Key Highlights

  • Supply shocks can raise prices while slowing economic growth and reducing real household incomes.
  • Headline inflation remained above target at 4% in May, while underlying inflation was also still elevated.
  • Australia is more resilient than during the 1970s because of credible inflation targets and more adaptable markets.
  • The Monetary Policy Board may raise the cash rate further if current settings do not return inflation sustainably to target.

Global events can feel distant until they begin affecting petrol prices, grocery bills, employment conditions or mortgage repayments. In recent years, Australia has faced a succession of supply shocks arising from the COVID-19 pandemic, Russia’s invasion of Ukraine, conflict in the Middle East, severe weather and continuing trade tensions.

These events can restrict the availability or increase the cost of essential goods. The consequences then move through businesses, households and the broader economy. Understanding this chain helps explain why inflation can remain elevated and why interest rates may rise even when economic activity is slowing.

What Is a Supply Shock?

A supply shock is an event that changes how easily an economy can produce or obtain goods and services. An oil supply disruption, for example, can increase fuel costs. Higher fuel expenses may then raise transport, construction and other business costs.

Adverse supply shocks create a difficult combination. They can constrain economic growth, reduce real incomes and increase inflationary pressure at the same time.

For households, this means prices may rise without incomes increasing proportionately. People can consequently afford fewer goods and services than before. Businesses may also face higher non-labour costs and attempt to pass some of those expenses on through higher prices.

Why Is Inflation Still a Concern?

Australian inflation declined considerably from its earlier peak, while underlying inflation moderated during 2024 and 2025. However, inflation subsequently increased and moved above target before the latest oil price rises.

Headline inflation stood at 4% in May. The effect of the Middle East conflict on fuel prices and headline inflation had been smaller than initially feared, but underlying inflation remained too high.

Underlying inflation removes some of the volatility associated with frequently changing prices. It therefore provides a clearer indication of persistent price pressure.

Higher fuel and construction expenses were partly reflected in an increase in new dwelling inflation in May. The RBA’s business and community liaison program also indicated that non-labour cost pressures had risen and that more firms were considering passing them on.

How Are Households and Businesses Responding?

Demand growth appears to be moderating, bringing overall spending closer to the economy’s supply capacity. There has so far been limited evidence that higher oil prices caused a major reduction in household expenditure, partly because of temporary measures such as lower fuel excise.

Consumer sentiment remains very weak, although it has recovered somewhat from its April trough. Household spending has proved more resilient than sentiment alone would suggest, while saving rates appear relatively stable.

Business confidence dropped sharply when the Middle East conflict began but later recovered to some extent. Business conditions and capacity utilisation recorded smaller declines. Investment was stronger than expected, largely because of expenditure on data centres.

What Is Happening in Housing and Employment?

Housing conditions have weakened by more than expected. Price declines have centred on Sydney and Melbourne, although prices in both markets remain around their levels before interest rates began rising in February.

Monetary policy does not directly target property prices. Housing matters because price changes can influence household expenditure, investment decisions and inflation.

The labour market has also eased somewhat more than anticipated. Unemployment rose by more than expected, although job advertisements remained comparatively resilient. Some businesses paused recruitment during the early stages of the conflict, with indications that hiring later began to resume.

Further easing in labour market conditions is likely to be required to help return inflation to target.

Why Does Productivity Matter?

Productivity describes how effectively labour and other resources produce goods and services. Australia’s persistently weak productivity growth has restricted improvements in real incomes and wages.

When the economy’s supply capacity grows slowly, additional demand can generate inflation more quickly. Business investment, including spending on new technologies such as artificial intelligence, may increase productivity and supply capacity over time. However, the scale and timing of these effects remain uncertain.

Monetary policy cannot resolve slow productivity growth. Its contribution is to maintain low and stable inflation while supporting sustainable full employment.

What Can Australia Learn from the 1970s?

Oil prices increased two- to three-fold during the shocks of 1973 and 1979. Inflation expectations eventually became embedded in household and business decisions, making inflation harder to reverse.

Australian inflation reached 12½% in 1982. By the end of 1984, it had fallen to around 2½%, but unemployment had climbed from approximately 6% at the beginning of the decade to 10½% in 1983.

Today, credible inflation targets, flexible exchange rates, deeper financial markets and more adaptable product and labour markets provide greater resilience. Supply shocks still impose costs, but the economy is better equipped to absorb them.

What May Shape Monetary Policy Next?

  • The flow-through of fuel costs into other prices
  • Changes in domestic demand and household spending
  • Labour market conditions and unemployment
  • Business cost pressures and pricing decisions
  • Productivity and the economy’s supply capacity
  • Whether earlier cash rate increases sufficiently reduce inflation

Risks

Multiple supply shocks occurring close together could intensify pressure on inflation and economic activity. Monetary policy also works with a delay, meaning the full impact of earlier cash rate increases has not yet appeared. If cost pressures become embedded, returning inflation to target could require tighter policy and weaker demand.