The members of the Reserve Bank of Australia's monetary policy committee discussed the possibility that financial markets were under-pricing downside risks associated with the Middle East conflict, noting that global equity prices had rebounded from an initial decline, according to the minutes of the committee's May meeting released on Tuesday.
The members concluded that financial conditions in Australia had tightened over the course of the year, and that it remained unclear how restrictive financial conditions were at the time of the meeting. The case to raise the cash rate target by 25 basis points at the meeting centered on the outlook for inflation.
They observed that domestic economic conditions evolved broadly in line with the February forecasts and that recent data confirmed that capacity and inflationary pressures were elevated early in the year. Underlying inflation had remained high in the March quarter, but marginally lower than forecast in February.
The central bank's staff's baseline forecast was for underlying inflation over the subsequent two years to be higher than previously expected, remaining above 3% until late 2027, and projected to return to 2.5% only in mid-2028, based on various assumptions.
While riskier asset prices had moved in response to the conflict and the resultant increases in oil prices, the net change since the onset of the conflict had been modest. The conflict and associated rise in fuel prices had contributed to a sharp decline in consumer confidence, consistent with a higher cost of living.
Corporate bond spreads in advanced economies retraced the rise observed immediately after the onset of the conflict and remained low relative to history. Measures of expected equity price volatility increased somewhat but remained well below the levels recorded during earlier episodes of heightened uncertainty.
The impact of the conflict shifted market-implied paths for policy rates in advanced economies materially higher. Government bond yields also increased, particularly at longer maturities, largely driven by higher real yields. The rise in bond yields over the preceding six months was more pronounced in Australia than elsewhere, consistent with the progressive increase in expectations for the future policy rate over that period.