The RBA has lifted rates to 4.6 per cent, concentrating much of the pain of fighting inflation on younger households with mortgages. A tighter budget could spread the burden more fairly, but serious spending cuts would mean poorer services.
To get inflation back in its target range of 2–3 per cent, the Reserve Bank has lifted its cash rate to 4.6 per cent. It’s the highest rate for 15 years.
The Opposition says it is all the fault of the Labor government, which is spending too much. The shadow treasurer, Tim Wilson, says that Chalmers cannot “kick his spending addiction”, which “keeps fuelling inflation and higher interest rates”.
The government’s response is to insist on the impact of overseas pressures, most notably the increase in oil prices. According to the treasurer, Jim Chalmers, “We have an inflation challenge in our economy not because unemployment is too low but because the price of petrol is too high.” Although Chalmers did concede that “we’ve got other inflationary pressures”.
So who is right? The Government or the Opposition? And more specifically, should fiscal policy have been tighter with less spending and a lower or no budget deficit, and how would that be achieved?
The budget
In a joint statement accompanying the release of the Final Budget Outcome for 2024–26 this week, the treasurer and the minister for finance claim that the 2025–26 budget deficit at 0.8 per cent of GDP was only half the deficit projected for that year by the Treasury just before the 2022 election, assuming a continuation of the then Coalition government’s policies.
As the Final Budget Outcome also says, “The Government has … limited real growth in payments to an average of 2.0 per cent a year over the last four years, well below the 30-year average of 3.4 per cent.”
Arguably, however, these “facts” flatter the Government. In the first of the four years cited in the previous paragraph, the previous surge caused by Covid spending was wound back and budget outlays fell. Instead, if we only count the two most recent years, 2024–25 and 2025–26, real government outlays grew by 5.5 per cent and 4.3 per cent respectively – significantly faster than the economy.
While on the other hand, it is equally arguable that the faster recent growth in government spending only reflected the need to offset the under-funding of services by the previous Coalition governments and restore service availability and quality. Furthermore, the forward estimates of government spending over the next four years show that if present policies are maintained, total spending will only increase at an average annual rate of 1.1 per cent between 2025–26 and 2029–30, and that government spending would fall as a share of GDP.
It is also interesting to note that when Peter Costello, the treasurer in the Howard Coalition government, launched the first Intergenerational Report back in 2002, the focus was very much on the impact of the expected ageing of the population on government spending. As that Coalition government understood, it was only to be expected that this ageing would result in government outlays increasing as a share of GDP.
Indeed, in that first Intergenerational Report, government outlays were projected to increase by 2.3 per cent of GDP by 2025–26 just due to population ageing. But in fact, the latest data show that the increase in the ratio of total government spending to GDP between 2002–03 and 2025–26 was only 2.0 per cent. In other words, the spending data do not show that the rate of government spending by Labor is higher relative to public demand than projected under the Howard government.
The Reserve Bank’s views
The Reserve Bank, which is entirely responsible for all decisions to vary its cash rate, gives the following reasons for its recent decisions to increase interest rates four times this year.
After three interest rate cuts in 2025, by the beginning of this year the Reserve Bank thought that inflation was picking up, although it was still substantially lower than its peak in 2022. Initially the Bank attributed the rise in inflation to capacity pressures being higher than expected, but with time global energy prices added to the problem and are now much higher than previously forecast. In particular, the Iran War has gone on for much longer and had much greater impact on inflation than was originally anticipated.
The RBA was also concerned from early on that higher inflation could lead to a change in expectations about future inflation, leading to a self-fulfilling prophecy unless action was taken to quickly reduce inflation. So far, however, wages have remained subdued and are not driving inflation, with the wage price index only increasing by 3.2 per cent in the last 12 months ending in June – less than the 3.8 per cent rate of inflation.
The other problem is that low productivity growth is a major constraint, and the Reserve Bank may have over-estimated the rate of productivity growth when it cut interest rates in 2025, thus resulting in greater capacity constraints than expected.
Obviously it would help everyone if productivity growth could be lifted. However, productivity growth is mostly driven by technological change. Indeed, that is the obvious reason why all developed economies are suffering from stagnant productivity at the same time. But there is not a lot that governments can do to accelerate the discovery of new technologies and thus raise the rate of productivity growth.
The way forward
The present reliance on monetary policy to combat inflation means that its impact is mainly confined to those households that have a mortgage. But this impact is significant. For example, a household with a typical $700,000 mortgage will have to pay an extra $100 per month following Tuesday’s decision. And compared with the beginning of the year, these households will now be paying as much as an extra $400 per month – a very substantial increase in their cost of living.
Furthermore, while these households with a mortgage only represent one third of all households, they are typically younger, and the impact of increasing interest rates will further increase inter-generational inequality.
A better and fairer outcome could be achieved if there were less reliance on monetary policy to reduce inflation and more focus on tightening the budget. That would involve one or both of the following two options – reduce public spending or increase taxation.
The Coalition clearly favours cutting government spending, but it refuses to say where and how.
The reality is that serious reductions in government spending can only happen if there are policy changes to reduce the availability of services, their quality and/or the eligibility conditions for assistance.
This requirement was recognised in the first budget brought down by the Abbott government back in 2014. However, the program cuts in that budget were so roundly rejected that every Coalition government since then has sought to avoid any such policy changes.
Instead, the Coalition has relied on stealth, with programs being underfunded in order to restrain spending and achieve the government’s budget targets. But while that has left us with unsatisfactory services, it has never worked in getting the budget back into balance, let alone a surplus.
For its part Labor, if it wasn’t so timid under Albanese, could raise substantial additional revenue without facing a damaging ideological challenge. A good place to start would be a carbon tax, which would raise substantial additional revenue needed to get the budget back in the black without any negative impact on economic growth.
Michael Keating is a former Secretary of the Departments of Prime Minister and Cabinet, Finance and Employment, and Industrial Relations. He is presently a visiting fellow at the Australian National University.