The Reserve Bank of Australia's monetary policy board lifted its cash rate by 25 basis points to 4.6%, the highest level since October 2011, as universally expected by economists and financial markets. Economist Saul Eslake argues that the RBA itself must accept some of the blame for the rebound in inflation and hence in interest rates.
Factors Behind the Inflation Rebound
Treasurer Jim Chalmers attributed the decision and the inflation concerns underpinning it to the war in the Middle East. Others, including shadow treasurer Tim Wilson and some economists, blamed it on “excessive” levels of, and growth in, government spending. Eslake writes that both factors, and others besides, have contributed to the rebound in inflation and interest rates that Australia has experienced this year.
Oil prices have rebounded from just over US$70 a barrel in late June to more than US$100 a barrel in recent weeks. The “crack spreads” between crude oil prices and prices of refined petroleum products such as gasoline and diesel have remained at elevated levels since the conflict began, and seem unlikely to come down given the damage done to refining capacity in the Middle East and in Russia. Additionally, the US and China appear to have run down their reserves as far as they deem prudent, and so are now exporting less and importing more oil, respectively.
Domestic Imbalances and Government Spending
The rebound in Australian inflation began well before the conflict in the Middle East. The RBA's preferred measure of “underlying” inflation bottomed out at 2.8% over the year to June 2025, and had already risen to 3.3% by February this year, before the outbreak of the conflict. Since then, this measure has risen to 3.6% over the year to July. So most of the increase in inflation which prompted the Reserve Bank to raise interest rates three times between February and May this year cannot be attributed to the conflict.
Rather, it reflects the persistent imbalance between “aggregate demand” and “aggregate supply”. The growth of aggregate supply has been held down by poor productivity performance during this decade, which effectively sets a “speed limit” on how fast the economy can grow without generating inflationary pressure. Growth in aggregate demand has been driven by both public and private spending.
Growth in public spending as measured in the GDP statistics has slowed from more than 4% a year in real terms in 2023-24 and 2024-25 to 2% in 2025-26. But the national accounts measures only include direct spending by governments and government-owned enterprises on goods and services. They don’t include cash payments to households and cost-of-living relief measures which the federal government and state and territory governments have handed out in recent years.
The final budget outcome document released on Monday showed that total expenses by the federal government rose by 5.1% in real terms in 2025-26, only marginally less than the 5.6% figure for 2024-25, and that both figures were higher than in all but five of the past 25 years. Based on estimates presented in their 2026-27 budgets, it is likely that spending by state and territory governments and their instrumentalities rose by about 6% in real terms in 2025-26 – the largest increase since 2019-20.
Most of the cost-of-living relief given by governments, whether by way of cash handouts or tax cuts (such as the temporary halving of fuel excise), has been untargeted, and most households appear to have spent it. That shows up in the national accounts as private sector spending – but it has really been facilitated by government policy.
RBA's Role and the Blame Game
The Reserve Bank itself has to accept some of the blame for the rebound in inflation, and hence in interest rates, because it cut interest rates prematurely last year. Its belief that inflation had sustainably returned to the 2% to 3% target band turned out to be wrong. The RBA was under considerable pressure from the government to cut rates – recall Chalmers’ assertion in August 2024 that the Reserve Bank had “smashed the economy”. But, with the benefit of hindsight, the RBA should have resisted that pressure.
In many ways this “blame game” is beside the point. As the RBA governor, Michele Bullock, reiterated this week, “high inflation hurts all Australians, especially the most vulnerable” and “it’s critical that we stop high inflation from becoming embedded in price-setting decisions across the economy or the problem will only get worse”. Politicians should avoid doing, or advocating, things that will “make the problem worse”, and let the Reserve Bank get on with its job.
