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Oil prices continued to drift lower this week as negotiations between the US and Iran progressed, albeit against a volatile backdrop. The flow of tankers through the Strait of Hormuz has lifted to around one-quarter of its pre-war average and the price of front-month Brent crude briefly fell below US$73/bbl, within a whisker of its pre-war level, before rebounding to around US$75/bbl following a renewed flare-up. While the risk of further disruption remains, the worst of the shock to global oil markets now appears to be behind us.
But the legacy of three months of sharply higher oil prices is still being felt. Higher fuel costs have lifted inflation and weighed on activity globally. In Australia, the fuel price surge coincided with already elevated domestic inflationary pressures and rising interest rates. While the recent drop in oil prices reduces that pressure, the question is whether it is enough to stop the RBA from acting on its tightening bias and delivering another rate hike.
Like the ships transiting the Strait of Hormuz, the flow of economic data in Australia lifted a notch this week, with inflation and labour market data releases for May. While lower oil prices are already evident in the data, it is unlikely to shift the RBA’s tightening bias.
Headline inflation fell to 4.0% in May, from 4.2% in April and a peak of 4.6% in March, largely reflecting fuel prices. Government cuts to the fuel excise have shielded consumers from the full impact of higher oil prices since April, and falling global prices should see pump prices fall further in June. But that relief is temporary. The partial unwinding of the excise from 1 July will add 16c/litre, with a further lift once the excise returns to pre-war levels, potentially as early as August. After three months of falls, fuel prices could turn back up.
Beyond the fall in the headline, underlying inflationary pressures continue to build with trimmed mean inflation lifting to 3.6% in May from 3.4% in April. Much of this recent increase reflects the broader impact of the Iran war on commodity prices. Higher fuel and petrochemical costs are feeding through into a range of categories, including construction and food. New dwelling costs rose 0.9% in May, the fastest monthly pace since Russia’s invasion of Ukraine in 2022, while higher input costs lifted dairy, restaurant meals and takeaway prices. With oil and other petrochemical commodity prices now retreating, the recent upward momentum in underlying inflation should soon begin to ease.
While the recent rise in underlying inflation is concerning, the more pervasive problem is that the level of underlying inflation remains too high on an ongoing basis, reflecting domestically generated pressures across housing and services. These prices are tied to a domestic cost base that is growing too quickly to be consistent with the RBA’s inflation target. How that cost base evolves depends critically on labour market conditions.
If the domestic cost base is to slow, it must come through weaker labour demand and a loosening in labour market conditions. But this is not what we are seeing. The May data instead point to continued resilience, with employment rising by around 40k and the unemployment rate falling to 4.4%. Given the usual volatility of monthly labour market data, that signal should be interpreted with caution. What matters more is the overall tightness of the labour market.
On that measure, conditions are easing, but only very gradually. Over the past three years, the unemployment rate lifted from 3.4% to 4.4%, as firms scaled back hiring rather than reducing hours. With the labour market cooling gradually, not weakening decisively, it is therefore unlikely to generate the spare capacity required to bring inflation back to target quickly.
The war in Iran has complicated the RBA’s trade-off between inflation and full employment. Temporary factors tied to the conflict have added volatility, widened the gap between headline and underlying inflation, and pushed up the most recent underlying outcomes. But these effects should unwind as energy-driven pressures fade. And once they do, the focus will shift back to domestic inflation dynamics.
Monetary policy is already restrictive, with the RBA’s three rate hikes this year expected (in time) to return inflation to target. But with domestic pressures easing only gradually, the pace of that adjustment is likely to be slow. If disinflation proves too slow, while not our central case, the RBA may still choose to act on its tightening bias.
