The jobs market is too strong and the unemployment rate too low for the Reserve Bank to stamp down inflation.
RBA deputy governor Michele Bullock says an unemployment rate of around 4.5 per cent is roughly the lowest possible level that's consistent with the RBA's two-to-three per cent inflation target.
The jobless rate has been stuck well below four per cent for months on end, coming in below expectations at 3.6 per cent in May.
The rapid economic recovery from the COVID-19 pandemic has pushed Australia "at or even perhaps above" estimates of full employment, which is basically when people are able to find a job without having to search for too long.
Ms Bullock said the level of employment was now almost eight per cent above its pre-pandemic level.
While the senior RBA official welcomed the widespread gains in employment, she warned the jobless rate would have to drift up to closer to 4.5 per cent to get the economy "closer to a sustainable balance point".
A tight labour market, characterised by greater demand than available supply, puts upwards pressure on wages and inflation. Conversely, spare capacity in the labour market tends to push wages and inflation down.
She said full employment had not taken a "back seat" to inflation targeting but it was important to take some heat out of the labour market or risk more job losses down the track.
"If high inflation were to become entrenched in people's expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment," she warned.
"A deep and long-lasting recession would be likely, which would mean a substantial rise in the unemployment rate."
She also said the RBA has been willing to tolerate a longer time frame to bring inflation back to target - around mid-2025 - than some of its international peers in the hopes of keeping more people in jobs in the process.
The RBA expects the unemployment rate to rise to 4.5 per cent by late 2024.
Her speech comes hot on the heels of minutes from the central bank's June interest rate decision, which indicate another "finely balanced" call between another hike or staying on hold.
The RBA ultimately landed on another 25 basis point increase to bring the cash rate to 4.1 per cent.
Keeping the cash rate unchanged was a live option but a pause in June would have been "reconsidered at subsequent meetings, with the benefit of additional data".
As indicated by the deputy governor, the board has become worried about inflation expectations that would keep it higher for longer.
Unit labour costs, an indicator of the average cost of labour per unit of output produced, have also been weighing on the RBA.
The minutes rehashed the central bank's concerns about sluggish productivity growth that could lead to high unit labour costs.
Board members were also mindful of the risk of widespread pay rises in line with inflation.
"Similarly, members observed that some firms were indexing their prices, either implicitly or directly, to past inflation," the board minutes said.
The rebounding housing market was also cause for concern as it would likely reduce drag on consumer spending.
Supporting the case for a pause was falling commodity prices and sinking international shipping costs.
There had been little change in medium-term inflation expectations in financial markets, which could help keep inflation expectations contained.
Additionally, the board noted that the RBA had a history of overestimating wage growth before the pandemic and that productivity could pick up by more than expected.
