With so much upheaval, predicting the path of the Australian economy almost requires an astrologer, says AICD Chief Economist Mark Thirlwell GAICD.
In a landmark moment for Australian monetary policy history, the Reserve Bank of Australia’s (RBA) new Monetary Policy Board began operating on 1 March. Just a few weeks beforehand, the “old” RBA board concluded its final meeting by delivering Australia’s first rate cut since November 2020, with a 25bp cut taking the cash rate target down to 4.1 per cent.
Although widely expected, with 90–10 odds on a cut, according to one financial market indicator, the decision proved controversial among the commentariat. Some of that reflected the proximity of the meeting to the upcoming federal election. But the case for a policy shift was also more finely balanced than implied by market pricing — an assessment confirmed by the RBA’s post-meeting communications, which saw Governor Michele Bullock GAICD explain it “wasn’t a lay down misère… it was a difficult decision”.
The tightness of the call raises some uncertainty about the future path of policy easing. At the time of writing, market pricing suggested the cash rate could end the year at around 3.4 per cent, implying another 70bp of cuts through 2025. Yet some commentators were instead speculating the RBA could be “one and done”.
One way to think about how far and how fast Martin Place might cut from here draws on the idea that key structural economic features of the economy tend to fluctuate around “normal” or “natural” values that represent a kind of equilibrium towards which the economy will eventually adjust. They include the steady state inflation rate, also known as π* (pi-star), the neutral real (inflation-adjusted) interest rate or r*, the natural rate of unemployment or u*, and the potential growth rate or y*. In a 2018 speech, US Federal Reserve Chair Jerome Powell explained that a conventional view of monetary policy is that policymakers should navigate by these “stars”.
Celestial journey
How does that navigation work? For an inflation-targeting central bank, π* is given by the inflation target, which in Australia tasks the RBA with achieving an inflation rate of two to three per cent. Following the RBA review, this has been tightened somewhat with more emphasis on hitting the 2.5 per cent midpoint of the band.
If π* tells us where the RBA wants to go, then r* informs us about the level of the cash rate once we get there. It is the real interest rate at which demand and supply in the economy are in balance, inflation is at target and the labour market at full employment. The nominal neutral rate then adjusts r* for inflation by adding a measure of inflation expectations. This gives the level of the cash rate consistent with inflation sustainably at target, absent further shocks. When the cash rate is above this level, monetary policy will be restrictive, exerting downward pressure on activity and inflation.
An important complication is that estimates of r* are uncertain and change over time. Last year, the RBA said its estimates of r* had risen since the pandemic, possibly due to a combination of higher global public debt, downward pressure on savings due to demographics and increases in investment. This year, the February 2025 Statement on Monetary Policy (SMP) reported downward revisions to some of those estimates. Currently, the neutral cash rate likely lies somewhere between three and 3.5 per cent, implying that returning monetary policy to a neutral setting would require additional cuts of 60–110bp.
Speed limited
Although this doesn’t tell us much about the likely pace of easing, the other stars can offer some guidance. Consider u*, the unemployment rate at which the labour market is in balance and the inflation rate is stable.
If the unemployment rate is below u*, excess demand in the labour market will push up wages, exerting upward pressure on inflation. Thus, the further the current unemployment rate is below u*, the more gradual the path back to neutral is likely to be.
Like r*, estimates of u* are both uncertain and changeable. Those estimates have tended to put u* at around 4.25 per cent, which is relatively close to the actual unemployment rate of 4.1 per cent at the time of writing. However, last year the RBA seemed to be assuming a u* closer to 4.5 per cent, implying a larger gap. More recently, in the February SMP, the RBA acknowledged its previous estimates may have been too high.
Finally, y* represents potential output growth or the overall speed limit of the economy. Potential output is a measure of the amount of goods and services the economy can produce (supply), consistent with low and stable inflation. When total demand in the economy is growing faster than potential output, inflationary pressures will tend to rise, requiring monetary policy to squeeze demand to bring demand and supply back into line.
Currently, real GDP growth is running at an annual rate of just 1.3 per cent (as of Q4:2024) which is well below Australia’s likely potential growth rate of 2.25–2.5 per cent. Even so, the RBA’s view has been that, contrary to the growth story, the level of demand still exceeds the economy’s supply capacity.
While it now judges this output gap has moved closer to balance, a key future uncertainty here relates to productivity, which helps determine y*. The RBA assumes Australia’s annual rate of labour productivity growth will return to around one per cent, roughly double the pre-COVID five-year average.
So, is our monetary policy fate really written in the stars? Only to some extent. As Fed chair Powell noted back in 2018, these stars can offer only qualified guidance. Except for the inflation target, they are all “latent” variables that cannot be directly observed, but instead must be inferred or estimated.
And there will always be uncertainty around the accuracy of those estimates, not least since these variables are changing over time.
More fundamentally, the underpinning idea of a strong tendency for the economy to return to equilibrium is itself challenged by our world of constant shifts and shocks.
AICD Chief Economist Mark Thirlwell has focused on the international political economy at the Bank of England, JPMorgan, Austrade and Export Finance Australia.
This article first appeared under the headline ‘Shifting Sands’ in the March 2025 issue of Company Director magazine.
Latest news
Already a member?
Login to view this content