Hand in hand is the surer way to land
Households are cutting consumption in a textbook response to higher interest rates. This, and a likely future of inflationary supply shocks, warrants a more coherent design to fiscal and monetary policy frameworks.
This week saw the RBA Board minutes observe that many households have been pulling back on spending even when their incomes have not been falling. We also saw a similar implication from the May release of the Westpac–Melbourne Institute Consumer Sentiment Survey.
As Westpac Economics colleague Matt Hassan noted, most households who expect to receive a tax cut plan to save most or all of it. Altogether, around 80% of the increase in post-tax income is planned to be saved. Plans do not always pan out and the households that do not expect to receive the tax cut might spend that pleasant surprise. Even still, these results tilt more to saving than did the responses to surveys concerning previous rounds of stimulus.
That households plan to save more out of the extra income than in previous episodes should not come as a surprise. It is the expected implication of contractionary monetary policy. One of the main ways that monetary policy dampens demand is by changing the incentive to save versus borrow or spend. It does not need to reduce people’s incomes to change their behaviour. The RBA minutes referred to this as ‘simply choosing’ to spend less, but there is no mystery behind the choice. It is what economists call the ‘intertemporal substitution channel’. People ‘simply choose’ to respond to the incentives created by higher interest rates.
Intertemporal substitution is likely to be more powerful than the ‘cash flow channel’ working via lowering the incomes of households with mortgages, not least because it affects everyone. In the Australian context, though, it is often forgotten. Because variable-rate mortgages predominate in the Australian market, the mortgage cash flow channel receives far more attention than its overall impact warrants. The commentary in the RBA minutes and the downward revision to its consumption forecasts suggest that the RBA, too, might have over-focused on the cash flow channel in its recent analysis.
Higher mortgage rates have been a struggle for many households recently. Across the whole household sector, though, they have not been as big a drag on incomes as inflation itself or the resulting tax bracket creep. As we have been highlighting for some time, higher tax payments have done more to weigh on real household incomes than higher net interest payments have done. And as we have also been highlighting, this additional fiscal squeeze distinguishes Australia from some peer economies, including the United States and Canada where tax brackets are CPI-indexed. It means that one cannot read across from those countries’ experiences to infer how much monetary contraction is needed here, or for how long. It matters if fiscal and monetary policy are working hand in hand or not.
Such a policy alignment contrasts with the common presumption that monetary policy needs to offset fiscal policy, in a macro-policy version of Newton’s Third Law. Post-Budget commentary arguing that additional spending would need to be met with higher rates falls into this camp. It assumes that there is no spare capacity in the economy when the spending occurs, so inflation must rise if it is not offset. It also tends to understate the role of automatic stabilisers relative to conscious policy decisions. In fact, so-called ‘parameter variations’ – in other words, the economy turning out differently than expected – have typically shifted budget outcomes more than explicit policy decisions have.
In the same vein, if monetary policy is poised to become a bit less contractionary late this year, it would make sense for fiscal policy to be set with a similar stance. It would certainly make fiscal and monetary policy more coherent – and the impact less uneven – than choosing this moment to achieve a significant fiscal consolidation, in the name of long-term sustainability or demand-shock absorption.
Treating monetary and fiscal policy purely as counterbalances rather than working in the same direction also sits oddly with the likely future of climate and supply-driven inflation shocks. If Australia and the world are indeed facing a more inflationary environment – or as the RBA Governor put it, ‘shock after shock after shock’ – surely it would make sense to refine the economic policy architecture to be more resistant to inflationary surges. And again, it would make sense for fiscal policy and monetary policy to operate hand in hand. This can be achieved by good system design as well as conscious coordination, without necessarily detracting from the independence of the central bank.
One obvious improvement would be stop indexing administered prices such as education fees and subsidised medicines to the CPI. This simply propagates a surge in inflation into the following year. Indexing by 2½%, the midpoint of the RBA’s inflation target, would avoid this issue.
Another refinement that would improve the response to inflation surges would be to index tax brackets by 2½%, as we have previously advocated. Fixed tax brackets lean against inflationary surges via bracket creep. This form of automatic stabilisation has its advantages. However, as we have seen in Australia recently, it can overdo the negative consumption response to inflation surges, leaving other sectors such as public demand or business investment relatively untouched. And without periodic tax cuts, the share of income paid in tax will rise forever. On the other hand, indexing brackets to CPI, as the US and Canadian tax systems do, means monetary policy and explicit fiscal actions must shoulder the load of inflation control. Lifting tax thresholds at a fixed rate retains the stabilisation properties of fixed brackets while avoiding the bias to higher taxation over time.
Indexing by 2½% would be preferable to CPI indexation in a range of other domains, too. Governments and others could build a preference for contract bids with escalation clauses fixed at 2½% annually, not CPI-linked indexation clauses. Capital gains could be taxed at the full marginal rate on a ‘real’ return using a 2½% annual inflation rate. This would remove the tax preference for capital gains over rental income – a significant distortion in the housing market – without the complexity of the pre-1999 system and without having to touch negative gearing. And all of these policy refinements would help anchor inflation expectations by keeping that 2½% figure front of mind.
There are, of course, other refinements that would help make the system more resistant to inflationary surges. Enhancing the automatic stabilisers in fiscal policy is one, for example by targeting welfare payments appropriately (though Australia is already much further down this road than peer economies). Efforts to make the supply side more resilient to shocks would also help. And fiscal austerity now, to minimise government debt and create space for stimulus later, might be less useful if future shocks are more likely to be supply-driven and inflationary, rather than demand shocks.
Achieving a soft landing after a large shock cannot be left to one policy tool that operates unevenly across the community and is not well tuned to all kinds of shock. Policies working hand in hand are a surer way to land.
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