No need for fiscal policy brake

Australian Financial Review

20th November 2007

The primary responsibility for controlling inflation lies with the Reserve Bank, writes Des Moore

Following the Reserve Bank of Australia's announcement on November 7 of a 0.25% percentage point increase in interest rates, and of underlying inflation expected to increase early next year to above the top of the target range of 2 per cent to 3 per cent a year, an important debate has ensued about whether fiscal policy should also be tightened.

This debate has spilled into the election campaign, with the leaders of both major parties clearly holding back on expenditure announcements they would otherwise have made after November 7.

However, Opposition leader Kevin Rudd added less to spending than the Prime Minister and most commentators have regarded this as a victory for Rudd.

The key question from an economic management perspective is whether inflationary pressures warrant a tightening of fiscal policy by either reducing government expenditure or reneging on promised tax cuts. The next government will face this question.

There is a strong case on both economic and social policy grounds to justify a much lower level of federal government expenditure and taxes. However, adopting a policy of smaller government is quite different from adopting a policy of lower expenditure with the purported objective of helping reduce inflationary pressures.

Even after allowing for promised additions to spending and taxation cuts, both major parties aim for a budget surplus of about 1 per cent of gross domestic product in 2007-08 and next year. They would be withdrawing more funds from the community than they would be putting into it. Although the compositional effects of spending additions and tax cuts might increase net demand, it seems unlikely this would be significant.

The Reserve Bank has said that moderation is needed in national expenditure growth and that increased public spending contributes to that growth.

However, the bank has also indicated it has not been concerned from a monetary policy perspective about the government's maintenance of an overall budget surplus policy. This has been pursued within the medium-term approach to fiscal policy of aiming for budget balance, on average, over the economic cycle - an approach endorsed by the opposition.

Of course, action to increase the budget surplus to,say, 3 per cent of GDP would effect some reduction in private sector expenditure growth. However, a resort to using fiscal policy to help control inflation seems neither necessary nor wise.

Past failures of attempts to fine-tune the economy has caused governments to abandon using fiscal policy for that purpose. This partly reflects the difficulty in assessing the effects of budget changes on such private sector activity and inflation: would an increase in the budget surplus to have the desired effect on inflation? By contrast, if increases in interest rates did not achieve the desired effect, they could more readily be repeated. Moreover, interest rate increases avoid the problem of what to do with the increased budget surplus.

The abandonment of fiscal fine-tuning also reflects acceptance of the desirability of avoiding politicised decision-making on budget changes for supposed economic management reasons. That is why decisions on interest rate changes have become depoliticised by giving the Reserve Bank independence to assess their need.

Suggestions of using fiscal policy also imply an inflationary situation almost out of control, which is clearly not the case. In fact, both Treasury and the bank consider that inflation is likely to stay below the top of the target range in 2008-09, with the bank adding that over the next two years it "projects that inflation will settle at a rate a little below 3 per cent".

The October report by Treasury and Finance on the Pre-election Economic and

Fiscal Outlook 2007 raised the headline (CPI) inflation rate forecast for 2007-08 to only 2.75% and maintained that forecast rate for 2008-09, adding that "wage and inflation pressures in the near-term are expected to ease over the forecast horizon".

The primary responsibility for controlling inflation lies with the Reserve Bank and, if it judges further increases in interest rates are needed, it should get on with the job.

The surprise is that the bank did not increase its cash rate between November last year and July 2007 in circumstances of strongly growing demand. Indeed, although changes in growth in monetary aggregates are no longer the determining factor in deciding changes in monetary policy, the one-third jump in growth of broad money from 9 to10 per cent a year in 2005-06 to over 12 per cent from October 2006 should surely have tipped the balance in favour of earlier additional action.