WEEKLY E-MAIL

23 February 2026

DEMAND, CAPACITY AND THE NEW INFLATION CHALLENGE IN AUSTRALIA

By Ethan Hardeman

Australia is experiencing a renewed inflationary lift, and while part of this upswing is expected to fade, the broader picture shows an economy under strain. A combination of robust private demand and historically high government spending is pushing the country close to its productive limits, and this tension between strong demand and constrained capacity is a key reason inflation has proven harder to contain.

Why the RBA Raised Rates

At its last board meeting on February 3, the RBA increased the cash rate by 25 basis points to 3.85%, citing a sharp rise in inflation in the second half of 2025 as the main driver of the decision. The RBA believes that deeper structural pressures are emerging as demand continues to outpace supply, and it is concerned that allowing inflation to remain elevated could weaken public confidence in the central bank’s commitment to its target.

Why 3.8% Inflation Still Matters & Its Impact on Living Standards

At roughly 3.8% year-on-year, inflation is far from the extreme levels seen in the 1970s or even during the surge in 2022; however, it is still outside the 2-3% target band. Persistently high inflation erodes the real value of wages and savings, damaging living standards.

Australians have already long felt this squeeze; since 2020, average prices have risen about 23% while wages have increased by only around 18%, meaning workers are effectively 5% worse off in real terms. When inflation becomes entrenched, households with mortgages also face sustained pressure, as interest rates must stay higher for longer to bring inflation back under control.

Source: Macrobond, AMP

The Role of Public Spending

Government spending is playing a major part in the inflation story. While some inflationary pressures are temporary, the economy is also grappling with elevated public expenditure, which adds to demand at a time when the supply side cannot keep pace. This dynamic makes the RBA’s job more difficult, as large government outlays counteract efforts to cool the economy through higher interest rates.

In the short term, the government can moderate the pace of public spending, which would in turn ease pressure on demand and reduce the need for further rate hikes. In the long term, they can strengthen the economy’s productive capacity by expanding supply, removing bottlenecks and red tape, allowing the economy to grow without pushing prices higher whenever demand rises.

Conclusion

Inflation in Australia is not spiralling out of control. Still, it is proving stubborn because strong demand – both private and public – is hitting a ceiling in what the economy can supply, and the RBA’s rate increases reflect this tension. Future stability will likely depend on a better balance between fiscal policy and monetary policy: The central bank cannot manage inflation on its own while government spending remains elevated.

Ethan Hardeman
Junior Paraplanner

If you have any questions or comments, please email me at ethan@gfmwealth.com.au

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