Government spending and inflation

Budget Resources

Kate Wagner

Introduction

From its recent high in December 2022, inflation has moderated in Australia, mirroring trends in price increases globally. However, inflation remains above the Reserve Bank of Australia’s (RBA) target band of 2–3%, with its Governor Michele Bullock asserting that ‘we must continue to be vigilant about the continued risk of high inflation’.

Increases to government spending are typically thought to lead to higher inflation in net terms, heightening the chance that the RBA responds through setting comparatively higher interest rates. The 2024–25 Budget included substantial new net spending, with new policy decisions decreasing the underlying cash balance by around $24.4 billion over the 4-year forward estimates (p 87). For some of this new spending, the government has stated that it will directly reduce the consumer price index (CPI). This article provides historical context to the degree of new government spending and discusses the ways that government spending feeds into CPI inflation.

Inflation and interest rates

In its most general sense, inflation is the rate at which prices change over a given time period. According to the RBA, the main causes of inflation fall into three broad categories: demand-pull, cost-push, and inflation expectations. Government spending that provides additional money to people and organisations can in turn mean the money is used to purchase more goods and services—that is, adding to demand and increasing prices—the ‘demand-pull’ mechanism. Economist Chris Richardson has estimated that for every $7 billion in additional government spending, the RBA would need to lift the cash rate 0.25 of a percentage point higher than otherwise.

Historical government spending

In each budget update, the expected budget balance over the forward estimates period can change for 2 broad reasons: new policy decisions, and ‘parameter and other variations.’ The latter comprises changes outside of the government’s direct control, such as changes to economic forecasts, and fall outside the scope of this article.

New policy decisions resulted in substantial government spending in the 2023–24 Budget—around $22.4 billion over the forward estimates. Figure 1 below shows the historical context for new government spending in different budget years. Each data point shows how new policy decisions since the previous budget affected the underlying cash balance over the forward estimates period. While the impact is substantially less than policy decisions during and after the COVID-19 pandemic, it is higher than much of the preceding decade.


Figure 1: Impact of policy decisions on budget balances over the forward estimates period

Note: Each data point shows how new policy decisions since the previous budget affect the estimated underlying cash balance over the forward estimates period. For instance, the final data point shows policy decisions since 2023-24 Budget, summing the impact of policy decisions from the 2023–24 MYEFO ($21.3 billion) and from the 2024–25 Budget ($22.4 billion). There is a series break in 2016–17, when the budget documents went from reporting the impact of the government’s new policy decisions for the budget year plus 2 years to the budget year plus 3 years.

Source: Table 3.2, Budget Paper 1 and MYEFO documents from 2014-15 to 2024-25.

While underlying cash balance (UCB) is the most commonly used metric for analysing the overall budget balance, there are cases where cash injected into the economy does not have a substantial effect on the UCB. For instance, when governments make policy decisions such as purchasing equity or providing loans, the bulk of the cash involved appears in the headline cash balance (HCB) but not the UCB.

While these policies do not have the same effect on government finances as spending appearing in the UCB (after all, if the government makes loans, it might reasonably expect them to be repaid), many of these arrangements still represent cash added to the economy and can affect aggregate demand. These arrangements are known as balance sheet financing, or alternative financing, and are reported in ‘net cash flows for investments in financial assets for policy purposes’. As Figure 2 shows, the forecast cash flowing from the government for these arrangements has increased with this Budget.

Figure 2: Net cash flows for investments in financial assets for policy purposes

Source: 2024-25 Budget, 2023-24 MYEFO, 2023-24 Budget, PBO historical fiscal data.

 

Government subsidies and CPI inflation

The RBA sets the cash rate with the aim of keeping headline CPI inflation between 2–3%. Conceptually, the CPI measures the percentage change in the price of a basket of goods and services consumed by households.

For some of the Government’s new measures, Budget paper no. 1 (p 1) stated that they would act to decrease CPI inflation:

The Government’s responsible cost-of-living relief measures of energy bill relief and Commonwealth Rent Assistance are estimated to directly reduce headline inflation by ½ of a percentage point in 2024-25 and are not expected to add to broader inflationary pressures.

The measures being referred to here are the Energy Bill Relief Fund – extension and expansion measure, worth $3.5 billion over the forward estimates, and Commonwealth Rent Assistance – increase the maximum rates, worth $1.9 billion over the forward estimates (p 167 and p 179).

Headline CPI is concerned with what the consumer pays, not with what the government pays or the seller receives. Accordingly, when households receive subsidies explicitly related to rents or utilities, these impact the CPI measurement. For example, if Commonwealth Rent Assistance increases (assuming market rent is unchanged), then payment recipients see their rent paid decrease, as shown in Figure 3. This in turn leads to a decrease in the headline CPI figure.

Figure 3: How Commonwealth Rent Assistance affects CPI Rent paid by consumers

Diagram - How Commonwealth Rent Assistance affects CPI Rent paid by consumers 

This does not, however, decrease the market rent, as those not receiving Commonwealth Rent Assistance still pay the same cost for housing. Commonwealth Rent Assistance was previously increased in the 2023–24 Budget, which increased maximum allowances by 15%, starting in September 2023.

Analysis of Rent CPI growth and market rents (Figure 4) identifies that market rent has increased substantially compared with rents measured as part of the CPI. From an economic perspective, increasing the money renters have to spend on rent would generally be expected to increase the market price for rent, if it had any effect at all.

Figure 4: CPI rent and market rent

Source: ABS Consumer Price Index; REIA 3 bedroom detached dwellings.

There is also typically a lag between market rents and rents as measured in CPI; as market rents reflect properties put on the rental market, whereas CPI measures rents more broadly, including for existing rental agreements. The divergence shown in Figure 4 is likely to be a combination of the subsidy and lag effects.

For the Energy Bill Relief Fund, Budget paper no. 1 (p. 63) forecasts electricity prices in the CPI with and without the subsidy (see Figure 5). The mechanism of the flow‑through to CPI is similar to the increase in Rent Assistance; however, unlike the ongoing Rent Assistance increase, the Energy Bill Relief Fund ceases after 2024–25.

Figure 5: Energy bill subsidy effect on CPI electricity prices

Graph - Energy bill subsidy effect on CPI electricity prices

Source: Budget paper no. 1 (p. 63)

How much does headline inflation matter?

Although the RBA’s target band for inflation refers to headline CPI inflation, it also looks at a broad range of inflation measures in considering interest rates settings. However, headline CPI inflation remains significant, as it is used to index some welfare payments and has the potential to impact on wage negotiations. Additionally, headline CPI is highly reported in the media, so directly applying downward pressure to this metric could also assist with the ‘inflation expectations’ channel of inflation.

According to the IMF, in periods of high inflation wages growth tends to lag behind more general prices growth because ‘wages are slower than prices to react to shocks’. Getting broader inflation lower remains in the best interests of Australians as they grapple with recent cost-of-living challenges.

 

All online articles accessed May 2024

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