- The RBA again kept rates unchanged following its April meeting;
- Financial markets have now virtually priced two 25bp rate cuts by mid next year;
- At first glance the tax cuts in the Budget should be good news for the economy;
- The Government expects a Budget surplus next year – but we have heard that before;
- If Labor wins we can expect another budget later in the year (at least economists will be excited!).
“Tonight’s the night the night, let’s live it up
I got my money, let’s spend it up.”
I Gotta Feeling - The Black Eyed Peas
The Black Eyed Peas were no instant success. They formed in 1995, but it was not until their third album (Elephunk) in 2003 that they become big. They have played at the Super Bowl, and the Champions League Final. According to Wikipedia, Billboard had them ranked 12th in the artist of the decade (for the 00’s). And one of their hits, ‘I Gotta Feeling’ was the first song to reach one million downloads in the UK.
That particular song came to mind as I was on a mini-break in the wonderful NSW coastal city of Terrigal. As I was sitting in the car with that song blaring from the radio, the words above seemed to me to sum up what this Budget is about. The Government (with probable Opposition support) is handing out plenty of money (particularly to low- and middle-income earners). And the politicians will not be the only ones happy if a few consumers decide to ‘spend it up’. Economists (particularly the ones at the RBA) will be flashing the thumbs up if Government largesse means a perkier consumer.
Of course it is not only the consumer who might be doing a jig. For economists, the night was not only the night (because of the Budget) but the day was the day (the RBA meeting). As Roy and HG would have said, ‘too much economics is barely enough’
RBA economic view: Mildly positive but focused on the downside
First, the RBA. Much of the RBA analysis in April had not changed from the previous month. While the sun is not shining on the world economy as it did in 2018, unemployment rates are low and wages growth is rising. Financial markets are not as hangdog as they were at the end of last year. And there are signs that the Chinese Government shoulder is getting the Chinese economy moving. The RBA acknowledges that the domestic economy slowed in the second half of last year held back by a weakening construction sector and a sluggish consumer. But infrastructure spending is strong, and capex budgets have gone up. Jobs growth has been robust, and wages growth is picking up. House prices are still falling, although some of the recent data (such as auction clearance rates) suggest things could be stabilizing.
Most global central banks over the past few weeks have become more worried about the growth outlook. Europe and Chinese central banks have provided some support to their economy, New Zealand has raised the possibility that they also might need to. Only the Federal Reserve is not talking about lower interest rates. But financial markets are not so reluctant, and have priced in a lower US cash rate from next year.
So given that global backdrop and some mixed local numbers it is understandable that investors (at the time of writing) have priced in one rate cut in H2 2019 and a good chance of a second one by mid-2020. More economists are now agreeing with financial market pricing. And it was interesting to note that the RBA changed its statement. They now appear to be placing more weight on the importance of upcoming data rather than implying that interest rates will be unchanged for an extended period.
What sort of information might be needed to get the RBA to move? A shift lower in global cash rates (which would likely put upward pressure on the $A) would be one. Signs that the Chinese Government shoulder is not big enough to get the economy moving at a decent clip would be another. Locally, a downturn in jobs growth would worry the RBA. But the next big local release will be the Q1 CPI numbers (released on 24 April). The RBA is still forecasting underlying inflation will be 2% (from current level of around 1.75%) this year. But if the CPI data indicates inflation is moving down towards 1.5% (and firms and consumers are saying that prices rises over the past few months have been minimal) that would be an important sign for the RBA that lower interest rates might be needed.
Treasury economic view: A decent but not great economy
The Treasury economic forecasts that underpin the Budget numbers (we will have to wait a month to see the RBA’s updated view) suggest an economy that will do Ok. Economic growth is expected to be 2.75% both next financial year and the year after (with 3% growth is projected in the following couple of years). Such a forecast is a little faster than the pace delivered this financial year, but not much better than trend. As a result the unemployment rate is expected to stay unchanged at around 5%. The most important forecast for Budget outcomes is nominal GDP (broadly the expected income growth in the economy) is expected to fall to 3.75% next year (from 5% this year) because of weaker commodity prices. Wages growth forecast for next year is not an unreasonable 2.75% (currently 2.25%).
None of the above is likely to be too far from the RBA forecasts. The RBA commentary over recent years has increasingly emphasised the risks around their forecasts. Interestingly, Treasury has done the same. If the economy evolves the way Treasury (and likely the RBA) forecasts then the dollars will be rolling into the Tax Office and surpluses are on the way. But if it moves towards the weaker economic risks that financial markets are currently emphasising then budget deficits may stay the order of the day.
One final point on the Treasury economic assumptions. It seems every year that there is always one particular forecast that raises a ‘red flag’ with commentators. A few years ago it was iron ore prices. Another year it was Treasury being too optimistic on the Chinese economy. Last year the worry was that the wages growth forecast was too high. But despite the worries about Treasury being too optimistic on wages the budget outcome turned out to be a lot better than most analysts expected. Stronger jobs growth was one reason, higher iron ore prices another. In the main, budget outcomes are more a reflection of how the economic forest grows (national income growth) rather than what happens to a particular tree (wages, iron ore prices).
China remains the key global economic risk
Key Chinese Economic Surveys (3 month average)
A sharp slowing in residential construction is almost certain
Number of unit approvals (rolling 3 month sum)
Growth in health and welfare spending in the economy remains strong
Health and welfare spending (annual % change)
US leading economic indicators have slowed, but are not dire
Economist Estimation of Probability of Recession US Economy Next Year
The pace of jobs growth is likely to slow but still should be reasonable
Business employment intentions
But given the economic risks a growing number of economists are looking for rate cuts over the next year, few think there will be a rate rise
Economist probability of cash rate level at June 2020
(Survey March 15 2019)
Budget balance: A Budget surplus – waiting for Godot?
Following a projected (underlying) deficit of about $4b (0.2% of GDP) this year, the Budget is forecast to be in a surplus of $7b next year (and $11b the year after). If you feel like you have heard the story of a budget surplus being just around the corner before you would be right. Ever since the day that budget deficits (rightly) started to be run during the GFC the Government of the day has forecast that a surplus will be just around the corner. In fairness the expectation we will get a surplus next year has more justification (a $4b deficit means we are virtually there already). But that surplus will only occur if the economy stays in decent shape. And the surpluses expected are quite modest by historical standards (mainly because the forecasts are quite modest).
By the standards of the wider economy the consistent emphasis on budget forecasts (as opposed to actual outcomes) is a little unusual. For example, while analysts take into account forecasts for company profitability their views are typically also heavily influenced by actual profit outcomes. By contrast the actual Budget result is met with little fanfare.
But there is no problem if we run a budget deficit if the economy is weak. Running a deficit is what a government should do if the economy hits tough times. And with the talk of economic slowing fiscal policy should shift out of first gear. This is particularly the case given that interest rates are currently so low. That said, one measure of the stance of fiscal policy (the structural budget balance as calculated by Treasury) suggests that fiscal policy could actually be a (small) detraction from the economy next year.
The shift back to a budget surplus has mainly reflected improvement in ‘budget parameters’ (ie, a stronger economy means less money needs to be spent for unemployment benefits). Political decisions has resulted in some big tax cuts in this budget. The rise in spending has been constrained (and indeed has been helped by an underspend on the NDIS). It will be interesting to see whether such spending constraint can be maintained particularly if household disposable income growth remains subdued.
Budget surpluses are almost here next year, few think there will be a rate rise
Australian Government underlying budget balance (% of GDP)
The recent run of budget deficits has been long by historical standards
Australian Government Primary Budget Balance
(% of GDP, Budget balance before interest payments)
After taking account of the economic cycle, little change is in the budget is forecast
Chart 8: Structural budget balance estimates
Spending constraint drives the budget surpluses
What is the changing budget balance ($b)
Government debt: Not high on the worry list
As was again emphasised in the budget papers, Australian Government debt is low by global standards. Many of the European countries, Japan and (now) the US have piled up the debt over recent years. By contrast, Australia is hanging out with the Scandinavian and the Kiwi’s at the top of the Government finances’ class. Our low level of government debt meant that fiscal policy could ride to the rescue when things got tough during the GFC. And the chance (likelihood) of a future recession is the reason why debt levels need to be kept relatively low. The Government has announced a policy of paying off net debt by 2029-30. A noble aim, but any economic slowdown (which is likely at some stage over the next decade) will make this tough to achieve.
But while we look good relative to the world, we are not what we used to be. A decade of budget deficits, investments into infrastructure projects (think NBN, Snowy Hydro and Sydney Second Airport) and superannuation liabilities has led to actual liabilities (relative to GDP) rising to well above its peaks reached when John Howard and Peter Costello came to Office (although the ratio has steadied over recent years).
Although we are not what we used to be, financial markets don’t seem to be too concerned. The insurance premia that investors’ demand for the credit risk (Credit Default Swap) of the Australian Government is about what it is for the US.
Government liabilities have risen since the GFC
Gross government liabilities (% of GDP)
But net debt is low by global standards
Net Government debt (% of GDP)
Financial markets are pretty comfortable about Australian Government credit risk
Selected AAA country Credit Default Swap spreads (5 year as at 2 April 2019)
Spending: A growing part of the economy
The main spending announcements in Budget were pretty modest, particularly by pre-election budget standards. There are more dollars for infrastructure as well as some (modest) additional spending on areas such as health and education. Over time Federal Government non-defence spending has become an increasingly important part of the economy. The recent sharp growth in federal government spending (relative to the economy) coincides with an extended period of weak consumer income growth (so voters look for more government help) as well as rolling out new major programs (notably the NDIS). Interestingly one factor that might allow the Government to return to surplus next financial year is that there has been some underspending on NDIS.
Over the past decade the strongest growth in spending has been on health and social welfare. But the area that has seen the biggest increase in spending has been public debt interest payments. The rise has occurred despite the extended period of very low interest rates and has reflected an extended period of budget deficits. Despite the recent rise, the amount that the government spends on interest payments is not a significant concern.
Ideally over the long-term Governments would borrow to support the economy during good times and run surpluses in the bad times. Economists are more relaxed if money is borrowed for worthwhile investment purposes. And over recent years the Federal Government has given more funds for investment (whether providing money to the states, or directed towards its own projects such as the NBN). This Budget announced a number of new infrastructure projects. Borrowing for net capital investment remains broadly around the same level over the next few years.
One bigger picture issue is that Budgets talk a lot about how much is spent but less on how well it is spent. In that regard, one good thing is that governments over recent years (of both political persuasions) have been disciplined about keeping a lid on spending on the public service.
Federal government spending has become a bigger part of the economy
Federal Government non-defence consumption spending (% of GDP)
The government has been spending more money servicing debt
Public debt interest
(Proportion of total general government budget spending)
There has been a modest boost to federal government net investment spending over recent years.
Chart 9: Contributions of recurrent and capital spending to the Government's borrowing requirement
The size of the public service has been steady over recent years
Number of Federal Government workers
Taxation: Less is more
The big news of the budget (beside the return to surplus) was the income tax cuts. Everyone eventually benefits. But lower- middle-income earners get their share now. Workers at the top end of the pile will need to wait until 2025 (or two elections away!). In total the income tax reductions come at a cost of almost $160b over the next decade.
Certainly something had to be done on income tax. Australian governments receives a higher proportion of revenue from income taxes (both company and personal) than most other governments in the OECD. The proportion of household income going to the taxman (or woman) is at its highest level in around 15 years. And the top marginal tax rate in Australia is both relatively high and cuts in at a relatively low level (relative to the median income). A progressive income tax is a key factor behind minimising income inequality in Australia. So given the weak growth of household disposable income of recent times it is understandable that the Government has initially focussed its tax cuts for lower- and middle-income earners.
The near-term cut in income taxes (if implemented) should clearly boost disposable incomes. Importantly for an economy that is struggling with weak consumer spending, the cuts are focussed on those that are more likely to spend (low income earners) than save.
Like in other recent budgets the Government announced asset writeoffs for business. The amount that can be written off was both expanded in size (from $25,000 to $30,000) and made available to more firms (scheme is now eligible for firms with $10m turnover).
Australia has a relatively high top marginal tax rate
OECD comparison of top marginal tax rate
More of households income has been going into paying taxes in recent years
Tax as proportion household income
A progressive tax system in one factor minimising income inequality in Australia
Contribution of government services to annual income
Politics: Now to the election
It is highly likely that an election will be announced shortly. A number of the policies from the Budget (notably tax cuts for low- and middle-income earners and the one-off cash payments to low-income earners) is likely to have bipartisan support. The fact that consumers say that they believe they are more optimistic about the economy than their own finances means that politicians will remain focussed upon kitchen-table issues. At this stage Labour is ahead in most polls (as they have been for some time). In the event of a Labor victory the Shadow Treasurer (Chris Bowen) has indicated that there will be an updated Budget in the September quarter.
The ALP is ahead in the opinion polls
Two-party preferred voting intentions
Consumers are more confident about the economy than their own finances
Consumers' differing views about the economy (6 Month average)
So a big economic day. It ended with income tax cuts that should help the economy, and financial markets increasing the chances of lower interest rates. Maybe as the Black Eyed Peas said tonight really is the night we can live it up. But for the economy tomorrow can always be a different day.
We live in interesting times!
Peter Munckton - Chief Economist