Cash Rate Decision with Conflicting Signals
The central bank's target band is 2–3 per cent average inflation. Headline CPI inflation is 4.1 per cent, but the trimmed mean is 3.4 per cent and falling. Unemployment is 4.0 per cent, slightly below the estimated non-accelerating rate of 4.5 per cent. Wage growth is 3.9 per cent and productivity growth is 0.8 per cent. Household debt is 185 per cent of income, and 40 per cent of mortgages are fixed-rate loans due to reset within 12 months. The exchange rate has depreciated 7 per cent, raising import prices. The board must set the cash rate at its next meeting.
1. Determine whether the board should raise, hold, or cut the cash rate, and justify using the inflation and labour market data.
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Inflation signals conflict. Headline at 4.1 per cent is above the band, but the trimmed mean at 3.4 per cent and falling is the better guide to underlying pressure because it strips volatile items. Still, 3.4 per cent is above the 2–3 per cent band, so underlying inflation is not yet contained.
Labour market: unemployment at 4.0 per cent is below the 4.5 per cent NAIRU, which points to tightness and upward wage pressure. Unit labour cost growth is roughly 3.9% − 0.8% ≈ 3.1 per cent, consistent with inflation above target if passed through.
Currency: a 7 per cent depreciation raises import prices, adding to inflation in the near term.
Decision: on balance, hold is the most defensible call, with a tightening bias. Raising now would act on headline and labour tightness but risk overreacting to a falling trimmed mean. Cutting would ignore inflation above band and a depreciating currency. A hold preserves optionality while the trimmed mean trend and the mortgage reset pass-through become clearer. A strong answer states the condition that would flip the decision: if trimmed mean stops falling, raise.
2. Explain how the mortgage reset profile changes the transmission of any rate decision, and assess the risk of a cut.
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Transmission: with 40 per cent of mortgages fixed and resetting within 12 months, a rate change today passes through to household cash flows with a lag and in a lumpy way. A hike would hit the resetting cohort all at once, producing a sharp consumption shock rather than a smooth one. This makes the timing of policy as important as its level.
Household debt at 185 per cent of income amplifies the consumption response: the same rate change produces a larger fall in disposable income than in a low-debt economy, so the effective policy tightening per basis point is larger than usual.
Risk of a cut: a cut would ease resets and support consumption, but with trimmed mean at 3.4 per cent, unemployment below NAIRU, and a depreciating currency, it risks entrenching inflation expectations above band and further weakening the exchange rate, adding import-price inflation. The asymmetry is important: cutting into above-band inflation with tight labour markets is riskier than holding, because the credibility cost of missing the band is harder to reverse than a delayed easing.