Henry Thornton - Economics: A discussion of economic, social and political issues. Henry is a former senior Reserve Bank officer who now operates a Blog - http://www.henrythornton.com - Following is a comment on Henry's proposal to increase the Budget surplus to 2-3% of GDP, with subsequent exchanges with "Henry" disguised as Ed.       


Controlling Inflation: Higher Interest Rates or Fewer Tax Cuts and Spending Hand-outs?



12th November 2007

Des Moore begs to differ from Henry on fiscal policy.

In announcing the increase in interest rates of a quarter percent to 6.75% on 7 November, Reserve Bank Governor Glenn Stevens indicated that the Bank had changed its previous assessment of the outlook for inflation. In its August statement it observed that “ongoing pressures are currently forecast to keep both underlying and CPI inflation near the top of the target range” of 2-3% per annum. But on 7 November its assessment was “by the March quarter of next year, both headline and underlying measure of inflation are likely to be above 3 per cent”. Unsurprisingly, the more comprehensive 12 November statement on monetary policy confirmed this assessment, although it added the important qualification that over the next two years “the Bank projects that inflation will settle at a rate a little below 3 per cent”. With the economy operating at close to full capacity (and domestic demand growing at 5 per cent pa), it is perhaps not surprising that underlying inflation has increased slightly and, despite the quarter per cent increase in cash rates, is expected by the Bank to increase further.


The surprise is that the Bank kept its cash rate at 6.25% from November last year until July of 2007. Given that this cash rate implied a real interest rate only slightly above the “neutral” rate of 3.0-3.5% (ie 6.25 % less inflation of 2.5% implied a real interest rate under 4%), the implication was that monetary policy was barely restraining expenditure in circumstances of strongly growing demand (and incomes). Indeed, although changes in the growth in monetary aggregates is no longer the determining factor in deciding changes in monetary policy, the one-third jump in growth of broad money from 9-10 per cent pa in 2005-06 to over 12 per cent pa from October 2006 should surely have tipped the balance in favour of earlier additional action (in the last two months the rate of growth increased further to 15-16% pa). It is not surprising that financial markets are now expecting a further increase (or increases) in rates in the near term.     


True, the Bank’s increased inflation forecast for the short term needs to be assessed against the October report by Treasury and Finance on the Pre-election Economic and Fiscal Outlook 2007. Although this report increased the budget time economic growth forecast for 2007-08 from 3.75% to 4.25%, it raised the headline (CPI) inflation rate forecast by only a quarter per cent to 2.75%. Based on a forecast slower rate of economic growth in 2008-09 (to only 3.5%), the report also maintained the same forecast inflation rate as in 2007-08 and, rather surprisingly, assessed that “wage and inflation pressures in the near-term are expected to ease over the forecast horizon”.


However, it now appears that both Treasury and the Bank consider that inflation is likely to stay below the top of the target range in 2008-09. It is not clear on what basis this assessment has been made, although possible reduced price effects from the higher exchange rate may be a factor. It might also be said that the problems in US financial markets will exercise a potential restraining general influence on inflation. Certainly, the Federal Reserve Bank assesses these developments as likely to slow growth in America in the near term, although it also warns that inflation pressures remain, particularly from rising oil prices. With unemployment in the US still below 5%, some slowing in US growth may in fact be welcome there. But any flow through- effects to Australia are likely to be small.


Against the background of a possible further upward movement in inflation, a question has been raised as to whether there should also be some tightening in fiscal policy in Australia in order to reduce the rate of growth in national expenditure. Suggestions have even been made that, whichever major party wins the election, it should renege on some of its large proposed tax cuts or expenditure hand-outs. The bottom line would then be, ceteris paribus, an increase in the budget surplus, now estimated to increase in 2007-08 from the original budget-time estimate of $10.6 billion or 1.0% of GDP to $14.4 billion or 1.3% of GDP (the 2008-09 estimate is similar).  The revised estimate for 2007-08 is now slightly higher than the outcome in 2006-07. (Note however that these figures exclude about $3 billion of Future Fund earnings).


Any such action would seem to be both unnecessary and most unwise. While I strongly endorse the need to keep the rate of inflation down, suggestions of using fiscal policy imply an inflationary situation that is almost out of control, which is clearly not the case. The primary responsibility for controlling inflation lies with the Reserve Bank and, if the Bank judges further moderation in growth in aggregate demand to be required to keep inflation within the target in the medium term (which it says is needed), it should be increasing interest rates further in the near term, particularly given the estimated lag of 12 months or so before an increase “bites”. If such action were taken it should not come as a surprise: in circumstances where the economy is growing strongly, and where it is operating at near full capacity, inflation is bound to require corrective action at the margin from time to time.


The time has long since past when governments in Australia use fiscal policy to attempt fine-tuning of the economy. Both the timing of changes in private sector activity and the effects on such activity of budget changes are difficult to assess. Moreover, past experience indicates a clear need to avoid politicised decision-making on budget changes for supposed economic management reasons: avoiding the temptation to make such changes for electoral reasons is also why decisions on interest rate changes have become de-politicised by giving the Reserve Bank independence to assess the need for such changes in order to meet the (politically-determined) inflation target.


Both major parties have in fact accepted the medium-term approach to fiscal policy of aiming for budget balance, on average, over the course of the economic cycle. This allows the budget to move automatically into deficit in the event of a recession or into surplus in circumstances of above trend growth. Although the original estimated budget surplus was excessive, this is what is now happening in 2007-08, with above trend growth adding the equivalent of 0.3 percentage points of GDP to the original estimated budget surplus.     


While there is debate about the aggregate net effect of policy changes in budget outcomes,  action by the government to increase the budget surplus by (say) a further 1-2% of GDP would of course have some effect in reducing the growth in private sector expenditure over the next year or so. However, even if such action were successful in terms of timing and desired aggregate effect on private sector spending, past experience suggests it would be unlikely to have the desired effect on inflation and would be difficult to repeat politically. By contrast, if increases in interest rates did not achieve the desired effect on inflation, they could more readily be repeated. Moreover, interest rate increases avoid the problem of what to do with the increased budget surplus: the adoption of the fiscal policy route would involve (in effect) an increase in taxation the proceeds of which flow to the government and would require subsequent policy decisions.  



None of the foregoing should be taken as suggesting that government spending or taxation should continue at existing levels. In recent years I have argued that there is a strong case for reducing the size of government and that this would likely increase the rate of economic growth.  But the case for such reductions is not related to the control of inflation per se but to the efficient functioning of the economy. Controlling inflation should be pursued by way of action by the Reserve Bank independently of the government.


Ed:  Henry is indisposed tonight, and has asked me to respond.  The bit I do not understand at all is this. You are, as you say, on the record as saying the overall size of government should be smaller - for reasons of efficiency. So when the economy is already running faster than is sustainable, why not begin reducing the size of government by cutting spending?  And when we have the mother of all resource booms, is it not prudent to increase the government surplus to make room for extra private investment spending? I agree that if these changes are not made, monetary policy will (and should) squeeze the economy to a point that inflation is contained.  The question is if fiscal policy plays its part making room for the boom in private spending, the overall outcome will be better. I strongly believe it will be, and I'd be amazed if you did not agree.


Des Moore, 14/11.   I have indicated in the commentary itself that I favour a smaller government but that does not mean that I favour a larger surplus. If both spending and taxation were reduced, that would make room for additional private sector spending, including investment.  So, if you want to pursue the" making more room" argument why not propose both? Politically, you have a much better chance of getting lower government spending if you accompany that with lower taxation. Advocating lower spending on its own is very difficult to achieve.


Ed:  I understand your political point.  I am simply making the economist's point that in current circumstances with a greatly overstretched domestic economy it would be best to start with spending cuts and hasten more slowly with tax cuts - those already in the pipeline are delayed in any case. A Rudd Labor government in its first year might well get away with what is economically most sound.  The Howard government in its first year arguably set itself up for several good years by cutting spending hard, albeit doing a fair bit of damage to some important things like spending on higher education and R&D.