ANZ sees RBA staying cautious despite cooling rate hike expectations

Diminished expectations of Reserve Bank of Australia rate increases have removed one element of support for the Australian dollar, at a time when US bond yields are climbing and the Federal Reserve remains on a tightening trajectory. This leaves the AUD vulnerable to additional US dollar strength. However, persistently high services inflation should restrict how much Australian rate expectations can decline, which limits the downside for short-end bond yields. Lower oil prices are benefiting Australian headline inflation but are not addressing the domestic services pressures that ANZ is monitoring, so the RBA’s cautious approach is expected to continue.

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Economic growth is moderating, but services inflation remains elevated, preventing the RBA from easing even as the argument for another rate increase weakens.

• ANZ economist Siddhant Kalra notes that market expectations for further RBA rate hikes have diminished as Australia's economic growth slows
• Third-quarter trimmed mean inflation rose 1.0% quarter-on-quarter and 3.7% year-on-year, exceeding forecasts and the RBA's 2% to 3% target range
• Market services inflation recorded its strongest annual increase since 2024
• ANZ associates market services prices with domestic capacity constraints
• The firm states that the robust outcome will keep the RBA cautious over the months ahead

Expectations for additional interest rate increases from the Reserve Bank of Australia have receded as more evidence emerges that the economy is slowing. However, ongoing inflation means the central bank is unlikely to let its guard down, said ANZ economist Siddhant Kalra.

The strain is most evident in the RBA's favoured core measure. The trimmed mean, which excludes the most extreme quarterly price movements, advanced 1.0% in the three months to September and 3.7% compared with a year ago. That came in above forecasts and above the ceiling of the central bank's 2% to 3% target band. Market services inflation, encompassing prices that depend largely on domestic demand and labour costs, posted its steepest annual gain since 2024.

Kalra emphasised the services detail as the critical element. Market services prices are tightly tied to domestic capacity pressures, so they indicate how much the Australian economy is operating at its limits, rather than external factors such as oil prices or the exchange rate. A robust reading suggests demand is still pressing against the economy's constraints, the type of inflation that central banks find most difficult to reduce.

ANZ indicated that the strength of the result is likely to maintain the RBA's cautious stance in the months ahead. This places the central bank in an uncomfortable position. Slowing growth argues against additional tightening, while sticky underlying inflation argues against indicating that rates have peaked, let alone paving the way for reductions.

The international environment adds to the complexity. Reduced oil prices are alleviating pressure on headline inflation, but other central banks are tilting hawkish. The US Federal Reserve is widely anticipated to raise rates in December following a hotter-than-expected October inflation reading, and the Bank of Japan is also expected to increase its policy rate.

For the RBA, the coming months are likely to be characterised by patience rather than action. Unless services inflation eases, a significant move toward lower rates appears distant, even if the hurdle for another increase has become higher.