RBA’s narrow pathway on inflation will need to widen

In response to the post-pandemic surge in inflation in 2022, the Reserve Bank took what it described as a narrow pathway approach to meeting its objectives.

In short, it tightened monetary policy by less than other central banks, as it hoped to stay close to full employment while still getting inflation to fall back to its 2.5 per cent target.

But did the RBA’s ‘narrow pathway’ ever exist?

With core inflation now above the RBA’s 2.5 per cent target for four years and once again rising, it is tempting to say it did not.

Our sense is that it did exist, but it was so extremely narrow that it was difficult to stay on it. Policy settings and the assessment of the economy needed to be very precise, which is particularly difficult in a highly uncertain global and local policy environment.

As we see it, the narrow pathway existed, but the economy fell off it. While we can never know the counter-factual, had the RBA not cut its cash rate in 2025, or not by as much, the economy might have stayed on the “narrow pathway”.

As regular readers of this newspaper may recall, we have asked the question about the existence of the narrow pathway before, in an opinion piece in November 2023. As we said at that time, we thought the RBA was trying to achieve something “extraordinarily ambitious”.

“A more significant economic downturn, or perhaps even a recession, will be needed to get inflation sustainably back to target.”

In the end, the RBA had more success than we had thought it might. From mid-2022 to mid-2025, core inflation fell from 6.8 per cent to 2.7 per cent and the unemployment rate only rose from 3.5 per cent to 4.2 per cent.

But the approach came unstuck in the second half of 2025. Two things seemed to go wrong. First, the economy hit its capacity constraints earlier than the RBA had expected. This was partly because the supply side of the economy was weaker than the RBA (or Treasury) had expected – because of weak productivity growth.

As a result, the “speed limit” of economic growth turned out to be lower than the RBA or Treasury had assumed – closer to 2 per cent than to 2.5 per cent.

The RBA did adapt, and revised down its assumption for productivity growth, but not until August 2025, by which time inflation had already started to rise.

Treasurer Jim Chalmers announced in a speech last week that the upcoming budget in May will also, finally, start to assume lower productivity growth.

However, there were some tell-tale signs that the economy was operating beyond its capacity in mid-2025. Surveyed capacity utilisation started to rise in mid-2025 and the unemployment rate remained below the RBA’s own estimate of full employment throughout the period and still is.

In addition to a weak supply side, demand also turned out to be stronger than expected, partly reflecting stronger-than-projected public spending through 2025.

Second, the RBA judged that monetary policy was still tight, when in fact the rate cuts it delivered last year seem to have taken it into expansionary territory. In short, the neutral rate of interest – which is always very difficult to estimate – seems to have been higher than the RBA was assuming.

Why does this matter now?

Primarily because inflation is still above target and the next global inflationary shock has just arrived, which has left the RBA with far less wriggle room in its policy setting now.

As a result, the RBA has already lifted rates by 50 basis points so far this year, while no other G10 central bank has lifted rates at all.

As we see it, there is now unlikely to be another narrow pathway because the challenge is different. With core inflation already above the RBA’s 2.5 per cent target for four years, a further extended period of above-target inflation would question the credibility of the RBA’s inflation target.

A swifter return to target is now likely to be needed as there is an increased risk that inflation expectations become unanchored. After all, if the RBA never actually achieves its 2.5 per cent target, why would people continue to believe that it will? And if people assess it that way, it may unanchor inflation expectations.

This time it is likely that a more significant economic downturn, or perhaps even a recession, will be needed to get inflation sustainably back to target.

The global energy shock may deliver it, or the RBA may have to make it happen with more substantial monetary tightening.

Fiscal policy has a role to play as well. The key for the May budget is that it

focuses on productivity-enhancing reform to help lift the economy’s speed limit and that it does not add to the inflation challenge by delivering broad-based fiscal stimulus. Any fiscal support ought to be highly targeted.

There is unlikely to be a narrow pathway this time.

This article first appeared in the Australian Financial Review on 26 March 2026.