Westpac: Budget not inflationary


Westpac with the note. I agree given the dire leading indicators for unemployment.


Households in Australia are collectively doing it tough. Their cash flows are being squeezed by the high cost of living, high level of interest rates and a rising tax take. Consumption per capita has fallen more than 2½% since the RBA started raising rates. Australia stands out from its peers on this front.

At the same time, inflation is too high and the labour market is tight, though not quite as tight as late last year. The labour force data for April confirmed this gradual easing, helping to cut through the noise of the first three months of the year. And the Wage Price Index release, also this week, shows that wages growth is starting to roll over from its recent peak, as was widely expected. To be fair, these are lagging indicators. But there is nothing in these data – or more leading indicators – pointing to even higher inflation pressures down the track.

The trade-off between a household sector under pressure and ongoing inflationary dynamics is the context the government faced in framing this week’s budget.

Structuring some of the support measures to reduce measured inflation makes sense in that context. The last thing the Government wants is to be blamed for a coming rate rise. Ideally, it would want to see the first couple of rate cuts ahead of the next election. The same imperative drove the reshaping of the Stage 3 tax cuts earlier in the year. Then, the government took care to keep the reduction in revenue within the envelope of the original version, and make sure everyone knew this. Because the original version was already in everyone’s forecasts, the modified version could not then be used to justify tightening monetary policy.

The government is walking that fine line between providing support and services to a household sector under pressure and avoiding adding to that pressure by boosting inflation and possibly interest rates.

Even still, the commentary after the budget has been very focused on the potential inflationary consequences. It is true that a dollar not spent on rent or electricity is a dollar available to be spent on other things. (This of course assumes that electricity companies and landlords do not raise underlying prices to offset some of the subsidy.)

And in principle, if some of that dollar is spent, that represents higher demand that could push up prices elsewhere. There are some unstated assumptions behind this reasoning, though. It assumes that most of the extra spending power is indeed spent, and that there is little spare capacity in the area where it is spent, so the main result is higher prices not a higher quantity sold. In other words, it assumes that the economy will be fully employed later this year when these support measures come into effect.

Furthermore, even though the reduction in measured inflation is temporary and in some sense artificial, households’ experienced cost of living will be genuinely lower as a result. This should, at the margin, help keep inflation expectations anchored, and will moderate the following year’s increases in those prices that are typically indexed to CPI.

The assumptions behind those inflation concerns also underpin current discussion around monetary policy. The presumption is that the problem is that the level of demand exceeds the level of supply, and so policy needs to be restrictive to dampen demand and get it back in line with supply. Again, there are some unstated assumptions here. One of these is that demand is the only thing that can move. It is like seeing a pair of scissors and thinking that only one blade does the work. In fact, the other blade – supply – might still be contending with the ripple effects of the pandemic. Some recovery in supply could play a role in rebalancing itself to demand.

And again, it assumes that a currently fully employed economy will still be fully employed when the time comes to start cutting rates. However, this cannot and should not be presumed.

One lens on this assumption is the economics profession’s own forecasts. Every quarter ahead of its Statement on Monetary Policy, the RBA polls private sector economists about our forecasts and views of the economy. Recently, it has expanded the sample of respondents from around 20 to around 40; aggregated results are compiled into a new statistical table on its web site. This round, the RBA added the output gap to the list of questions. Importantly, it only sought an estimate for the December quarter 2023, the latest available published data for GDP. The estimates ranged from –1.2% of GDP to +1.0%, with a median of 0.3%. That spread should tell you how uncertain these invisible concepts are. (Full disclosure: my guesstimate in the survey was +0.5%, and it is just a guesstimate.)

But taken together with the estimates of potential output growth (range 1.8% to 3.0%, median 2.5%) and economists’ forecasts for actual GDP growth over 2024 (range 0.2% to 2.3%, median and Westpac 1.6%), we can reasonably conclude that some economic slack is expected by the time the fiscal support and rate cuts occur. It’s a little bit more complicated than that because the potential output estimates were for ‘over the next couple of years’, and potential output growth could be boosted this year because population growth – and so labour supply – will still be stronger than average. (Westpac Economics expects population growth to slow from 2½% last year to 2% this year, normalising to around 1½% over 2025). But the direction is clear.

If we as a profession are to take our own forecasts seriously, the economy will not quite be fully employed by year’s end. Withdrawing some of the restrictive stance of policy at that point – or putting $75 in each household’s pocket each quarter – might not be as inflationary as it would be if done today. There are risks to this strategy, and both the RBA and the government will need to walk a fine line. But neither of them is pursuing the policy equivalent of running with scissors.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.