There are so many ways you can look at last night's budget. I've decided to focus on just one aspect - the effect on interest rates.
Demand, or more accurately, aggregate demand, is generated by consumers, business, the government and the export sector.
AD = C + I + G + X-M
Demand is also the driver of inflation. As we stand, the export sector is putting enough upwards pressure on prices (due to the mining boom) such that other parts of that demand equation can be flat or even negative and we will still get upwards pressure on prices.
Last night we saw a government produce a budget in deficit by over $50 billion. That's quite a stimulus. That $50 billion slots very neatly into the government spending (G) part of the equation above. With some business investment also being driven by the mining boom, we're left reliant on a weak and timid consumer to maintain some sort of balance.
Fact is this budget will create further upwards pressure on prices and will no doubt leave the Reserve Bank in a position to raise interest rates sooner rather than later. That will put more pressure on households and will likely slow consumer spending further.
This isn't a terribly bad thing as long as this is where it stops. That is, inflation eventually subsides, interest rates come back down again and the economy returns to equilibrium. The issue I think is that as long as our terms of trade remains as robust as it is, the government can't in good conscience spend as much as it is - it will simply drive up inflation and leave to an interest rate environment that is at risk of derailing the retail sector, the consumer and therefore the mortgage holder.
Given the fragility of the Australian property market, an endogenous shock is the last thing we need. If China pulls back in the near term, however, this budget could be exactly what the economy needs. Problem is, the government is in fact reliant on on-going stimulus from China in order to make ends meet as it is!
The government is reliant on a delicate balance: a consumer willing to take on higher costs of living and a Chinese ecnomomy that will continue on as it is without too much disruption.
It's essentially a risky budget.
David Taylor
