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What is guiding RBA monetary policy?
As expected by the market, most forecasters and QIC (see RBA to hike) the RBA commenced its rate hike cycle this week with a 25 basis point (bp) increase in the cash rate. The question now is, how high will this rate-hike cycle go? Currently, the market has another 25bp rate hike fully priced by August, but with an 80% chance of a rate hike at the Bank’s meeting in May, which follows the next release of quarterly CPI at the end of April. The market is also pricing a significant (45%) risk that the RBA follows up with another rate hike by year end.
Hence, the market is signalling that this cycle will include at least two 25bp rate hikes, taking the cash rate to 4.10%, with a roughly 50% chance of three rate hikes and a cash rate leveling off at 4.35% by the end of the year. What does the RBA think? Unfortunately, this is a little more difficult to determine. Of course, the RBA and Governor Bullock have emphasised that they are not giving forward guidance and will be driven by the data.
On the other hand, the RBA and Governor Bullock have telegraphed their “conditions” for their next potential rate hike, which won’t be coming until the May meeting. That condition is that underlying inflation remains elevated, meaning that the quarterly growth in the trimmed mean (i.e., underlying) measure of inflation for the March quarter of 2026 is 0.9% (or 3.6% annualised). Along with their policy meeting, the RBA also released their latest economic forecasts including their inflation forecasts. And, no surprises, their revised forecasts are for March quarter underlying inflation of 0.9%.
Of course, if inflation were to print at such an elevated rate (well above the RBA’s target band on an annualised basis), the RBA would be right to continue with their tightening cycle. Even a print of 0.8% would see that annualised rate above their target and the Bank would be justified to hike rates once more. For a March quarter inflation print below 0.8%, the RBA’s decision becomes less obvious. While the difference between a print of 0.9% and 0.7% may seem trivial, the difference in momentum between those two figures is significant and would flag downside risks to the inflation outlook over the remainder of the year.
What do we think? Our bottom-up estimate of inflation over the current quarter is currently sitting right on 0.8%. Hence, if we’re right on the inflation call, our view is that the Bank will deliver another rate hike in May. Our estimates indicate ongoing price pressures emanating from the construction and labour-intensive related categories including housing, market services and health services. What about May and beyond?
In its latest forecasts, the RBA increased sharply its inflation forecasts over the remainder of 2026. Its forecast for underlying inflation by year end of 3.2% is now outside the upper bound of its target range of 3.0%, compared to its previous forecast of 2.7%, which was close to its target rate of 2.5%. If inflation follows the path of the RBA projections, another rate hike sometime after May is a near-certainty. What has caused the RBA to upgrade its inflation forecasts so dramatically?
The RBA has identified three factors: (i) the stronger than expected global economy spilling over to an uplift in demand for Australian goods and services; (ii) stronger than expected domestic demand, and in particular, increased capital expenditure by businesses; and (iii) monetary policy not being as restrictive as they had previously thought at a cash rate of 3.6%. As a consequence of the stronger international and domestic demand, the RBA went from assuming that demand and supply conditions in the Australian economy were balanced, to a view that the economy was experiencing excess demand. Hence, to relieve pressure on inflation, the RBA needs to raise interest rates to slow the growth rate in demand and bring demand and supply back into balance. A corollary of the rebalancing of demand and supply is that economic growth must slow to below trend, and the revised RBA forecasts comprise an upward revision to inflation and a downward revision to growth, which is now forecast to be below trend over the second half of the year.
What do we think? Our view is that the RBA is currently overstating the extent of excess demand in the economy. Unlike the RBA, which estimates that demand exceeds supply by a significant 1 percentage point, our estimates indicate that demand and supply conditions are approximately balanced. This is a view also held by most other professional forecasters and larger institutions such as the OECD.
Hence, our view is that the economy requires less tightening than the RBA believes to bring inflation down. But if our view is that demand and supply conditions are balanced, why do we need any tightening in interest rates at all to bring inflation down? Would not inflation naturally fall back to trend in a balanced economy? The answer is yes it would, if you thought that the neutral cash rate (that rate consistent with demand and supply balance) was 3.6%. Our view, consistent with the RBA’s revised view, is that at 3.6% the cash rate is not consistent with a balanced economy.
Hence, the rate should be higher. What should that rate be? We estimate the neutral rate is somewhere between 3.75% and 4.0%.
Tying the threads together means the RBA will raise rates just once more this year in May. Beyond May, the tightening of monetary policy combined with an economy that is finding its equilibrium will result in a shift down in inflation momentum making further rate hikes unnecessary.