Balancing Global And Local Uncertainty – What Will The RBA Do Next?

Key points:

• Recent data confirms that Australian inflation remains too high.
• In the absence of the Iran conflict, the RBA would likely raise interest rates again in May to provide greater confidence that inflation will moderate back to around 2.5%.
• The situation in the Strait of Hormuz continues to be the most important near-term driver of the economic outlook. An extended disruption could lead to global recession, while a near-term resolution would likely support improving outlooks in both the Australian and US economies.
• The Middle East conflict complicates the RBA’s decisions. While inflation will likely rise further in the near term, there has also been a very significant impact on consumer and business confidence and auction clearance rates. Ordinarily the RBA would not consider raising interest rates with this level of uncertainty.

The March quarter CPI confirms that Australian inflation remains too high

Australian inflation was already too high even before the release of the March and Q1 CPI data this week. The outcomes were a little better than expected with the important trimmed mean measure printing at 0.8% q/q and 3.5% y/y.  This compares unfavourably with the RBA’s 2.5% target for inflation. Above-target inflation is the reason the RBA Board voted to increase interest rates at its February and March board meetings and why a further interest rate increase might well be on the cards next week.

The latest data of course largely reflects conditions before the sharp increase in fuel prices that transpired in March. Prices have eased somewhat in April, as global oil prices moderated in the early part of the month, but would be even higher without substantial support by Australian governments to temporarily reduce fuel taxes until June in the hope the Middle East situation can be resolved by then.

Before this assistance, which commenced in April, petrol prices rose 33% in March, directly adding around 1.1 percentage points to the monthly and annual inflation rate. Diesel prices rose even more sharply, which will add substantial broad-based pressure to prices, given diesel’s importance in transport and production processes throughout the economy.

How to incorporate the Middle East conflict into the economic outlook 

It’s probably easiest to consider the outlook for the economy and interest rates under two scenarios:

1. The pre-Iran outlook; and
2. The pre-Iran outlook with an energy shock “overlay”.

Encouragingly, prior to recent developments in the Middle East, the economic outlook in Australia and the important US economy was improving. This reflected a combination of continuing strength in AI investment spending (particularly in the US), associated data centre rollouts globally, the beneficial effects of interest rate reductions in 2025, upturns in parts of mining, commercial and residential construction, and continuing tailwinds from spending on health, ageing and defence.

The surge in oil prices in the past two months is mostly due to the closure of the Strait of Hormuz, through which 20% of global energy supplies transit daily. Two very different paths for the world and Australian economies present, depending on how the conflict plays out. An extended closure of the Strait of Hormuz threatens not only much higher oil prices, but potential interruptions to supply also. Together, the increase in business costs would likely lead to recession as consumer demand drops and firms respond by cutting production and staff. That scenario could be accentuated if central banks raise interest rates to combat higher inflation.

The situation however could also quickly unwind if agreement was soon reached to re-open the Strait of Hormuz. If the period of closure totalled only three months (relatively short-lived in economic and business terms), there would be a good prospect of the re-establishment of the pre-existing more favourable economic outlook that was emerging.

The RBA Monetary Policy Board's May Decision

There have been plenty of occasions when commentators have not made the distinction between what the RBA should do, and what they will do.

The Board will need to consider the following:

• An above-target inflation starting point that in the absence of the sharp rise in energy prices in March and April would likely have seen the Board vote for another interest rate rise either in May or June. There is considerable risk that inflationary expectations and pricing and wages behaviour will permanently shift higher if inflation remains above 2.5% for another extended period.
• The duration of any Strait of Hormuz disruption remains highly uncertain. A quick resolution could see the recovery re-establish, while a prolonged disruption could push the economy toward recession. With monetary policy operating with a lag of six to nine months, any decision now may take effect in a very different economic environment.
• Sharp drops in consumer and business confidence and auction clearance rates. Ordinarily, it would be inconceivable to envisage the RBA tightening policy in the wake of such negative developments and it’s a reminder that the economic data will be a long way behind the real economy at times such as now. This will likely make the information the RBA is hearing through its business liaison program very important in the May decision.
• The May budget is likely to incorporate spending restraint.

These are all important considerations, with a number of inherent conflicts. If it were not for the Iran conflict, the RBA would likely increase interest rates again to be more confident inflation will return to target, perhaps earlier than the mid-2028 date forecast in February.

While the Board may still decide to do this next week, given the very significant drops in business and consumer confidence and in auction clearance rates, a prudent course of action could also be to await further information on how the conflict might play out for the economy.

What it means for your business  

It’s again a very uncertain time and one that for many businesses will include both a drop in consumer demand and a substantial increase in transport and other input costs.

If the situation in the Strait of Hormuz can be resolved soon, there’s a good prospect that the economy can re-establish the prior improving trajectory with considerable opportunity presenting through defence, mining, aged care, commercial and residential construction, renewables and AI.

Unfortunately, recent inflation outcomes suggests the RBA will lift interest rates further in the months ahead unless the Strait of Hormuz is closed for an extended period, which would likely usher in much less favourable business conditions. While this will be unwelcome news for many businesses and those with mortgages, the very large increase in the cost of living and the cost of doing business in recent years has also been very challenging. That’s why the RBA attaches so much importance to returning inflation to 2.5%.

Author: Ivan Colhoun  Consulting Economist for Bank of Sydney Bachelor of Economics (Hons) Ivan is a highly experienced chief economist and keynote speaker on the Australian economy and financial markets. His career has included leadership roles within financial and professional service organisations, as well as the Reserve Bank of Australia.