Renowned Chief Economist weighs the forces shaping Australia's economy as rate rises and Middle East tensions cloud outlook
The Australian economy entered 2026 on a reasonable note.
The unemployment rate was a bit above 4% and many businesses were still concerned about not being able to find employees with the right skills. Consumers were spending although inflation was making a dent into their incomes. Orders growth for businesses was about average and capex spending plans were elevated. The biggest problem businesses faced was higher-than average cost growth constraining profitability. Conditions were typically softer for SMEs than larger businesses.
But as the economy travelled through 2026 it hit a couple of bumps. The RBA had become concerned that inflation was too high and hiked the cash rate by a quarter percentage point in February (with follow-up quarter percentage point rate rises in both March and May). It was expected that the tightening of monetary policy would lead to some slowing in economic growth and some rise in the unemployment rate.
Global tensions mount
But then came the conflict in the Middle East. The resulting big jump in energy costs impacted consumer spending power and increased input costs to businesses, particularly those in the agricultural, mining, construction, transport and manufacturing sectors. The result was a marked decline in consumer and business confidence. The rise in energy costs if maintained could lead to both an increase in inflation and a reduction in economic growth. SMEs were more heavily impacted than larger businesses as most of them have less ability to pass on higher costs to customers.
The important factor determining how big an impact the Middle East conflict will have on the economy will be how long the conflict lasts. Once the conflict ends, supply-chain disruptions could remain elevated for some months. Other important factors determining the economic fallout include whether the fall in business and consumer confidence sustainably impacts spending, how much (and in what form) fiscal support governments provide and developments in financial markets.
One other important question is how much of the rise of inflation from the Middle East conflict ends up being permanent. Historically, the RBA has been able to look through significant price jumps from rising oil prices. The reason is that they were confident that not only would higher oil prices not sustainably impact other prices in the economy, but the oil price increase would quickly reverse.
That may happen again this time. The problem on this occasion is the jump in fuel prices follows a five-year period when the annual inflation rate has averaged 4.5%. This increases the risk that the jump in oil prices might have a longer-term impact upon domestic inflation outcomes, and therefore have potential interest rate implications.
A difficult road ahead
These trends will impact sectors of the economy in different ways. For example, the combination of higher interest rates and rising energy prices will impact households’ disposable incomes. This will constrain spending on consumer discretionary items, notably by lower-income households and consumers with large mortgage commitments.
The agricultural sector has been hit by higher fuel and fertiliser costs at a time when there is a rising possibility of a dry season on the Eastern Seaboard. The economic impact upon the commercial property market is mixed. The outlook for sectors such as Retail and Office will depend upon the strength of the economy and employment. There are structural supportive demand factors in other areas such as for data centres.
Historically the health industry is less impacted by fluctuations in the economy. But less impact is not no impact. Higher inflation reduces the amount of goods and services that households can buy, including health services. This is a particularly big issue for low-income groups. Like most industries, businesses in the health sector are also grappling with elevated cost growth, notably labour costs.
The next 1-2 years might be a little difficult for the Australian economy. Economic growth will be a bit weaker and the unemployment rate a bit higher. Hopefully this bad news of a weaker economy leads to good news of an inflation rate returning to pre-COVID norms.
Not all bad news
There are reasons to be optimistic about the medium-term outlook for the domestic economy. The Middle East conflict has reminded countries about the importance of diversifying their energy and mineral supply sources. This should be supportive for the Australian mining sector given our reputation as a reliable supplier.
The Australian economy entered 2026 in sound shape. The unemployment rate was low and households had boosted their saving rate. Australian Government debt (as a percentage of GDP) is low by peer economy standards.
There is also a lot of construction and engineering work still in the pipeline. That includes work on data centres, infrastructure and areas of mining. There is also plenty of residential construction activity happening although increasing costs from higher energy prices could weigh on the sector.
The 2026-27 Federal Budget had some positives for SME’s, including the $20,000 instant asset writeoff being made permanent. Further details are necessary to understand the full implications of the proposed changes to the capital gains tax, negative gearing and the taxation of trusts.
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