Two leading Australian investment banks have warned that the Federal Government’s $34 billion in tax cuts over the next five years threaten to boost inflation and interest rates. The warnings came in morning notes to clients from Goldman Sachs JBWere and Merrill Lynch.

They are not ringing endorsements and mean the Government’s credibility as safe, sound economic measures is being questioned by a group that has been direct beneficiaries: the funds management, broking and corporate sectors which have made billions of dollars, especially since the China boom got underway.

Both banks have also been big beneficiaries in the privatisation push, especially Goldman Sachs which bought JBWere because of its inside running in this area, especially on the Telstra sales.

Their opinions will be relayed through their banking, broking and research networks overseas. The comments will add to upward pressure not only on rates, but also on the value of the Australian dollar.

In fact Goldman Sachs this morning, in a separate comment, said the Aussie dollar “trading above 90¢ provides more negative than positive outcomes for the domestic economy, particularly with import prices from China continuing to rise in this environment.”

Merrill Lynch, while describing the cuts as credible, went on to say they could add to our already strong economic growth this year and over the next three years.

It warned they would add to inflationary pressures and interest rates “in the medium term.”

Goldman Sachs warned:

The new tax cuts clearly increase the risk of an interest rate hike in early 2008.

In paying for the tax cuts the Government has yet again been the beneficiary of a strong revenue environment courtesy the terms of trade. Indeed, the Coalition is in the enviable position of announcing the largest taxation package in its term of office and simultaneously revising up its underlying cash surplus over the next 4 years.

Treasury’s also revised its economic growth forecasts aggressively, suggesting GDP growth of 4.25% in 2007-08 (prev. 3.75%). This compares with our 3.8% 2007-08 GDP forecast ahead of today’s policy announcement.

The new tax cuts clearly increase the risk of an interest rate hike in early 2008. A distinguishing feature of the election is the ALP’s claim that its election commitments are funded by planned spending cuts.

A clear break from that policy and/or an endorsement of magnitude of the tax cuts would suggest a further interest rise is indeed warranted.

Here’s what Merrill Lynch said in its note this morning:

Consumer demand has been very strong since 2005, and this is reflected in rising core inflation. The private sector has responded to the terms of trade boom with a massive capital expenditure program, and now State governments have been forced to upgrade infrastructure, adding to final demand.

With the RBA lifting rates in August to 6.5%, and non-farm GDP for 2006-07 coming in at 5.2%, the Australian economy would benefit from public saving, in our view. We calculate these tax cuts as adding about 0.5% to GDP in 2008-09, and up to 1.0% per year in the outyears.

We believe this stimulus will not be welcomed by the RBA, and will add pressure to inflation, and hence interest rates into the medium term.

In the near-term, we expect the November 7 monetary policy announcement to be governed strictly by the data (Q3 CPI on October 24). A read of more than 0.9% for Q3 trimmed-mean inflation would very likely be followed by a 25bp hike.

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Peter Fray
Peter Fray
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