A senior official of the Reserve Bank of Australia has delivered a stark assessment of how renewed conflict in the Middle East is reshaping the global inflation landscape and feeding directly into Australia’s domestic price dynamics. Speaking at a major investment forum in Sydney, Assistant Governor Sarah Hunter set out how the central bank is interpreting the recent surge in oil prices through its inflation framework, warning that the external shock is arriving at a time when the Australian economy is already operating under significant capacity constraints and elevated underlying inflation.
Her speech outlined a careful but increasingly uneasy balancing act for monetary policy. On one hand, inflation in Australia had already been running above the RBA’s 2 to 3 per cent target band before the geopolitical shock emerged, driven in part by strong domestic demand and tight labour market conditions. On the other hand, the escalation in the Middle East, particularly its implications for global energy markets, has introduced a fresh supply-side pressure that is pushing headline inflation higher while also threatening to entrench expectations of continued price growth.
Hunter began by restating the central bank’s definition of price stability, emphasising that the RBA’s focus is not on individual price movements but on the average change in prices across the entire basket of goods and services consumed by households. This distinction, she noted, is critical in understanding why central banks do not respond to every fluctuation in commodity prices or imported goods. Instead, they aim to prevent temporary or sector-specific price shocks from spreading into persistent inflationary trends that affect wages, contracts, and long-term expectations.
In the current environment, however, the boundary between relative price changes and broader inflation dynamics is becoming harder to maintain. The surge in global oil prices triggered by the Middle East conflict has fed directly into fuel costs in Australia, with petrol prices rising sharply before partially retracing in recent weeks. Diesel prices, which play a larger role in freight and industrial activity, have remained elevated. According to Hunter, these direct effects alone are sufficient to lift headline inflation noticeably in the short term, with the RBA’s latest forecasts projecting a peak of 4.8 per cent in the June quarter.
But the more consequential issue for monetary policy is not the immediate spike in fuel prices. It is the way in which those costs propagate through the broader economy. Fuel is not only a final consumption good but also a key input into production and distribution across multiple sectors, including transport, logistics, agriculture, construction, and retail supply chains. As a result, higher energy costs tend to ripple outward, raising the cost base for firms well beyond the petrol station.
Hunter emphasised that the extent to which these higher costs translate into sustained inflation depends on three interrelated factors: the degree of spare capacity in the economy, the speed at which firms adjust their prices, and the expectations businesses hold about future inflation. In an economy operating below capacity, firms may be less able to pass on cost increases for fear of losing customers. But when capacity is constrained, as current RBA assessments suggest, firms face less competitive pressure and are more willing to raise prices quickly.
This dynamic is particularly relevant in Australia’s present conditions. Labour market indicators and capacity utilisation measures suggest that the economy is still operating at a tight level, even as growth is expected to moderate. In such an environment, inflationary pressures arising from external shocks are more likely to be passed through into final prices rather than absorbed by margins. The RBA’s internal research, cited in the speech, suggests that this kind of environment contributed meaningfully to the inflation surge observed in 2022 and 2023, when global supply disruptions and domestic demand pressures reinforced one another.
Another key theme of the speech was the importance of inflation expectations. Hunter stressed that while firms do not adjust prices continuously due to administrative and contractual frictions, they do attempt to anticipate future cost pressures when setting current prices. This means that inflation today is partly shaped not just by current conditions but by what businesses believe will happen in the months and years ahead.
If firms expect higher inflation to persist, they are more likely to incorporate those expectations into wage negotiations, long-term contracts, and pricing decisions. This can create what economists describe as second-round effects, where an initial supply shock leads to a more durable increase in inflation. The risk, according to Hunter, is that expectations become unanchored from the central bank’s target, making it more difficult and more costly to restore price stability later.
She pointed to historical episodes in which rising inflation expectations forced central banks to adopt more aggressive tightening cycles, ultimately resulting in sharper slowdowns in economic activity. The implication for current policy is that maintaining credibility and anchoring expectations within the target range is essential to avoiding a more disruptive adjustment in the future.
The speech also placed significant emphasis on the non-linear relationship between spare capacity and inflation, often illustrated through the Phillips curve framework. When labour markets are loose, reductions in unemployment tend to have only modest effects on inflation. However, when the economy is already close to or beyond full capacity, small additional pressures can lead to disproportionately large increases in prices. This non-linearity helps explain why inflation can accelerate rapidly in tight labour market conditions, even in response to relatively modest shocks.
Hunter noted that recent RBA research suggests that the interaction between capacity constraints and external shocks played a meaningful role in Australia’s recent inflation experience, amplifying the effect of global supply disruptions. This is particularly relevant in assessing the current oil price shock, which is occurring against a backdrop of already elevated domestic cost pressures.
Looking ahead, the RBA’s baseline outlook assumes that the Middle East conflict will eventually ease and that oil prices will partially reverse from their current elevated levels. Under this scenario, headline inflation is expected to decline after peaking in mid-2026, while underlying inflation gradually returns toward the target band by early 2028. This disinflation path is also supported by the assumption that higher prices will weigh on household real incomes, dampening consumption and easing domestic demand pressures over time.
However, Hunter made clear that this is only one possible outcome among several. The risks surrounding the outlook are substantial and skewed in both directions. On the upside, oil prices could remain elevated for longer than currently assumed, particularly if geopolitical tensions escalate further or disrupt broader energy supply chains. In such a scenario, inflation could prove more persistent, especially if firms respond by embedding higher cost expectations into pricing structures.
There is also a risk that inflation expectations themselves could become destabilised if households and businesses begin to anticipate prolonged price increases. Given the sensitivity of expectations to fuel and energy costs, even a temporary spike in oil prices could have longer-lasting effects if it influences wage bargaining and pricing behaviour across the economy.
On the downside, however, the central bank also acknowledged the possibility that higher prices could suppress demand more sharply than anticipated. If households respond to cost-of-living pressures by cutting back spending more aggressively, and if businesses reduce investment amid heightened uncertainty, inflationary pressures could ease more quickly. In addition, an increase in labour supply, as individuals seek additional work in response to real income losses, could expand productive capacity and reduce underlying price pressures.
Against this uncertain backdrop, the RBA’s Monetary Policy Board has already taken a pre-emptive stance. Hunter confirmed that the Board recently raised the cash rate to 4.35 per cent, citing the combined effect of domestic capacity constraints and the external oil price shock. The decision reflects concern that without tighter policy, inflation could remain above target for longer and risk becoming embedded in expectations.
At the same time, she emphasised that monetary policy is not on a predetermined path. Instead, future decisions will depend on incoming data and the evolving balance of risks. This reflects a broader recognition that the current inflation environment is being shaped by a complex interaction of domestic demand conditions, global supply shocks, and behavioural responses from firms and households.
The speech ultimately conveyed a clear message: while the immediate source of inflationary pressure may lie in geopolitical disruption abroad, its persistence and domestic impact will be determined by conditions within the Australian economy itself. In an environment where capacity is constrained and expectations are fragile, external shocks can travel quickly and embed themselves more deeply than in calmer times.
For policymakers, the challenge is no longer simply about responding to inflation after it appears in the data, but about preventing temporary shocks from evolving into sustained inflationary regimes. In Hunter’s framing, that task has become significantly more complex in a world where geopolitical instability is once again an active driver of economic outcomes, and where the boundaries between external and domestic inflation pressures are increasingly blurred.
