4 December 2025
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Until a few months ago, the RBA was sitting pretty. It looked like they had achieved their goal of delivering a ‘soft landing’. Growth was improving, thanks to a more confident consumer and rising house prices. The tight labour market was moving back into balance and wages growth was easing; all without a sharp rise in unemployment. And trimmed mean inflation was back in the target band and forecast to land at 2.6%, even assuming two or three more interest rate cuts in this cycle.
Today, the picture looks far more complicated. Inflation surprised us all in the September quarter (chart 1). The trimmed mean CPI jumped by 1.0% in the quarter (here). Unemployment spiked to 4.5% in September, but then quickly backtracked to 4.3%, with a strong 42.2K new jobs created in October. And house prices have accelerated more rapidly than expected, led by surging investor demand and support for first home buyers.
This has complicated the interest rate outlook and raises difficult questions for the RBA Board heading into 2026. The RBA didn’t give much away in its November Statement — maintaining their cautious approach. Their updated forecasts built in the September inflation surprise and flowed through a little more price pressure into the December quarter (we estimate they now have a trimmed mean forecast of 0.8%/qtr in Q4 25, up from 0.6%).
More important was the recent speech by Deputy Governor Hauser (here) which gave a clear indication that the RBA is worried about the starting point for this cyclical upswing and the implications for interest rate policy.
As Hauser articulated in his speech, there are two alternate ways of looking at the current economic picture (and one future scenario).
• On one view of the economy, monetary policy is still restrictive, the economy is growing below potential, the labour market is broadly back in balance (and softening), wages growth is easing, and the spike in inflation is largely driven by temporary factors.
In this world, we should see inflation ease back again over coming months, and the annual rate fall back towards the middle of the target band through 2026 and 2027. Unemployment could rise a little further. This would likely see at least one rate cut in 2026.
• On another view of the economy, monetary policy is no longer restrictive, financial conditions are loosening, demand is lifting strongly and starting to hit supply constraints, real unit labour costs are still too high, and the inflation surprise was more persistent, owing to demand outpacing supply.
In this world, inflation should continue to run a bit hot into early 2026, the labour market will stabilise and again start to tighten, and, in time, this will feed into broader wage pressures. This would bring rate hikes firmly onto the table in 2026.
In our view, the spike in inflation in the September quarter does contain some signal. But not enough to prove that demand is now outstripping supply across the broader economy.
Trent Saunders has recently unpacked the inflation surprise in more detail (here). He found that roughly three‑quarters of the quarterly acceleration in headline inflation came from transitory price categories, while the remaining quarter was driven by persistent categories (chart 2).
Housing costs were a key contributor to higher inflation in the September quarter. This element does look like a capacity issue. The construction sector remains highly constrained and dwelling approvals have risen by almost 10% since the start of the year (chart 3).
With house prices also on the rise, it is not surprising that dwelling costs are again picking up. This pressure had been building prior to the September quarter release (chart 4). Given the large weight of housing in the CPI basket, this is material for the inflation outlook. If the housing market continues to strengthen, we should expect more price pressure.
Another key area of strength was market services prices. Our current assessment is that this mainly reflects temporary margin rebuilding, rather than broad capacity constraints. Demand for many of these discretionary services fell sharply during the cost-of-living squeeze, supressing profits and making it harder to pass on higher input costs.
With demand and general business conditions picking up, these firms look to have taken advantage of that to opportunistically claw back some profit margin. The areas of inflation strength broadly match the strength we are seeing in our internal consumer spending data (chart 5).
This margin rebuilding process could persist for several months, if demand stays relatively strong. We expect this, along with higher dwelling costs, to keep inflation a little elevated as we move into 2026. As such, we have lifted our trimmed mean forecast for Q4 25 to 0.8% (from 0.6%).
This is one key reason why we don’t expect further rate cuts in the near term. Even if we have not hit full capacity across the economy, annual trimmed mean inflation will simply be too high for the RBA Board to be comfortable cutting rates.
The inflation spike may not represent a ‘smoking gun’ (i.e. proving that the economy has run out of spare capacity) but that doesn’t mean we are out of the woods. Over time, the economy cannot grow above its potential rate, without generating inflation pressure. And three facts appear clear:
Harry Ottley recently updated our estimate of Australia’s potential growth rate to 2.1% (here). Persistently weaker productivity growth has dragged down our growth ‘speed limit’ over time. This is a common global story, but Australia has not been able to buck the trend, despite impressive improvements in female and older-age participation in the labour force.
In his speech, Deputy Governor Hauser noted that Australia is starting this cyclical upswing with less spare capacity than in past cycles (chart 6). We agree, and this matters a lot for the inflation and interest rate outlook.
For much of the pre-COVID decade the Australian economy was operating with substantial excess capacity. GDP growth was relatively tepid, real wages were hardly growing, and the unemployment rate sat between 5-6% (above most current estimates of full employment). The result was that inflation regularly undershot the RBA target band (chart 7).
The labour market has softened considerably since unemployment hit 3.4% in October 2022, but at 4.3% the jobless rate still sits well below pre-COVID levels. Total labour utilisation (unemployment and underemployment) also hasn’t weakened as much as the headline rate (chart 8). This helps to explain why many firms still report finding it difficult to find workers.
The strength of public spending during this cycle, notably on health, disabilities and infrastructure, has also left us with a smaller output gap than a normal cycle, despite weakness in private demand.
In many ways this is something to celebrate. Unlike past cycles, the RBA hasn’t had to ‘break’ the economy and drive-up unemployment to bring inflation back under control. Equally, running an unemployment rate at closer to 4.5%, rather than 5.5% is a major structural improvement.
However, this lack of spare capacity (or starting headroom), combined with a lower growth ‘speed limit’ does present new challenges. It means that whenever growth improves, inflation will emerge more quickly. The RBA will need to remain ‘on alert’ to this risk, meaning interest rates can’t fall as far, and rates will need to stay higher than in past cycles.
So, have we breached this speed limit already? Is inflation likely to continue picking up over coming months, requiring a monetary policy response? In our view, the answer is no, but we are getting closer. Our assessment is that the economy is close to full capacity, but not yet beyond it.
Annual GDP growth in Australia stepped up to 1.8% in Q2 25 and has likely strengthened further since then. We forecast the economy will be running just above potential (at 2.2%) by March 2026 (chart 9). Importantly, that is where we expect growth to top out. In our view, slower household income growth, modestly restrictive monetary policy, and the shift from an easing to a hiking bias on rates will see growth stabilise at around potential. The RBA November forecasts have growth peaking a little lower at 2.0%.
Survey measures are a useful cross-check on the official GDP data. The composite PMI (manufacturing and services) has strengthened and sits at around 52.6 in October. This suggests the economy is steadily expanding. Capacity utilisation has also been increasing recently, after a steady decline, and is sitting at relatively high levels by historical standards (chart 10).
The labour market is harder to read but appears to be broadly in balance and close to full employment. Nominal wages growth has been steadily falling, and trend unemployment sits at our current estimate of the NAIRU at 4.4%. Job vacancy data is mixed, some measures have come off quite sharply — some measures are now back to pre-COVID levels, but others remain a little elevated (chart 11).
Our internal data provides a leading signal on wages and employment. It suggests that both measures have started to stabilise. It will be important to watch these series closely for any signs of a strengthening in the labour market that could signal broader capacity constraints.
Trent Saunders and Harry Ottley will shortly update our estimates of the output gap and the NAIRU to shed more light on this question.
Our house view is that the economy is currently close to full capacity, but that it will stay at around that level throughout 2026. Near term inflationary pressures around housing and market services, combined with a general lack of spare capacity in the economy, will prevent any further rate cuts. At the same time, given we don’t expect growth to rise above potential, we don’t expect inflation to lift further, avoiding the need for rate hikes. As a result, we are forecasting steady interest rates through 2026.
The main risk to this view is that a) capacity is more constrained than we currently judge and/or b) the economy continues to build up steam and grows above potential in 2026. Both are possible and this would see the prospect of interest rate hikes come onto the table in 2026.
As always, inflation and the jobs market will be the key indicators to watch moving forward. The new monthly CPI indicator complicates the picture, given the RBA does not have a track record interpreting this series. In our view, if the full quarterly CPI outcome for December is above 0.8% and the trend unemployment rate turns around and starts to decline, the RBA will be forced to adopt a much more hawkish tone at their February meeting, and the possibility of rate hikes in 2026 will come back onto the table.
The key downside risks centre around the labour market. A material lift in the unemployment rate would suggest more capacity in the economy, with scope for inflation to ease more quickly. There is also a risk that a hawkish RBA could take more heat out of the consumer recovery and the buoyant housing market than we currently expect. This could see rate cuts come back onto the table later in 2026.
Finally, Deputy-Governor Hauser made another critical point in his speech around the importance of productivity. He noted that if Australia could materially lift productivity growth, the economy could grow faster, without sparking inflation. He argued that we should strive to lift the economy’s speed limit, to avoid being boxed in to a lower growth, higher inflation future. In other words, rather than driving along a bumpy, windy dirt road, we could instead take the four-lane expressway.
Delivering ambitious and large-scale economic reform has proven difficult in Australia in recent decades. However, if it becomes apparent to the public over the next few years that low productivity is keeping inflation high and preventing further interest rates cuts, this might finally be the catalyst Governments need to pursue stronger action on reform.
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