Comment

John Hewson
Albanese’s budget reality check

As the government moves towards its first budget in October, uncertainties about our economic outlook are mounting. That’s partly because it is increasingly difficult to read the world economy, and there’s a growing belief that our interest rates must be getting close to a peak with the Reserve Bank of Australia’s increases. It’s also unclear just how long the impact of those moves will take to flow through.

In a recent speech, the RBA governor, Philip Lowe, emphasised the uncertainties against which the central bank is setting monetary policy. Lowe is very sensitive these days, facing an independent review and having to admit to the significant errors in his economic forecasting. Indeed, his repeated comment last year that interest rates were unlikely to rise until 2024 has drawn accusations of false and misleading conduct, which those in business recognise carries very severe penalties. They believe that had any of them made similarly false statements to the stock exchange or in selling their products, they would be facing the full force of the law.

There is also the risk of class actions arguing that the RBA has a duty of care in the conduct of monetary policy.

 

In his speech to The Anika Foundation this month, which came a year after he last spoke to the group, Philip Lowe was at pains to explain that the magnitude of the lift in inflation compared with what he had predicted a year before had “come as a surprise”. The RBA had predicted inflation during 2022 would be just 1.75 per cent, but they are now expecting it will be 7.75 per cent, in what he conceded was “a very large forecast miss”.

This was against a backdrop of several years of inflation below 2 per cent, and just 1.6 per cent in underlying terms. Today those figures are 6.1 per cent and 4.9 per cent, respectively, and the peak is yet to be reached.

Lowe emphasised that our experience is reflective of what has happened internationally – in the United States, Britain, Canada and the euro area. His starting point in explaining this “unexpected surge” was the Russian invasion of Ukraine and various problems in the production of energy around the world.

This chimes with the views of other central bankers. The European Central Bank claims about three-quarters of the surprise in inflation in the euro area was unexpected developments in markets for oil, gas and electricity. The Bank of England estimates that higher energy prices will boost inflation by a whopping 6.5 percentage points this year.

Our petrol price has risen by 32 per cent during the past year, adding 1.2 percentage points to our overall increase in consumer prices, plus some knock-on effects from higher fuel prices.

Lowe also claimed that traditional inflation models “face some real challenges”. But this focus on the aggregate output gap – or how far the overall economy is running below its capacity – ignores developments in individual sectors. It also misses the uneven effects of shocks across them, such as the surge in demand at a time of impaired supply due to Covid-19.

A good example of a particular sectoral effect in Australia is in home-building, where the construction costs of a new home have increased by 20 per cent during the past year. This apparently added some 2 percentage points to headline inflation. The very strong demand in this sector resulted from exceptionally low interest rates and the Morrison government’s cash injections and grants of up to $35,000 for some first-home buyers. This housing market stimulation was driven much more by politics than by good economic policy.

These inflation models also focus on inflationary expectations, which Lowe feels haven’t been a major factor in our inflation surprise. Indeed, he refers to market pricing that suggests a degree of confidence that our inflation will return to the target range of 2-3 per cent, although the RBA expects it to rise further before then.

The concept of using increases in interest rates as the main monetary policy instrument in circumstances where supply cost pressures are prominent can be defended as a means of influencing inflationary expectations. That is, rate hikes demonstrate that the RBA is serious about controlling inflation and, more broadly, is prepared to try to influence inflation psychology, despite the likely muted impact on demand.

The prospects for the global economy are clouded as it is hard to read the intentions among central banks who are mostly also shifting to raise rates to tackle inflation. The pacesetter here has been the US Federal Reserve, where governor Jerome Powell has been clear and decisive in his anti-inflationary strategy and, if anything, pushing the pace. However, recently some of the regional Fed presidents, many of whom also vote on policy, have expressed concern about the pace of hikes, which adds to the difficulty in predicting the course of interest rates and whether they are likely to tip the US economy into recession.

It is noteworthy that some of the recent  improvements in sharemarkets have simply been a recognition that central banks are acting against inflation. In a similar vein, the pronounced weakness during this week has been out of concern that inflation is still turning out higher than expected, as witnessed in the worse-than-expected US inflation report, which raises the prospect of even more aggressive rate hikes in the world’s largest economy.

 

With all the concern about the pace of the RBA’s interest rate increases and their likely negative effect on our growth, the most recent numbers for the June quarter were mostly seen as encouraging. GDP rose by 0.9 per cent in the quarter and by 3.6 per cent from a year earlier, as households drew down their savings – accumulated during the pandemic, often from direct government support, together with a large trade surplus – to sustain their spending. The savings-to-income ratio fell for a third consecutive quarter, from 11.8 per cent to 8.7 per cent, as household spending outpaced the growth in household income.

But the economy is still held back by skills shortages and declining real wages. As the treasurer said, “This is an economy that is growing, but the challenges are growing as well.” These challenges include clouds over the sustainability of China’s expansion amid continued Covid impacts, a collapsing property sector and a number of significant structural challenges in the context of slowing world growth.

The real question is what will sustain growth. We are yet to see the full impact of rising interest rates on households. House prices have fallen across the country and further significant declines are predicted on the basis of rate increases to date, and with the RBA suggesting more to come, albeit perhaps not the big jumps that we have seen in recent months. Evidence is also mounting of significant increases in mortgage stress.

While consumer spending was instrumental in sustaining growth in the most recent quarter, consumer confidence has not been strong. This week there was a small improvement in the Westpac Melbourne Institute Index of Consumer Sentiment, which had fallen for some nine months.

A particular challenge for the forthcoming budget is for the government to decide how far to go in implementing its election spending commitments to sustain growth without adding to inflationary pressures, against the background of a tightening monetary policy and the need to begin budget repair. There are significant opportunities to cut other expenditure, especially by eliminating the Morrison government’s spending largesse via various rorts and grants to mates and donors, as well as closing down the National Party’s regional slush and infrastructure funds.

It is now clear that we simply can’t afford the stage 3 tax cuts, and that is over and above the extent to which they would further compound the inequity of the tax system. It is true that Albanese has committed to keep them, but he also left himself some wriggle room if circumstances were to change.

Circumstances are now much more difficult than he could have imagined at the time of making that commitment, and the leadership now required is to level with the Australian people and clarify the government’s priorities: it’s these tax cuts versus, say, child, aged and disability care.

This article was first published in the print edition of The Saturday Paper on September 17, 2022 as "High prices to pay".

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