The next RBA rate move is more likely to be up than down

Third-quarter inflation surprised sharply to the upside, and when a big surprise like this comes along, there are typically two possible responses.

One is to dismiss the data as statistical noise that will prove temporary. However, this is difficult to do on this occasion. The rise in inflation was broad-based, the upside surprise was substantial, and it affected all the key core measures designed to strip out the volatility.

About 50 per cent of inflation components rose by more than 3 per cent, the highest share in six quarters, and the trimmed mean – the RBA’s preferred measure – jumped to the top of the target band at 3 per cent year-on-year.

The other possible response is to try to explain why inflation has picked up more than expected.

Of note, economic growth has been stronger than expected, lifting demand, which could be putting more upward pressure on inflation. However, as growth has been only a bit faster than the RBA’s forecast, it will be hard to argue that a surprisingly strong upswing in demand has been the driving force.

Instead, it probably reflects the supply side of the economy being weaker than originally assumed.

For us, weak productivity holds the key. The last time the RBA published forecasts in August, it revised down its own working assumption for productivity growth, which is something the central bank does not do very often. It may turn out that its new, lower assumption is still too high.

The RBA is assuming productivity growth of 0.7 per cent a year, but the average over the past decade is just 0.3 per cent. HSBC’s working assumption is 0.4 per cent.

If it turns out that the rate of productivity is lower than previously thought, it means the potential growth rate for the economy – its “speed limit” – is lower as well.

This means that even the current pace of economic growth, with GDP rising by 1.8 per cent over the past year, might already be faster than the economy can sustain.

This is only a moderate rate of growth compared with history, and the economy may still feel quite sluggish to some observers. Unfortunately, this might be as good as it gets in an economy with dismal productivity growth.

Demand is outpacing supply

There are now two stats that support this view.

One is capacity utilisation, which has risen again recently. It never fell below its long-run average, even when the economy slowed markedly in 2024, and is now at levels that imply the economy is operating beyond its capacity.

The other is last week’s inflation print, which implies that demand is now outpacing supply.

This will keep the RBA firmly on hold this week, and we expect the central bank’s tone to be hawkish. Inflation concerns will once again be in the spotlight.

“Time will tell, but we may soon be asking whether the RBA should have cut as much as it has.”

These developments should also invite the RBA to reassess some of its underlying assumptions about the economy.

First, as discussed, it may mean the potential growth rate is even lower than expected. The output gap – or the difference between growth in demand and supply in the economy – probably never closed, and the risk now is that it could get more positive, supporting more inflation.

Second, the RBA may judge that the current cash rate setting is not as restrictive as it had thought. That is, the neutral rate – which is the interest rate that neither slows growth nor speeds it up – may be higher than it had assumed.

After all, if monetary policy is currently restrictive, as the RBA has been claiming, why are growth and underlying inflation in an upswing?

Finally, these developments may firm up the RBA’s own published view that the “full employment” level of the unemployment rate is 4.5 per cent, rather than the lower estimate from the Treasury of 4.25 per cent.

If inflation is already rising with the unemployment rate at 4.3 per cent in the third quarter, it is hard to argue that there is spare capacity in the jobs market.

Time will tell, but we may soon be asking whether the RBA should have cut as much as it has. After all, core inflation never made it back to 2.5 per cent and the unemployment rate has remained below the central bank’s own estimate of full employment.

We don’t expect more rate cuts, and although any change in the cash rate looks to be some time away, the next move is more likely to be up than down.