Today, we’re diving into how the Reserve Bank of Australia (RBA) sets interest rates as it nears its target of 2.5% inflation, and what happens when that target is reached. Back in 1898, Swedish economist Knut Wicksell published *Money, Interest and Commodity Prices*, introducing the concept of the natural rate of interest. This is the real interest rate that maintains price stability. Unlike Wicksell’s time, modern central banks, including the RBA, focus on stabilising the rate of inflation rather than the price level itself.
In Australia, the RBA aims to keep inflation at 2.5%. To achieve this, it sets a real interest rate, known as the neutral rate, which can only be determined in practice by observing what rate stabilises inflation at 2.5%. Looking at data from January 2000, we see significant fluctuations in Australia’s real cash rate, but over the long term, the average real rate has been 0.85%. This suggests that the RBA can maintain its 2.5% inflation target with an average real cash rate of 0.85%. This is a valuable insight as the RBA approaches this target.
As inflation nears 2.5%, we can estimate that the cash rate will settle at 2.5% (the inflation target) plus the long-term real rate of 0.85%, resulting in a cash rate of 3.35%. At the RBA meeting on Tuesday, 12 August, when the trimmed mean inflation rate for June had already dropped to 2.7%, the RBA reduced the real cash rate to 0.9%, resulting in a cash rate of 3.6%.
We anticipate that when the trimmed mean inflation for September falls to 2.5%, as expected, the cash rate will adjust to 2.5% plus the long-term real rate of 0.85%, bringing it to 3.35%. The September quarter trimmed mean will be published at the end of October, just before the RBA’s November meeting. We expect the RBA to hold the cash rate steady at its September meeting, but when it meets in November, with the trimmed mean likely at 2.5%, the cash rate is projected to fall to 3.35%.
