The Reserve Bank of Australia (RBA) has lifted the cash rate by 25 basis points to 3.85%, adding to pressure on households and businesses. While the move was widely expected by markets and most economists, the Reserve Bank says inflation risks remain too high to be comfortable.
The RBA said inflation “picked up materially” in the second half of 2025. Governor Michele Bullock told a press conference:
Based on the data we have seen and the conditions here and around the world, the board now thinks it will take longer for inflation to return to target and this is not an acceptable outcome.
The rate rise reflects concern that inflation will not return to the RBA’s 2–3% target range until June 2027, according to the bank’s updated forecasts also released today.
Stronger than expected economic growth means capacity pressures are rising and keeping inflation higher than expected. Progress could stall unless interest rates are pushed a little higher.
It was the first rate increase since November 2023, and followed three cuts in 2025 when inflation was cooling.
Policy set for a year ahead
In the lead-up to the meeting, there appeared to be a gap between market expectations and the RBA’s own comments. Markets and many economists focused on the latest inflation data, which showed a renewed uptick, particularly in prices for services. That data strengthened the case for a rate rise at this meeting.
The RBA, however, has repeatedly emphasised it does not set policy based on short-term movements in inflation.
That message has been reflected in recent meeting minutes and reinforced in a January ABC interview with Andrew Hauser, the RBA’s deputy governor. He said interest rate decisions are guided by where inflation is expected to be in about a year’s time – not where it has been over the past quarter or two.
Today’s decision suggests that, on that forward-looking view, the RBA became less comfortable with the inflation outlook. Rather than a temporary overshoot, the path back to the 2-3% inflation target will take longer than previously thought.
What’s driving inflation?
The latest consumer price index (CPI) figures help explain the Reserve Bank’s caution. Trimmed mean inflation – the RBA’s preferred underlying measure – was 3.3% in the year to December, up from 3.2% in the year to November. That puts underlying inflation clearly above the target range.
More importantly, recent inflation pressures have been led by services prices. Costs related to rents, insurance, health and education have continued to rise, reflecting domestic pressures such as wages and business operating costs.
In its statement, the RBA pointed to stronger demand and ongoing capacity constraints as key concerns:
Private demand is growing more quickly than expected, capacity pressures are greater than previously assessed and labour market conditions are a little tight.
Services inflation tends to fall slowly. Unlike petrol or food prices, it does not usually reverse quickly once it picks up. For the RBA, this persistence increases the risk inflation could remain above target for longer than hoped.
Why the RBA moved now
Faced with these risks, the bank appears to have concluded that waiting would have been the bigger gamble. If inflation stayed above target for too long, or if expectations began to drift higher, the RBA could later be forced into sharper and more disruptive rate rises.
By lifting the cash rate to 3.85% now, the Reserve Bank is trying to stay ahead of the problem. A modest move today may reduce the chance of more aggressive action later.
Australia is out of step
This decision also puts Australia out of step with several other major economies.
In the United States, the Federal Reserve cut interest rates three times in 2025 and is signalling further cuts are likely this year. The European Central Bank has moved even faster, cutting rates eight times between June 2024 and June 2025 to boost growth.
By contrast, Australia’s inflation challenge appears more domestically driven, particularly through persistent services inflation. That helps explain why it is moving in the opposite direction to many of its global peers.
Credibility and what comes next
The quick turnaround after the last rate cut in August may raise questions about the RBA’s earlier judgement. But inflation risks remain tilted to the upside.
The board judged that inflation is likely to remain above target for some time and it was appropriate to increase the cash rate target.
For households and businesses, the message is clear. Borrowing costs and mortgage repayments are rising again.
What happens next will depend largely on whether services inflation begins to cool and whether wage growth shows clearer signs of moderation.
If inflation resumes a steady decline towards the target band, this increase could be a one-off rise. If not, the RBA has signalled it is prepared to do more.
For now, the message from the Reserve Bank is simple: inflation is lower than it was, but still too high for comfort – and interest rates are likely to stay higher for longer until that changes.
Stella Huangfu does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
