The head of Australia's central bank on Tuesday said that inflation is the crucial challenge over the next one or two years after policymakers raised interest rates to a 12-year high earlier this month to tame high prices.

Below is an extract from the Reserve Bank of Australia’s minutes from the November policy meeting where the central bank decided to raise the cash rate by 25 percentages points to 4.35 per cent:

Surprising 'resilience'

"The case to raise the cash rate target by a further 25 basis points centred on the risks arising from the outlook for inflation being stronger than it had been some months earlier. Members noted that underlying inflation in the September quarter had been higher than previously expected, inflationary pressures were evident across a broad range of consumer items, and inflation was most apparent in items for which inflation typically took longer to subside (such as services). Collectively, these observations implied that it would take some time for inflation to return to target.

Members also noted that the greater-than-expected resilience of domestic demand over preceding months had implications for the inflation outlook.

In particular, the staff’s forecasts for a more modest slowing in output growth, and for the unemployment rate to be lower over the forecast profile than previously assumed, implied that overall demand would remain higher for a significant period. As a result, it would take longer to bring aggregate demand and supply into balance than previously expected. Members observed that the forecasts were predicated on there being an additional one to two increases in the cash rate over coming quarters and an assumption that productivity growth would recover over the year ahead. Moreover, members noted that lowering inflation from its current level would require growth in aggregate demand to remain subdued; this was unlike the disinflation achieved to date, which had occurred largely because of fading supply shocks. As a result, it was expected to take longer to return inflation to target than it had taken so far to reduce inflation from its peak.

Market expectations

Members also observed that, while longer-term inflation expectations remained broadly anchored, there had been signs of a slight upward drift in some financial market measures of inflation expectations. If sustained, this would contribute to higher inflation. Furthermore, members noted growing signs of a mindset among businesses that any cost increases could be passed onto consumers. In this environment, members assessed that tightening monetary policy at this meeting would help to mitigate the risk of an unwelcome rise in inflation expectations. A scenario prepared by the staff illustrated that even a modest further increase in inflation expectations would make it significantly more challenging and costly to return inflation back to target within a reasonable timeframe.

Collectively, these observations underpinned the case to raise the cash rate target at this meeting to mitigate the risk that progress in returning inflation to target is further delayed.

After weighing up these two options, members agreed that the case to raise the cash rate target at this meeting was the stronger one. Members noted that the risk of not achieving the Board’s inflation target by the end of 2025 had increased and that it was appropriate that monetary policy should be adjusted to mitigate this. They observed that delaying such an adjustment would create a risk that a larger monetary policy response might be required in coming months, especially if inflation pressures turned out to be stronger than expected.

Risk of higher inflation

More generally, members noted that it was important to prevent inflation expectations from increasing significantly, given the costs of that eventuality. They agreed there was a risk of inflation expectations increasing if the Board left the cash rate target unchanged at this meeting, particularly given the Board’s repeated statements that it has a low tolerance for inflation returning to target after 2025. Members also noted that the staff’s inflation forecasts would be for higher inflation if they had not been predicated on one or two rate rises."

Members discussed the implications of this decision on household finances. While some households were benefiting from rising house prices, substantial savings buffers and higher interest income, others were experiencing a painful squeeze on their finances. Members noted that a larger-than-typical share of borrowers had been drawing down funds in their offset accounts – even while households in aggregate continued to build up balances in offset accounts – which was consistent with those households finding it harder to finance their expenditure from current incomes. At the same time, members observed that this share had not risen over prior months and that banks had not seen a significant rise in the incidence of households experiencing difficulties making their mortgage payments. Nonetheless, financial pressures on households would be exacerbated by inflation remaining higher for a longer period than forecast.

Board 'resolute'

Members agreed that whether further tightening of monetary policy is required to ensure that inflation returns to target in a reasonable timeframe would depend on how the incoming data alter the economic outlook and the evolving assessment of risks. In making its decisions, the Board will continue to pay close attention to developments in the global economy, trends in domestic demand, and the outlook for inflation and the labour market. The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that outcome."