Tightening countdown? The Australian Reserve Bank is expected to remain on hold again this week amid a resurgence in inflation, which may lead to a turnaround in interest rate hikes in 2026.

The Reserve Bank of Australia will announce its latest interest rate decision on Tuesday. Economists expect that the RBA will keep the cash rate unchanged at 3.6% for the third consecutive meeting, with market pricing of overnight index swaps confirming this view. At the same time, traders and economists are closely watching for any signs of a hawkish shift in the RBA's stance, which could indicate a possibility of rate hikes next year. Due to reignited inflation pressures, resilient domestic demand, and a tight labor market, the swap market is betting on a policy shift towards tightening in mid-2026. Therefore, market attention for the RBA's final meeting of the year will focus on the tone of the meeting statement and the subsequent press conference by RBA Governor Michele Bullock. Belinda Allen, Director of Australian Economic Research at the Commonwealth Bank of Australia, stated: "Increasing evidence suggests that economic capacity is shrinking, and the risks of inflation moving higher outweigh the risks of it moving lower, suggesting that the restrictive level of the cash rate is not as high as initially thought. We do not believe that the December meeting will explicitly consider a rate hike, but a rate cut is also not likely to be considered. The meeting statement will have to acknowledge that the balance of risks for the economy and inflation has shifted." The RBA is entering one of the shortest and most gradual easing cycles among developed countries, second only to Norway, having accumulated a total of 75 basis points in rate cuts within just six months after starting the easing cycle later than most other central banks. In contrast, traders are increasing bets that the Federal Reserve will cut rates for the third consecutive time later this week, citing reasons such as pressure from US President Trump for looser policy and data showing softening in the job market. Divergence in policy between the RBA and the Federal Reserve has led to massive sell-offs in Australian government bonds, with the benchmark 10-year bond yield climbing to 4.73%, its highest level since November 2023. This has widened the yield spread between Australian and US bonds to the highest level in over three years. Ben Willshire, Global Rates Trading Strategist at Citigroup, said, "This clearly reflects a fundamental shift in market views on the RBA's policy path, with the data and signals from the fixed income market clearly pointing towards an inclination for higher interest rate levels." As a result, the Australian inflation data for the fourth quarter to be released at the end of January next year will hold special significance. Some economists warn that if inflation data exceeds expectations again, it could prompt the RBA to open the door for rate hikes at its policy meeting on February 2-3. Recent data has shown underlying resilience in the economy: rising house prices in November, stronger-than-expected business investment in the previous quarter, and resilient household consumption. Bullock's latest assessment suggests that the output gap in the economy has closed meaning any unexpected growth in demand will quickly higher prices. Last week, she hinted while testifying before parliament that officials may need to shift back towards a tightening policy and closely monitor whether inflation pressures are strengthening again. Australia's economy is displaying resilience, but price pressures are reemerging Nevertheless, based on past performance, the RBA's policy communication on Tuesday is likely to still not provide explicit commitments, as the committee will continue to rely on data for decision-making. Policymakers may want to wait for more signals to determine whether recent inflation breaches the upper limit of the RBA's 2-3% target range are temporary fluctuations or more serious issues. However, Nick Stenner, Head of Economic Research for Australia and New Zealand at Bank of America, and former RBA official, suggests that Bullock "is likely to acknowledge that if the current strength of the economy continues, the next step could be a rate hike. We expect that restarting a cycle of rate hikes will require a high threshold, especially considering that the labor market is gradually softening." Paul Bloxham, Chief Economist at HSBC Holdings Australia, stated, "The economy is neither overheating nor cooling down." He believes that the next move is more likely to be a rate hike rather than a cut. He added, "A series of data releases over the past few weeks clearly indicate that the RBA does not have the need or room to further lower the cash rate. Inflation is above target, growth is on an upward trend, and the unemployment rate remains below its estimate of full employment levels."