Australian economy picks up speed, but managing inflation and rates is getting harder

Australia’s economy grew at its fastest annual rate in almost three years in the December quarter, rising 2.6%, although this is still modest growth by historical standards.

Gross domestic product (GDP) for the quarter rose 0.8%, picking up from 0.5% in the September quarter, according to the Australian Bureau of Statistics. Both private-sector and government spending contributed to growth.

But the report predates the latest conflict in the Middle East. The economy now faces the challenge of higher petrol prices and geopolitical uncertainty, which could slow future growth.

Treasurer Jim Chalmers said the numbers were encouraging at a time of “intense global economic volatility”.

The combination of a possible slowing in economic growth and inflation above the Reserve Bank of Australia’s target band makes its next move on interest rates especially tricky.

What areas of the economy are growing most?

Household spending grew by 0.3% in the quarter, and by 2.4% through the year. At the same time, people were saving more of their income. The household saving ratio increased to 6.9%, up from 6.1% in the September quarter. It is now at its highest level since the September quarter 2022.

Government spending grew by 0.9%; 1.0% by state and local governments, 0.8% by the Commonwealth. State spending was the main driver, reflecting electricity rebates, health, education and police.

Claims that inflation is mostly being pushed up by rampant government spending are exaggerated. While it makes a contribution, it is only one of many factors. The private and public sectors each contributed 0.3 percentage points to growth in the latest quarter.

Read more: Is federal government spending really to blame for higher inflation? It’s not clear cut

GDP per person grew by 0.9% over the course of 2025. This represents a modest improvement in material living standards (one but not the only component of quality of life). It is better than declines in real GDP per person in some recent periods.

Short-term pressures

The Middle East war has led to higher oil prices. This adds to Australia’s inflation; however, we have no way to tell whether this is a short- or long-term effect. The war could be over next week, or last for months.

Moreover, raising interest rates in Australia would not target the underlying cause of the shock. Reserve Bank Governor Michele Bullock is right to be cautious about predicting the war’s economic impact.

A rule of thumb is that every US$1 rise in the price of a barrel of oil translates into 1 cent a litre at the bowser for Australians. If the oil price stays around $20 a barrel higher than before the US and Israeli attacks on Iran, petrol prices here would rise 20c per litre, or about 10%.

As petrol has a weight of around 3% in the consumer price index, this would add 0.3% to inflation.

Read more: Why surging oil prices are a shock for the global economy – but not yet a crisis

The other short-term influence on economic conditions will be the federal budget in May. If it helps improve productivity over time, that will ease capacity constraints and allow higher growth without added inflation.

An important step would be to encourage more competition in sectors dominated by a few large firms, such as supermarkets and banking. That would make them likely to invest in better machinery or processes, and use labour more efficiently.

The longer-term view

The 2.6% growth rate in 2025 is above the Reserve Bank’s estimate of the long-term potential growth rate of 2%.

But is 2% really the best we can sustain? Should 2% be the “speed limit” for our economy?

“Speed limit” is merely a metaphor for capacity constraints. If the economy grows faster than available resources such as labour and capital, and improvements in efficiency, can keep up, then firms will compete for resources and drive up prices.

There are differing views on whether this would happen at 2% growth. Treasury thinks the sustainable growth limit is a bit higher, at 2.2%. Former Reserve Bank assistant governor Luci Ellis also thinks 2% is too pessimistic.

Economic growth used to be much higher. Fifteen years ago, former RBA governor Glenn Stevens speculated the “speed limit” was 3% (a pessimistic view then).

The average growth rate of 2.2% in the past decade is well below the average annual growth rate of 3.5% Australia managed in the 1990s and 3% in the 2000s. It compares even less favourably with the growth rate of more than 5% in the 1960s.

There is a risk of 2% growth becoming a self-fulfilling prophecy if the Reserve Bank raises interest rates any time the economy grows significantly faster. The evidence that the economy is currently overheating is limited. Wage growth, for example, has been under 3.5% since late 2024.

What does it mean for interest rates?

The Reserve Bank had forecast real GDP growth of 2.3% in 2025, so today’s number is unlikely to lead to a significant policy revision.

The RBA’s latest forecast is based on the assumption that its key interest rate, the cash rate, would increase further this year. Another interest rate rise is likely.

While Bullock regards the March meeting, and indeed “every meeting”, as “live” – meaning rate changes may be on the table – she also recently referred to a need to be “patient”.

So the Reserve Bank may not move at its next meeting on March 17. Waiting until the May meeting would allow it to see whether inflation in the March quarter remained elevated.