How will the budget affect inflation?

A rounding error

Last night Jim Chalmers handed down his first regularly scheduled budget on behalf of the Albanese government. However much of the spending package has drawn criticism, with plenty of economists arguing that by putting more money in households’ pockets the increased spending may exacerbate the current high rate of inflation. Raising the rate of inflation would make the Reserve Bank of Australia’s job of bringing down inflation harder, perhaps necessitating even higher interest rates.

But is this right? 

It is certainly true that government spending generally stimulates the economy. However when thinking about economics it is crucial to not just list the various costs and benefits of a given policy, but actually attempt to quantify them.

Quantifying the cost

For example, consider the $40-a-fortnight increase in payments to those on JobSeeker and Youth Allowance. This is expected to cost the Australian budget around an extra billion dollars annually. Compared to an Australian economy which produces almost  $2.5 trillion worth of goods and services each year it is a drop in the bucket. The JobSeeker uplift would increase total spending by only 0.041% even if we assume that the recipients immediately spent every additional dollar they were sent and saved none of it.

What about the entire spending package? Adding up every single policy decision made since the last budget has made for a bit over $20 billion to the economy over the next four years, with $12 billion of that in 2023-24. That translates to a 0.5% increase as a fraction of GDP in 2023-24 or the 0.2% increase over the forward estimates - assuming a multiplier of around 1.

Translating an increase in household spending to the rate of inflation requires the use of an economic model or two. I am sure there are many different ways to translate between GDP and inflation but one approach is to first translate the change in GDP to an expected change in the unemployment rate (via Okun’s Law) the RBA suggests Okun’s coefficient is around 0.3-0.4. To translate the reduction in unemployment rate to an increase in inflation we also need some time of the Phillips Curve. Recent work suggests that this relationship is non-linear being steeper at low rates of unemployment. At low rates of unemployment they find that a 1 percentage point fall in the unemployment rate is associated with an increase in wages growth of around 0.7 percentage points.

So combining these numbers on the back of our envelope suggests that the budget will add

0.5 x 0.35 x 0.7 = 0.12 percentage points spread over 2023-24.

This is obviously a very, very small impact. And it is likely an upper bound for these estimates. The impact is even smaller if you look at the out years (when monetary policy has more of an impact), you assume the multiplier is smaller (true of the transfers to middle income households) or if you adjust for the fact the spending is focused in areas with more unemployment and thus where the Phillips Curve is flatter.

This is not to say that every spending decision is good and wise. Obviously opportunity costs still exist. Money could always be reallocated - sometimes in better ways. But the principal cost of these spending measures is that alternative option (including paying down debt) not the resulting inflation.

If you feed this into a standard monetary policy rule it would not even call for a single 25bp hike. The RBA may well decide to hike interests in the months to come. But if they do so it will be because the inflation rate is already well over 6 per cent and needs to be brought back to target - not because the government gave the unemployed an extra $2.86 a day.