The government has announced a number of measures designed to ease cost of living pressures. The budget papers estimate that they will take 0.75 percentage points off the CPI in 2023-24, reducing inflation to a forecast 3.25 per cent in 2023-24.[1]

Prior to the budget some economists had argued that the efforts of the government to reduce cost of living pressures would themselves increase inflation. In this view, anything that puts a dollar into people’s pockets leads to higher inflation and higher demand.[2] For those economists, it seems any new spending drives up inflation. The idea is that government spending adds to total demand for goods and services, and so adds to inflation.

The budget included a $14.6 billion cost‑of‑living plan. Those who worry about the inflationary consequence of government spending assume that all additional spending is used by producers to increase prices rather than supply more goods and services. A more careful analysis would suggest the spending will have virtually no inflationary effect.

$14.6 billion is a lot of money. But, given that it breaks down over four years, and is happening within an economy that produces over two trillion dollars of goods and services every year, it will have a trivial impact. The extra spending will be roughly 0.14 per cent of the total economy. If that all went into higher prices, then the increase in inflation would be a fairly trivial 0.14 per cent. And that is the extreme upper limit.

Research, by the IMF and others, shows that the relationship between economic activity and inflation has weakened considerably. The governor of the RBA has said that the relationship between economic activity and prices is “quite flat”.[2] The recent inflation surge emanated from the commodity price hike and opportunistic profit push from within the sectors of the economy characterised by concentrated oligopolies who abuse their market power.

The commodity price increases and supply chain interruptions provided cover for price increases, but that cover has now disappeared and there is no reason to suggest that producers will do anything other than sell more if demand increases. In any event, the economic outlook described in the budget papers is one of subdued growth and higher unemployment, which is hardly consistent with worsening inflation.

[1] The latter is a through-year measure meaning it goes from the June quarter 2022 to the estimate for the June quarter 2023. See BP No 1.

[2] RBA Governor Philip Lowe talked in technical terms relating to the Phillips Curve being quite flat. Lowe P (2021) “Transcript of Question & Answer Session: Recent Trends in Inflation”, Address to the Australian Business Economists, Sydney, 16 November.

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