Julia Gillard has emphatically linked the government’s surplus-driven budget to lower interest rates, arguing it will give the Reserve Bank of Australia a buffer against unstable offshore markets, and “plenty of room” to cut its cash rate.

The Prime Minister has repeatedly shot down claims by economists that tighter fiscal policy will crush the economy, arguing the surplus is an economic and political necessity that will push down our dollar and put us a step above volatile international markets. We put it to some of Australia’s key economists to weigh in on the claims, asking them how a surplus will influence interest rates, and just how much cover it will give the RBA.

Paul Brennan, head of economics at CitiGroup, questioned the economic sense behind the government’s push to surplus, calling it a political exercise.

“You’ve got to ask why you’d run a contractionary budget when the economy is growing below trend. To deal with this two-speed economy it’s more sensible to be using fiscal policy to target weaker sections of the economy,” he said.

“The Reserve Bank will do what it needs to do, regardless of this political exercise. But they have already indicated that they’re warming up to a rate cut so I don’t think they need the encouragement of a budget surplus to get them across the line.”

Shane Oliver, chief economist at AMP, says the government’s claims have some merit, but agrees it’s all about selling the surplus.

“The link [between the surplus and lower interest rates] is a very loose one, but we have to consider the scope of the economic turnaround — which, depending on the figures, is somewhere in the vicinity of $40 billion. That’s massive, and it will take a lot out the economy. So I agree with her, but I think she is drawing that link to make the focus on the surplus a bit more palatable,” he said.

“If it can be sold as way to facilitate interest cuts, then they will. That being said, the sheer size of the shift from deficit to growth would have to add in some way to the case for lowering interest rates.

“But personally I think the rates should be lower anyway; they should have been cut back in February. And ultimately I think that’s what the government is angling for — more cuts beyond the May move. So the fiscal tightening will add to the case for those further cuts.”

Chris Caton, chief economist at BT Financial, agreed it won’t be the surplus that prompts the RBA: “It’s true that the RBA has laid out the case for a rate cut in May. But bear in mind that tighter fiscal policy will give them more movement, not the surplus. Tightening fiscal policy is moving in the right direction, but what the government are proposing, in such a short time frame, will do more harm than good.”

Michael Knox, director of strategy and chief economist at RBS Morgans, is more receptive to the Prime Minister’s claims. The actions of the RBA, he says, will be influenced by inflation data and rising employment.

“There’s no doubt that there is an empirical relationship between surplus budgets and falling interest rates,” he said. “Surplus will give the RBA more opportunity to cut rates if they don’t perceive inflation as a threat.

“I honestly think that the RBA has been expecting surging employment because of mining expansion. They’ve been provisioning for this employment rise, so I think they’ll be very wary of this driving inflation, so they will be looking for confirmation of a weakening inflation outlook in published data.”

Professor John Quiggin, from the University of Queensland’s School of Economics, says the looming budget shows the short memory of the Gillard government. “I guess we haven’t learnt a lot from the global financial crisis,” he said.

“This really is an attempt to return to the pre-crisis norm — one where the government focuses on balancing the budget, and the Reserve Bank responds by cutting interest rates.

“It doesn’t make a lot of sense — we should be getting fiscal and monetary working together; focusing on the contraction of fiscal policy to get an expansive monetary policy. This is a model that has failed in most countries, and even Australia abandoned it during the financial crisis. We should be designing fiscal and monetary policy, instead of tightening fiscal policy and expecting the usual results.”

Peter Fray

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