What a difference 7 months can make when framing an Australian Budget. The international and local economic outlook have changed considerably, and not in line with anyone’s best forecasts back in March. When the previous government delivered its pre-election Budget in March the focus was still on escaping the lingering effects of the pandemic, economic growth prospects were relatively bright, even with the unpredictable consequences of the war in Ukraine. International supply chain problems were recognized as force likely to continue lifting inflation, but not too high and only temporarily. The RBA was still so confident that inflation would not lift too much that it had the cash rate sitting at an emergency low 0.10% and believed it unlikely that any lift would be needed before 2024.
Back in March the key Treasury economic forecasts setting the economic parameters for the Budget, were disputed by most analysts, but no more so than in previous Budgets. The key forecasts in the March Budget were real GDP growth still riding high at 3.5% in 2022-23 with firm consolidation in 2023-24, 2.5% lift. CPI inflation was forecast to recede to 3.0% in 2022-23 and come back further to 2.75% in 2023-24.
Since March, the inflation outlook has worsened considerably and the policy responses put in place here and internationally to contain the problem – moves by central banks to tighten monetary conditions quickly and in some cases sharply, aiming to batten down demand – have led to marked reductions in economic growth forecasts. Even with weaker economic growth in prospect, such is the scale and breadth of the inflation problem revealed this year that it will take a lengthy period of suppressed demand, even recession, to bring inflation back to central banks’ current targets.
Treasury’s economic forecasts in the Budget on Tuesday night are likely to show real GDP growth around 2% in 2022-23 and probably below 2% in 2023-24, skirting recession but not quite there with the soft growth forecasts driven by weaker growth in domestic household spending as well as much weaker global economic growth prospects hurting Australian export growth.
Forecast weak growth causes unemployment to rise over the next two years to around 4.5% from 3.5% currently and that in turn means that annual wage lifts only slowly. Inflation, still high in the very near term, caps out near 8%, and then declines to around 5% in 2022-23 and 4% in 2023-24.
With the backdrop of these likely Treasury economic forecasts, the Government has heralded a Budget that will help households deal with the cost-of-living pressure presented by high inflation and will deliver key election policy promises such as larger payments for childcare to almost every family plus a number of key infrastructure projects.
It will not add to inflation pressure because some of the spending will free-up more people to work and because there will be savings in the budget (a culling of many of many of the spending programs of the previous government, although not stage 3 tax cuts just yet). Also, the Government will not be spending all of the $100 billion odd boost to the Budget bottom line from much higher-than -expected company tax revenues generated by much-higher-than-expected export commodity prices over the past year.
Essentially, if the Government’s Budget is not to add to the current high inflation problem the Government must make sure that change in its net spending does not boost aggregate demand in the economy. If the Budget boosts aggregate demand it works against the RBA’s efforts at demand suppression and leads to high inflation sticking around for longer and the need for higher interest that will probably stick around longer as well.
Assessing precisely how any Budget will add to aggregate demand and when is not easy. A rough proxy is movement in the Budget underlying cash balance, after allowing for changes in economic parameters such as growth and inflation influencing the Budget bottom line.
Back in March, the previous Government forecast the 2021-22 (there was still three months of the financial year to go) underlying cash balance at -$A79.8 billion, or -3.5% of GDP. With economic growth expected to stay very strong in 2022-23 on Treasury forecasts up another 3.5% on top of then expected 4.25% growth for 2021-22, the Budget underlying cash balance was forecast to recede only by $1.8 billion to $78.0 billion, or -3.4% of GDP in 2022-23.
Treasury’s economic forecasts at the time were consistent with the deficit in the underlying cash balance receding by more than $A40 billion in 2022-23. The March Budget was boosting economic growth to the tune of almost a percentage point of GDP in 2022-23, at a time when economic growth was already rising strongly and inflation was showing signs of lifting.
As it turned out, the strength of the economy and fast rising inflation, especially in commodity prices led to a windfall for the 2021-22 Budget outcome. Between the March Budget when the outcome was forecast at -79.8 billion and the end of the last financial year in June, budget receipts increased $27.7 billion beyond March Budget forecast (higher company tax mostly on high commodity prices) and budget spending was $A20.1 billion less than forecast (far less people receiving benefits as unemployment fell). The 2021-22 underlying budget deficit came in at -$A32 billion or -1.4% of GDP, $A47.8 billion less than forecast three months earlier in March!
The movement in the underlying budget deficit relative to forecast in 2021-22 says that we are still in a very tricky phase assessing the contribution of the Budget to boosting aggregate demand or not. The economy is still growing strongly early in 2022-23, but weaker growth is in prospect in the second half. Strong past growth and high commodity prices imply a neutral underlying budget deficit position around the 2021-22 -$A32 billion outcome for 2022-23.
If, on Tuesday night, the Treasurer, Jim Chalmers, presents a Budget which after all new spending and savings comes in with a bottom line forecast near -$A30 billion in 2022-23 he can claim reasonably that the Budget is not adding to inflation in the near term. A forecast of a higher deficit, however, implies upward pressure on aggregate demand making the RBA’s task containing inflation harder.
Adding to a tricky situation, the Q3 CPI report is out the day after the Budget. The consensus forecast which seems to be roughly in line with the latest RBA forecasts is that the CPI will rise around 1.6% q-o-q, 7.0% y-o-y with trimmed mean (underlying inflation) up 1.5% q-o-q, 5.6% y-o-y. Any upside surprise implying that inflation could stay higher than previously expected, will rebound back to consideration of the Budget and whether it is adding to the inflation problem.