Budget Resources
Kate Wagner
Introduction
From its recent high in December 2022, inflation hasmoderated 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 assertingthat ‘we must continue to be vigilant about the continued risk of highinflation’.
Increases to government spending are typically thought tolead to higher inflation in net terms, heightening the chance that the RBA respondsthrough setting comparatively higher interest rates. The 2024–25Budget included substantial new net spending, with new policy decisionsdecreasing the underlying cash balance by around $24.4 billion over the 4-year forwardestimates (p 87). For some of this new spending, the government has stated thatit will directly reduce the consumer price index (CPI). This article provideshistorical context to the degree of new government spending and discusses theways that government spending feeds into CPI inflation.
Inflation and interest rates
In its most general sense, inflation is the rate at which priceschange over a given time period. According to the RBA, the maincauses of inflation fall into three broad categories: demand-pull,cost-push, and inflation expectations. Government spending that providesadditional money to people and organisations can in turn mean the money is usedto purchase more goods and services—that is, adding to demand and increasingprices—the ‘demand-pull’ mechanism. Economist ChrisRichardson has estimated that for every $7 billion in additional governmentspending, the RBA would need to lift the cash rate 0.25 of a percentage pointhigher than otherwise.
Historical government spending
In each budget update, the expected budget balance over theforward estimates period can change for 2 broad reasons: new policy decisions,and ‘parameter and other variations.’ The latter comprises changes outside ofthe government’s direct control, such as changes to economic forecasts, andfall outside the scope of this article.
New policy decisions resulted in substantial governmentspending in the 2023–24 Budget—around $22.4billion over the forwardestimates. Figure 1 below shows the historical context for new governmentspending in different budget years. Each data pointshows how new policy decisions since the previous budget affected theunderlying cash balance over the forward estimates period. While the impactis substantially less than policy decisions during and after the COVID-19pandemic, it is higher than much of the preceding decade.
Figure 1: Impact of policy decisions on budget balances over the forwardestimates period
Note: Each data point showshow new policy decisions since the previous budget affect the estimated underlyingcash balance over the forward estimates period. For instance, the final datapoint shows policy decisions since 2023-24 Budget, summing the impact of policydecisions 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 documentswent from reporting the impact of the government’s new policy decisions for thebudget year plus 2 years to the budget year plus 3 years.
Source: Table 3.2, Budget Paper1 and MYEFO documents from 2014-15 to 2024-25.
While underlying cash balance (UCB) is the most commonlyused metric for analysing the overall budget balance, there are cases wherecash injected into the economy does not have a substantial effect on the UCB. Forinstance, when governments make policy decisions such as purchasing equity orproviding loans, the bulk of the cash involved appears in the headline cashbalance (HCB) but not the UCB.
While these policies do not have the same effect ongovernment finances as spending appearing in the UCB (after all, if thegovernment makes loans, it might reasonably expect them to be repaid), many ofthese arrangements still represent cash added to the economy and can affectaggregate demand. These arrangements are known as balance sheet financing, or alternativefinancing, and are reported in ‘net cash flows for investments in financialassets for policy purposes’. As Figure 2 shows, the forecast cash flowing fromthe government for these arrangements has increased with this Budget.
Figure2: Net cash flows for investments in financial assets for policy purposes
Source: 2024-25 Budget, 2023-24 MYEFO, 2023-24Budget, PBO historical fiscal data.
Government subsidies and CPIinflation
The RBA sets the cash rate with the aim of keepingheadline CPI inflation between 2–3%. Conceptually, the CPI measures thepercentage change in the price of a basket of goods and services consumed byhouseholds.
For some of the Government’s new measures, Budgetpaper no. 1 (p 1) stated that they would act to decrease CPI inflation:
The Government’s responsible cost-of-living relief measuresof energy bill relief and Commonwealth Rent Assistance are estimated todirectly reduce headline inflation by ½ of a percentage point in 2024-25 andare not expected to add to broader inflationary pressures.
The measuresbeing referred to here are the Energy Bill Relief Fund – extension andexpansion measure, worth $3.5 billion over the forward estimates, and CommonwealthRent Assistance – increase the maximum rates, worth $1.9 billion over theforward estimates (p 167 and p 179).
Headline CPI is concerned with what the consumer pays, notwith what the government pays or the seller receives. Accordingly, when householdsreceive subsidies explicitly related to rents or utilities, theseimpact the CPI measurement. For example, if Commonwealth Rent Assistanceincreases (assuming market rent is unchanged), then payment recipients seetheir rent paid decrease, as shown in Figure 3. This in turn leads to adecrease in the headline CPI figure.
Figure 3: How Commonwealth Rent Assistance affects CPI Rent paid by consumers
This does not,however, decrease the market rent, as those not receiving Commonwealth Rent Assistancestill pay the same cost for housing. Commonwealth Rent Assistance waspreviously increased in the 2023–24 Budget, which increased maximum allowancesby 15%, starting in September 2023.
Analysis of Rent CPI growth and market rents (Figure 4)identifies that market rent has increased substantially compared with rentsmeasured as part of the CPI. From an economic perspective, increasing the moneyrenters have to spend on rent would generally be expected to increase themarket price for rent, if it had any effect at all.
Figure 4: CPI rent and market rent
Source: ABS Consumer PriceIndex; REIA 3 bedroom detached dwellings.
There is also typically a lag between market rents and rentsas 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 subsidyand lag effects.
For the Energy Bill Relief Fund, Budgetpaper no. 1 (p. 63) forecasts electricity prices in the CPI with andwithout the subsidy (see Figure 5). The mechanism of the flow‑through toCPI is similar to the increase in Rent Assistance; however, unlike the ongoingRent Assistance increase, the Energy Bill Relief Fund ceases after 2024–25.
Figure 5: Energy bill subsidy effect on CPI electricity prices
Source: Budget paper no. 1 (p. 63)
How much does headline inflationmatter?
Although the RBA’s target band for inflation refers to headlineCPI inflation, it also looks at a broad range of inflation measures inconsidering interest rates settings. However, headline CPI inflation remains significant,as it is used to index some welfare payments and has the potential to impact onwage 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 wagesgrowth tends to lag behind more general prices growth because ‘wagesare slower than prices to react to shocks’. Getting broader inflation lowerremains in the best interests of Australians as they grapple with recentcost-of-living challenges.
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