Three Cuts Forward, Four Hikes Back

The SMP suggests that interest rates will surge past their Covid peak

Today the Reserve Bank of Australia hiked the cash rate 25 basis points to 3.85%. But the biggest news was event was buried in the forecast table of the Statement on Monetary Policy. The RBA’s forecasts, taken at face value, imply that four interest rate hikes in 2026 is the most likely outcome.

The RBA’s forecasts are conditioned on a set of “technical assumptions.” The most important of these is the cash rate path, which is derived from market pricing as of January 28. That assumed path has the cash rate rising to around 3.9% by mid-2026 and peaking at 4.3%. In other words, the forecasts already assume roughly two more 25 basis point hikes beyond today’s move ie three hikes in total.

What doe these three hikes produce in terms of inflation outcomes over the forecast horizon?

Trimmed mean inflation is forecast to be 3.7% by June 2026, falling to 3.2% by December 2026, then 2.8% by June 2027. Even at the end of the forecast horizon it is still above the midpoint of the target at 2.6%.

Even with three rate hikes in 2026, the RBA does not forecast trimmed mean inflation returning to the midpoint of the 2–3% target band at any point in the entire forecast horizon. The best they can manage is 2.6%, still above target, two and a half years from now.

The whole point of the RBA’s inflation-targeting framework is to set policy such that inflation returns to the midpoint of the 2–3% target band within a “reasonable timeframe.”

So if three hikes gets you only to 2.6%, you need at least four to credibly aim for 2.5%. This isn’t a heroic extrapolation. The forecast profile is very flat on the way down. An additional 25 basis point hike - taking the cash rate to 4.6% higher than the post pandemic peak!! - is the minimum marginal tightening required to bend the inflation path down to the midpoint within a reasonable timeframe. Four hikes in 2026.

And I don’t think the picture on the unemployment side gives any reason to think that that will dissuade the RBA from hiking four times. Under the current set of forecasts, the unemployment rate picks up to peak at 4.6% by the end of the forecast horizon. It’s a bit unclear what the RBA views as the NAIRU or the level of full employment, because they don’t explicitly publish that number. But given the recent run of inflation data, a NAIRU estimate of higher than 4.6% is highly likely. My own model suggest it’s closer to 5%.

Of course this is not set in stone. A sharper-than-expected slowdown in private demand, a global disinflationary shock or a material appreciation of the Australian dollar, which the RBA has assumed holds flat at current levels would change the trajectory.

But each of these is a hope, not a baseline. The baseline, as revealed by the RBA’s own published numbers, is that the current degree of tightening — including the hikes markets have already priced — is insufficient. The RBA will either need to tighten further, or it will need to accept inflation settling above target. Given the unanimous vote today, that acceptance looks unlikely.