RBA Hikes Rate to 3.85% Amid Stubborn Inflation

The Reserve Bank of Australia (RBA) has increased its cash rate by 0.25 percentage points to 3.85%, a move widely anticipated by markets. The decision comes in response to persistent inflation and surprisingly strong growth in private sector demand.

The RBA's Monetary Policy Board noted that while some indicators suggest an easing, the labor market remains tight. This combination of renewed price pressures and a robust economy left the central bank with little choice but to continue its tightening cycle.

Updated Forecasts Signal a Hawkish Stance

Alongside the rate decision, the RBA released revised economic forecasts that paint a picture of stronger near-term growth and, crucially, higher inflation.

The upgrades to the inflation outlook are significant. The new projections imply quarterly trimmed mean inflation will run at about 0.9% for the next two quarters before settling into a 0.7% quarterly pace. According to this forecast, annual trimmed mean inflation will still be at 3.2% by the end of 2026, remaining above the RBA's target.

The central bank expects the temporary factors driving recent price spikes to fade after mid-2024. At the same time, restrictive monetary policy is projected to cool the economy, guiding inflation back toward the 2–3% target range by mid-2028, with the forecast ending at 2.6%.

Despite this long-term path, the RBA Governor expressed discomfort with inflation remaining above the 2.5% midpoint so far into the future. This sentiment underscores the bank's commitment to bringing inflation under control.

What's Driving the RBA's Thinking?

The RBA's latest move was heavily influenced by a series of strong underlying inflation reports. This data, combined with stronger-than-expected private demand and a labor market that appears to have stopped easing, convinced the board that more action was needed.

The Role of Supply Capacity

A key theme in the RBA's analysis is its assessment of the economy's supply capacity. The bank now believes capacity constraints were tighter in late 2025 than previously thought, contributing to higher inflation.

However, this analysis raises a critical question about a potential feedback loop. The RBA appears to revise its estimates of supply capacity downward each time it is surprised by a high inflation reading. While the bank maintains it doesn't react mechanically to past data, this pattern effectively links its future forecasts to recent inflation surprises. For example, recent data has led the RBA's models to suggest a higher NAIRU (the unemployment rate consistent with stable inflation), which in turn builds more inflationary pressure into its future projections.

The Labor Market Debate

While the RBA views the labor market as tight, the data presents a mixed picture. Of the 15 standard indicators the RBA tracks for labor market tightness, 11 have eased while only four have tightened. The bank appears to be placing significant weight on the few tightening indicators, particularly those from business surveys.

Long-Term Outlook and Policy Path

To achieve its inflation target, the RBA's forecasts outline a sustained period of sluggish economic growth. GDP is expected to grow at a rate below the RBA's own pessimistic 2% estimate of trend supply capacity. With the unemployment rate still rising at the end of the forecast period, it raises the possibility that inflation could eventually fall below the target if the timeline were extended. This outlook supports the view that while rates are rising now, cuts could be on the table in late 2027 or early 2028.

Other Economic Factors

Exchange Rate: The Australian dollar has appreciated noticeably since the last forecast, which should theoretically help dampen inflation. However, the RBA has downplayed this factor, attributing the currency's strength primarily to the domestic interest rate outlook rather than broader factors like the sell-off in the U.S. dollar. This may understate the disinflationary impact the exchange rate could have in the coming quarters.

Productivity and Investment: The RBA Governor has emphasized the role of the Productivity Commission in identifying policies to lift economic efficiency. However, this focus may overlook the crucial contributions of capital accumulation and private-sector innovation. The RBA's own weak forecasts for housing and business investment offer little reason for optimism on this front.

What to Expect Next from the RBA

Governor Bullock gave no explicit forward guidance on the future path of interest rates. However, with forecasts showing inflation remaining uncomfortably high even after this month's hike, further increases are clearly a possibility.

The RBA has set a low bar for another rate hike. The board will likely wait for the next quarterly inflation report before making its next move. Unless that report delivers a significant downside surprise, another rate hike in May appears likely.