Play in May, Don’t Go Away

The higher outlook for the cash rate is quite the turnaround. We expect another rate hike in May. Other pathways are possible as risk scenarios.

• With inflation now higher (and overall demand growth stronger) than previously expected, the RBA raised the cash rate in February. The question then becomes, how much more is coming and when? We believe that another cash rate increase will occur, in May.
• There are pathways that result in the next rate hike occurring at the March meeting, but this is less likely. The RBA believes (as we do) that much of the recent increase in inflation is temporary, which reduces the urgency of follow-up hikes.
• If things turn out as we expect, the RBA will be able to point to some turnaround in inflation, as temporary factors wash out by the time the August meeting comes around. This will enable the Board to take a ‘wait-and-see’ approach with policy already restrictive. There are scenarios where it will want to raise rates even further then, but they are not our baseline expectation.

The shift in the interest rate outlook in Australia since six months ago is quite the turnaround. Inflation has kicked up in ways that were not apparent or expected in mid 2025. One reason was that, while a slowdown in public demand growth and pick-up in private demand growth were both expected – as can often be an issue – the net of the two has been more positive than anticipated. Prices tend to respond sooner than volumes when demand surprises. Above-average inflation in many administered prices didn’t help. The RBA has responded to this, first by preparing the ground for a rate hike and ruling out the previously expected cuts, and then by delivering that rate increase at its February meeting. The question then becomes, how much more should we expect the cash rate to rise, and when?

We currently expect one more rate rise, in May. Other paths are possible if the data flow turns out differently than our expectations.

The main plank supporting this view is that the RBA Monetary Policy Board appears to be dissatisfied with the inflation trajectory implied by its staff forecasts. It therefore thinks it needs to do more than the roughly one extra hike that was priced in at the time those forecasts were finalised. It is unlikely that the data flow will turn softer soon enough to prevent it from moving in May. Even if the labour market does unravel unexpectedly, that will not happen soon enough to affect a May decision. Similarly, we think there is enough near-term momentum to inflation that the narrative that “it is showing some persistence” cannot be walked back by May. Our expectation for the March quarter inflation print is only marginally lower than what we believe the RBA’s to be. Near-term inflation outcomes would have to surprise noticeably to the downside to stay the RBA’s hand at its May meeting.

Recall that RBA’s forecasts are based on the technical assumption that the cash rate follows market pricing at the time the forecasts are finalised. As the Governor repeatedly emphasises in post-meeting media conferences, this is not a forecast or promise from the RBA. Rather, it is necessary to ensure that the forecasts are coherent across financial market variables. The market path for the cash rate is the one consistent with the exchange rate being where it is, another technical assumption in the RBA’s forecasting framework.

You can, however, glean something about what the RBA thinks regarding the rates outlook from the inflation forecast that the market path delivers. If it is uncomfortably high for too long, this is a sign that the Board thinks it might need to do more than was priced in. Again, an alternative path is not baked in, but it does give a guide to the balance of probabilities. And if the tone of the post-meeting press conference is any guide, at least some Board members think they will have to do even more than the 60bp increase over 2026 that was priced in at the time.

Could the rate increase come as soon as March, as a back-to-back hike? We cannot rule this out, but it is not our base-case expectation. While the staff forecasts are consistent with the RBA believing it might have to do more, the divergence from a more desirable inflation path was not large. And it is clear both from the post-meeting communication and today’s testimony before the House of Representatives that the RBA thinks that “[m]uch of the increase in inflation is judged to be temporary” and only some of it is persistent. It is plausible that there are members of the Board and/or the staff that see the need for tightening as more urgent, and therefore possible that some votes for a hike will be recorded in March. Given the RBA’s published assessment of the nature of the increase in inflation, though, we do not think the majority will vote for a March hike.

Beyond May, we think it is possible that the RBA will want to keep raising rates, but that this scenario is less likely than an extended period on hold in a restrictive stance, one that is not far off the earlier peak. Our assessment of the outlook is that a downward trajectory in underlying inflation will emerge and will start to be evident in the Q2 data. Part of this will be the start of the unwinding of the temporary component of the recent increase. Those who are more familiar with the ‘long and variable lags’ of monetary policy will note that this would be a very quick turnaround for monetary policy to have done the deed. Watch also for the labour market slowing more and sooner than the RBA is forecasting as a signal supporting on-hold policy beyond May.

A factor that received less attention in the RBA’s post-meeting communication and testimony is the role of the exchange rate in shaping the inflation outlook. Some of the recent pick-up in inflation came from consumer goods. Most of these are imported, and the weakness earlier in 2025 in the AUD, especially relative to the USD, would have played a role in this. (Recall that China’s currency is managed closely to the USD, so the AUD/USD rate effectively comprises around 40% of Australia’s trade-weighted index.) With the AUD now noticeably higher since the previous forecast round, the contribution to overall inflation from this source will go into reverse. Our own models as well as a commercially available whole-economy model suggest that pass-through of lower prices of imported goods through to retail prices could slow overall inflation noticeably sooner than the RBA’s forecasts imply. Our own forecasts make some allowance for this, but the model-implied effect implies that this could be stronger than we assume. (There are, of course, also upside risks to inflation, notably from home-building costs.)

Bottom line: we expect another hike in the cash rate in May, and while the risks are that they move sooner or do more, the likely data flow supports a one-hike-in-May scenario.