Shuffling the surplus cards

By bringing the mid year outlook forward, the government will give the Reserve Bank more time to decide whether to cut rates again.

The highlight of this morning’s Mid Year Economic and Fiscal Outlook will undoubtedly be whether the 2012-13 Budget is still on track for surplus and, assuming it is, the policy changes that have had to be made to get there.

Last week, I wrote why the return to surplus was important from an economic perspective (Why Swan should deliver a surplus, October 16), and those points remain valid now.

The bringing forward of the MYEFO to today is based on some sound logic. One reason is to maximize the impact of policy changes which can that take effect from today or 1 November for example, rather than 6 to 8 weeks into the future.

Another reason behind the earlier than normal MYEFO touches on the trade off between fiscal and monetary policies. On 6 November, the Reserve Bank of Australia has its monthly Board meeting. While the Board will consider a massive check-list of issues in deciding whether to cut interest rates or not, fiscal policy settings will as always be in the mix.

For the November RBA meeting, it will have before it the fact that the economy will face particularly restrictive fiscal settings. The tighter the fiscal settings, the more inclined the RBA will be to cut interest rates. If the spending cuts in the MYEFO, which have been reported to be around $4 billion a year, add to the extent of the reduction in real government spending, overall government demand will be cutting around 1.5 percentage points from GDP growth in 2012-13.

This is where the government is expecting some political benefit as it works to build its economic management credentials ahead of next year’s election. It will deliver a surplus which is widely seen as good news and it will go into the election campaign with mortgage and small borrowing interest rates around 200 to 250 basis points lower than when it took office.

The interest in the budget bottom line should extend beyond 2012-13. At Budget time, the 2013-14 surplus was thin at $2.0 billion, before edging up to $3.4 billion in 2014-15 and $7.5 billion in 2015-16.

These small surpluses means there will be almost no scope for the government to shuffle money between years to get the 2012-13 surplus locked in. The government clearly changed the timing of some of its payments and spending earlier this year which contributed to the wider deficit in the 2011-12 Budget. In other words the policy tightenings announced today will be real.

The other element of the MYEFO could be the updated economic parameters underpinning the Budget numbers.

On this score, there are unlikely to be any significant changes.

It is likely that Treasury will forecast GDP growth around trend which at Budget time was 3.25 per cent in 2012-13 and 3 per cent in 2013-14. It is unlikely that anyone would seriously think these forecasts will be changed by more than 0.25 per cent if at all.

Linked to the solid outlook for GDP growth will be the forecasts for employment growth and the unemployment rate, both so absolutely critical for the government revenue estimates.

At Budget time, Treasury was forecasting the unemployment rate to average 5.5 per cent in June 2013 and stay at that level in June 2014. If there is a change in the forecast for the unemployment rate, it would be a little higher, perhaps to 5.75 per cent but the fact the RBA has already cut interest rates 100 basis points since the Budget was framed in May, Treasury is likely to hold the 5.5 per cent unemployment rate forecast for now. It is a similar story with the budget time employment growth forecast which should see PAYG tax revenues hold up.

The other economic forecast of interest in the MYEFO will be for the terms of trade and, linked to that, nominal GDP growth. At Budget time, Treasury was forecasting the terms of trade to fall by 5.75 per cent in 2012-13 and drop a further 3.25 per cent in 2013-14. These falls in the terms of trade fed into nominal GDP growth forecasts of 5.0 per cent and 5.25 per cent in the next two years.

A month ago, with the iron ore price in free fall, the terms of trade forecast looked way too optimistic. In recent weeks, the iron ore price has rebounded around 30 per cent making the terms of trade and nominal GDP growth forecast seem reasonable. Such are the hazards of economic forecasts.

That said, it is likely that once Treasury cuts through the noise in recent market trends, the terms of trade outlook will be trimmed a little. This feeds into projections for company profits, wages and capital gains which explains the government’s revenue shortfall and the need for further savings.

The MYEFO will be the final fiscal update before the Federal Budget in May 2013.

The Government will be hoping for some good economic luck between now and then with GDP growth, job creation and the terms of trade exceeding its revised forecasts. If it turns out that the economy is stronger than expected, the framing of the 2013-14 Budget in May next year will be around bigger than expected surpluses.

If the economy undershoots, as it has in the last two years, the government will obviously be looking at more savings to meets its surplus objectives and in an election year, that could be uncomfortable.


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