Countdown to austerity? The Reserve Bank of Australia is expected to stay on hold again this week, and inflation may cause a U-turn in interest rate hikes in 2026

The Zhitong Finance App learned that the Reserve Bank of Australia will announce the latest interest rate decision on Tuesday. Economists expect that the Reserve Bank of Australia will keep the cash interest rate unchanged at 3.6% for the third consecutive session at that time. Market pricing for overnight index swaps also confirms this view. Meanwhile, traders and economists are on high alert to whether the RBA's position shows signs of a hawkish shift, which may indicate a possibility of interest rate hikes next year. As inflationary pressure reignites, domestic demand is resilient, and the labor market remains tight, the swap market is betting that the policy will shift back to austerity in mid-2026. As a result, the market's attention to the RBA's last meeting of the year will focus on the tone of the conference statement and the one-hour press conference to be attended by Federal Reserve Chairman Michelle Bullock.

Belinda Allen, head of Australian economic research at Commonwealth Bank of Australia, said: “There is growing evidence that economic capacity is shrinking, the risk of upward inflation is greater than the downside risk, and cash interest rates are not as restrictive as initially thought.” “We don't think the December meeting will clearly consider raising interest rates, but interest rate cuts will also not be considered. The conference statement will have to acknowledge the shift in the economic and inflationary risk balance.”

The Reserve Bank of Australia is entering one of the shortest and most moderate easing cycles among developed countries other than Norway. After starting the easing cycle later than most other central banks, it only took six months to cut interest rates by a total of 75 basis points.

In contrast, traders are increasing their bets, believing that the Federal Reserve will cut interest rates for the third time in a row later this week. The reasons include pressure from US President Trump for more relaxed policies and data showing that the job market is weakening.

Policy differences between the Reserve Bank of Australia and the Federal Reserve have led to a large-scale sell-off of Australian Treasury bonds, and the 10-year benchmark Treasury yield has climbed to 4.73%, the highest level since November 2023. This raised the yield premium on Australian Treasury bonds to the highest level in more than three years.

Ben Wilthill, a global interest rate trading strategist at Citigroup, said that this “clearly reflects a fundamental shift in the market's view of the RBA's policy path. The data and fixed income market conveyed a loud and clear message — policy tendencies firmly point to higher interest rates.”

Therefore, Australia's fourth quarter inflation data, which will be released at the end of January next year, will have special significance. Some economists have warned that if the inflation data rises again beyond expectations, it may prompt the Reserve Bank of Australia to open the door for interest rate hikes at the next policy meeting on February 2 to 3.

Recent data shows the potential resilience of the economy: housing prices continued to rise in November, commercial investment was stronger than expected in the previous quarter, and household consumption also showed resilience. Bullock's latest assessment is that the economy's output gap has been closed — meaning any increase in demand that exceeds expectations will quickly translate into higher prices. Last week, while testifying in Congress, she suggested that officials might need to switch back to austerity policies and closely monitor whether inflationary pressure intensifies again.

The Australian economy has shown resilience, but price pressure is building up again

Despite this, judging from past performance, the RBA's policy communication on Tuesday will probably still not give clear promises, and the committee will continue to rely on data for decision-making. Policymakers may want to wait for more signals to determine whether recent inflation above the upper limit of the Reserve Bank of Australia's 2-3% target range is a brief fluctuation or a more serious problem.

However, Nick Steiner, head of regional economic research at Bank of America for Australia and New Zealand and a former RBA official, said that Bullock “is likely to admit that if the current economic intensity continues, the next step may be to raise interest rates. We anticipate that the threshold for restarting the rate hike cycle is high, especially given the gradual weakening of the labor market”.

Paul Broxham, Australia's chief economist at HSBC Holdings, said, “The economy is neither too hot nor too cold.” He believes that the next step is more likely to be to raise interest rates rather than cut interest rates. He added: “A series of data over the past few weeks clearly shows that there is no need or room for the Reserve Bank of Australia to further reduce cash rates. Inflation is above target, growth is on an upward trend, and unemployment is still below its estimate of full employment.”