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Tuesday, May 10, 2011

Budget not tough enough to stop a June/July hike

First some thoughts from me and then the economists:

--Fiscally responsible, which is the least one should expect, but not tough enough.

--Initiatives to improve the supply of labour to Australia's fully-employed labour market, the participation rate, vital spending on national infrastructure (exclusive of the NBN waste), long overdue support for mental health, a rolling back of middle-class welfare, and maintenance of the liquidity of the government debt markets are all commendable measures.

--Having said that, I don't think this Budget will give any comfort whatsoever to a policy-challenged RBA, and a rate hike in June/July remains very much a 'live' possibility. If anything, the Budget disappointed in the austerity stakes. And the ramp-up in public spending on infrastructure, combined with tax incentives to encourage private investment, will only exacerbate supply constraints in the near-term (although these are much needed programs given Australia's infrastructure deficiencies).

--The chief problem is that public sector spending as a share of total economy-wide spending remains too high post the GFC-induced binge.

--The economy is operating close to its capacity, with a fully employed labour market and clearly emerging wage and inflation pressures.

--The nation is embarking on one of the biggest private capex booms in post-war history, and the public sector is consuming too many scarce resources.

--The Government has avoided making tough decisions on spending, and is leaving the (capacity-liberating) hard yakka to the RBA's blunt monetary policy instrument.

--Depositors will benefit from higher returns; expect to see 7% plus term deposit rates before too long. Cash will be king.

--House prices are going nowhere, as we have forecast since early 2010, although investors will benefit from robust rental growth.

--The sharemarket will face significant headwinds as the RBA turns the monetary policy screws over 2011-12. Don't expect the Aussie equities market to recover its 2007 peak until perhaps 2013-14 or beyond.

Now over to the economists. Here's JP Morgan:

"A potential source of disappointment is the lack of “big-ticket” expenditure savings – real bell-ringers, rather than bits and pieces all over the place - that would have signalled that the Government is really serious about cutting the spending that blew out during the GFC. While the Government is promising to do its bit in tightening conditions in the economy by delivering a surplus, the heavy lifting still will be left to the Reserve Bank – the cash rate is headed up, most likely within the next few months. This Budget has moved in the right direction, but has not done enough to prevent interest rates from rising."

And ANZ:

"The markets and analysts, however, will likely be disappointed by the very small size of projected budget surpluses in the years beyond 2012-13 and the return to stronger rates of spending growth (albeit still below the self-imposed 2% per annum real cap), though to be fair this does include a very mild assumption about a decline in the terms of trade of 20% over a 15 year projection period. The challenge over coming years will be to continue to improve the structural position of Australia's fiscal accounts in case the terms of trade weakens more substantially. The structural position was substantially weakened between 2004-05 and 2007-08, principally as the main benefits of the once in 150 year surge in the terms of trade were returned to the electorate in the form of tax cuts and middle-class welfare. This budget takes some useful steps in this direction in spite of the Government's minority status, but is likely to be criticised for not going far enough...

What distinguishes this budget is the extent of focus on microeconomic matters and arguably a relatively smaller focus on the broader macro aspects of policy. This is not to say that the micro aspects are not important, just that a greater emphasis on improving the structural budget position over the full four-year budget forecast/projection period would have been welcome. Good examples of some of the positive micro aspects (albeit with a macro bent) include the wind back/pausing of some welfare payments and the increase in skilled migrant visas (to a record 125,850)...

The markets are likely to view the stance of the Budget as not sufficient to dissuade the RBA from further interest rate hikes in the months ahead."

And, finally, RBS:

"There's no unique measure of fiscal stimulus, but the Reserve Bank often uses the forecast change in the Budget balance as a share of GDP as a shorthand indicator. On this basis, the Budget is a 2.1pp drag on growth in 2011-12, with a further drag of 1.7pp in 2012-13.

This is substantial turnaround and would be one of the biggest improvements in the Budget balance in the post-WW2 period. On our rough calculation it would only be surpassed by the "horror" Budget of 1951-52, when tight fiscal policy saw a 3pp turnaround in the Budget bottom-line.

Whether or not fiscal policy actually turns out to be such a drag on growth is hard to judge, largely because history shows that it is very difficult to accurately forecast the Budget balance, especially two years into the future...

Although the Government did run a large deficit during the global financial crisis, it pales in comparison with the deficits seen in the US and the UK, where deficits exceeded 10% of GDP.

If all goes to plan it should return to surplus much earlier than other countries and its challenge remains dealing with the resources boom. After all, the time for fiscal stimulus is well behind us even as the Government tilts its policy mix towards dealing with some the regional and industry inequality created by the boom.

Another unusual problem is that a return to surplus will create tension between a strong demand for bonds - the product of strong offshore demand and tougher prudential regulations that will encourage banks to hold more Commonwealth bonds as liquid assets - and insufficient supply.

The Commonwealth faced a similar problem in 2003 when surpluses meant that it could have paid down the bond market. Instead it decided to keep enough bonds on issue to maintain the liquidity of the futures market (c$50-55bn of stock) and used some of the surpluses to establish the Future Fund to finance the unfunded pension liabilities of Commonwealth employees

As Skye Masters discusses in her note on the Government's plans for the bond market and issuance, this time it has decided to keep bounds outstanding at around 12-14% of GDP (by way of comparison, the OECD average for public debt to GDP is 100%!).

It will consult with the market, but this is a very welcome development and raises the broader issue of whether the Government should set up a standard sovereign wealth fund - by perhaps broadening the mandate of the Future Fund - or establishing a macro stabilisation fund. While we are very positive on the long-term outlook for Asian commodity demand, the inevitability of the business cycle means either option would be a good one."