May 2024
The economy has been going through huge ups and downs since COVID arrived in early 2020. Since most of you weren’t taking a great deal of notice of the economy that long ago, let me give you a quick summary. To slow the spread of the virus while a vaccine was being developed, governments locked the economy down, getting as many people as possible to work from home, closing schools and many shops, and telling people to stay in their homes as much as possible. Australia’s borders were closed to people coming and going, though many overseas students were encouraged to return to their home countries. The Australian states closed their borders to interstate travel.
This hugely reduced economic activity, causing an immediate recession and sending unemployment shooting up. But to ensure this didn’t cause lasting damage to the economy, the Reserve Bank cut the official interest rate to almost zero and the federal government spent a fortune on JobKeeper payments and many other things. As well, the state governments spent up big.
This worked like a charm. As soon as the lockdowns ended, the economy rebounded. Once people were allowed out of their homes, they really caught up with their spending. The economy boomed, with employment growing and unemployment falling like a stone. The boom, coming before our borders had been reopened to immigrants, caused the rate of unemployment to fall to 3.5 per cent, its lowest in almost 50 years. With job vacancies far exceeding unemployment, the economy had returned to full employment for the first time in five decades. Everything seemed wonderful, until we – like the other advanced economies – noticed prices shooting up.
The return of inflation
Until then, and like all the advanced economies, Australia had enjoyed years of low inflation, with the rate of price increases staying in the RBA’s target range of 2 to 3 pc on average since the mid-1990s. In the years before the pandemic, the RBA even had trouble getting inflation up to the bottom of the target range. But from early in 2022, prices started rising rapidly and, by the end of 2022, inflation reached a peak of 7.8 per cent. Similar things were happening in the other advanced economies. What caused this sudden surge in inflation, the worse we had seen for 30 years?
Two quite separate developments. The first factor was us being hit by global supply-side price shocks arising from disruptions caused by the pandemic. When people were locked up in their homes, they couldn’t get out and buy services such as restaurant meals, go to shows and sporting matches, or travel. But they could use the internet to buy things to improve their homes, new appliances or even new cars. So, while spending on services collapsed, spending on goods took off. This sudden surge in the purchase of goods led to shortages – including a shortage of computer chips - and higher prices. Because, these days, all the rich countries import many manufactures from places such as China, this surge in demand for goods led to shortages of ships and shipping containers. So the pandemic led to temporary supply shortages, which pushed up prices. As well, Russia’s attack on Ukraine caused a big increase in oil and gas prices.
But the second factor, adding to these problems on the supply – or production – side of the economy, was a strong surge in the demand for goods and services. Where did this come from? From all the economic stimulus the managers of the macro economy had applied during the lockdowns to hold the economy together. The official cash rate was already down to 0.75 per cent, but the RBA cut it almost to zero, 0.1 per cent. It also used unconventional measures – “quantitative easing”, or the buying of second-hand government bonds – to lower medium-term interest rates. As well, from a virtually balanced budget in the financial year to June 2019, the government’s hugely increased spending caused annual deficits of $85 billion (4.3 pc of GDP), $134 billion (6.4 pc of GDP) and, in 2021-22, $32 billion (1.4 pc). The state governments greatly increased their spending also.
With the wisdom of hindsight, it’s clear the economic managers provided a lot more monetary and fiscal stimulus than turned out to be needed. As a result, this excess demand for goods and services outstripped our businesses’ ability to increase their production of goods and services, thus causing prices to rise. So the surge in prices in 2022 had two quite different causes. The supply-side problems were beyond our control, but would sort themselves out in time. The excessive demand, however, was caused by our own miscalculations and so required the economic managers to move the two instruments for managing the strength of demand – monetary policy and fiscal policy – from a stimulatory setting to a restrictive setting.
The policy response to high inflation
The RBA responded to the worsening inflation in May 2022, just before the federal election in which the Morrison Coalition government was replaced by the Albanese Labor government. The RBA began increasing the official cash rate and, by November 2023, had raise it 13 times, from 0.1 pc to 4.35 pc. Note that, although 4.35 pc is not high by the standards of earlier decades, this was the biggest and fastest increase in rates ever, meaning it had a particularly sharp effect on those households with big home loans. There’s no doubt the present “stance” of monetary policy is very restrictive.
The surge in tax collections
And while all this was happening to monetary policy, the budget’s “automatic stabilisers” were tightening fiscal policy. Since the change of government in May 2022, the boom in the economy and the return to full employment caused income tax collections to grow strongly. (As well, the world prices of iron ore and other export commodities have stayed much higher than Treasury was expecting, causing mining companies to pay more company tax than expected.)
When more people get jobs, they go from being on JobSeeker to paying income tax. When strong demand for labour allows those who want to to move from part-time to full-time work, they pay more income tax. And when higher inflation causes people to get bigger pay rises, this increases their average rate of income tax, often by pushing them into a higher tax bracket. What people call “bracket creep”, economists call “fiscal drag”. It’s one of the budget’s main built-in, “automatic stabilisers” which, without any explicit decision by the government, act automatically to take a bigger tax bite out of people’s pay rises, so leaving them less to spend and helping to slow demand.
The incoming Labor Treasurer Jim Chalmers’ main part in this has been to spend as little of this revenue windfall as possible, allowing almost all of it to flow through to the budget’s bottom line. So, from a deficit of $32 billion in the year to June 2022, the budget flipped to a surplus of $22 billion in the year to June 2023. That’s a turnaround of $54 billion, equivalent to 2.3 pc of GDP. The “stance” of fiscal policy switched from expansionary to contractionary, adding to the downward pressure on demand coming from monetary policy. And we know from the new budget that fiscal policy stayed contractionary in the financial year just ending, 2023-24, with another surplus of $9 billion expected.
The price mechanism and “gouging”
Before I move on to the question of the cost of living, I must tell you about a big difference between the thinking of economists and the thinking of normal people. Economists believe that the best way to allocate resources in an economy is via the use of markets. They believe that the forces of supply and demand in a particular market interact to set the price of the particular good or service. And they believe that, when something happens to disrupt the market, the “price mechanism” works to bring demand and supply back together, and re-establish “equilibrium”. If something happens that causes the demand for a product to exceed its supply, sellers are able to increase the price they are charging. This price increase sends different messages to the buyers than to the sellers. The message to buyers is: don’t use any more of this product than you have to, and see if you can find cheaper substitutes for it. The message to sellers is: producing this product has become more profitable, so make more of it. So, putting the two sides together, the “price mechanism” works to reduce demand and increase supply, thus causing the price to fall back to pretty where it was before the disruption.
I hope you know all that. The point is that when businesses respond to excess demand for their product by using the opportunity to raise their prices, economists regard this as the completely normal way markets work to restore equilibrium. It’s thus a good thing. But consumers see it very differently. They often object to businesses raising their prices even though their costs haven’t increased. They criticise it as “gouging” the customers. (My opinion? I think markets don’t always work as well as economic theory assumes they do.)
The cost of living
Whereas economists focus on inflation and ensuring prices don’t rise too rapidly, and worry about wages rises in response to the higher prices helping to keep inflation high, ordinary people worry about the rising “cost of living”. They focus on how fast prices are rising – particularly the prices they see in the supermarket - but tend not to notice that what matters most to them is whether their wage or other income is keeping up with prices. And many may not notice that they suffer when their wage rises cause their average rate of income tax to rise, leaving them less money to spend.
Voters have had a lot to complain about in the past two years or so. Consumer prices have rising at a much faster rate than usual. As well, until recent months their wages haven’t kept up with the rise in prices. And the government has been taking a bigger tax bite out of their wages.
But what makes it worse is that the standard way central banks and governments stop the cost of living rising so fast is to make it worse to make it better. When prices are rising because households’ demand for goods and services is rising faster than the economy’s ability to supply them, the standard response by the economic managers is to squeeze households’ budgets so they can’t spend as much. When this causes demand for their products to slow, businesses aren’t able to raise their prices as much. The main way the RBA squeezes households is by raising the interest rates they pay, particularly on their mortgages. And this time, for different reasons, rents have been rising rapidly.
All this presents a problem for our politicians. The voters are crying out for them to do something to fix the cost-of-living crisis. But the only way the authorities can achieve a lasting improvement in the rate at which prices are rising is to keep the pain on for a while yet. This is why Mr Chalmers is doing fairly minor things like giving every household a $300 electricity rebate. What will do much more to ease some of the pain is the rejig of the long-planned stage 3 tax cuts. Those tax cuts are the main reason the budget is now expected to swing from a surplus of $9 billion in the year just ending, to a deficit of $28 billion in the new financial year. The budget’s forecasts say this move to expansionary fiscal policy will not stop inflation returning to the target range in the coming year and will ensure we avoid recession and achieve a “soft landing”, with the unemployment rate rising no higher than 4.5 pc. Let’s hope this is what happens.
