The Reserve Bank's own forecasts pointed to subdued economic growth this year, yet the Monetary Policy Board raised rates again in September. The explanation lies in the economy's speed limit.

At first glance, it looks like a contradiction. In August, the Reserve Bank of Australia forecast that the economy would grow by just 1.4 per cent over the year to December 2026. Then, on 29 September, the Monetary Policy Board lifted the cash rate target by 25 basis points to 4.60 per cent, its fourth increase this year.

Raising interest rates when growth is modest can seem counterintuitive. Higher rates are designed to slow the economy, so why apply the brakes when it is not exactly racing? The answer, according to the RBA's recent communications, is that the speed at which the economy can grow without generating inflation has itself slowed.

What the August forecasts showed

The August Statement on Monetary Policy set out a path for gross domestic product, measured as year-ended growth:

  • 1.9 per cent in June 2026
  • 1.4 per cent in December 2026
  • 1.5 per cent in June 2027
  • 1.6 per cent in December 2027 and June 2028
  • 1.8 per cent in December 2028

Over the same period, unemployment was forecast to drift up from 4.4 per cent to 4.8 per cent, household consumption growth was forecast at 1.6 per cent over the year to December 2026, and employment growth at 1.4 per cent over the same period. That is a picture of an economy expanding slowly rather than contracting.

Two caveats apply. First, those forecasts were prepared with a cash rate assumption of around 4.3–4.5 per cent, before the September hike. Second, the economy has not followed the script exactly. The Board's September statement said output growth has slowed but was stronger than expected in the June quarter.

The speed limit problem

The key to the puzzle is productivity. An economy's sustainable growth rate depends on how fast its workforce grows and how much more each worker can produce. When productivity stalls, that sustainable rate, often called potential growth, falls.

Governor Michele Bullock made the point directly to the House of Representatives Standing Committee on Economics on 18 September: "Continued weak productivity growth means that the economy cannot grow strongly without putting pressure on inflation."

At her 29 September media conference she was blunter still: "The bottom line is that productivity is doing nothing."

The Board's September statement echoed this, noting that weak productivity constrains potential growth. If the economy's speed limit is low, even growth of around 1.5 per cent may be enough to keep demand pressing against capacity. Modest growth, in other words, is not necessarily slow enough.

Inflation is the target, not growth

Ultimately, the RBA's yardstick is inflation, which it aims to keep within a 2–3 per cent target range. On that front, the Board judged the economy was falling short, and by more than the growth figures alone might suggest.

"Inflation is too high and has been driven by domestic capacity pressures," Bullock said. Headline inflation, measured by the monthly CPI indicator, was 4.0 per cent over the year to August. Over the year to the June quarter, headline CPI was 3.9 per cent and trimmed mean inflation, the RBA's preferred underlying measure, was 3.6 per cent. Bullock put underlying inflation at "about 3.5 per cent", roughly a percentage point above the 2.5 per cent midpoint.

The Board's statement also said that some upside risks flagged in August were materialising, including higher global energy prices, AI-related demand pushing up technology goods prices, capacity pressures and firms raising or planning to raise prices. Short-term inflation expectations are high, and recent inflation outcomes had been stronger than expected.

Against that backdrop, the Board judged that "a further tightening of financial conditions" was warranted to return inflation to target within a reasonable period. "Higher interest rates are needed to ensure inflation returns to target," the Governor said.

Is a recession on the cards?

Slower growth plus higher rates naturally raises the question of recession. Bullock addressed it at her media conference: "That is not our central base case at this moment."

She also rejected the suggestion that Australia was experiencing stagflation, the combination of stagnant growth and high inflation. "I wouldn't call inflation of 3.5 per cent and an unemployment rate of 4.6 per cent stagflation," she said.

On jobs, the Governor noted that "the unemployment rate has risen from 3.5 per cent over the past couple of years to 4.6 per cent", but that "there's been over a million jobs created." A higher jobless rate, she said, "doesn't mean job losses." Notably, 4.6 per cent is the level the August forecasts had pencilled in for June 2027.

Other parts of the economy remain firm. The Board said business investment and debt growth are strong, even as consumer spending eases gradually, housing prices have fallen in most capital cities and new housing loans have declined noticeably.

None of this means the Board is indifferent to growth. Its statement acknowledged that uncertainty is high and that the effects of the housing downturn are uncertain. The Governor also stressed that earlier rises are still working through: "A lot of that effect is still to flow through," she said, with policy taking "12, perhaps even 18 months" to have its full effect.

That lag cuts both ways. Some of the slowing already forecast reflects rate rises not yet fully felt. But with a low speed limit and inflation still well above target, the Board judged that further tightening was warranted, given its stated focus on preventing high inflation from becoming embedded.

What happens on 3 November is open. "I'm not going to give you forward guidance," Bullock said, though she noted that "The Board will increase interest rates again if that's what's needed to get inflation down." The September minutes are due on 13 October and the next CPI release on 28 October.

The bottom line

A 1.4 per cent growth forecast for 2026 sounds soft, but the RBA's concern is not the pace of growth in isolation. It is growth relative to what the economy can sustain. With productivity weak, potential growth is low, so even modest expansion can keep capacity tight and inflation elevated. That is why the Board raised rates in September despite subdued forecasts, while stating that a recession is not its central case.