Statement on Monetary Policy – May 2026Overview

Prior to the conflict in the Middle East, inflation in Australia was materially above target, and the economy and labour market were operating with ongoing capacity pressures. GDP growth picked up strongly in the December quarter 2025, as expected, to be above estimates of the potential rate of growth. Labour market outcomes have been broadly as expected recently and conditions remain somewhat tight.

The conflict has led to sharp increases in commodity prices, particularly energy, which has pushed inflation higher. This has contributed to market expectations for the cash rate shifting higher. Large increases in fuel prices drove a significant increase in headline inflation in March. Trimmed mean inflation also remained elevated at 3.5 per cent over the year to the March quarter, although it only captured one month of the conflict. There are indications that higher fuel prices are likely to have second-round effects on prices for goods and services more broadly.

The near-term outlook for inflation has been revised higher. In time, the labour market and capacity pressures are expected to ease by a little more than expected in the February Statement, reflecting that the cash rate is assumed to increase to 4.7 per cent by the end of 2026, compared with 4.2 per cent in February. In the baseline forecast, inflation is expected to ease towards the midpoint of the target range by mid-2028. Given uncertainty around the duration and severity of the conflict, the outlook for inflation and economic conditions is more uncertain than usual, and this Statement presents two alternative scenarios to illustrate aspects of this uncertainty.

The Monetary Policy Board decided it was appropriate to increase the cash rate target by 25 basis points to 4.35 per cent. The Board assessed that inflation is likely to remain above target for some time and that the risks remain tilted to the upside, including to inflation expectations.

Capacity pressures in the Australian economy remain elevated and inflation was above target before the onset of the conflict.

GDP growth picked up strongly in the December quarter, as expected, to be above our estimates of its potential growth rate. Survey measures of capacity utilisation remained above average in February and March, suggesting that capacity pressures persisted into early 2026.

Private investment was stronger than anticipated in the December quarter while household consumption growth was weaker than expected. Recent spending data suggest that there was a little less underlying momentum in household consumption prior to the conflict than had been anticipated.

The labour market has evolved broadly as expected and conditions remain somewhat tight relative to full employment. The unemployment rate was unchanged at 4.3 per cent in March. A range of other indicators, including the underemployment rate and underutilisation rate, also suggest that labour market conditions remain somewhat tight.

Underlying inflation picked up to 3.5 per cent over the year to the March quarter, though the quarterly outcome was a little lower than expected in the February Statement. The elevated rate of underlying inflation in the March quarter reflected ongoing strength across a broad range of components, including market services.

The conflict has driven global oil prices sharply higher.

The conflict in the Middle East has severely disrupted energy production and shipping in the region, driving sharp increases in the global prices of oil and liquefied natural gas. The conflict has also had a significant impact on the production and trade of other commodities that are key inputs into industries such as agriculture and manufacturing. These disruptions will persist for some time even after the conflict ends. Measures of global economic uncertainty have increased.

The conflict has contributed to a modest tightening in global financial conditions. Market expectations of central bank policy rates have increased in advanced economies, including in Australia, consistent with an expectation that central banks will tighten policy to meet their inflation targets. Uncertainty surrounding the conflict has made global financial markets more volatile, though they have remained functional and risk premia have returned to low levels in recent weeks.

In line with these developments, Australian financial conditions have tightened, in part reflecting the impact of the conflict on cash rate expectations, and recent cash rate increases, which have been passed on to lending and deposit rates. The Australian dollar has appreciated on a trade-weighted basis since the February Statement and remains consistent with its fundamental determinants, including the rise in government bond yields in Australia relative to those in major advanced economies. Even so, the extent to which Australian financial conditions are restrictive overall remains uncertain, with credit growth well above its long-run average and funding remaining readily available for banks, households and businesses. Market participants expect the cash rate to increase by 60 basis points to 4.7 per cent by the end of 2026.

Higher oil prices have already pushed inflation higher and sentiment lower.

The effects of the conflict on global and domestic inflation are already evident, with data for March showing a sharp increase in headline inflation in most economies, including Australia.

In Australia, headline inflation increased to 4.6 per cent in March, with the higher fuel prices contributing 0.8 percentage points. The outcome also reflected the expiry of electricity rebates and strength in underlying inflation. The full effects of higher fuel costs on underlying inflation will take time to materialise as they typically pass through to other goods and services prices gradually.

Financial market measures of long-term inflation expectations remain anchored around the midpoint of the inflation target, while short-term inflation expectations have risen. Short-term inflation expectations have risen this year, particularly since the conflict in the Middle East. If the increase in inflation expectations persists, this could feed into actual price- and wage-setting behaviour and pose the risk of inflation being above target for even longer.

The conflict has also led to a sharp drop in consumer sentiment and business confidence, though timely consumer spending data do not suggest a material slowing in household consumption over the same period.

Inflation is expected to ease towards 2½ per cent by mid-2028, and growth is forecast to be lower than previously expected.

The inflation outlook for Australia’s major trading partners has been revised higher, while revisions to GDP growth in each region vary. Overall, the disruptions to global energy supply from the conflict are expected to weigh on global economic activity in the year ahead and largely offset the boost from AI-related investment.

In the baseline forecasts, which assume oil prices recede somewhat gradually over coming quarters, the near-term outlook for inflation in Australia is materially higher than expected in the February Statement. Higher fuel and raw material costs are expected to boost inflation over the next few quarters. Headline inflation is expected to peak at 4.8 per cent in mid-2026, and underlying inflation is expected to remain above 3 per cent until mid-2027.

Australian GDP growth is forecast to be a little lower than previously expected due to higher fuel prices and the assumed higher path for interest rates. In the near term, higher fuel prices will erode real household disposable incomes, which is expected to slow household consumption growth. As this temporary effect wanes, the assumed higher path for interest rates (reflected in market pricing) is expected to weigh on activity and the labour market. Labour market conditions are expected to ease by a little more than expected in the February Statement, which would leave it operating with a little spare capacity by mid-2028. As capacity pressures ease and fuel-related costs decline, underlying inflation is projected to ease towards 2½ per cent by mid-2028.

Uncertainty about the duration and severity of the conflict and its effects on the Australian economy mean the outlook is more uncertain than usual.

A plausible risk is that the conflict is more prolonged and results in more significant and longer-lasting damage to energy production. If energy prices remain high over the forecast period because of a longer or more severe conflict, inflation can be expected to be higher, which will reduce growth in household disposable incomes and household consumption, and businesses potentially reducing investment spending. If uncertainty becomes particularly high, households and businesses could cut their spending by much more, which would mitigate some of the increase in inflation but lead to a higher unemployment rate.

The Monetary Policy Board decided to raise the cash rate target.

The Board assessed that inflation is likely to remain above target for some time and that the risks remain tilted to the upside, including to inflation expectations. Higher fuel prices are adding to inflation and there are indications that this is likely to have second-round effects on prices for goods and services more broadly. This is in addition to the high inflation around the start of 2026, reflecting capacity pressures in the economy. The Board will be attentive to the data and the evolving assessment of the outlook and risks to guide its decisions. Having raised the cash rate three times, monetary policy is well placed to respond to developments and the Board is focused on its mandate to deliver price stability and full employment.