A balanced outlook, but unbalanced risks

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Why the RBA remains worried even as the economy adjusts

The Reserve Bank of Australia (RBA) kept the cash rate unchanged at 4.35% this week, surprising almost no-one. Financial markets, economists and the Bank itself had spent much of the past fortnight converging on the view that the June quarter inflation data had removed the immediate need for further tightening.

Yet while the decision itself was uneventful, the discussion surrounding it was not. The August Statement on Monetary Policy (SOMP) presented a broadly balanced outlook for the Australian economy, but the risks identified by the RBA appeared far less balanced. That distinction was evident throughout Governor Bullock's press conference, where she repeatedly emphasised upside inflation risks and went so far as to remark that she personally thought “it's quite possible we might need to go” again. 

 

It was the distinction between the outlook and the risks, rather than the decision itself, that emerged as the key message from the meeting.

 

For a central bank that generally avoids providing explicit guidance on future interest rate decisions, the comment was striking. It was the distinction between the outlook and the risks, rather than the decision itself, that emerged as the key message from the meeting.

The economy is adjusting

The SOMP recognises the significant adjustment the economy has undergone this year, with capacity pressures easing sharply. Consistent with this, inflation surprised on the downside in the June quarter, labour market conditions have eased, and the housing downturn has been sharper than expected. These developments provide evidence that restrictive monetary policy is having its intended impacts and that excess demand is gradually being removed from the economy.

A benign central forecast

Reflecting these developments, the central forecast outlined in the SOMP is for continued gradual adjustment. Economic growth is expected to slow over 2026 and remain below trend over the forecast horizon, while unemployment is forecast to rise further as restrictive monetary policy continues to weigh on demand. Inflation is projected to continue its gradual return towards target and, importantly, the baseline outlook does not rely on any further tightening in monetary policy.

 

Taken together, the forecasts describe an economy slowing sufficiently to reduce inflation over time, without requiring a recession or further rate hikes.

 

Despite the slowdown in demand, the SOMP projects a lengthy return to target, with underlying inflation taking until 2028 to reach the midpoint of the inflation band. This reflects supply-side constraints that continue to limit the economy’s productive capacity. Productivity growth remains weak which means capacity pressures persist despite slower growth. The Bank’s forecasts suggest it takes until 2027 for aggregate demand and potential supply to return to balance, accounting for the gradual path to the inflation target.

So why the concern?

With the central forecast showing the economy adjusting as needed, what was the catalyst for the concern showed by Governor Bullock at the press conference? The answer lies in the Bank’s assessment of the distribution of risks around the central forecast, which the SOMP judges to be skewed firmly towards higher inflation.

The SOMP identifies several developments that could result in inflation proving more persistent than the central case. The conflict in the Middle East remains a source of energy-price volatility. The Bank sees risks that the conflict could again escalate, leading to higher oil prices. Even the more benign central case could generate cost pass-through into supply chains beyond what was assumed, particularly if higher inflation expectations become embedded in wage and price setting behaviour. Finally, the AI investment boom which is currently centred on data-centre construction could add to demand in parts of the economy already facing capacity constraints.

The bigger risk may be closer to home

The most pertinent risk, however, may not be the Middle East conflict or the AI investment boom. Rather, it is the possibility that excess demand in the economy is greater than the RBA’s central assessment suggests. The Bank now estimates that capacity pressures have eased more than it expected in May, reflecting softer inflation, easing labour market conditions and the sharper-than-expected housing downturn. Yet it also acknowledges that this assessment remains uncertain. Weak productivity growth is central to that uncertainty.

 

If productivity remains weaker than assumed, there is less spare capacity than the RBA currently estimates.

 

If productivity remains weaker than assumed, the economy’s ability to grow without generating inflation will be lower, leaving less spare capacity than the RBA currently estimates. In that scenario, inflation could be a more persistent problem.

Not yet time to declare victory

The RBA’s challenge is therefore no longer simply to slow demand. It must determine whether demand has slowed enough in an economy whose speed limit remains low and uncertain. If capacity pressures have eased as much as the Bank expects, current policy settings should be sufficient to return inflation to target. But if weak productivity means the economy remains more capacity-constrained than estimated, the progress on inflation may prove difficult to sustain. Until that uncertainty is resolved, evidence that monetary policy is working to slow demand is unlikely to be enough for the RBA to declare victory on inflation.