The verdict is in for the Reserve Bank: the weight of evidence against it from economists, financial markets, businesses, and broader public opinion left the Bank with little choice but to retract its May Monetary Policy Statement and effectively plead guilty to previously misreading the economy. Rather than having to wait until August 2025 for the first cut to the official cash rate (OCR), which was 15 months from the publication date of the Bank’s previous forecasts, the first interest rate cut occurred yesterday. That first cut has occurred only three months since May – representing a massive 80% error in the timing of the Bank’s prediction. Whoops!

While we book a physiotherapy appointment to address the whiplash we’ve experienced, we’re also turning our mind to where things head next. Although we’ve now revised our own interest rate forecasts, the Bank’s U-turn means we remain sceptical of the Bank sticking to its word, and caution is needed until we see some consistency from the Bank. More importantly, we’re still left wondering about how forward looking the Bank is.

Following yesterday’s Statement, we now expect the OCR to be 4.75% at the end of this year and 3.5% at the end of 2025. This outlook represents a downward revision to our OCR track of 50-75 basis points through until the end of next year, with rate cuts at every review between now and mid-2025, with another couple of cuts in the second half of next year (see Chart 1).

The earlier shift towards easier monetary conditions is good news for households. We now expect one-year mortgage rates to be under 6% by the end of next year (see Chart 2), with our forecasts of the effective mortgage rate also having shifted down by as much as 30 basis points. In fact, one-year mortgage rates could be as low as 5.4% by the end of 2025, depending on how banks’ lending margins evolve.

And, as Chart 3 shows, with a higher proportion of mortgage lending fixed for shorter terms as people wait for interest rates to drop, there is a possibility that the OCR cuts will free up money in household budgets a bit more quickly than we have currently allowed for.

Not much has actually changed in the economy since the Bank’s May Statement, when it mused about interest rate rises and signalled the OCR would stay at 5.5% (or possibly higher) for longer.

• Economic growth for the March quarter was in line with the Reserve Bank’s forecast of 0.2%.
• Headline inflation was lower than the Bank expected (3.3% vs 3.6%pa forecast), but non-tradable inflation was higher (5.4% vs 5.3%pa forecast). The Bank had expressed particular concern about the persistence of domestic, or non-tradable, price pressures in May, which suggests that it might pay more attention to the higher non-tradable outcome than the lower headline result.
• The unemployment rate and private sector labour cost growth were in line with the Bank’s forecasts. Employment growth for the June quarter was stronger than the Bank expected (0.6% vs 0.3%pa forecast).

Weak business and consumer sentiment across a wide range of measures seems to have jolted the Bank, and the Monetary Policy Committee also argued that “high-frequency indicators point to a material weakening in domestic economic activity in recent months.” However, the weaker trend in confidence and other partial indicators was already apparent throughout the first few months of the year, yet it had seemed previously to be ignored by the Bank in its assessment of economic conditions.

The Bank’s forecasts now expect:

• inflation of 2.3%pa rather than 3.0%pa in the current (September) quarter – see Chart 4
• GDP growth of -0.4%pa rather than +1.0%pa in December 2024
• an unemployment rate of 5.4% rather than 5.0% by March next year

The Bank’s inflation track is surprisingly subdued – we are picking 2.6%pa inflation in the September 2024 quarter, a call that we felt was quite low and therefore reasonably bold. The Bank’s flip-flop on inflation is demonstrated in Chart 4, which shows that the Bank’s latest forecasts are closer to its February predictions than the higher inflation outlook that was presented in May.

Back in 2021/22, when the Reserve Bank was too slow to react to increasing cost pressures and let inflation get out of hand, people lost confidence in its inflation-fighting credentials. Higher inflation expectations and changes in price-setting behaviour effectively meant the Bank would need to keep interest rates higher for longer to restore people’s faith in its commitment to getting inflation back within the 1-3%pa target band and keeping it there.

The Bank is now facing a different, but related, credibility problem. People in the business community are openly questioning the Reserve Bank’s forecasting ability. And based on the latest results, rightfully so.

The Bank’s incompetence at correctly forecasting the OCR even three months in advance is alarming, particularly when one considers that the OCR is directly controlled by the Bank.

One objection by the Bank might be that its future OCR track is a “mechanistic” outcome of its forecasting process, rather than a genuine forecast or even forward guidance. However, this stance points towards a wider problem that the Bank has – one of communication.

On several occasions over the last two years, the tone of the Bank’s statements has shifted markedly from one announcement to the next (and often back again at the following statement). Furthermore, in discussions with economists, the Bank has rejected assertions that it is not being as clear as it should be, instead laying the blame for misinterpretation with analysts or financial markets.

In addition, we question how closely the Bank listens to the messages it gets about the economy during its meetings with businesses. The Bank’s seeming obliviousness to the deterioration in economic conditions earlier in 2024 is at odds with the feedback we have received throughout this year.

Ultimately, the Bank has demonstrated a concerning lack of ability to look forward and consider future economic conditions when setting monetary policy throughout the last three years. This lack of foresight showed through in the Bank’s reluctance to rapidly raise interest rates early in the tightening cycle and a stubborn insistence that inflation was transitory. Just as it was too slow on the way up, the Bank also looked like it would be too slow in cutting interest rates on the way down. If inflation is under 3%pa in the current quarter, as expected, the Bank is effectively waiting until current data confirms the consequences of previous actions, rather than being able to extrapolate forward and assess future outcomes. The interest rate relief that it is providing now will only be fully felt by businesses and households in 12-18 months’ time.

If we were starting with a clean slate, we believe that this week’s OCR decision was the right one. It was only the Bank’s prior messaging and forecasts that had pushed back our expectations of the timing of interest rate cuts until February next year. We have little choice now but to take everything that the Bank says with a sizable serving of salt.

The forward path for interest rates appears more certain – although we’d have said that after the May Statement too! The Bank’s forecasts, and our own, see interest rate cuts in most meetings until the end of 2025. There’s also a good chance the Bank considers a 50 basis point cut at some stage before the end of 2024.

But – and it’s a big but – the downward path for interest rates could be slower or less consistent. The Reserve Bank has stressed that the “pace of further easing will depend on the Committee’s confidence that pricing behaviour remain consistent with a low inflation environment, and that inflation expectations are anchored around the 2 percent target.”

Given the Bank has leant heavily on high-frequency data to justify its U-turn, coupled with a more aggressive view of disinflationary pressures coming through, what happens if the data starts to surprise on the upside? For example, if inflation comes in above the Bank’s expectation of 2.3%pa for the September quarter, or “high-frequency data” starts to show a turnaround in trends that the Bank thinks is too quick, what would the Bank do?

The Bank appears to be very influenced by current data at the moment, rather than being anchored by the economy’s outlook for the next 18 months, and it also seems to be happy to pick and choose what data it cares about most at whim. Given these tendencies, and the Bank’s continual shifts in view, there is a reasonable chance that an upside surprise could lead to a pause or slowdown in interest rate easing.

We highlight this possibility, not because we currently expect it to happen, but because recent times have shown we have to be aware of any and all options for monetary settings.