Westpac Economics sees inflation heading back to target in the year ahead, but this will not be enough to shift the RBA’s more hawkish mindset. Rates on hold in 2026, with risks on both sides.
- Westpac Economics has revised its outlook for the RBA cash rate to an extended hold for the whole of 2026. While the RBA recognised that some of the recent inflation surprise reflected temporary factors, it has clearly taken signal from it. Inflation is expected to moderate in 2026, but not soon enough to induce the RBA to step back from its current hawkish view of the risks. If our broader set of forecasts are borne out, rate cuts are still feasible in February and May 2027.
- There are risks on both sides of our base case view. We reserve the option to put rate cuts in 2026 back on the table if the labour market starts to unravel. We think that rate hike talk is premature. We cannot rule out that more near-term bad news on inflation spooks the RBA and induces a near-term hike, but in our view, it is not the most likely outcome. If it does happen, though, our forecasts for growth, the medium-term inflation outlook and the labour market would need to be revised down, and a subsequent reversal of that policy tightening would be in play in 2027.
The Australian economy has been playing out broadly as Westpac Economics expected. Public sector demand growth is slowing and indeed was negative over the first half of 2025. Private sector demand growth is recovering, and the labour market is gradually easing. Underlying growth in labour costs is also easing, and productivity growth is already running faster than the RBA’s pessimistic trend assumption. Our forecasts see 2026 as involving further recovery from the period of very weak private sector demand growth. The ‘shaky handover’ risk, of private sector growth not picking up as public sector demand growth normalised, looks to have dissipated.
Inflation saw a bump in September quarter and October month. The main sources of the surprise had little to do with domestic demand or labour market pressures. Rather, a sizeable part of that bump looks to have been administered prices and noise. The RBA recognised this at the time but has since communicated that it is more worried about upside risks to inflation. And since what matters for monetary policy is how the RBA sees things, this means that rate cuts are off the table for the time being.
We expect inflation to get back to the RBA’s target (and below the midpoint of the 2–3% range on a trimmed mean basis), but not until later in 2026. This is too late to give the RBA enough comfort to start cutting rates on our previously expected timetable of May and August 2026. Accordingly, we push out the earliest feasible timetable for rate cuts beyond 2026. If our inflation and labour market view is right, by the end of 2026 it will become apparent that domestic inflation pressures have eased. This would leave the way clear to remove remaining policy tightness in the first half of 2027 – we pencil in February and May 2027 for that normalisation. If the labour market weakens noticeably more than we expect, we reserve the option to put earlier rate cuts back on the table.
Following the inflation surprises, markets immediately rushed to the other side of the boat to price in rate hikes. The probability of a hike is not zero, and the RBA was right to warn the community of the possibility. In our view, however, a near-term hike is far from the base case. Labour market data has been less bullish than the inflation data, and the Monetary Policy Board will need to balance this with its fears about inflation. Further upside surprises on inflation in the rest of the December quarter or early 2026 would tip the balance but would not be warranted if our own inflation forecasts are borne out. If a near-term hike does happen, though, our forecasts for growth, the medium-term inflation outlook and the labour market would need to be revised down, and a subsequent reversal of that policy tightening would be in play in 2027.
Our assessment that inflation is still headed down accounts for the role of past restrictive policy and the unwind of earlier government policies. Too much market commentary has understated the role of policy lags. Monetary policy takes time to affect the labour market and inflation, with most estimates pointing to a peak effect after at least a year. This means that recent outcomes mainly reflect the influence of the peak cash rate a year or so ago, and thus that further labour market easing is likely. Some of that policy restrictiveness was masked by the ramp-up in the jobs-rich ‘care economy’ and strong public sector infrastructure spending. As these offsetting factors fade, along with the growth boost from last year’s tax cuts, the effects of past restrictive policy remain in the system because of these usual lags. This would be true for some time even if the 75bp reduction in the cash rate since the peak had fully removed policy restrictiveness, which we do not think is the case. At current levels of the cash rate and other interest rates, monetary policy remains mildly restrictive. Given the usual lags, this will continue to be evident in the data throughout 2026.
