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The long road back to the RBA's inflation target
Australia's economy has entered the next phase of the business cycle. After proving remarkably resilient through 2025, growth slowed to a below-trend pace in the first half of the year, as consumers became more cautious and sentiment toward the housing market weakened significantly.
Yet despite restrictive monetary policy, the economy has so far avoided a sharp downturn and continues to operate with excess demand. Inflation remains elevated and has risen this year rather than fallen. The key challenge for policymakers is whether current settings deliver enough of a slowdown to eliminate the excess demand that is keeping inflation above target.
The slowdown so far has been gradual, with the economy remaining well positioned to avoid an abrupt downturn and a large rise in unemployment. Several factors are helping to support household spending despite restrictive monetary policy. Households built up savings buffers through 2025 as interest rates were reduced and disposable incomes lifted. Those savings are now helping support consumption despite higher borrowing costs. Modest tax cuts are also benefiting household cash flows. At the same time, labour market conditions remain relatively resilient. While employment growth has softened, employers are still hiring and the unemployment rate remains low at 4.4%, which is putting a floor under wages and incomes.
Business investment is also supporting economic activity, but that support is far from broad-based. While many businesses have become more cautious in response to weaker demand and higher borrowing costs, investment associated with the rollout of artificial intelligence continues to accelerate. Expenditure on data centres, electricity networks, power generation and related infrastructure is providing an important source of demand at a time when other parts of the economy are slowing. As a result, growth is becoming more reliant on AI-related capital expenditure, a pattern that is increasingly evident across the global economy.
Together, these factors are cushioning the slowdown in activity and helping sustain excess demand, despite restrictive monetary policy.
How much of a slowing are we expecting? QIC forecasts growth of around 1½ - 1¾% over 2026 and 2027. While this would normally be expected to place meaningful downward pressure on inflation, the disinflationary impact is likely to be smaller than in previous cycles. The reason is that supply-side growth is also weak.
The economy's broader supply-side problem is weak productivity growth. Productivity has remained subdued for almost a decade, constraining the economy's ability to expand supply and limiting the pace at which excess demand can be eliminated. But productivity is not the only supply-side constraint. While labour demand is slowing, labour supply growth is also slowing as population growth and net migration moderate. This is helping to offset softer demand for labour and slowing the pace at which inflationary pressure is being removed from the economy.
Inflation also remains vulnerable to further supply-side disruptions. While oil prices have fallen sharply since the signing of a Memorandum of Understanding between the US and Iran, the conflict highlighted how quickly geopolitical developments can disrupt energy markets. And while AI investment has the potential to lift productivity over time, the near-term impact is likely to be more inflationary than disinflationary. Before AI delivers a positive supply shock, the investment required to build that future will boost demand and slow the return of inflation to target. Together, these factors suggest inflation is likely to prove more persistent than would normally be expected at this stage of the cycle.
The persistence of inflation naturally raises the question of whether the RBA should lift rates further. In our view, the answer is no. While inflation is likely to remain above target, it is set to moderate and there is clear evidence that restrictive monetary policy is already slowing the economy. Housing activity has weakened, consumer spending has moderated and business investment remains subdued outside a narrow group of projects linked to data centres and renewable energy. Additional rate increases would accelerate the elimination of excess demand, but at the risk of generating a sharper downturn in interest-sensitive sectors of the economy, potentially tipping the economy toward recession.
At the same time, an early easing cycle would carry its own risks. Elevated inflation could become entrenched in expectations, further delaying the return of inflation to target. The most likely outcome is therefore an extended period of policy restraint while excess demand continues to fade and inflation moderates. Although we expect the next move in interest rates to be lower, progress on inflation is likely to be gradual, delaying the start of the easing cycle until the second half of 2027.