Will the RBA Opt for a Rapid Policy Reversal?

[Ben Graham]

• Core inflation in Australia rose to 3.4% y/y, exceeding both forecasts and the Reserve Bank of Australia’s 2–3% target range, increasing pressure on the central bank to act.
• Markets are pricing in a high probability (~76%) of a February rate hike, potentially marking a sharp policy reversal less than six months after the last rate cut.
• Strong labour market conditions and accelerating services inflation suggest underlying demand pressures remain elevated, testing the RBA’s credibility and policy resolve.

The latest inflation data from Australia has once again raised concerns among monetary policymakers and investors. Core inflation (the trimmed mean) — regarded by the Reserve Bank of Australia (RBA) as the key measure of underlying price pressure — rose in the fourth quarter to 3.4% year on year. This reading not only exceeded market expectations (3.3%), but also moved above the upper bound of the RBA’s inflation target range (2–3%).

On a quarterly basis, core inflation came in at 0.9%, in line with forecasts. However, the annual acceleration suggests that the disinflation process may be less durable than previously assumed.

Headline inflation accelerates – energy and services in focus

Price pressures are also evident in headline inflation. In December, CPI rose to 3.8% y/y, up from 3.4% a month earlier. The largest contributors to the increase were:

• Housing: +5.5%
• Food and non-alcoholic beverages: +3.4%
• Recreation and culture: +4.4%

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Australia Inflation Rate, source: TradingEconomics

The composition of inflation deserves particular attention. Services inflation accelerated to 4.1% y/y, from 3.6%, typically signalling strong domestic demand and persistent wage pressures. Goods inflation, meanwhile, stood at 3.4% y/y, with electricity prices surging by 21.5%, further complicating efforts to rein in inflation.

Labour market strength strengthens the case for tighter policy

Elevated inflation is accompanied by a relatively tight labour market. Unemployment has fallen to around 4%, suggesting that demand-side pressures in the economy remain strong. This macroeconomic mix — high inflation and low unemployment — significantly narrows the central bank’s room for manoeuvre and increases the risk that price pressures become entrenched.

It is worth recalling that the RBA cut interest rates as recently as August, but already signalled in December that the next move could be a rate hike if inflation data proved concerning.

Financial markets price in a February rate hike

Market reaction has been swift. OIS contracts now price in around a 76% probability of a rate hike at the 2–3 February meeting. Such a move would represent a sharp pivot in monetary policy — less than six months after the last rate cut. At the same time, three-year government bond yields fell to 4.28%, possibly indicating that some investors view the recent rise in inflation as temporary or expect only a one-off tightening move by the RBA.

Among major financial institutions, consensus is building around the upcoming meeting. Westpac Banking Corp. and ANZ Bank both expect a 25-basis-point rate hike, taking the cash rate to 3.85%. Westpac, however, stresses that such a move does not necessarily mark the start of a sustained tightening cycle. A “wait-and-see” approach remains plausible, particularly if inflationary pressures prove short-lived and begin to ease in the months ahead.

A stronger Australian dollar signals investor confidence

Within the G10 currency universe, the Australian dollar has performed notably well. Since the start of the year, it has appreciated by over 4%, making it the second-best-performing currency in the group. The currency’s strength reflects both expectations of higher interest rates and investor confidence in Australia’s relative resilience amid global economic uncertainty.

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Daily Timeframe of AUDUSD, source: TradingView

The RBA decision as a test of credibility

The upcoming RBA meeting in early February will carry significance beyond a single interest-rate decision. Following a recent easing cycle, the central bank now faces a credibility test: whether to pivot decisively in response to rising inflation or treat the latest data as a temporary disturbance. What is clear is that the recent inflation readings have substantially increased pressure on the RBA, and the February decision could set the tone for Australian monetary policy in the quarters ahead.

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