Monetary policy in an era of shocks

1. A run of supply shocks

At a Sydney fundraising lunch for a youth mental health charity, her third as Governor, the head of the Reserve Bank of Australia described recent years as a succession of disruptions on the supply side: the pandemic, the energy surge after Russia invaded Ukraine, and now the Middle East conflict, extreme weather and trade disputes. She compared this period with the oil crises of the 1970s and argued that today's economy absorbs such shocks better, largely because credible inflation targets keep expectations steady. Shocks still cut growth and real incomes, so the bank's task is to stop them from turning into lasting inflation. Because price and capacity pressures were already elevated, the bank raised rates earlier in the year.

2. Where inflation stands

After the post-pandemic surge, Australian inflation fell markedly in 2024 and 2025 and looked set to return to target. It then climbed again, above target even before oil prices jumped. Headline inflation reached 4% in May, and the underlying measure, while following the bank's May forecast, remains too high. This reflects demand pressing on capacity and some pass-through of fuel costs, for example into the price of new homes, and firms report rising non-wage costs they intend to pass on. A recent survey showed inflation is the top economic worry of Australians.

3. How the economy is adjusting

Five months into the conflict, its full effect is still unclear and commodity prices remain volatile, while earlier rate rises have not yet fully worked through. Demand is slowing broadly as planned. Household spending has held up better than very weak confidence suggests, helped by a temporary cut in fuel tax, and saving rates are steady. Business confidence fell at the outbreak but has partly recovered, and investment has been stronger than expected thanks to data centres. Housing has cooled more than forecast, with price falls concentrated in Sydney and Melbourne, though prices are near their level of February; fewer than 1% of borrowers owe more than their home is worth, and few face serious repayment difficulty. The bank does not target house prices, only their effect on spending and inflation. Unemployment has risen a little more than expected and some firms paused hiring, but job advertisements stay firm; some further loosening of the labour market is still needed.

4. From calm to turbulence

From the late 1980s to the 2008 crisis, the so-called Great Moderation brought steadier growth and inflation. Better frameworks helped, such as floating exchange rates, labour reforms and inflation targets, but so did luck: fewer commodity and productivity shocks and the integration of China, which lowered costs worldwide. Monetary policy could then focus on demand, and price stability and full employment rarely conflicted. Since the pandemic, repeated adverse supply shocks have lifted prices and held back growth together. For Australia they mean a loss of real income, on top of years of weak productivity. Business investment, including in artificial intelligence, is key to lifting capacity, though its effects are uncertain. When supply grows slowly, any level of demand produces more inflation, sharpening the trade-off between the bank's two goals.

5. Lessons from the 1970s

In 1973 and 1979 oil prices rose two- to threefold. The bigger damage came afterwards, as firms passed on costs, workers sought compensating wage rises and inflation spread and persisted. Early policy tried to protect activity, expectations became entrenched, and only harsh tightening and deep recessions brought inflation down. In Australia inflation reached 12.5% in 1982 and unemployment climbed from about 6% to 10.5% in 1983. Today the economy uses far less oil per unit of output, inflation targets anchor expectations and flexible supply chains adapt faster, so a single shock is less likely to cause lasting high inflation and unemployment; several overlapping shocks are harder to handle.

6. Policy outlook

The bank's aims are unchanged. Even if the oil disruption fades, fuel costs will keep spreading to other prices, and domestic pressures were already too strong. Some further slowing in demand growth is likely needed, and the open question is whether this year's tightening is enough. Monetary policy cannot fix slow productivity, which limits non-inflationary growth and real wage gains. The board stands ready to raise rates again if required.