Borrowers have been hit with a further rate hike after a one-month reprieve and the central bank has warned that "further tightening may be required".
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In a pre-budget move that surprised markets, the Reserve Bank of Australia decided to lift its official cash rate to 3.85 per cent - its highest point in 11 years - adding almost $100 to monthly repayments on an average mortgage.
The hike comes a week after official figures showed that headline inflation grew by 7 per cent in the first three months of the year, a 0.8 of a percentage point decline from the previous quarter but still well above the central bank's 2 to 3 per cent target band.
RBA governor Philip Lowe said inflation was "still too high" and said the bank's central case was that it will take two years to get back to the top of the target range.
"Given the importance of returning inflation to target within a reasonable timeframe, the board judged that a further increase in interest rates was warranted," he said.
Treasurer Jim Chalmers said the rate rise was a "pretty brutal reminder" of the difficult economic environment.
"This is a really difficult decision for a lot of Australians who are already under the pump," Dr Chalmers said. "This is a reminder of the difficult economic conditions in which we are framing this second budget."
The treasurer said the budget would contain a package of measures aimed at relieving cost of living pressures on households.
"It will be a responsible budget to see people through a difficult period. It will prioritise the most vulnerable Australians [but] will not add significantly to the inflation challenge," he said.
While the pace of goods inflation is easing, Dr Lowe said the price of services was climbing fast and labour costs were rising "briskly".
While aggregate wages growth was consistent with achieving the inflation target, the RBA governor repeated concerns of the risk of a damaging price-wage spiral developing, particularly given the very low level of unemployment.
"The board remains alert to the risk that expectations of ongoing high inflation contribute to larger increases in both prices and wages," he said. "It will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms."
The RBA continues to expect that the economy will avoid a recession but predicts growth in the coming two years will be modest.
![The RBA has delivered its latest decision on interest rates. Pictures by Keegan Carroll, Elesa Kurtz The RBA has delivered its latest decision on interest rates. Pictures by Keegan Carroll, Elesa Kurtz](/images/transform/v1/crop/frm/3BUUzmFAhrhLyX9rFCubPq5/26535d42-d651-493d-86f5-4fd85a36a126.jpg/r0_0_3840_2159_w1200_h678_fmax.jpg)
Dr Lowe said gross domestic product would increase by 1.25 per cent this year and 2 per cent in 2024-25. The short-term forecast is significantly lower than the central bank was predicting three months ago, suggesting it expects the economy will need to weaken substantially if inflation is to come down.
As a result of the slowdown, the RBA thinks the unemployment rate will edge higher to reach 4.5 per cent by mid-2025.
The RBA governor said the strength of household consumption remained a significant source of uncertainty, as did the outlook for the global economy.
He warned against expecting an end to the current tightening cycle.
"Some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will depend upon how the economy and inflation evolve," he said.
"The board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that."
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Dr Lowe will deliver a detailed explanation of the reasons for the rate decision in a major speech in Perth on Tuesday night and the Reserve Bank will provide its latest assessment of the economy and the outlook when it releases its Statement on Monetary Policy on Friday.
There will be enormous interest in the RBA's projections for inflation, growth and employment.
It has been forecasting that inflation will stay above the 2 to 3 per cent target band until mid-2025 but there is speculation it will come down more quickly than that, raising the possibility that interest rates could come down as soon as late this year.
Opposition treasury spokesman Angus Taylor said the RBA rate hike was a "wake up call for the government".
Mr Taylor said the inflation being felt now was "homegrown" and the government needed to do much more to tackle inflation and reduce pressure on interest rates.
"They need to deliver a budget surplus. An ongoing commitment to to budget balance is absolutely crucial to take pressure off interest rates and inflation," he said.
His call was echoed by KPMG chief economist Brendan Rynne, who said a budget that did not add to aggregate demand might be sufficient.
"Arguably the maintenance of current levels of expenditure will not help in the fight against inflation," Dr Rynne said. "Today's announcement tells us that fiscal policy needs to do more and adopt a contractionary, rather than neutral stance.
"An approach of not adding to aggregate demand by not spending more may not be sufficient."
EY Oceania chief economist Cherelle Murphy said the rate increase meant that government "has very little room for spending that is not offset by savings elsewhere".
Ms Murphy warned that although the end of the rate hiking cycle was getting closer, "further rate hikes are possible - and we think likely".