Last night was the Australian 2023/24 Budget. Like all Budgets it existed and was filled with politics – but I was surprised to find my twitter filled this morning with people calling it highly inflationary, and others saying it would reduce inflation.
The arguments appear to be:
- Government spending more, inflation!
- Government surplus and energy subsidies, disinflation!
I’m a bit slow, so I wanted to think things through a bit step-by-step to figure out where people were coming from.
If you’re keen to come on that journey, then let’s go!
Framework: Aggregate Demand
Right so the government didn’t even pretend that this Budget would “unlock Aussies productivity potential” – which is fair enough as it didn’t. So when thinking about inflationary pressure we can just think about our old friend Aggregate Demand.
Y = C + I + G – T + X – M
What’s that? Read it this way – the amount of aggregate demand for things made in Aussie depends on how much people are spending on consumption, how much they are investing (in a factor of production sense), the amount the government spends, the amount the goverment takes in taxes, the amount people from overseas buy from Aussies (subtracting how much the Aussies buy from overseas).
If the Y value goes up here, there is greater demand, and we start seeing upward pressure on the general level of prices – or in other words inflation.
So how do these things fit together with the arguments above?
- G goes up, more inflation mate.
- The surplus is the balance of G and T, so T has risen more than G and inflation goes down.
- Energy subsidies make CPI lower.
As you can see from above, only the first two of the arguments fit in – and as we’ll get into these beforehand as the energy subsidy discussion is frankly dumb as hell. Gotta agree with Steven Hamilton that the Treasury officials that wrote it down should feel embarrassed.
Monetary policy offset and inflation – what are the shocks
The arguments above missed two important things for really defining our “counterfactual” to talk about inflation i) what are the actual “shocks” that lead to the change in the surplus ii) what does monetary policy do.
Start with monetary policy offset. If aggregate demand goes up and pushes up inflation, the central bank tightens matters to pull it back down – therefore we’d expect higher interest rates if it was inflationary. As the currency didn’t budge and we haven’t seen any change in market expectations of rate setting – it looks like markets perceive this as neither inflationary or deflationary. Nice, but I’m not going to stop talking.
So when we talk about the Budget being “inflationary” we aren’t necessarily saying that it increases inflation, or that CPI rises, we are saying that the central bank would need to response with a tighter stance of monetary policy than it would otherwise.
Now how does this fit into shocks. For this we want to think about how fiscal settings compare to the RBAs expectations.
- If the tax take is higher because nominal growth is stronger than the RBA expected, then they may take this information and expected aggregate demand to be higher. If government spending is then also higher this further increases aggregate demand. So inflationary pressures rise.
- If the tax take was exogenously higher OR government spending was expected to be larger than what was actually announced these both subtract from aggregate demand. In that case inflationary pressures cool.
We should remember that a surplus doesn’t tell us the stance of the fiscal impulse itself – we need to understand where we are in the cycle. The tax take is endogenous (i.e. depends on how strong economic activitiy is)!
The government is running a structural deficit, and is increasing in size relative to the rest of the economy – both important things that may be relevant for the inflation outlook. However, the key thing to say if the Budget is inflationary relative to where we were pre-Budget is to ask what the shock is.
And I have to be honest, I don’t know – and won’t know until the RBA tells us at the next policy review 😉 .
You heard the government – energy subsidies. Inflation solved mate.
Imagine this my friend. The government gives you $100 to spend on energy OR the government pays the provider $100 for you. How are these two situations different?
Yeah they ain’t, you have a reduced bill and can use the money you may have used on power on other things (including buying more power mind – which we will come back to).
The CPI measure will be mechanically reduced by the subsidy the government gives, but it will not be reduced if the government puts the money in your hand. But these are the same situation! There is the same demand for goods and services, there is the same amount of income sitting there for the person, there is the same government expenditure.
And as a result, the impact on true inflation in terms of what is happening with aggregate demand – and thereby interest rates – is the same.
An energy subsidy reduces the relative price of energy – it doesn’t change the general rate of increase in all prices which is inflation. The RBA is targeting the later, and looks through changes in the former to do so.
As a result, the decision to do it by subsidy is all politics – it doesn’t “make the Banks job easier” and frankly that is an embarrasing thing for people to be saying who should know better.
Note: The point that its “small” is fair – the energy subsidy is hardly going to drive hyperinflation. But the Treasurer explicitly said it would make the RBAs job easier, word for word, in front of all Australians on ABC. That’s the sort of rhetoric economists over here should be calling out more.
It gets a little bit worse though. By lowering the price it will also increase underlying demand for energy consumption, which will push up the gross price of energy – if the current price truly represents that energy is very scarce, the subsidy is going to be largely passed through to producers.
But this isn’t an inflation point (unless you want to start discussing greedflation), so I’m just going to leave that there.