How the RBA Actually Sets the Cash Rate: The Reaction Function

Key takeaways

• The RBA has a dual mandate: price stability and full employment.
• The Board responds to forecast inflation, because policy affects the economy with a lag of roughly 12 to 18 months.
• The Taylor rule is a simplified description of this behaviour, not the RBA's actual decision rule.
• Because the response is systematic, markets price expected moves into swap rates before they happen — which is why fixed rates already embed the forecast.

What is a reaction function?

It is the relationship between economic conditions and the policy response. In simplified form, the Board raises rates when forecast inflation is above target and the labour market is tight, and lowers them when inflation is below target or unemployment is rising.

The classic academic version is the Taylor rule:

Policy rate = neutral rate + inflation + 0.5 × (inflation − target) + 0.5 × (output gap)

The RBA does not mechanically apply this. But the rule captures the essential logic, which is why it is a useful mental model for anticipating direction even when it misses the exact level.

Why does the RBA target forecasts, not today's data?

Monetary policy works with a lag. A rate change today affects spending, employment and inflation over roughly the next 12 to 18 months. Setting policy to today's inflation would mean always being late.

This explains a pattern that frustrates borrowers: the Board can raise rates while inflation is falling, if the forecast says it will not fall far enough or fast enough. Conversely it may hold when inflation is high, if it believes tightening already delivered is still working through.

It also explains what "data dependent" means precisely: not that the Board reacts to each release, but that each release updates the forecast that policy responds to.

What does this mean for your loan?

Three practical consequences:

• Fixed rates already embed the expectation. Swap markets price the anticipated path, so a fixed rate is roughly the market's forecast plus a margin. You are buying certainty, not a forecast advantage.
• Watch labour market and inflation data, not commentary. Quarterly CPI, the monthly indicator and the unemployment rate move the forecast; opinion pieces do not.
• The neutral rate matters more than the current one. Estimates of where policy is neither stimulating nor restraining differ substantially, which is precisely why forecasters disagree about how far the cycle runs.

Frequently asked questions

What is the neutral rate?

The theoretical cash rate at which policy neither stimulates nor restrains the economy, often written r*. It cannot be observed directly, only estimated, and estimates vary by more than a percentage point — which is a large part of why economists reach different conclusions from the same data.

Why do economists disagree about rate forecasts?

They use different estimates of the neutral rate, different views on how quickly past changes transmit to households, and different inflation forecasts. Small differences in those inputs compound into materially different predicted paths.

Does the RBA consider house prices?

Not as a target. Financial stability is a consideration, but housing is primarily addressed through macroprudential tools administered by APRA — such as the serviceability buffer and the DTI cap — rather than by the cash rate.

Related reading

• Cash Rate at 4.35%: What It Costs the Average Australian Mortgage
• Fixed vs Variable in a Hiking Cycle: The 2026 Decision Framework
• APRA's DTI Cap Explained: The 20% Rule That Started February 2026

Sources

• Statement on the Conduct of Monetary Policy — Reserve Bank of Australia
• Statement on Monetary Policy, quarterly forecasts — Reserve Bank of Australia
• Consumer Price Index, Australia — Australian Bureau of Statistics