The Reserve Bank of Australia (RBA) has warned inflation expectations risk becoming more deeply entrenched as the economic fallout from the Iran conflict compounds already elevated domestic price pressures, reinforcing the central bank’s decision to lift interest rates earlier this month.
Speaking at the Bloomberg Forum for Investment Managers in Sydney on 19 May,, RBA assistant governor Sarah Hunter said the latest oil shock had arrived at a particularly difficult time for the Australian economy, with inflation still above target and capacity constraints persisting across parts of the economy.
Her comments came as the RBA’s May board minutes revealed policymakers remained concerned inflation could prove more persistent than previously expected, particularly given the combination of strong domestic demand, constrained supply capacity and rising energy costs.
The minutes showed board members considered the risk that higher oil prices could feed more broadly into prices and wages, while also acknowledging inflation had moderated more slowly than anticipated in recent months.
Hunter said the central bank remained focused on preventing short-term inflation shocks from becoming embedded in longer-term expectations among households and businesses.
“The recent rise in oil prices is particularly challenging to navigate. Higher oil prices mean higher costs and higher consumer prices in the near term – that is a given,” Hunter said.
“But this shock has come against a backdrop of elevated capacity constraints and domestic cost pressures.”
The RBA raised the cash rate to 4.35 per cent at its most recent meeting, with the board concluding tighter policy was needed to ensure inflation returned sustainably to the 2–3 per cent target band.
According to the minutes, members judged inflation risks had become “more balanced but still tilted to the upside”, particularly as stronger-than-expected demand and persistent services inflation continued to weigh on progress returning inflation to target.
Hunter echoed those concerns in both her speech and subsequent Bloomberg TV interview, noting RBA research suggested businesses were more likely to pass higher costs through to consumers when inflation was already elevated and capacity remained tight.
“Our research suggests pass-through will be faster and more extensive, and the risk of inflation expectations drifting higher is elevated,” she said.
The assistant governor said Australian petrol prices rose by 36 per cent at their peak following the conflict, while diesel prices remained significantly above pre-conflict levels.
The RBA’s latest forecasts expect headline inflation to peak at 4.8 per cent in the June quarter, substantially higher than projected in February, largely due to the direct and indirect effects of higher fuel prices. Underlying inflation has also been revised higher in the near term.
Hunter said policymakers were paying particularly close attention to inflation expectations, especially as fuel prices remained highly visible to consumers.
“We know that in particular when households see movements in fuel prices – so when you drive past a petrol station every day and you see the cost of diesel, it’s higher than it was pre-conflict – we know these are particularly salient, that they can have an impact on expectations,” she said.
“What we’re seeing at the moment is that short-term expectations … are elevated.”
While Hunter said medium and longer-term inflation expectations had not yet become unanchored, she acknowledged the environment remained highly uncertain and subject to rapidly changing geopolitical developments.
“The longer it goes on, obviously the longer prices remain elevated for oil and other products, the more that will come through into the local economy and will make that inflation outcome worse,” she said.
The RBA minutes similarly noted uncertainty surrounding the Middle East conflict remained a key risk to both the inflation outlook and broader economic activity.
Hunter also highlighted signs domestic capacity pressures had re-emerged during the second half of last year, partly reflecting stronger-than-expected household demand and a more resilient global economy than anticipated.
“We’ve got a stronger pickup in domestic demand than we were expecting,” she said.
“Some of the fallout from tariffs that we were discussing a year ago perhaps wasn’t as severe as many people were expecting.”
The assistant governor said the RBA remained committed to bringing inflation back to target, despite the increasingly complex backdrop confronting policymakers globally.
“We think we can do it. Absolutely. And we have a lever to do it,” she said.
Hunter also flagged weaker productivity growth as another challenge for policymakers, with the RBA currently estimating productivity growth at around 0.7 per cent year-on-year over the near term, below historical averages.
“If we could see that productivity pace pick up a bit and that didn’t come through in inflationary pressures, that would be great,” she said.
“It’s not a policy that we have really any control over. We don’t have the right levers.”
When asked whether Australia could avoid recession as economic growth slowed in the second half of the year, Hunter said the RBA’s baseline forecasts did not currently anticipate a downturn, although risks remained on both sides of the outlook.
“These kinds of supply shocks are really hard for us to navigate in terms of achieving our mandate,” she said.
“And so we’re focusing on what that means and then giving our best advice to the Board so they can make their decisions.”
