When normal people think about the economy, most think about the trouble they’re having with the cost of living. But when economists think about it, what surprises them is how well the economy’s travelling.
It’s been going through huge ups and downs since COVID arrived in early 2020. By 2022, it was booming and the rate of unemployment had fallen to 3.5 per cent, its lowest in almost 50 years. Meaning we’d returned to full employment for the first time in five decades.
Trouble was, like the other rich economies, prices had begun shooting up. The annual rate of inflation reached a peak of almost 8 per cent by the end of 2022.
The managers of the economy know what to do when the economy’s growing too fast and inflation’s too high. The central bank increases interest rates to squeeze households’ cash flows and discourage them from spending so much.
The Reserve Bank started raising the official “cash” interest rate in May 2022, just before the federal election. It kept on raising rates and, by November last year, had increased the cash rate 13 times, taking it from 0.1 per cent to 4.35 per cent.
While this was happening, Treasurer Jim Chalmers was using his budget – known to economists as “fiscal policy” – to help the Reserve’s “monetary policy” to increase the squeeze on households’ own budgets, reducing their demand for goods and services.
Why? Because, when businesses’ sales are booming, they take the chance to whack up their prices. When their sales aren’t all that brisk, they’re much less keen to try it on.
The government’s tax collections have been growing strongly because many more people had jobs, or moved from part-time to full-time, and because higher inflation meant workers were getting bigger pay rises.
As well, iron ore prices stayed high, meaning our mining companies paid more tax than expected.
Chalmers tried hard to “bank” – avoid spending – all the extra revenue. So, whereas his budget ran a deficit of $32 billion in the year to June 2022, in the following year it switched to a surplus of $22 billion, and in the year that ends next month, 2023-24, he’s expecting another surplus, this time of $9 billion.
So, for the last two years, Chalmers’ budget has been taking more money out of the economy in taxes than it’s been putting back in government spending, thus making it harder for households to keep spending.
Guess what? It’s working. Total spending by consumers hardly increased over the year to December 2023. And the rate of inflation has fallen to 3.6 per cent in the year to March. That’s getting a lot closer to the Reserve’s target of 2 to 3 per cent.
The Reserve’s rate rises have been the biggest and fastest we’ve seen. Wages haven’t risen as fast as prices have and, largely by coincidence, a shortage of rental accommodation has allowed big increases in rents.
And on top of all that you’ve got the budget’s switch from deficits to surpluses. Much of this has been caused by bracket creep – wage rises causing workers to pay a higher average rate of income tax, often because they’ve been pushed into a higher tax bracket.
Bracket creep is usually portrayed as a bad thing, but economists call it “fiscal drag” and think of it as good. It acts as one of the budget’s main “automatic stabilisers”, helping to slow the economy down when it’s growing too quickly and causing higher inflation.
The Reserve keeps saying it wants to get inflation back under control without causing a recession. But put together all these factors squeezing household budgets, and you see why people like me have worried that we might end up with a hard landing.
Which brings us to this week’s budget. The big news is that in the coming financial year the budget is expected swing from this year’s surplus of $9 billion to a deficit of $28 billion.
This is a turnaround of more than $37 billion, equivalent to a big 1.3 per cent of annual gross domestic product. So, whereas for the past two financial years the “stance” of fiscal policy has been “contractionary” (acting to slow the economy), it will now be quite strongly “expansionary” (acting to speed it up).
Some people who should know better have taken this turnaround to have been caused by a massive increase in government spending. They’ve forgotten that by far the biggest cause is the stage 3 tax cuts, which will reduce tax collections by $23 billion a year.
The same people worry that this switch in policy will cause the economy to grow strongly, stop the inflation rate continuing to fall and maybe start it rising again. But I think they’ve forgotten how weak the economy is, how much downward pressure is still in the system, and how long it takes for a change in the stance of policy to turn the economy around.
Treasury’s forecasts say the economy (real GDP) will have grown by only 1.75 per cent in the financial year just ending, will speed up only a little in the coming year and not get back to average growth of about 2.5 per cent until 2026-27.
So, the rate of inflation will continue falling and should be back into the target range by this December. All this would mean that, from its low of 3.5 per cent – which had risen to 4.1 per cent by last month – the rate of unemployment is predicted to go no higher than 4.5 per cent.
That would be lower than the 5.2 per cent it was before the pandemic, and a world away from the peak of about 11 per cent in our last big recession, in the early 1990s.
So maybe, just maybe, we’ll have fixed inflation and achieved the softest of soft landings. Treasury’s forecasting record is far from perfect, to put it politely, but it is looking possible – provided we don’t do something stupid.