From Scott Haslem, Chief Investment Officer at LGT Wealth Management
The decision
Today, in the wake of last week’s higher than expected inflation data for Q326, the Reserve Bank of Australia (RBA) hiked the policy rate by 0.25% to 4.85%. Having eased policy three times during 2025, the RBA has lifted rates five times in 2026, taking cash rates to a post-GFC 18-year high (November 2008). Interestingly (and somewhat expected), the decision was not unanimous (6-3), with a minority of members voting to keep interest rates unchanged. As is often the case, commentary focused on justifying the decision, with the accompanying statement noting capacity pressures were “a little tighter than previously estimated” and that higher energy prices were “being passed through to prices of other goods and services”. The RBA also noted it had revised its inflation outlook “materially higher”.
However, the fact that the vote was not unanimous, together with the removal of the previous clear tightening bias, overall leaves the decision today on the more neutral or dovish side. While the RBA’s commentary will continue to be scrutinised, in the end, the data ahead on growth, unemployment and inflation will be the arbiter of the rates outlook.
How did we get here?
There will undoubtedly be ferocious debate about how we got here – a post-1970s-era economy birthed in government reforms through the 1980s and early 1990s, enhanced by relatively disciplined fiscal management, aided by moderate tax burdens and government debt levels that combined with rising labour supply (skilled migration) to drive productivity growth that was the envy of the world. Now we have the seventh-highest inflation rate in the G20 (behind Argentina, Brazil, India, Russia, South Africa and Turkiye), and have lifted interest rates this year more than any other country in the G20.
Could it be:
- the lack of productivity-enhancing policies from both sides of politics over the past twenty years (despite repeated prodding from economists and academics)
- policy decisions that are still making the economy less productive (such as increased regulations or unwinding past labour market reforms),
- rising tax burdens that make us internationally less competitive or dent private sector incentives to grow and innovate (noting current income tax receipts are growing by 8% annually)?
Indeed, even today, the RBA statement notes “weak productivity growth continues to constrain potential growth”.
That debate aside, the revealed outcome of the past year is that we have a new lower speed limit of 2% real growth compared to a prior pace of almost 3%. This is not too bad from a relative perspective internationally. Unfortunately, though, it has been the case for some time that the least productive areas of our economy – government services – have been consuming an increasing share of that growth capacity. Indeed, together with government capex, government ‘demand’ has been at or around a real 2% pace for some time, leaving little scope for the private sector – typically more productive – to participate without inflation overshooting its 2.5% target.
Where to from here?
Near term, given what appears to have been relatively deaf ears from governments (but particularly the Federal government) to slow its expenditure this year, rising interest rates will mean the private sector is going to bear the brunt of a necessary slowing in growth. Yes, mortgage holders and those with debt will be at the front of the queue. But we should remember that rising interest rates also impact the broader economy, from:
- encouraging those with savings to invest rather than consume
- slower business investment (a faster pace of which typically helps lift productivity) due to a higher required return (or hurdle) rate for new investment.
Could rate cuts be on the horizon in 2027?
Looking ahead, there is a meaningful chance that economy-wide growth and demand slow sharply into Christmas this year (note the recent softer trading updates from Nick Scali, Bunnings, Chemist Warehouse and JB Hi-Fi), as we have been expecting, and the unemployment rate rises above 5% by early 2027 (now 4.7%, up from 4.1% at the start of this year). If government expenditure actively slows over the coming year, there is a reasonable chance the RBA could be trimming the cash rate in H227 on the back of weak growth that improves the inflation outlook.
Any hint this is the playbook will see domestic bonds start to rally (and maybe curves flatten) during H127 and may in time improve the equities earnings outlook post what will likely be a weak February 2027 reporting season (equities will “look across the valley”). Lower global oil and energy prices will likely have a part to play here, as will the likely recent headwinds for the housing sector as it adjusts to the post negative gearing policy regime (…and state governments adjust to shortfalls in stamp duty revenues). If total government spending does not slow sufficiently, there remains the risk that 4.85% will not be the peak of the cash rate cycle. A 4.85% cash rate is only modestly above headline inflation of 4.3% (September month), with the implied 0.5% ‘real rate’ less than what has been required in the past to reverse inflationary pressures.
Of course, there will be much discussion over coming weeks over who is to blame and how we fix the mess (and Victoria’s election will provide an interesting backdrop to those discussions). The answers are the same as they have been for some time. They just need to be embraced. There will be ‘spin’ from the Federal government on how they have delivered two consecutive budget surpluses, and while that does compare favourably with other countries (like the US at 6% deficits), it turns a blind eye to:
- the explosion of off-budget spending
- forecast deficits for years to come
- the current 7-8% spending growth
- the (somewhat obvious) assessment that cyclically, with elevated commodity prices and relatively low unemployment, we should be running material budget surpluses and improving our structural debt and fiscal position.
And of course, announced spending cuts only help the situation if those policies aren’t reversed or savings measures delayed.
The bottom line
Ultimately, the lags of policy – with five hikes this year – will likely do the trick in getting inflation under control over the coming year. The price will be slower growth, weaker corporate earnings, less business capex (outside of data centres) and higher unemployment. Sometimes these situations historically are less avoidable, and follow good times that just became ‘too good’. For now, it looks more like we are finally paying the price for a lack of productivity-enhancing reform, and that price is being made materially higher by the fact that monetary and fiscal policy are disappointingly fighting against each other and pulling in opposite directions.
