RBA raises rates as persistent inflation outweighs labour market weakness

The RBA has lifted the cash rate to 4.60 per cent despite rising unemployment. Here’s why the Bank took the risk, and whether this could be the peak for rates.

The Reserve Bank has increased the cash rate by 0.25 percentage points to 4.60 per cent, responding to persistent inflation despite increasingly clear signs that the labour market is weakening.

Inflation continues to be a major concern. Annual inflation eased from 3.8 per cent in June to 3.5 per cent in July, but underlying inflation has shown little improvement. Trimmed mean inflation remained at 3.6 per cent, services inflation was 3.7 per cent and non-tradables inflation remained elevated at 4.4 per cent.

The labour market, however, is now sending a very different signal. Unemployment rose to 4.6 per cent in August, up from 4.5 per cent in July. Employment still increased by 39,500 people, but all of the growth came from part-time work. Full-time employment fell by 6,300 while part-time employment increased by 45,800. The number of unemployed Australians increased by 28,200.

The increase in unemployment partly reflected more people entering the workforce, with participation rising to 67.1 per cent. Even so, the trend unemployment rate is also now 4.6 per cent. The labour market has been weakening more quickly than the RBA had anticipated, with the Bank already noting in August that conditions had eased by more than expected.

The timing makes the decision particularly significant. Just a week ago, the RBA was arguing that the labour market remained somewhat tight and that further easing would be needed to bring demand and supply back into balance. The latest unemployment figures suggest that adjustment is now happening.

By increasing rates regardless, the RBA has placed greater weight on the inflation risk. Inflation remains well above the midpoint of the target range and domestic price pressures continue to be persistent. The Bank’s concern is that leaving these pressures in place for too long could make inflation harder to bring under control.

Housing continues to complicate the inflation story. Housing costs increased by 5.0 per cent over the year to July. New dwelling prices rose by 5.7 per cent as builders passed through higher labour and materials costs, while rents increased by 3.6 per cent.

These are pressures that higher interest rates are poorly placed to solve. Higher rates can reduce household demand, but they do not reduce construction costs, increase the number of tradespeople or deliver more homes. They can also make new housing development less viable at a time when Australia already has a significant shortage of housing.

For the established housing market, another increase will add to the downturn already underway. The RBA has acknowledged that housing prices and activity have weakened by more than it previously expected, reflecting the combined impact of higher rates, the Federal Budget changes and weaker sentiment. A cash rate of 4.60 per cent will further reduce borrowing capacity and increase repayment pressure, while rising unemployment is likely to add another layer of caution for buyers.

The increase does not, however, make further rate rises inevitable. The RBA is now dealing with much greater tension between inflation and the labour market. If inflation remains persistent, another increase is still possible. But if unemployment continues to rise and employment conditions weaken further, the case for additional tightening will become much harder to make. The next few inflation and labour market releases will therefore be critical in determining whether 4.60 per cent is the peak or whether rates need to move higher again.