Reserve Bank warns productivity lift needed to bring inflation down

In explaining its decision to raise the official cash rate to 3.85 per cent earlier this month, the central bank highlighted negligible improvement in what is being produced per worker as a key hindrance to taming inflation.

"[An] upside risk to inflation was the possibility that productivity growth remains very weak," the minutes of the RBA Board's May 2 meeting said.

The central bank's forecast for inflation to return to the top of the 2 to 3 per cent target band by mid-2025 was "predicated on productivity growth returning to around the modest pace recorded prior to the pandemic", the minutes said.

"If this did not occur, growth in unit labour costs would be uncomfortably fast".

Labour productivity per hour has slumped in the past two years to be at its lowest level in more than two decades while unit labour costs are climbing, adding to production costs and putting upwards pressure on prices.

Much of the public discussion about the federal budget has been focused on whether or not it will add to inflation pressures.

But the Reserve Bank minutes show that at its meeting a week before the budget, the central bank board, chaired by RBA governor Philip Lowe, spent almost no time discussing fiscal policy (except to note measures to reduce the size of energy bills) and was instead much more concerned about the inflationary threat posed by rising rents and labour costs.

It said rising unit labour costs were expected to be a key driver of underlying inflation, alongside rents as demand for housing intensified.

"Strong population growth and low rental vacancy rates could ... see rents grow even faster than envisaged," the RBA board said.

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Figures to be released on Wednesday are expected to show wages grew by between 3.5 and 4 per cent in the first three months of the year. While this is still well short of the pace of inflation, which grew 7 per cent over the same period, the fact that such gains are occurring virtually unsupported by productivity gains is concerning the central bank.

"Unit labour costs [have] been growing strongly, owing in part to the very limited productivity growth over the preceding three years," the RBA Board minutes said. "A rise in productivity growth will be needed to ensure consistency of the wages growth forecast with the Bank's inflation target."

While the RBA described the May rate hike decision as "finely balanced", several economists think there is a significant risk monetary policy will be tightened further.

ANZ's head of Australian economics, Adam Boyton, said the multiple mentions of productivity in the board minutes was "noteworthy".

Mr Boyton expects there to be one more rate hike, in August, but admitted there may be more, or they may come sooner.

National Australia Bank economists also expect the cash rate to reach 4.1 per cent. But Commonwealth Bank economist Gareth Aird said his base case remained that interest rates had reached their peak (though he admitted there was the risk of a further hike) and predicted they would start to come down late this year.