Further rate hikes to drive 'more pronounced cooling' in labour market: KPMG

Inflation pressures, declining household consumption and flat productivity growth is likely to constrain economic growth for Australia this year, according to the latest KPMG Australian Economic Outlook.

The outlook said while Australia's economy outperformed expectations in the December quarter, the underlying composition of this growth "points to a less encouraging picture".

Real GDP growth rose 0.8 per cent for the December quarter, while annual growth lifted to 2.6 per cent. However, must of this quarterly strength was driven by inventories and public demand, while private demand contributed only modestly, the report noted.

Household consumption per capita fell slightly in the December quarter, and productivity remained subdued.

"Overall, the headline GDP result suggests a fragile expansion," said KPMG.

KPMG also warned that the outlook for inflation had become more challenging as the conflict in the Middle East has continued to unfold.

"The challenge with this current crisis relates to how long will the conflict with Iran last, and how quickly will oil markets return to normal," it said.

"The oil futures market has been grappling with this question for more than nine weeks now, and while the near term price has fluctuated significantly during that time, the forward price curve has consistently suggested oil prices will start recede sooner rather than later."

KPMG's economists said while the oil futures market does not expect the conflict will be protracted, prices are still predicted to take several years to return to near long-run marginal cost of production levels.

"The implications of this oil price spike will also take some time to play out. Inflation is expected to surge globally as oil is a ubiquitous input across virtually every sector within an economy; with food prices likely to feel the impact first followed by other goods and services later in the year," the firm said.

Central Banks will be faced with the challenge of how to respond to this inflation pulse, the outlook said.

"Do they ‘look through’ the oil shock and keep policy rates steady or will they respond to higher inflation by lifting policy rates even though for many economies this is a Terms of Trade shock outside their capacity to influence?"

For Australia, KPMG said the elevated oil prices have increased the risk that higher energy costs will feed inflation expectations and wage-setting behaviour.

"In this environment, the RBA is likely to place greater weight on preventing inflation expectations from becoming entrenched, even at the cost of weaker activity, raising the risk of a further increase in the cash rate," it said.

"Importantly, while additional tightening would be aimed at reinforcing the disinflation process, it would come from a starting point where monetary policy is already assessed to be neutral. As a result, any further increase in the cash rate would push policy into restrictive territory."

The firm warned that this would materially raise the likelihood of softer economic growth and a more pronounced cooling in labour market conditions through 2026.

"This is a key consideration for the policy outlook. The March rate increase was a close call, reflecting internal disagreement within the RBA around the extent of remaining spare capacity in the economy," it said.

With inflation risks now skewed to the upside and growth expected to slow, KPMG said the RBA may find it increasingly difficult to continue walking a narrow path that delivers both low inflation and low unemployment.

"The margin for error has narrowed, and future policy decisions are likely to involve a sharper trade-off between inflation control and economic momentum."