Will Australia’s budget spending stoke inflation?

Highlights

• The government has introduced fuel tax cuts and expanded the Paid Parental Leave scheme under the new budget.
• As per historical evidence, demand-driven policies can create further inflationary pressures.
• It will be enticing to see how soon the RBA will take a tighter stance on interest rates following the latest changes in the budget.

The latest budget announcement by the Australian federal government targeted cost-of-living pressures faced by the population over the recent months. Among many other measures, the government introduced fuel tax cuts and expanded the Paid Parental Leave scheme under the new budget. Some experts believe that these measures could weigh heavily on the government’s balance sheet. Meanwhile, the giveaway budget has sparked questions around whether the provided support would incite inflation.

Like many other nations, Australia has seen a sudden spike in commodity prices and overall living expenses due to the war in Ukraine. Fuel prices have been soaring uncontrollably as sanctions on Russian goods has hurt the global oil supply. At the same time, the floods across central and eastern Australia have caused widespread disruptions, urging residents to flee from their homes.

Amid this backdrop, the federal government decided to introduce a generous boost to the economy right ahead of the elections. The excise tax on fuel has been halved from about 44 cents a litre to 22 cents a litre. Meanwhile, the government has planned to provide a one-off AU$420 cost-of-living offset to over 10 million individuals from July 2022. The government has also introduced a range of other measures to support Aussie businesses and consumers. With the economy still maintaining record-low interest rates, experts are contemplating if these support measures would escalate inflation in the country.

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Will inflation increase further?

Basic economics dictates that “there is no such thing as a free lunch”. While the government’s efforts are focused on helping households manage the rising costs, they would be introduced on the back of increasing government debt and a potential hike in taxes.

As evident from the past, demand-driven policies usually lead to rising inflation. The expansionary measures introduced during the first lockdowns had helped ease the economy, with rising costs emerging as a side-effect. This is typical for any economy that sees a boost to its money supply. As consumers demand more, producers face the pressure of increasing their supply. Consequently, the demand-supply balance breaks, with overwhelming demand levels forcing producers to charge more for their goods and services.

Image description: Rising inflation is a side-effect of demand-centric policies.

As the latest budget majorly offers demand-centric policies to households, similar fears of inflation have surfaced again. However, this time the supply-side pressure also seems to be strong. The economy is in a very different shape compared to a year ago, with new headwinds constantly affecting the outlook.

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What to expect from interest rates?

The Reserve Bank of Australia (RBA) has repeatedly stated that inflation needs to rise further for interest rates to be increased. While the headline inflation target of 2-3% has long been surpassed, the government wants to target higher core inflation, which does not include economic shock changes and other seasonal factors.  

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The RBA primarily wants wages to rise, which could reflect in the underlying inflation. As the labour market moves closer to record-low levels of unemployment, a revival in wages is the need of the hour. As per the Phillips Curve equation used in economics, inflation usually rises further with a reduction in the jobless rate.

With the jobless rate standing at record-low level, the current circumstances have increased the prospect of the RBA implementing a tighter rate hike policy soon. However, experts believe that the timing of the rate hike may not be affected by these changes introduced in the budget.

Economists across major banks have updated their interest rate hike expectations. While market pundits expect seven to eight interest rate hikes this year, economists are forecasting about half as many hikes. However, the overall consensus suggests rate hikes could commence from mid-2022 despite no clear indication being given by the RBA.

Bottom line

Treasurer Josh Frydenberg expects inflation to fall to 3.5% in the next fiscal year and to 2.5% in 2023-24. The expectation is built on the fact that the supply-side pressures would continue for some more time. Additionally, experts suggest that the benefits promised under the new budget amount to only a small percentage of GDP. Thus, economic forecasters seem to be at ease despite increasing inflation speculations.

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