Our economic outlook for Australia

Elevated inflation remains the overriding concern of the Reserve Bank of Australia (RBA). Despite falling housing prices, trimmed-mean inflation remained elevated at 3.7% year over year in the third quarter, well above the RBA’s target range and its earlier forecast. Higher oil prices skew near-term inflation risks to the upside, while AI-related data-center investment is adding to demand and capacity pressures. More fundamentally, the economy continues to operate beyond its sustainable capacity, with unemployment low by historical standards. This raises the risk that above-target inflation becomes embedded in wage- and price-setting behavior. Preventing that outcome is arguably a more pressing challenge for the RBA than for many other major central banks.

Weak productivity remains the economy’s key supply-side constraint. Although growth has slowed and unemployment has risen, the output gap—how far the economy is running above a level consistent with stable inflation—likely remains positive, albeit narrowing. This suggests that weaker potential growth is limiting the extent to which slowing activity eases capacity pressures. Subdued productivity has also contributed to an acceleration in unit labor cost growth. Together, weak productivity and a tight labor market are sustaining domestic cost pressures, making the disinflationary impulse insufficient to return inflation to target within an acceptable timeframe.

How the RBA addresses developments continues to shift. Its recent hawkish turn signals a move toward a more forceful approach to inflation control. This implies greater tolerance for economic weakness and less willingness to ease policy preemptively as signs of monetary policy transmission emerge. With inflation persistent and weak productivity constraining potential growth, a further moderation in demand is likely needed to restore balance between demand and supply.

Our base case is that the RBA pauses for the remainder of the year as it assesses the effects of its 25-basis-point rate hike, to 4.85%, on November 3. This outlook depends on clearer evidence of slowing demand, easing labor-market conditions, and sustainably lower underlying inflation. If activity proves more resilient than expected, or higher energy prices generate broader and more persistent inflation pressures, an additional rate increase remains a material risk.