basis points, bringing it to 3.6 percent. Markets are pricing in further easing by year-end, with expectations centred on a rate close to 3.1 percent. If inflation drifts lower and labour conditions weaken, those cuts may well follow.

A Simple Reaction Function

To better understand how the RBA responds to inflation and growth developments, I estimate a simple monetary policy reaction function similar to those I have fitted for the ECB, the Riksbank and the Swiss National Bank.

Since inflation has been the dominant issue for all these central banks, I assume the RBA adjusts its policy rate in response to current inflation, the existing level of the rate, and the change at the previous meeting. I use data from the 64 policy meetings held between February 2019 and May 2025.

All three variables are statistically significant and have sensible magnitudes and expected signs. The model that uses the most recently published trimmed mean inflation rate fits the data best.

According to this model, the policy rate would be cut by 14 basis points in August, with a standard error of 12 basis points. From that, I can calculate the probabilities of various outcomes.

The chart below shows the model assigns a 3 percent probability to a 0.50% cut (or more), 51 percent to a 0.25% cut, and 46 percent to no change or an increase.

Source: my estimates.

It is important to note that this forecast is based on a simple summary of past RBA behaviour. The model does not include all relevant factors, such as the weakening international outlook. It should not be relied on in isolation. At best, it serves as a complement to a fuller economic analysis. Still, it supports the market consensus that a 25 basis point cut next week looks likely.

Conclusion

The RBA has used tight monetary policy to bring inflation back within its target range. As inflation has fallen, it has begun to ease policy cautiously and gradually. While markets were surprised by its decision in July to hold interest rates unchanged, that now looks understandable. The available data on inflation was somewhat dated, and the RBA’s scepticism appears justified.

But with inflation data for the second quarter of 2025 now published, the picture has become clearer. Markets expect the RBA to cut the policy rate at its meeting on 12 August. That expectation is supported both by the broader economic context and by my simple, back-of-the-envelope model of past policy behaviour. A 25 basis point cut looks likely.

The views expressed are my own. The work presented is preliminary and may contain errors. It should not be construed as investment advice. Readers are encouraged to seek professional investment guidance.