Reserve Bank worries about inflation pressures building, risk of a recession

The Reserve Bank is growing increasingly anxious about price pressures building in the economy.

Speaking in Sydney today, the RBA's chief economist, Sarah Hunter, said the warning signs of further price hikes were evidenced by rising "inflation expectations".

Inflation expectations refer to how people's beliefs about where prices are heading can influence their decisions.

For example, if you expect prices will continue to rise, you may be influenced to buy something now rather than later at a potentially higher price.

That would then add to higher demand and prices in the short term, meaning inflation expectations can become self-reinforcing.

The central bank now sees this phenomenon as a clear and present danger, especially given the ongoing conflict in the Middle East and the resultant oil price shock.

"If expectations rise persistently, it becomes harder for the central bank to bring inflation back to target, as it must both bring expectations back down and restore the balance between supply and demand," Dr Hunter told an investment gathering hosted by Bloomberg.

The latest official figures show headline inflation at 4.6 per cent for the 12 months to February 2026.

The trimmed mean, a measure of underlying or core inflation, was 3.3 per cent over the same period.

With core inflation already well above the RBA's bullseye target of 2.5 per cent, any further price pressures in the economy will need stamping out.

Recession fears brought into inflation discussion

While inflation expectations have, according to the RBA, so far been anchored, Dr Hunter says it now has evidence further price pressures may be building.

She says the central bank's liaison program, which collects information from businesses and industry associations, suggests that price rises are flowing through the economy, "with fuel surcharges raised by firms at the start of supply chains that flow into a broad set of industries".

"For example, some construction firms, who have been relatively highly exposed to transport and oil-derived raw materials cost increases, are reviewing prices for new contracts.

"This is particularly the case in regions where demand is still growing strongly and supply capacity is constrained, consistent with the findings of our recent research."

The risk now is that unanchored inflation expectations, with an ongoing oil supply shock, could see inflation push higher.

This, Dr Hunter warned, would result in further interest rate hikes to quash demand sufficiently to bring inflation down.

"Doing so may require a more substantial slowing of economic activity, as we saw during the early 1990s recession," she said.

"So it's crucial for central banks to keep inflation expectations anchored around the inflation target."

Dr Hunter's remarks were consistent with discussions by the interest rate-setting board ahead of its decision to raise the cash rate this month.

Oil price key to inflation

The board minutes, published Tuesday, show members are watching rising bond yields, as they relate to global financial market perceptions that many advanced economies are managing the potential for another inflation breakout.

"Government bond yields had also increased, particularly at longer maturities," the minutes showed.

The wild card remains the duration of elevated oil and fuel prices.

"The rise in fuel prices had already had an impact on inflation and short-run inflation expectations in Australia," members noted.

"It was also consistent with staff analysis showing that pass-through of cost increases to final prices tends to be faster and larger when inflationary pressures are already high or have been high in the recent past.

"Measures of long-run inflation expectations remained consistent with the inflation target, although members discussed the ways in which this could change."

One way this may change is through planned tax reforms stemming from the federal budget.

"We'll be looking to see what impacts some of those changes to tax treatments and how they flow through into the housing market, how they might flow through the economy more broadly," Dr Hunter told the Bloomberg gathering.

"We're still digesting the budget and what it means, and so we'll have more to say about it in coming months in our next set of forecasts, and beyond that … in general, that household wealth channel is important."

RBA to monitor housing market

Dr Hunter acknowledged that future lower household wealth would feed into monetary policy discussions. For example, if house prices were to fall.

"But in the type of scenario … if it's a weaker outlook for consumer spending, then that flows through to weaker aggregate demand," she said.

"And again, monetary policy will respond to that as appropriate.

On a more positive note, Westpac's latest consumer sentiment survey showed the recent short-term reprieve from sky-high fuel prices is lifting spirits among shoppers.

Consumer sentiment rose by 3.5 per cent in May, partly reversing April's sharp decline.

"The improvement in consumer sentiment follows a decline in fuel spending, reflecting the halving of the fuel excise and lower oil prices," the report said.

The survey period coincided with the federal budget.

"Responses over the course of the survey week show a slight improvement in sentiment following the federal budget announcement on Tuesday. This is despite few consumers expecting to benefit directly," Westpac economist Matthew Hassan wrote.

He said the budget's "intergenerational" themes had been reflected in a notable skew in responses across different age groups.

"Among baby boomers and generation X, those expecting to be worse off [from the budget] outnumbered those expecting to benefit by 30 to 36 per cent compared with a gap of just 9 per cent for millennials and small net positive spread (+1 per cent) among generation Z (or zoomers)."

The "time to buy a dwelling" index fell by 16.1 per cent to 72 per cent, its lowest level since late 2024.

"Most of the fall came before the budget with post-budget responses showing a slightly less pessimistic read of 74.8, [per cent]," Mr Hassan said.