Wed Jan 29

Lower inflation in the December quarter boosts chances of an interest rate cut

Written by: John Hawkins, Senior Lecturer, Canberra School of Politics, Economics and Society, University of Canberra

Australia’s headline inflation rate dropped to a three-year low of 2.4% in the December quarter, according to the Consumer Price Index ^[1], adding to pressure for an interest rate cut by the Reserve Bank as soon as next month.

Since it peaked at 7.8% in December 2022, inflation has now fallen for seven out of eight quarters.

The closely watched core inflation measure dropped sharply to 3.2% from 3.6%, below market expectations, but the central bank is concerned about how sustainable the fall in inflation will be. Strength in the labour market is also weighing against the need for a cut in interest rates.

The long-running quarterly measure of the CPI is a better indicator than the more volatile monthly version ^[2]. But the monthly rate is currently very similar; it ended the year at 2.5%^[3].

Why did inflation fall?

A main reason headline inflation fell was the electricity rebates, which led to the price of electricity falling by 25.2% during 2024.

The fall in global oil prices, which led to petrol prices dropping 7.9% during 2024, also contributed to the decline in inflation.

The rental market is easing ^[4], with rents slowing from growth of 7.3% during 2023 to 6.4% during 2024. Increases in Commonwealth Rent Assistance contributed to the deceleration. This still leaves a lot of families facing rental stress ^[5].

Home builders offering discounts have moderated the “new dwellings” component of the CPI. It increased by only 2.9% during 2024, a marked deceleration from the growth rates of around 20% seen in 2022.

Urban transport fares also fell during 2024.

Working against the downward trend were increases to the tobacco excise, in addition to the standard indexation, which led to tobacco prices rising by 12.2% during 2024.

Insurance costs continue to rise, increasing by 11% during 2024. If the Californian fires lead to insurers revising up their assessment of the risks posed by climate change, insurance premia could rise further ^[6].

The decline in the Australian dollar, while not as alarming as some media reports would suggest, would have added to the price of some goods, particularly those imported from the United States or whose price is denominated in US dollars.

The decline in inflation may be a pleasant surprise to the half of voters who were expecting inflation to get worse ^[8].

The “underlying” rate of inflation ^[9], which looks through temporary measures such as the electricity subsidies and is the preferred measure of the central bank, has also declined. It is now 3.2%.

Australia’s inflation performance is similar to that in comparable countries. It is slightly lower than inflation in the United Kingdom (2.5%) and the same as in the euro area. It is higher than in New Zealand (2.2%) and Canada (1.8%).

The fall in inflation to a rate significantly below the 3.5% at which wages ^[10] are increasing means that the cost of living crisis is abating, although not yet over.

The quarterly increases in the CPI during 2024 were 1.0% in March and June and 0.2% in September and December. As the large increases in the first half of 2024 are replaced, the annual rate should drop further in coming quarters.

What does it mean for interest rates?

The current Reserve Bank board meets next on February 18. By the following meeting, on April 1, the decisions will be taken by the new monetary policy board, which will have two new members.

This is the second consecutive quarter that inflation has been within the Reserve Bank’s medium-term target band ^[12] of 2–3%. It is now just below the mid-point of the band.

Inflation is also below the Bank’s latest forecasts ^[13] of 2.6% (and 3.4% for the “underlying” rate).

But the bank has stated ^[14] it will only cut interest rates when “members are confident that inflation is moving sustainably towards target”.

Inflation that is low just because of temporary electricity subsidies may not be regarded as ‘sustainable’. That is why the Bank places more emphasis on the underlying inflation measure. While not yet within the target band, underlying inflation has been steadily heading there and is now only just above it. This may be enough to give the Bank board members the confidence they seek. Financial markets now think so.

The government would dearly like to see rates coming down before the election, likely to be in April or May. It faces a nervous wait.