David Bassanese
4 minutes reading time
As I expected, the Reserve Bank decided to raise the official cash rate to 4.1% today, citing a “material risk” that inflation will stay above the 2-3% target range for longer than previously expected. This heightened risk reflected several factors that had become evident since the last rate hike in early February:
- A solid Q4 GDP report and a sustained decline in the unemployment rate to 4.1%, suggesting the economy was operating at a tighter level of capacity than previously thought.
- The upside risk to energy inflation due to the eruption of hostilities in Iran.
- A concerning recent lift in consumer inflation expectations.
Prior to these recent developments, the outlook for interest rates was crucially dependent on the degree to which the H2 2025 lift in inflation reflected temporary factors or the upturn in demand. In that regard, the upcoming March quarter consumer price index (CPI) report in late April was seen as important in answering this question. This likely meant the RBA would wait for this report before deciding whether to raise interest rates again at the May policy meeting.
But recent developments, namely the strength in the economy and the surge in energy costs, seem to have cemented the case among RBA officials for at least one more rate hike even before the details of the Q1 CPI report were known. The RBA’s signalling in recent weeks suggested at least the Governor and Deputy Governor were of a mind to raise rates and wanted the market to know. What was less clear was whether the other, more independent Board members would agree.
As it turns out, the decision did end up being a close call, with five voting members agreeing to hike rates and four desiring to leave them on hold. The hawks won the boardroom battle!
The split decision reflects the tensions associated with raising rates in the face of a global energy price shock. This shock puts upward pressure on inflation and poses a downside risk to economic growth. Some Board members clearly felt the mixed economic effects of the energy shock warranted keeping rates on hold while others (likely including the RBA Governor and Deputy Governor) were more concerned about the upside inflation risks – especially given recent solid GDP and employment reports along with the lift in consumer inflation expectations.
Where to from here?
Today’s very split RBA decision suggests a rate hike at the next policy meeting in May is not a done deal. Much will still depend on the outcome of the Q1 CPI report in late April. It will also depend on how sustained the recent surge in energy prices proves to be. A quick cessation of Middle East hostilities would ease pressure for another rate rise should it lead to lower oil prices. It will also depend on the immediate reaction of business and consumer activity to these back-to-back interest rate increases.
The worst case scenario is a sustained lift in energy prices should the war in the Middle East descend into a quagmire, with not only a blocking of supply through the Strait of Hormuz but more enduring damage to oil production facilities. In that case, Australia faces the very real prospect of aggressive further rate hikes to contain inflation expectations. The RBA may well be forced to tolerate the economy falling into recession, with an unemployment rate of 5% or more.
The best case scenario is a quick resolution to the hostilities and a pleasingly low Q1 CPI which obviates the need for the RBA to hike again in May 2026.
My base case is that, one way or another, Middle East hostilities will have ended by May and crude oil prices will be materially lower than they are at present. That said, my view is that this would still not be enough to stop the RBA hiking again in May, given the prospect of a further uncomfortably high inflation result for the March quarter, not helped by the elevation in energy costs over recent weeks.