As widely predicted, the Reserve Bank (RBA) lifted the cash rate by 25 basis points to 4.1 per cent at its March meeting this week, in a decision that highlights growing uncertainty about the economy.

 

The increase was passed by a 5-4 vote, signalling the RBA’s Monetary Policy Board was divided about when to make the move.

 

Why did the RBA raise the cash rate for the second time this year?

Two key concerns fuelled the decision.

 

The first is the RBA’s long‑held view that the Australian economy is running close to capacity - in other words, demand is stretching the economy’s ability to supply goods, services and labour without pushing prices higher.

 

The second is the inflation risk, which has been made worse by the conflict in the Middle East. Higher petrol prices have lifted short‑term inflation expectations, something the RBA is watching closely.

 

These factors persuaded a slim majority of the board that another rate rise was warranted this month. The rest of the Board agreed higher rates were needed, but wanted to wait a little while.

 

Why a split RBA decision matters

Although the RBA just lifted rates, the close vote shows there is less agreement about what happens next. 

 

At the post‑meeting press conference, the Governor stated that all Board members accepted rates needed to rise further, but opinions differed on timing. 

 

A close vote is a signal that the outlook for another increase in May is less certain, even though it remains the most likely outcome.

 

A lot now depends on how the Middle East conflict evolves from here. That includes both the extent to which higher energy prices continue to affect inflation and inflation expectations and the negative impact the conflict has on growth, financial markets and wider confidence.

 

What’s happening in the Australian economy? 

Back at home, the Board remains concerned about the ongoing price pressure driven by the domestic economy.

 

Late last year, people and businesses were spending more than the RBA expected. 

 

More recently, the labour market has continued to remain solid, leading the Board to reassess just how tight the economy is.

 

The RBA still believes Australia can only grow by about 2 per cent a year without sparking inflation - a relatively cautious view that reflects downbeat expectations around productivity and population growth.

 

While inflation lifted to above 3 per cent late last year, the central bank believes that part of that increase was driven by temporary factors, rather than the firmer picture on demand.

 

Energy prices add another layer of risk

Traditionally, central banks like the RBA try to ‘look through’ one-off/temporary supply shocks (like oil price spikes), so long as inflation expectations remain contained. In Australia, longer‑term expectations still appear stable, even as near‑term expectations have lifted alongside fuel prices.

 

The RBA also flagged the risk that a prolonged period of high energy prices and uncertainty could degrade supply capacity and potentially keeping inflation higher for longer. That said, this scenario would have non-trivial negative implications for global growth as well. 

 

RBA governor Michele Bullock noted that detailed modelling of the conflict’s economic impact has not yet been completed, meaning the RBA’s assessment may evolve as more analysis becomes available.

 

What happens next?

The Board continues to view the economy as running too tight, with demand growing faster than supply capacity. While this remains the RBA’s view and inflation is above target, rate hikes will remain on the table. 

 

Our base case remains for a May rate hike, but much will depend on how the conflict in the Middle East evolves between now and then.

 

A version of this article was first published on Westpac IQ