Australia’s Inflation Fight Raises Recession Risks as Rate Hikes Loom

Australia’s inflation problem is putting the Reserve Bank of Australia in a tight spot: with supply still constrained and energy costs rising, rate hikes may be the quickest way to cool demand, but they also increase the risk of recession.

The RBA has already raised rates four times, yet inflation is climbing. The pressures come from several directions. Conflict in the Middle East has pushed global energy prices above the levels assumed in the bank’s August forecasts, demand tied to artificial intelligence is lifting prices for technology goods, and domestic capacity remains under strain.

That mix matters because higher borrowing costs can restrain spending, but they cannot quickly expand the supply of goods, services or energy. The policy choice is therefore uncomfortable: productivity and capacity need to improve, while demand may have to weaken if they don’t.

Supply constraints meet stubborn demand

The RBA’s latest statement said inflation was already too high and that some upside risks identified in August were materialising. It pointed to the widening Middle East conflict, higher global energy prices and rapid increases in technology related costs associated with AI demand. The bank also cited ongoing pressure on domestic capacity.

In practical terms, businesses are facing higher input costs while customers continue to spend. The RBA’s business liaison program indicates that firms are considering passing production cost increases on to customers. When those increases spread through the economy, inflation can persist even as households feel the squeeze.

There has been a modest improvement in one supply side measure. GDP per hour worked, a measure of labour productivity, reached zero in the latest national accounts after spending time in negative territory. But the measure was still down 0.2 per cent over the year. That is too little progress to ease the underlying capacity problem quickly.

Business investment added nothing to GDP in the June quarter, while household consumption contributed 0.2 percentage points. That result has focused attention on household spending as a source of demand. Yet it also shows why the policy problem is broader than consumer behaviour: weak investment and subdued productivity limit the economy’s ability to meet demand without price pressure.

Energy costs could keep inflation elevated

The conflict involving Iran is tightening oil supplies and pushing fuel prices higher. That raises costs across the economy, from transport to production, and adds to household expenses. If businesses expect those costs to stay high, they may be less willing to reverse price increases later.

RBA deputy governor Andrew Hauser has described signs that some companies are beginning to question whether prices will return to their previous levels. If firms expect elevated costs to endure, they may build that expectation into future pricing decisions. The danger for central bankers is that expectations of persistent inflation become harder to dislodge.

That possibility strengthens the case for keeping demand in check, but higher rates work through household budgets and business decisions rather than directly resolving supply shortages. Mortgage payments and other borrowing costs rise; consumers have less to spend; and firms may see weaker sales. A slowdown can eventually reduce price pressure, though the path may involve job losses and weaker output.

Economists see different paths for rates

Former National Australia Bank chief economist Alan Oster sees a serious downside if the RBA has to tighten much further. He said his worst case would involve two or three additional rate rises, which he believes would clearly cause a recession. Oster also expects weaker growth and unemployment potentially rising above 5 per cent if that scenario plays out.

His warning captures the trade off facing the central bank: rates may need to rise enough to cool demand and prevent inflation expectations from drifting, but the same restraint can push the economy into contraction. Oster’s forecast remains conditional; he said he would wait to see the RBA’s decisions before revising his outlook.

Betashares chief economist David Bassanese expects a more limited tightening cycle. His base case is for a rate rise at the RBA’s next meeting, followed by a hold at the final meeting of the year in December. That would offer households some relief before Christmas, although Bassanese says the risks remain tilted toward further increases.

Bassanese points to signs of weakness in the economy, including a very weak outlook for house prices, as reasons the RBA may not need to lift rates again in 2027. If it does, he warns, recession risks would intensify.

State Street Investment Management economist Ma Krishna Bhimavarapu also expects the cash rate eventually to reach a level beginning with five. The timing, he says, will depend on how quickly the economy slows in the coming months. That leaves the next rate decisions tied closely to incoming evidence on activity and inflation.

The cost of waiting

Treasurer Jim Chalmers has said the government is managing the budget more responsibly than its predecessors and accepts its role in fighting inflation. But fiscal restraint alone has not resolved the mismatch between demand and the economy’s capacity to supply. Productivity remains weak, private investment was flat in the June quarter, and external energy costs have moved higher.

That leaves the RBA relying heavily on monetary policy. Higher rates can reduce spending, but if household demand falls sharply, the effects can travel through employment and business income. A shop that stops replacing departing staff, for example, reduces the income available to those workers and can contribute to further declines in spending.

The immediate outlook therefore hinges on two competing developments: whether inflation stays persistent as energy and other costs feed through, and whether economic activity weakens enough to restrain prices without a deeper downturn. Oster’s recession scenario is a warning about the cost of additional tightening; Bassanese’s more restrained forecast shows that economists still see room for the economy to slow without further rate increases next year.

For now, Australia’s weak productivity leaves little room to meet demand through a rapid expansion in supply. The RBA’s next steps will depend on whether inflation cools before the burden of higher rates becomes visible in jobs and growth.