Article by Matthew Cranston, courtesy of The Australian.
10.11.2025
Australia’s economy is at risk of being “boxed in” by its own capacity constraints that could lead to higher inflation and “little room” for further interest rate cuts, the Reserve Bank has warned, while economists say government spending on unproductive investments will compound the risk.
After the Reserve Bank last week left interest rates on hold and admitted it may have “misjudged” the capacity in the economy, the central bank’s deputy governor, Andrew Hauser, told investors on Monday that the capacity buffer in the economy was now the smallest it had been in an economic recovery for 40 years and could lead to higher inflation.
The warning comes as the Prime Minister signalled billions of dollars in rebates “won’t be a permanent feature” and stressed “the need to make sure that the economic management is got right”.
Mr Hauser told a UBS Australasia Conference in Sydney that through the past 40 years the capacity buffer typically provided room for a period of above-trend growth in activity and rising demand without generating excessive inflationary pressures.
“But this time looks different,” Mr Hauser said.
“Our central estimate suggests that demand was slightly above potential output at the time GDP growth started to pick up last year.
“The bigger-picture challenge for the economy over the medium term … is how to create more supply capacity.
“If we fail to do so, we may find ourselves boxed in on the rail. On that view, there may be little scope for demand growth to rise further without adding to inflationary pressures, and hence there may be little room for further policy easing.”
The RBA lifted forecasts on inflation last week, saying the key measure of underlying inflation would not return to the bank’s target range until midway through next year.
Immediately following Mr Hauser’s speech, financial markets priced in even less of a chance of a rate cut by June next year. Overall financial bets still point to no rate cuts at all next year, leaving the official interest rate at 3.6 per cent.
Economists such as Optimal Economics chief economist Stephen Walters said part of the problem with Australia’s tighter spare capacity was that government was pouring taxpayer money into unproductive investments.
“The deputy governor belled the cat today by saying there are costs involved of a low-productivity economy,” Mr Walters said.
“What we’re learning now is that if you have a low-productivity performance for an extended period of time, your productive capacity comes down, so as growth starts picking up, you immediately end up with an inflation problem.
“I’m very concerned about the amount of taxpayers’ money that’s getting poured into propping up unproductive industries under the Future Made in Australia banner.
“This is reinforcing our low-productivity economy when we should be directing resources into higher-productivity parts of the economy, like mining.”
UBS chief economist George Tharenou said the deputy governor’s comments were “on the hawkish side”, and that as such UBS maintained its view that the “RBA will hold the cash rate unchanged ahead, with a terminal rate of 3.6 per cent”.
“CPI is already at or above the top of their target band, and the labour market is still a ‘bit tight’,” Mr Tharenou said.
Mr Hauser highlighted that the tight capacity would continue to be driven by the labour market, where “firms continue to report recruitment difficulties” and “unit labour costs are growing strongly”.
The official unemployment rate will be released on Thursday, with most economists expecting an easing back to 4.4 per cent after having risen to 4.5 per cent last month. The RBA does not expect the unemployment rate to reach more than 4.4 per cent for the next two years.
Mr Hauser also said there was anecdotal evidence that suggested the capacity buffer is still tight, referencing the NAB business survey. “No models, no equations – but the same result: capacity utilisation was higher at the start of the current recovery than in any similar situation in recent decades, and materially above the whole-period average,” Mr Hauser said.
Potential output growth has fallen from 2.5 per cent per year in the decade before the pandemic to 1.5 per cent in 2020-25; and the Reserve Bank now expects that to only pick up “a little” to around 2 per cent in each of the next two years. This reflects the RBA’s downgrade to near-term annual trend productivity growth, from 1 per cent per year to 0.7 per cent.
Other scenarios Mr Hauser put forward include that “maybe there’s more capacity today than the estimates suggest”, that “ demand is weaker” and that “capacity pressures have only a weak effect on inflation”.
If that’s the case, then “further policy easing may be necessary at some horizon”.
The third scenario sees the economy become more productive as firms make “fuller use of existing staff” and “paused investment projects are brought back online”. This drives up labour productivity.
But “here there is work to do”, Mr Hauser said, because capital expenditure intentions suggest “little or no growth over the 2025-26 financial year” and private investment as a share of GDP remains well below its peak.
