Danger zone: why war in the Middle East has landed the RBA’s inflation fight in tricky territory

The Reserve Bank of Australia (RBA) is prepared to take stricter action against rising inflation, but this move comes with increased economic risks. Governor Michele Bullock stated that the RBA aims to gradually steer inflation back to its 2.5% target while preserving the recent post-pandemic job gains. Unemployment has risen by one percentage point over the past four years, yet it remains relatively low at 4.6%.

Central banks have managed to lower inflation, but often at the expense of higher unemployment, according to Bullock.

The RBA has been outside its 2-3% inflation target range for six years, which poses a challenge as households and businesses must believe inflation will decrease in the future. The persistent Middle East conflict is now the most significant threat to the RBA's cautious approach to controlling inflation. Initially, many believed the conflict would be brief, but it has continued, leading to permanent increases in fuel, fertiliser, and transport prices, unlike previous fluctuations.

Bullock is concerned that businesses might also anticipate similar price increases, which could further complicate efforts to bring inflation back to target without resorting to more aggressive interest rate hikes. The central bank remains committed to "doing what it takes" to achieve the inflation target, a sentiment echoed by many economists who expect another rate hike within the next six weeks, particularly at the Melbourne Cup day meeting.

Financial markets now anticipate a 50% probability of an additional rate increase in the coming year.

While the RBA may be justified in taking a tougher stance against inflation, this approach raises the risk of a severe economic slowdown. The central bank hopes that, over the next few years, achieving lower inflation will justify the potential costs.