May Interest Rates decision: RBA to deliver relief but expectations are softening

The Reserve Bank is expected to deliver a 0.25 per cent drop in interest rates to 3.85 per cent tomorrow.

That would put rates below 4 per cent for the first time in two years, but economists warn the Reserve Bank will tread very carefully from here.

The conditions for a cut are about as good as they can be, with inflation safely in the two to three per cent band across both headline and underlying measures.

The economy is sluggish at 1.3 per cent annualised GDP growth, still well below the pre-COVID average of 2.4 per cent. But it has ticked up from its post-COVID low of 0.8 per cent in the September quarter.

Here are the key issues on the RBA board table.

International picture brightens

Global headwinds continue to buffet Australia’s prospects, primarily the tariff chaos unleashed on the world by Donald Trump.

Last week, before the announcement of a 90-day pause, most economists had been suggesting a more aggressive stance of easing by the RBA. This week, with the expectation that the US can’t afford to decouple from China, prospects for the global economy have improved.

Luci Ellis, Westpac’s chief economist and the former head of economics for the Reserve Bank, said the RBA was right to be cautious about moving too fast amid all the drama.

Ms Ellis described the US tariff approach as one of “ambit claims” – high initiating starting points as a negotiating tactic.

Now that they have been rolled out, the consensus is that the US will not fall into recession, and more importantly for Australia, China’s growth prospects have improved.

“We have maintained the view ... the RBA did not need to and would not panic,” Ms Ellis said.

Westpac expects a 0.25 per cent cut tomorrow.

Domestic issues front and centre

With Trump’s turmoil beginning to fade, it is domestic pressures the Bank will be watching.

Inflation is not an issue, according to Commonwealth Bank’s Gareth Aird, who says the bank’s view is the “proverbial inflation dragon has been slayed.”

That means the RBA can turn its attention to other data.

The most influential was last week’s employment figures, starting with wages growing 3.4 per cent over the year. Much of that growth came from enterprise bargaining agreements in aged care and child care, and is not expected to cause a wage breakout across the economy. The increase is also slower than the 4 per cent peak last year.

The labour market remains strong, with unemployment unchanged at 4.1 per cent, while 89,000 new jobs were added in April.

Of course, much of the jobs growth is thanks to government spending, so it is not reflective of a booming private economy. Still, a tight labour market will be on the Bank’s mind.

Consumer and business conditions remain weak. Despite a recent small lift in confidence, both indicators are still in negative territory.

Business conditions fell, according to the latest NAB survey, with capital expenditure dropping to its lowest level in a year, and profitability down due to higher input costs and weaker trading conditions.

Devika Shivadekar, chief economist at business advisory firm RSM Australia, said the RBA had to balance competing priorities, which would make it wary of moving too aggressively.

Businesses are struggling with higher wage costs for a less productive workforce, with younger employees yet to deliver and a lack of available skilled staff.

Ms Shivadekar noted the unexpected jump in April jobs figures, but said the increase wasn’t matched by a similar rise in hours worked. That suggests that despite the uptick in hiring, businesses aren’t operating at full steam.

A rate cut would help businesses offset those labour costs, she said, and could encourage borrowing for productivity-enhancing investment.

The case against

Some of the more hawkish economists suggest the economy is already on the up and could recover while keeping a lid on inflation if rates stay on hold.

Warren Hogan, economic adviser to Judo Bank, believes the country is facing a bigger wage issue than the headline numbers reveal.

He argues that with productivity going backwards by 1 per cent annually, wage growth of 3.4 per cent is effectively closer to 4.4 per cent – squarely in the inflationary zone. While he expects a cut tomorrow, he warns that easing into an upswing – assuming trade turmoil settles – risks reigniting inflation.

Warwick McKibbin, former Reserve Bank board member, has other concerns. He believes government spending is pushing the economy along at such a pace that a rate cut would heap stimulus upon stimulus.

“As far as I can see, the guardrails on fiscal policy have been removed, and that puts pressure on inflation,” Mr McKibbin told Bloomberg. He thinks the RBA should hold and watch the global economy.

Ms Shivadekar shared similar concerns, noting that government spending could weigh on the RBA’s decision.

“There is a potential, given the clear mandate to the Labor government, that some policies that could be stimulating in nature – whether it comes to the jobs market, further subsidies, or additional rebates – may emerge,” she said.

Words matter

Most economists are banking on a rate cut tomorrow and two to three more by year’s end.

But they don’t expect to hear anything like that from Governor Michele Bullock.

Ms Shivadekar said the Governor is likely to stay neutral with her language on forward guidance, wary of sending a message that could destabilise the fragile recovery.

“We are increasingly in a world where behavioural economics is taking more and more importance, and it is very important to control expectations,” Ms Shivadekar said.

Signalling an easing cycle could unlock consumer spending and drive prices higher, which would be particularly damaging in a low-productivity environment.

Cutting harder – say, by 0.5 percentage points – might suggest the economy is in worse shape than it is, spooking consumers into saving rather than spending.

The expectation is that Governor Bullock will remain cautious and “data dependent”. So far, that approach has helped steer the economy toward a soft landing.

It means animal spirits will be constrained, and the slow grind out of low growth will continue.

For what it’s worth, the cash rate should drop to 3.35 per cent based on the median forecasts for 22 economists.

That would put an extra $400 a month into the hands of someone with a $750,000 mortgage – a boost to growth, if households feel confident enough to spend it.

For now, they don’t. New data from CommBank shows 86 per cent of borrowers used the extra cash from the last rate cut to pay down debt.

As they say, it’s a balancing act.