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Inflation dragon lurks despite government optimism, warn economists

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6 minute read

Despite the government’s optimistic inflation expectations, economists warn that the inflation dragon still lurks in our future.

While the Treasurer has praised the government’s budget as an inflation-fighting and responsible document, economists have cautioned that certain measures, like the $300 energy bill subsidy, might temporarily reduce inflation. However, the additional spending could contribute to inflationary pressures in the future.

Other items tipped to put pressure on inflation include the broader cost-of-living support, which adds $7.8 million on top of the already announced changes to stage three tax cuts, and the Future Made in Australia measures.

Commenting on the budget, AMP’s chief economist, Shane Oliver, warned that while the cost-of-living measures could help lower measured inflation, the new stimulus risks boosting demand.

“Federal and state fiscal positions point to a sharp shift from fiscal contraction, which helps lower demand and inflation, to expansion over the year ahead,” Oliver said.

“And government support for high wage increases for some sectors risks adding to wages growth given the flow on and influencing effects at a time when wages growth is already at its maximum level consistent with the inflation target. All of which risks making the RBA’s job harder,” he explained.

While conceding that the direct lowering in measured inflation from cost-of-living measures will be welcomed by the RBA, Oliver said the central bank will be wary of the rise in new stimulus.

“The net effect adds to the risk of higher-for-longer interest rates but is probably not enough to change our forecast for a rate cut later this year.”

According to the government’s projections, inflation will return to the Reserve Bank’s target range as soon as June next year by hitting 2.75 per cent where it will remain for another two years before lowering to 2.5 at the end of financial year 2026–27.

But the Treasurer said on Tuesday, he is quite confident inflation could hit 2.75 per cent by December, a prediction that is in extreme contrast to the RBA’s expectation of 3.8 per cent in December.

HSBC’s Paul Bloxham is also sceptical of the government’s ability to lower inflation with cost-of-living measures.

Noting that while more spending on rental and energy subsidies has the intention to lower inflation, because of its targeted nature, Bloxham isn’t convinced the government’s predictions are on point.

“While it may do so mechanically for those components – rents and electricity prices - we expect the boost to household disposable incomes from these subsidies, and the substantial boost to disposable income from the personal income tax cuts, will see increased consumer spending, which will support underlying inflation, rather than lower it,” he said.

Similarly, Challenger’s chief economist Jonathan Kearns said the cost-of-living subsidies and relief measures add to household incomes, particularly of households that will spend a large share of that additional income, and so will contribute to at least some extra spending.

Moreover, he cautioned that temporary cost-of-living relief measures simply move inflation, pushing it to later years, stretching out the inflation problem.

“The RBA frequently notes that it ‘looks through’ temporary supply-driven inflation shocks, and by that logic, it should not be fooled by temporarily lower measured inflation. The inflation dragon still lurks in our future,” Kearns said.

“If anything, the budget adds to, rather than reducing, the excess of demand relative to supply in the economy which is driving persistent inflation and is of concern to the RBA.

“It’s not clear that the RBA can respond to lower measured inflation with lower interest rates when the underlying demand-supply imbalance remains,” he cautioned.

Offering a positive interpretation of the budget, Kearns said that by reducing near-term inflation, the budget lessens the chance of rising inflation expectations, and with it, the ingrained strong wage growth and effective indexing of prices.

But he admitted “it’s unlikely this effect is large enough to dominate”.

Surplus was ‘good luck’

Key budget measures Oliver highlighted in his post-budget analysis include cost-of-living relief, tax cut benefits, healthcare funding, housing initiatives, support for selected industries, international student management, and measures for aged care and childcare.

However, while the government has celebrated these as being made possible by a second consecutive surplus, Oliver has raised doubts about the extent to which the government can claim credit for these achievements.

Namely, Oliver explained that this budget, like all of those since 2020, has benefitted from extra revenue flows coming from higher personal tax collections due to a stronger jobs’ growth and higher commodity prices.

“This is not smart management but good luck flowing from conservative forecasts,” Oliver said.

“While the budget now looks better for this financial year, with another surplus – which could turn out to be even bigger, because of the extra spending in subsequent years, it now looks worse from 2024-25.”

And it sure does look worse, with the government forecasting a deficit of $28.3 billion in 2024–25, $42.8 billion in 2025–26, $26.7 billion in 2026–27, and $24.3 billion in 2027–28.

According to Oliver: “The budget has added to medium-term structural deficits. This leaves it vulnerable if the economy weakens and sees no money put aside for a rainy day over the forecast period.”

Oliver is also concerned about the potential growth of a “bigger government”, noting that spending as a share of GDP is expected to remain significantly higher than pre-pandemic levels. This trajectory could solidify a larger government sector, posing a risk of dampening medium-term productivity growth even further.

He also cautioned against overly optimistic expectations regarding the government’s Future Made in Australia policy, pointing out potential “long-term costs” to productivity and living standards.

On productivity specifically, he said there’s not a lot in the budget to improve Australia’s medium-term productivity performance.

“This is the key to growth in living standards but needs urgent reform in terms of tax, competition, the non-market services sector, industrial relations, education and training and energy generation.”

Maja Garaca Djurdjevic

Maja Garaca Djurdjevic

Maja's career in journalism spans well over a decade across finance, business and politics. Now an experienced editor and reporter across all elements of the financial services sector, prior to joining Momentum Media, Maja reported for several established news outlets in Southeast Europe, scrutinising key processes in post-conflict societies.