15 October 2020

Fiscal policy is king as Australia’s macro model changes

Last week’s budget delivered one of the most substantial shifts in how Australian policymakers manage the economic cycle in at least 25 years. Taken literally, the wording of the budget puts fiscal policymakers firmly in the driver’s seat for managing the economic cycle, which has been a primary responsibility of the Reserve Bank since it adopted its inflation target in 1993.

This is a necessary and positive move, given the scale of the economic shock, the fact that the RBA’s own policy settings are near their limits, and the fiscal levers are much more powerful at this stage. At the same time, it raises key questions about the RBA’s mandate, policy coordination, and the interaction of politics with the economy, the election cycle, and the independent central bank.

Let’s start with what the budget stated. Although most of the headlines related to the budget focused on the big boost to spending and the tax cuts, the budget also delivered a new economic policy framework and included a new specific policy target.

The framework is a two-stage plan, with the first phase focusing on job creation and the second, ‘medium-term phase’, looking at stabilising and then reducing debt. A specific target was set by stating that the first phase of the budget plan will remain in place until ‘the unemployment rate is comfortably below 6% and on a path towards previous levels’.

Of course, full employment is one of the central bank’s mandates. The Reserve Bank Act states that the central bank aims to deliver stable prices, full employment and improvement of ‘the economic prosperity and welfare of the Australian people’. For the past 25 years or so, this set of goals has been deemed best achieved by using the RBA’s inflation target, which states that the central bank seeks to keep CPI inflation between 2% and 3%, on average, over the medium term.

The budget itself forecasts that CPI inflation will be below the RBA’s 2-3% inflation target band until 2023/24 (when it reaches just 2%). The budget also forecasts that the unemployment rate does not fall below 6% until 2023/24. With that set of forecasts and with the fiscal policymakers now seemingly in charge of delivering the unemployment rate target, much of the RBA’s macroeconomic management role is now subsumed by fiscal policy.

In practice, we expect that this will mean that fiscal policy settings will be incrementally adjusted as required to keep the unemployment rate on a falling trajectory. Coordination between Treasury and the RBA has been strong, and the Treasury Secretary sits on the RBA board.

If the unemployment rate rises, the main policy response would presumably come from fiscal policymakers, with the RBA playing a fiscal advisory role. We expect the RBA’s approach will be to state that as long as the unemployment rate is falling, then the economy is moving in the right direction, which should in turn eventually lift the inflation rate back to its target.

This would be the ideal outcome. Fiscal policy and the monetary authority working together to use the fiscal policy tools available to support the recovery and achieve macroeconomic stability.

But there are other, more challenging scenarios, particularly as politics, economics and the election cycle start to mix. Although there has been bipartisan political support for the economic stimulus measures in the face of the COVID-19 outbreak, much as there was during the 2008/09 Global Financial Crisis, this may not hold once the worst is over.

If Australia is fortunate enough to be on a solid recovery path over the coming quarters and as we approach the next election, which is likely to be held in 2022, there may be more political challenges to fiscal policy measures. After all, fiscal measures to support jobs growth have distributional consequences.

Advice from the independent central bank advocating, or supporting, particular fiscal strategies could become politically relevant.

This week the RBA Governor, Phil Lowe, is scheduled to give a speech, which will be his first public appearance since the budget.

We expect him to welcome the strengthening of the role that fiscal policy will play in supporting the recovery and we doubt that he will characterise the budget announcements as a revolutionary shift. Instead, we expect the emphasis will be on the fact that all arms of policy are helping to support the economic recovery. We see the Governor as more likely to characterise the developments as an incremental step. However, often a collection of incremental steps add up to one big one.

A key strength of monetary policy for managing the economic cycle has been that policy moves could be made rapidly, have a large effect, and were independent of politics. With fiscal policy now in the economic driver’s seat, we may be in for a bumpier ride.

This article first appeared in The Australian Financial Review.