Australia: Policymakers shifting gears
- Australia’s federal budget was presented in May with large spending on tax cuts, infrastructure investments, healthcare and aged care
- The new budget represents a shift in strategy, as the government moves away from the pre-pandemic goal of budget surplus towards continuing support for the economy
- This strategy pivot will result in an increase of net debt instead of a decrease in the coming years
- Simultaneously, Australia is already one of the biggest spenders on fiscal stimulus to combat the pandemic within the G20 while the RBA maintains a loose monetary stance
- The combination of loose monetary and fiscal policy is pushing up inflation expectations
- However, the RBA does not expect a hike in cash rate before 2024, as they believe spare capacity in the economy could constrain material wage growth up to 2024
Budget points to pivotal change in fiscal strategy
The federal budget for 2021-22 was presented in May. The budget deficit is forecast to be some 33% lower (AUD 161bn compared to AUD 211bn) than anticipated in last October’s budget projection. The key explanation for this is a better-than-expected economic recovery.
Some of the main spending items are: tax cuts for middle-and low-income earners (AUD 7.8bn), infrastructure investments (AUD 15.2bn.), increased healthcare expenditures to support people with disabilities (AUD 13.2bn) and aged care reforms (AUD 17.7bn). Furthermore, the coalition had some spare money for long term investments in the environment: a meagre AUD 1.6bln has been earmarked to reduce carbon emissions. The latter policy choices seem to overlook the fact that natural disaster costs have more than doubled over the last decade and may cost the Australian economy AUD 100 billion each year according to some estimates.
Looking at the budget from a broader perspective, however, a pivotal shift in strategy by the coalition is becoming visible, away from the rhetoric of prudence in the pre-Covid period toward higher spending and budget deficits (Figure 1). Obviously, no one expected the Covid-19 pandemic and it is clear that debt rose as a result. Nevertheless, the focus is clearly shifting away from the ambition of a budget surplus in normal times. The word “surplus” doesn’t even appear in the document, while it was mentioned 18 times (including a whole chapter on “returning to budget surplus”) in the last pre-Covid budget. Instead, the focus now is on reducing unemployment and raising economic growth: “A strong economy with low unemployment will position the Government to deliver on its medium term strategy of stabilising and then reducing debt as a share of GDP over time.”. This will result in net debt levels rising rather than falling going forward to, at least, 2024-25 (Figure 2).
Like many governments around the world, the Australian government already let the money flow over the past 12 months to combat the economic consequences of the pandemic. Globally, Australia has in fact been one of the biggest spenders with regard to the size of its Covid-19 fiscal stimulus package compared to GDP (Figure 3). In a recent publication we showed that the economic contraction in Australia would have been close to -18%, instead of the realised -2.4% if it weren’t for that loose fiscal policy. This policy “success”, in combination with the fact that the 2020-21 deficit is much lower than anticipated, does make loose fiscal policy easier to sell for the coalition. At the same time, it arguably puts them in a favorable position for the next election.
Meanwhile, the RBA is still on the same ultra-loose policy path and believes it will continue to stay there for the foreseeable future. Can this combination of loose monetary and fiscal policy be sustained, especially considering that the economic engine is now firmly running with an expected growth of over 4.5% this year?
Inflation. Inflation. Inflation?
With such an abundance in liquidity and stimulus measures, there are several risks looming, of which inflation is the most obvious. The combination of loose monetary and fiscal policy and high economic growth pushing up inflation expectations. In Australia some economic indicators are indeed pointing towards higher inflation levels: employment is proving to be more resilient than expected, with unemployment falling towards pre-crisis levels at 5.4% (in the first month without Jobkeeper). House prices are seeing their steepest increase in 18 years. In other countries central banks are starting to react to such inflationary pressure. For example, the central bank of New Zealand just flagged that they expect to see rates hike twice before the end of 2022 and six times before the end of 2024.
So what is needed for the RBA to take a more hawkish tone? Wage growth is the prime answer to that question. In the Bank’s opinion this will remain subdued for some time to come due to spare capacity in the economy. According to them, for material wage growth to occur, the Australian labour market has to return to a level of tightness which they still consider unlikely until 2024 at the earliest. However the next important decision will be made in July in regard to the policy of Yield Curve Control (YCC). The may RBA minutes noted that “members agreed that, at the July 2021 meeting, the Board would consider whether to retain the April 2024 bond as the target bond for the 3-year yield target or to shift to the next maturity, the November 2024 bond.”. If the RBA decides to maintain the April 2024 bond, the maturity of the yield target would gradually decline until April 2024 when the bond matures. This would be a first, albeit small, step in tapering YCC and a first sign of tighter monetary policy. If the RBA decided to shift to the next maturity, inflationary pressures might increase. Especially if a tight labor market materializes sooner than later. Which we feel might be the case with closed borders, strong economic performance, and pent-up demand for commodities due to global economic recovery.