RBA: Rates ratchet higher

The Reserve Bank of Australia (RBA) raised the cash rate by 25 basis points to 4.35% today, its third hike in recent months, and the decision was entirely defensible given the hand it has been dealt. The Board was already staring down an economy running above potential when the Middle East conflict erupted in late February. That conflict broke an already-tight inflation situation wide open. Doing nothing would have been a gift to inflation expectations; acting was the only credible move.

What is striking, though, is the framing of the decision. The Board acknowledges that monetary policy is now "well placed to respond to developments" - language that subtly signals this may not be an open-ended hiking cycle. Markets are pricing in another 35 basis points by year-end (reaching 4.70%), and the RBA's forecasts are built around that path. The Board is not pushing back on that pricing, but it is reserving judgement. In plain terms: more hikes are possible, but the bar for further action is rising.

A supply shock on already stressed ground

Australia entered this conflict in poor shape on inflation. GDP was above potential, capacity utilisation elevated, underlying inflation at 3.5%, and the labour market still tight. The conflict then delivered a textbook supply shock with oil up 66%, LNG up 44%, and the Strait of Hormuz closure removing roughly 10% of global oil and 20% of global LNG supply from circulation. The RBA attributes Australia's position as awkward - benefiting on export revenues from LNG and coal, but hurting on the import side where diesel prices are up 51%. On balance, the direct GDP hit is modest so far and early spending data support that but the inflation hit is real and front-loaded, which is why the RBA had to act.

A genuine policy dilemma

The RBA deserves credit for laying out two adverse scenarios explicitly. The numbers are sobering. Scenario 1 (prolonged conflict, oil peaks ~US$145/bbl) sees headline inflation hit 5.2% and GDP around 0.5% below baseline by mid-2028 which is uncomfortable, but manageable. Scenario 2 adds a confidence and demand shock which includes sharp equity falls, precautionary household and business spending cuts. Counterintuitively, inflation peaks lower in this scenario, but at the cost of unemployment rising to 5.1% and inflation undershooting target by mid-2028 under the assumed rate path.

The implication is clear: the appropriate policy response looks very different depending on how the conflict evolves, which is why the Board is signalling conditional caution rather than committing to a policy direction.

Costs are biting, pricing discipline won't last

The business liaison findings are interesting. The frequency of cost-increase mentions is higher than at any point in recent decades. Fuel surcharges cascaded through supply chains almost immediately; construction, agriculture, retail and hospitality are all feeling it. 

Yet most consumer-facing firms haven't raised final prices yet, citing competitive pressure, margin buffers, and uncertainty about the conflict's duration. 

The RBA has built faster-than-historical pass-through into its forecasts because inflation expectations were already elevated and firms have fresh post-pandemic muscle memory for raising prices. Once pass-through begins in earnest from the June quarter, particularly in construction, groceries and travel, the second-round impulse could prove stickier than the baseline assumes.

On wages, hiring intentions have softened but haven't broken. Workers are beginning to factor higher inflation into bargaining: a dynamic the Board is watching carefully.

Higher, longer, thinner margin for error in forecasts

The revisions tell a consistent story. Headline CPI peaks at 4.8% in mid-2026 (vs 4.2% previously) and underlying inflation stays above 3% until mid-2027, roughly six months added to the disinflation timeline. The return to the 2.5% midpoint is pushed to mid-2028. Growth is revised modestly lower throughout, weighed down by weaker household consumption momentum and additional monetary tightening now baked into market pricing. Unemployment drifts to 4.7% by mid-2028, leaving the economy with just enough spare capacity to bring inflation home.

The bottom line: the RBA is threading a narrow needle - tightening enough to anchor expectations without tipping into a scenario where unemployment rises sharply. That's achievable under the baseline, but the Middle East conflict has made the margin for error meaningfully thinner.