Among the evidence Governor Michele Bullock cited for September's rate rise was a message from the Reserve Bank's own conversations with firms: costs are expected to keep climbing strongly.

Official statistics tell a central bank where the economy has been. Talking to the people who run businesses can tell it where things might be heading. That is why one line from Governor Michele Bullock's 29 September media conference deserves a closer look.

"Indeed, businesses in our liaison program continue to expect strong increases in their costs over the year ahead," the Governor said, as she explained why the Monetary Policy Board had lifted the cash rate target by 25 basis points to 4.60 per cent.

The comment was brief, but it goes to the heart of the Board's concern. Inflation is not only about what prices have done; it is about what firms and households expect them to do next, and how they behave as a result.

What the liaison program adds

The RBA's liaison program involves regular discussions between Bank staff and businesses about the conditions they face. It offers a qualitative, on-the-ground read that complements the published data on prices, wages and activity, and can help pick up shifts early.

The word "continue" in Bullock's remark is significant. It suggests the expectation of strong cost growth is not a one-off reading but a persistent theme. Combined with other signals, it helped persuade the Board that inflation risks were tilting the wrong way.

The Board's 29 September statement said several upside risks to inflation flagged in August were now materialising. Among them were firms raising, or planning to raise, their prices. The statement also said short-term inflation expectations are high and that recent inflation outcomes had been stronger than expected.

Where the cost pressure is coming from

The RBA's recent communications point to several sources of pressure on business costs.

  • Energy and transport. Bullock described the Middle East conflict as "a big shock" and said "fuel prices, fertiliser prices, transport prices, all these things now are permanently higher."
  • Labour. The August Statement on Monetary Policy described unit labour cost growth of 3.3 per cent over the year to the March quarter as "elevated". The August minutes recorded that the near-term wage forecast had been "slightly upgraded" due to recent wage decisions and agreements.
  • Technology. The Board flagged AI-related demand pushing up technology goods prices, a point Bullock also made to a parliamentary committee on 18 September.
  • Capacity. "Inflation is too high and has been driven by domestic capacity pressures," the Governor said. Firms operating near full stretch face higher costs to expand and have more room to pass them on.

Weak productivity compounds the picture. When output per worker barely grows, rising wages translate more directly into higher costs per unit produced. Bullock put it bluntly: "The bottom line is that productivity is doing nothing."

Why expectations matter

The worry for a central bank is that cost expectations become self-fulfilling. If firms broadly anticipate strong cost growth, they may build it into their pricing plans in advance. Workers and households who expect higher prices may adjust their own behaviour too. Over time, that can make elevated inflation harder to shift.

The Board said it is focused on preventing high inflation from becoming embedded. Its September statement judged that "a further tightening of financial conditions" was warranted to return inflation to target within a reasonable period.

The scale of the gap is clear in the data. Headline inflation, as measured by the monthly CPI indicator, was 4.0 per cent annually in August. Over the year to the June quarter, headline CPI was 3.9 per cent and trimmed mean, the RBA's preferred underlying measure, was 3.6 per cent. Bullock described underlying inflation on 29 September as "about 3.5 per cent", roughly a percentage point above the 2.5 per cent midpoint of the target range.

She also gave a sense of the pace needed. Quarterly inflation, she said, needs to be "more around .6 rather than .8 and 1". About 0.6 per cent a quarter is consistent with roughly 2.5 per cent a year.

Uneven pressure, and no spiral

A tougher operating environment does not affect all firms equally. The RBA's Financial Stability Review, released on 1 October, found that most businesses can absorb higher costs, though conditions are tougher in some sectors. Business insolvencies "remain elevated in some industries, particularly hospitality, construction and transport", the review said.

At the same time, many firms are still expanding. The Board's statement described business investment and debt growth as strong, and the Financial Stability Review noted business credit growth has been "above its post-GFC average for a couple of years".

That combination, strong investment and borrowing alongside expectations of rising costs, is consistent with an economy where demand remains robust relative to its capacity.

Rising costs and rising prices can raise the spectre of a wage-price spiral, where each feeds the other. The Governor rejected that description at her media conference: "I concur with his view that, no, this is not a wage price spiral."

Monetary Policy Board member Iain Ross AO, speaking in a personal capacity on 22 September, reached a similar conclusion, saying "there is no evidence of the emergence of a wage-price spiral in the present circumstances".

So the liaison signal is less about wages chasing prices and more about a broad range of input costs, from fuel to labour to technology, remaining under upward pressure.

The Board has not committed to a path. "I'm not going to give you forward guidance," Bullock said, while also stating that "The Board will increase interest rates again if that's what's needed to get inflation down."

The September minutes are due at 11.30 am AEDT on 13 October, the next CPI release is on 28 October, and the next decision is at 2.30 pm on 3 November. The Board has said it will remain attentive to the data, and further readings on business costs and pricing intentions are likely to form part of that picture.

The Governor also noted that the full effect of this year's earlier rises has not yet been felt. "A lot of that effect is still to flow through," she said, adding that policy can take "12, perhaps even 18 months" to work through fully.

The bottom line

The liaison program gave the Board a direct line into how businesses see the year ahead, and the message was that strong cost increases are still expected. Set against high short-term inflation expectations, firms raising prices and underlying inflation about a percentage point above the target midpoint, that signal helped tip the balance towards September's hike. The Board's stated aim is to stop high inflation becoming embedded, and business cost expectations will remain one of the gauges it watches.