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Shadow Board Confident that Monetary Policy Needs to Tighten in Face of Higher Inflation
Annual CPI inflation rose to 3.8% in the 12 months to December 2025 (0.2% in seasonally adjusted terms over the month), keeping inflation well above the Reserve Bank of Australia’s 2–3% target band. The main underlying measure published alongside the CPI release—trimmed-mean inflation—was 3.3% over the year to December, edging higher from November. Recent activity indicators remain mixed but point to an economy that is still expanding: real GDP rose by 0.4% in the September quarter 2025 (2.1% over the year), while wage growth remained firm at 0.7% in the September quarter (3.4% over the year). Household spending has also been stronger than earlier in 2025, rising by 1.0% in November (seasonally adjusted) and sitting 6.3% higher than a year earlier. Against this backdrop of above-target inflation and a negative real cash rate, the RBA Shadow Board recommends, with 74% confidence, that the cash rate be increased to 3.85%, to prevent inflation continuing to rise and becoming entrenched.
The labour market remains relatively tight by recent historical standards. In December 2025, the unemployment rate was 4.1% (seasonally adjusted), while employment increased by 65,100 and the participation rate edged up to 66.7%. Underemployment was 5.7%, and monthly hours worked 2,001 million. Taken together, these data suggest that labour demand is still absorbing labour supply at a pace consistent with moderate employment growth. For monetary policy, the key issue is not simply the unemployment rate, but whether the combination of tight labour conditions and moderate wage growth sustain services inflation at a rate consistent with returning inflation to target in a timely way. At the same time, unemployment’s drift away from its 2022–23 lows implies that there is at least some easing in labour market pressure which, if it continues, would reduce the risk of inflation persistence.
Australian financial conditions have tightened at the margin over recent weeks. The Australian dollar was around US$0.70 on 30 January 2026, with the trade-weighted index at 64.5. In sovereign debt markets, yields have moved to levels consistent with a higher-for-longer view of near-term policy. The 1-year government bond yield was about 4.06% and the 2-year yield about 4.17%, implying a small positive slope at the front end of the yield curve. Further out, the 5-year yield (about 4.42%) sat above the 2-year yield, as did the 10-year yield (about 4.82%), delivering an upward-sloping yield curve consistent with expectations of policy remaining restrictive in the near term, before easing later. Equity prices have proven resilient, much like global equity prices: the S&P/ASX 200 closed at roughly 8,869 on 30 January, 450 points above the low made in late November 2025.
Consumer sentiment has softened at the start of 2026. The Westpac–Melbourne Institute Consumer Sentiment Index slipped 1.7% to 92.9 in January (from 94.5 in December), remaining clearly below the neutral 100 mark. The deterioration was concentrated in near-term expectations: the “economic outlook, next 12 months” sub-index fell 6.5% and the “family finances, next 12 months” sub-index fell 4.5%. At the same time, households’ interest-rate expectations have shifted noticeably: Westpac reports that around two-thirds of respondents now expect mortgage rates to rise over 2026. These results are consistent with a consumer sector that is still spending—supported by population and nominal income growth—but doing so with a cautious outlook that could amplify any further tightening in financial conditions.
Business surveys point to a modest improvement in late 2025, although the picture remains uneven across sectors. In the National Australia Bank December survey, business conditions rose to +9 and business confidence edged up to +3. The improvement in conditions reflected stronger sales and profits: trading conditions rose to +10, profitability to +7, and employment held around +4, while capacity utilisation remained high at 83.2%, suggesting limited spare capacity in parts of the economy. Timelier PMI (Purchasing Managers’ Index) indicators imply that growth in private demand is positive but not strong: the January flash PMI readings from Judo Bank and S&P Global show manufacturing at 51.6 and services at 50.4, with the composite at 50.3, just above the expansion threshold. For policy, the central question is whether improving trading conditions and high capacity utilisation translate into continued pricing power (particularly in services), or whether the modest pace of output growth limits firms’ ability to pass on higher costs.
The global backdrop remains supportive of growth, but with clear downside risks for Australia via trade, commodity prices, and financial conditions. The UN’s World Economic Situation and Prospects 2026 study projects world output growth of 2.7% in 2026 (after 2.8% in 2025), before a modest lift to 2.9% in 2027; it also expects global inflation to ease further, and world trade volume growth to slow to around 2.2% in 2026. The UN stresses that trade tensions, fiscal strains, and elevated uncertainty continue to cloud the outlook. Other major multilaterals paint a somewhat different (generally stronger) central case: the International Monetary Fund projects global growth at 3.3% in 2026, while the World Bank projects 2.6%. For Australia, the practical implication is that the external environment is unlikely to deliver a strong disinflationary impulse on its own: global inflation may ease, but the outlook for demand in key trading partners remains moderate (the UN projects China growth around the mid-4s in 2026). In this setting, domestic drivers—especially services inflation, wage dynamics, and capacity constraints—are likely to remain central in determining how quickly inflation returns to target and how long policy needs to remain restrictive.
The Shadow Board assigns a 24% probability that holding the overnight rate at 3.6% is optimal (56% in the previous round), a 2% probability that reducing the overnight rate to below 3.6% is appropriate (3% in previous round), and a 74% probability that raising the rate above 3.60% is warranted (41% in the previous round). Hence, the Shadow Board’s perceived inflation risks have shifted significantly to the upside.
Six months out, the Board attaches a 10% probability that the cash rate should be lower than the current setting of 3.60% (20% in previous round), 26% that the current setting is optimal (38%), and 64% that a higher rate is required (42%). At the 12-month horizon, probabilities are 22% for a lower interest rate (35%), 18% for a rate hold (29%), and 59% for a higher rate (37%). Three years out, the Board attaches a 54% probability of a lower rate being optimal (62%), 12% to the current setting (12%), and 35% to a higher rate (26%).
The distribution for the current recommendation is unchanged at 3.35%–4.60%. For the 6-month horizon, the distribution inched up at the lower bound, to 3.10%–4.85%. The distribution is unchanged for the 12-month horizon, with a range of 0.10%–4.85% (twelve months) but widened for the 3-year horizon, with a range of 0.10%–5.60% (three years).
