Download the PDF
The RBA should act sooner rather than later to head off inflation fears
ABS data released this week showed headline inflation was running at 3.6% in the December quarter, up from 3.2% in the September quarter. Headline inflation has retraced from its low point of 2.1% in the June quarter of 2025.
In addition, after barely scraping under the upper bound of the RBA’s inflation target of 3% in the June quarter and having spent three years above 3%, underlying inflation lapsed into an immediate retracement to the upper bound of 3% in the September quarter and then rose to 3.4% currently. This lift in inflation saw the market move to price a 70% chance of a hike at the RBA’s meeting next week.
So what has pushed inflation higher? Looking at other parts of the economy, the labour market remains tight. The unemployment rate is 4.1%, lower than our estimate of the non-inflationary rate of 4.3%. Combined with relatively soft productivity growth, this has kept unit labour cost growth elevated and fed through into higher services prices. Labour shortages are apparent in certain industries, most notably the construction industry.
Over the last five years, construction work in the pipeline has increased by around $100 billion, from around $169 billion at the beginning of 2020, to $278 billion currently. Highlighting the difficulty the construction industry has had in keeping up with the surge in demand, construction work done has only increased by around $30 billion over the same period, so that construction work done is currently lagging the pipeline by an historically large margin of around $190 billion.
It is therefore unsurprising that one of the key drivers in the recent lift in inflation has been housing costs as bottlenecks created across the construction sector spill over into costs in the residential sector. These broader pressures on residential costs have been added to by RBA interest rate cuts over 2025 which have fuelled a recovery in housing demand, giving construction companies space to rebuild margins.
All that said, what is the RBA’s thinking on inflation and the economy? At their last meeting in December 2025, the RBA kept rates on hold, and expressed patience with inflation, waiting for more data to assess whether the lift in prices experienced in the September quarter of 2025 was transitory or at risk of becoming entrenched.
In her press conference, the Governor cited a tight labour market and evidence that inflation was becoming stuck above target as conditions for the Board to consider a rate hike in February. Even though monthly labour market data are volatile, the unemployment rate has failed to sustain the September break above the non-inflationary unemployment rate of 4.3% and is back at 4.1%.
Also at her press conference, Governor Bullock specifically identified persistence in price rises for market services, new dwellings and durable goods as items important in the Bank’s future rate determination. With the latest release of the December inflation data, growth in market services (excluding volatile items and travel) prices remains above the upper end of the RBA’s target at 3.1%.
Annual growth in the prices of new dwellings continued its steady climb from 0.4% in June 2025 to 3% in December and, although at a lower rate of inflation than market services and new dwellings, durable goods have also experienced ongoing price inflation from 0.3% in June to 1.3% in December. Consequently, evidence of persistence in high or rising rates of inflation in these key categories is now in effect.
In its November Statement on Monetary Policy, the RBA expected underlying inflation to be 2.7% by the end of 2026. Given the RBA was forecasting underlying inflation in the December quarter of 2025 to be 3.2%, it is highly likely that they will raise their 2026 year-end forecast (due out next week) to at least 2.8%; closer to the upper bound of their inflation range than to their target of 2.5%.
The RBA cut the cash rate by 75 basis points over 2025, with rates having been on hold since September. If the RBA were to raise rates next week, it would be one of the shortest easing cycles in the Bank’s history. It would also open the RBA to criticism that it cut rates too far too soon. However, if a lesson is to be learned from the Philip Lowe era, the RBA must not be wedded to the past or feel under threat if it decides conditions have altered and it is appropriate to change course.
Today, the Australian economy is facing a rise in inflationary pressures with growth recovering and returning to balance. The labour market is strong with pockets of labour shortages impacting certain sectors including the critical construction sector. Almost all indicators point to a rate hike. Of course, inflation may retrace over 2026 as we and the RBA expect, as productivity continues to lift and the growth in unit labour costs moderates.
But if we’re wrong, the risk is that inflation becomes even more entrenched. The outcome would be the need for multiple rate hikes to bring inflation to heel with the risk of derailing the recovery and the rebalancing of the Australian economy that is clearly underway; a derailing that one 25bp rate hike is unlikely to pose. One 25bp rate hike now will send a signal to the market that the RBA is serious about inflation. It is now time for Governor Bullock to send such a signal so that the Bank maintains the credibility that she has painstakingly rebuilt since she has been at the helm.