Australian second-quarter inflation has unexpectedly fallen below expectations, giving the Reserve Bank of Australia (RBA) more room to assess economic conditions and prompting traders to significantly reduce their bets on another rate hike this year.

Data released by the Australian government on Wednesday showed that the trimmed mean consumer price index (CPI) rose 3.6% year-on-year in the second quarter, below the 3.7% forecast by economists. The quarterly increase was 0.8%, also lower than the anticipated 0.9%. Furthermore, headline CPI rose 4% year-on-year and 0.6% quarter-on-quarter, both falling short of economist expectations of 4.1% and 0.7%, respectively.

The RBA aims to keep inflation at the midpoint of its 2%-3% target range, a level it has not achieved in over four years. The central bank had raised interest rates at each of its first three meetings this year in an attempt to counter a resurgence in inflationary pressures that emerged before the Middle East war triggered a global energy shock.

Inflation remains elevated despite the latest data

While the latest second-quarter CPI figures show prices are still high, the likelihood of the RBA resuming its rate hike cycle on August 11 has diminished. At that time, the bank will also release its updated quarterly economic forecasts. Following the data release, traders sharply reduced their bets on another rate hike from the RBA this year. The market now prices in roughly a 50% probability of a hike, down from over 90% before the data. The Australian dollar fell 0.5%, while the yield on three-year government bonds, which are most sensitive to monetary policy, dropped 11 basis points.

Commenting on the latest CPI data, My Bui, an economist at AMP Capital in Australia, said, "This data is softer than we expected. It's reassuring to see some moderation in the price increases for previously very hot service categories in June." However, Bui added, "Inflation is still running too high, so we still see the possibility of another rate hike this year."

Eugenia Fabon Victorino, head of Asia strategy at Swedbank, echoed this sentiment, stating, "We think it's too early to rule out further tightening from the RBA." She pointed out that core inflation remains too high, and the trend of falling energy prices may not be sustainable as the Middle East situation heats up again, which "should keep the RBA on alert for a broadening of price pressures."

Beyond the persistent high inflation, employment data released last week also provided ammunition for market participants betting on a rate hike this year. The data showed that after a downward revision to 44,000 jobs added in May, June saw a surge of 76,300 new jobs, more than five times expectations. This underscores the continued strength of the labor market.

The RBA remains vigilant about inflation. RBA Governor Michele Bullock acknowledged during a Q&A session following a key speech on Tuesday that "the longer inflation deviates from the target, the more concerned the board becomes." She noted that in the latest economic forecasts, the central bank expects core inflation to fall below 3% only by the end of next year, well after it has remained elevated for an extended period. Speaking about the current Middle East conflict, Bullock said, "We can only hope that there are no more shocks." The global economy has already weathered the Russia-Ukraine war and the COVID-19 pandemic, both of which fueled global price pressures.

In early July, RBA Assistant Governor Sarah Hunter warned that with increasing global instability, more supply shocks could emerge in the future, reinforcing the importance of maintaining a low and stable inflation target. The Australian economy has become more susceptible to inflation, as weak productivity growth over the past decade has lowered the economy's potential growth rate—the pace at which it can grow before stoking price pressures.

Furthermore, the intermittent and repeated ceasefire negotiations between the US and Iran complicate the RBA's policy setting. The parties are attempting to end the war, reopen the Strait of Hormuz, and restore oil shipments, while markets are swayed by the changing prospects of a peace deal versus renewed violent conflict, leading to persistent volatility in fuel prices.

June CPI data showed that annual tradable goods prices (typically influenced by exchange rates and global factors) rose 1.5%, while non-tradable goods prices (driven mainly by domestic factors like utility bills and rents) increased 4.9%.

Stephen Smith, a partner at Deloitte Access Economics, explained, "In other words, lower oil prices and the government's temporary reduction in fuel excise duties have eased import price pressures. However, price pressures in the services sector, which aren't necessarily directly linked to the Middle East conflict, have strengthened, indicating that domestically generated inflation pressures in Australia have not been effectively contained."