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 Òongoing pressures are currently forecast to keep both underlying and CPI
inflation near the top of the target rangeÓ of 2-3% per annum. But on 7
November its assessment was Òby the March quarter of next year, both headline
and underlying measure of inflation are likely to be above 3 per centÓ.
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 Òthe Bank projects that inflation will settle at a rate
a little below 3 per centÓ. 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 ÒneutralÓ 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 BankÕs 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
Òwage and inflation pressures in the near-term are expected to ease over the
forecast horizonÓ.
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
ÒbitesÓ. 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.