Steve Campbell: How Middle East tensions are intensifying inflation risk

Inflation was already too high before the Middle East conflict for the RBA not to act. The knock-on effects from higher oil prices only intensify the inflation risks, explains Pendal’s head of cash strategies STEVE CAMPBELL

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THE Reserve Bank tightened monetary policy by 25 basis points for the second consecutive meeting, taking the cash rate to 4.1%.

It was a close call with five members voting to tighten and four calling for no change.

Leading into the decision the market had priced a 70% likelihood of a hike. This had changed quickly from February, when the market priced the probability of a hike at around 10%.

So, what changed? Several things.

First, the RBA had been deliberately emphasising March as a live meeting.

The probability of an increase rose to around 35% after a March 3 speech by RBA governor Michele Bullock. Her comments put a March move firmly in focus.

Earlier, there had earlier been a view that the RBA was more likely to change policy after the next quarterly inflation data was released in late April.

At the time Bullock shot this view down: “I am not making a prediction about March, but it will be a live meeting.”

On March 10, comments by RBA deputy governor Andrew Hauser saw market expectations move above 60%.

The comments came on a podcast, suggesting the RBA was already doing some preparation for the likely heavy criticism a hike would bring.  

“If we fail to act decisively enough to prevent inflation staying high or even rising – and expectations of inflation dis-anchor – it will be bad for everyone.

“It’s worth us continuously reminding ourselves just how toxic inflation is.”

These comments changed market pricing. Alongside rising inflationary concerns, the market in Australia moved to price in multiple hikes by the end of the year, as shown in the following graph:

Secondly, hostilities in the Middle East encouraged a focus on a stagflation scenario.

In 2022 it took two weeks for bonds to lose the “risk off” bid and gain a very strong “inflation on” offer.

This time it took less than two hours – and again it is the “inflation”, not “stagnation”, part of stagflation driving interest-rate markets.

So, what happened on the domestic economic data front since the RBA’s February meeting?

January employment data showed a labour market that remained too tight for the RBA, with the unemployment rate staying at 4.1%.

The monthly inflation series showed annual inflation at 3.8% and trimmed mean at 3.4%, both marginally higher than market consensus.

Fourth-quarter economic growth rose by 0.8%, resulting in growth of 2.6% for 2025. The RBA’s forecast was for 2.3%.

None of this data would have comforted the RBA.

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Inflation?

In her speech, Bullock noted that while there were temporary factors at play, some of the inflation pressure was due to demand exceeding the economy’s supply capacity.

The RBA is concerned that the longer inflation stays above the target, the greater the risk that people expect inflation to stay high.

Growth?

Australia’s economic growth over the second half of 2025 surprised the RBA.

Private demand was stronger, the global economy held up better than expected and financial conditions were seen as easier than previously thought.

Throw into the mix the supply side of the economy that is now seen as having less excess capacity to absorb the pickup in demand.

The conflict in Iran?

Obviously this puts upward pressure on inflation and threatens economic growth both in Australia and with our major trading partners.

Both Bullock and Hauser did make a point on the effect of a higher oil price.

Australia is a net energy exporter and “if you assume that the oil price is well correlated with the price of gas and other outputs that we export, there will be some positive demand effect for Australian exporters that offset some of those effects on activity”.

The issue for the RBA was that inflation was already forecast to be above its target band for 2026 prior to the Iran conflict.

The move higher in the oil price only increased the risk that higher inflation expectations become more embedded.

Today’s decision ended up being a close call.

Inflation remains too high.

That was the case before the conflict in the Middle East. Events in Iran only added to inflation risks and the RBA responded. Just.

Where to next for the RBA is anyone’s guess. The next meeting is on May 5. As shown since its last meeting, six weeks is a long time and things can change quickly. Buckle up

If you’d like to hear more about how Pendal’s Income & Fixed Interest team is positioning for this environment, please contact us through your account manager by reply email.

About Steve Campbell and Pendal’s Income and Fixed Interest team

Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.

Find out more about Pendal’s cash funds:

Short Term Income Securities Fund
Pendal Stable Cash Plus Fund

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here