How the Reserve Bank controls inflation

The Reserve Bank of Australia (RBA) is charged with maintaining annual consumer price inflation between 2% and 3%-a target designed to foster sustainable economic growth while preventing excessive price rises.

It does this by adjusting the cash rate, which is the interest rate banks pay to borrow money.

When the RBA raises the cash rate, borrowing becomes more expensive and interest rates on home loans and other forms of credit typically rise too, while savings accounts offer better returns. When the RBA lowers the cash rate, the opposite happens.

Keeping inflation within the 2%-3% target matters because both very low and very high inflation can harm the economy. If inflation is too low or dips into negative territory (deflation), economic growth can stall, wages can stagnate and businesses may struggle.

Conversely, if inflation is too high (as it was recently), the cost of living rises sharply, eroding household budgets and creating financial instability. By tweaking the cash rate, the RBA seeks a balance that promotes steady growth without letting prices spiral out of control.

When inflation hit 3.8% in June 2021, the RBA initially held the cash rate steady. While inflation dipped back in the following quarter, it soon began to climb again, reaching 6.1% by June 2022.

At that point, the RBA acted, introducing a series of rate hikes to curb rapidly rising prices. Some economists have made the argument that it should have acted sooner.

Inflation peaked at 6.8% in late 2022 following eight consecutive increases, with the RBA lifting cash rate from near zero to 3.1%.

Although inflation began easing after that, the RBA continued raising rates, culminating in November 2023 with an increase that brought the cash rate to 4.35%. By then, inflation had fallen to 4.1%.

In the months since, the cash rate has remained unchanged, and inflation has continued to decline, most recently settling at 2.4%.

However, the RBA has still not cut rates, largely due to trimmed mean inflation-a measure that strips out the most volatile price changes to reveal underlying trends. In September 2024, while headline inflation had fallen to 2.8%, the trimmed mean stood at 3.6%, indicating that underlying price pressures remained relatively high.

The RBA had projected trimmed mean inflation to ease to 3.4%, but the latest data showed a slightly better-than-expected decline to 3.2%.

While still above the target range, this has reinforced expectations of a rate cut, with 73% of economists in Finder's RBA Cash Rate Survey predicting a February reduction. However, opinions remain divided on how many cuts will follow in 2025.

Around 20 economists foresee two or fewer, including Matthew Greenwood-Nimmo (University of Melbourne), Dr Andrew Wilson (My Housing Market), and Adelaide Timbrell (ANZ). Eleven, including AMP's Shane Oliver, Lateral Economics' Nicholas Gruen, and Oxford Economics' Sean Langcake, expect three cuts, while four cuts were forecast by UNSW's Evgenia Dechter and Bendigo Bank's David Robertson.

The most aggressive forecast came from Stephen Koukoulas of Market Economics, who stands apart in expecting six cuts, which would bring the cash rate down to a very digestible 2.85%.

"The inflation rate is now within the RBA's target range and is expected to stay there," Koukoulas said.

"While the labour market remains relatively strong with unemployment at 4%, the RBA's new mandate prioritises maintaining full employment. The longer monetary policy remains restrictive, the greater the risk that unemployment will increase.

"By shifting to a slightly more accommodative stance, the RBA could generate additional cash flow in the economy while preventing a significant deterioration in the labour market. A series of rate cuts would help counteract potential rising unemployment while ensuring economic output remains steady. With inflation under control at around 2.4%, the focus should be on keeping the economy running efficiently without undue pressure on employment."

Even with the possibility of multiple rate cuts, the RBA will still keep a close eye on inflation.

For homeowners, each cut could translate into an annual saving of around $1000 in interest on the average loan.

Whether you choose to spend, invest or save that extra cash has implications for inflation-and in turn, for how the RBA approaches future adjustments.

An often-overlooked strategy is simply to maintain your current repayment amount even if your interest rate falls.

By doing this, you can pay off your home loan faster, reducing your principal more quickly and ultimately cutting years off your mortgage term. It's also a decision that helps keep spending in check, reducing the risk of reigniting inflation.

While further cuts may be likely, the RBA won't hesitate to respond if trimmed mean inflation remains stubbornly above target.

Meanwhile, staying focused on your repayment goals could deliver greater long-term benefits. And in the race between inflation and your mortgage, it's always a win when the finish line arrives a little sooner.

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