Stubborn inflation spooks Reserve Bank, heightens govt risk

In December, the central bank's board thought that while more interest rates were likely, it was not on a pre-set path and even flagged the possibility that the cash rate could stay unchanged "for a period".

But it appears to have been unnerved by developments since then, not least persistently high global inflation and the detail of the December quarter consumer price index which showed underling domestic price pressures were unexpectedly high.

And while there are mixed signals about the strength of consumer spending, the RBA is concerned that solid domestic demand is exacerbating the inflation problem.

Adding to its anxiety is the possibility that very high demand for workers could eventually lead to a wage-price spiral.

Linked to this is the fear that the longer inflation remains elevated, the more it becomes entrenched in people's expectations, and the more ambitious wage demands become.

In his statement announcing Tuesday's rate hike, Reserve Bank governor Philip Lowe was unequivocal that elevated price pressures are the central bank's overriding goal.

"The [RBA] board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that," he said.

All along, the challenge for the central bank has been to hike interest rates sufficiently to drag inflation back within its 2 to 3 per cent target band without snuffing out growth and sending the economy into recession.

Dr Lowe admitted in his statement that the path to such a so-called "soft landing" is a narrow one.

The betting so far has been that Australia will avoid a recession, due in no small part to signs that the giant Chinese economy is rebounding after COVID-zero policies were scrapped, as well as the resilience of the local economy.

These are treacherous economic and political waters for the Albanese government to navigate.

On one hand, it is facing calls to provide more cost-of-living relief to hard-pressed households and to fund ambitious reforms and spending plans in health, defence, aged care, the NDIS and housing.

But it is alert to the risk such expenditure could, unless managed carefully, exacerbate price pressures in the economy.

The Opposition has zeroed in on this as a potential point of vulnerability, accusing the government of lacking a credible path to a budget surplus and so adding to the inflation problem.

This line of attack is not biting yet but the longer inflation lingers and the higher interest rates go, the greater the scrutiny will be on the government's economic management credentials.