Top economists warn Reserve Bank faces pressure for interest rate hikes
Financial markets have abandoned hopes of Christmas rate cuts and are now betting on RBA hikes as early as February after inflation data shattered economists’ forecasts.
The shift in interest rate expectations has been swift and brutal.
Two months ago, financial markets were sure the Reserve Bank would cut by Christmas and again in 2026.
Now they’re betting on rate hikes, possibly as soon as February and certainly by September.
This monumental shift in view has sent shockwaves through Australian financial markets – more so in bonds than stocks – as economists scrambled to tear up their forecasts.
Australia’s benchmark 10-year government bond yield hit a 12-month high of 4.7 per cent last week versus 4.1 per cent in mid-October – a dramatic move that primarily reflects the new reality confronting Australian policymakers.
The stock market is about 5 per cent below its October peak.
The culprit? A string of data showing the Australian economy is running hotter than expected, with household spending surging and inflation proving stubbornly persistent.
NAB chief economist Sally Auld says the Reserve Bank’s monetary policy board now faces challenges unique to economies that achieve a soft landing – avoiding recession while taming inflation.
“Soft landings leave the economy starting the next expansion with minimal spare capacity,” Auld says. “As such, a return to trend growth will start to see capacity constraints bind.”
Her analysis suggests those constraints are already biting.
Core inflation accelerated to 1.0 per cent in the September quarter and looks set to print 0.9 per cent in the December quarter. That would mark five consecutive quarters of annual core inflation running at 3 per cent or higher.
Meanwhile, the economy has hit its stride, growing at an annual rate of about 2 per cent – right at the Reserve Bank’s estimate of trend growth. But that leaves no cushion for error.
“It is quite possible given our take on domestic economic fundamentals that the RBA are not too far away from a more hawkish tone to their communications,” Auld says.
NAB’s business survey paints a concerning picture. Capacity utilisation is running two percentage points above its long-run average, with six of eight industries operating above normal levels.
Auld says the Reserve Bank may need “a modest recalibration of the policy stance” in the first half of next year, likely around 50 basis points of rate hikes. She stresses timing matters.
“It is better to move earlier, and by less, than to wait and to be forced to do more,” she says.
UBS chief economist George Tharenou goes further. He was the first big bank economist to explicitly forecast rate hikes.
Tharenou expects a 25 basis point increase by the final quarter of 2026, followed by another hike early in 2027, but says the risk is heavily skewed to earlier or more aggressive hikes.
“Based on the RBA’s historical reaction function to inflation outcomes, the trigger to hike rates has, arguably, already been met,” Tharenou says.
He points to monthly inflation data that shows headline consumer prices spiked to 3.8 per cent in October, well above expectations. Trimmed mean inflation also jumped to 3.2 per cent.
Citi chief economist Josh Williamson shares that concern. His team was caught off-guard by October’s household spending data, which surged 1.3 per cent – more than double expectations.
“At this pace, the economy’s going to get a speeding ticket,” Williamson says.
Annual spending growth hit 5.6 per cent, the strongest since September 2023.
Williamson argues that the economy is already operating above its productive capacity.
He sees “material upside risk” to Citi’s current forecast of no rate changes in 2026.
Not everyone is convinced rate hikes are inevitable.
Westpac chief economist Luci Ellis takes a contrarian view, arguing there’s too much pessimism about the economy’s ability to grow without stoking inflation.
“Estimates of growth in the capacity of Australia’s economy around 2 per cent look too low,” Ellis says.
She believes trend growth is closer to 2.25 per cent, potentially higher if artificial intelligence delivers productivity gains.
Ellis also notes much of the recent inflation spike comes from government-controlled prices – electricity, water rates, tobacco, childcare and education.
“The RBA’s mandate to hit its 2.5 per cent inflation target would mean keeping the rest of the economy weak and market-sector inflation low, to offset this policy-driven inflation,” she says. “Surely there is a better way.”
Westpac still forecasts two rate cuts in 2026, in May and August.
But Ellis acknowledges the risk the Reserve Bank stays on hold longer.
Reserve Bank governor Michele Bullock has already laid the groundwork for a more hawkish stance. In recent testimony before a Senate committee, she warned that persistent inflation pressures “might have implications for the future path of monetary policy”.
While the economy may not be operating beyond its potential, “demand is recovering enough to allow businesses to pass on costs”, Bullock said.
The money market has already absorbed the message. Traders are now pricing in about 30 basis points of rate hikes by November 2026, so at least one quarter per cent hike is considered likely.
It’s a remarkable turnaround from just weeks ago when nearly 50 basis points of rate cuts were expected by late next year.
The Reserve Bank’s monetary policy board will hand down its final interest rate decision for 2025 at 2.30pm AEDT on Tuesday.
While no change to the 3.6 per cent cash rate is expected, the accompanying statement will be scrutinised for any shift in tone.
What’s clear is that the debate has fundamentally changed.
The question is no longer when rates will fall, but whether they’ll rise – and by how much.
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Originally published as Top economists warn Reserve Bank faces pressure for interest rate hikes
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