Swan tightens the screws

Government spending will fall by a record 4.4% in 2012-13, and the market could fall further once investors realise just how tight the fiscal settings are. Already a .25% rate cut is being priced in.

Today’s Mid Year Economic and Fiscal Outlook shows how fiscal policy has been an important shock absorber for the economy over the most recent business cycle. In other words, the government is delivering classic counter-cyclical fiscal policy settings.

It should reinfoirce the coveted triple-A credit rating from all three ratings agencies.

Here is the context.

Around four years ago, when recession or even global depression beckoned, the government delivered a massive fiscal stimulus which saw real government spending surge 12.7 per cent in 2008-09 with further growth of 4.2 per cent in 2009-10. The stimulus was big. Recession was avoided and the budget went into deficit hitting a peak of 4.2 per cent of GDP in 2009-10. In the next two years, government spending was cautiously scaled back, with real growth averaging just 2.4 per cent in each year. The budget deficit fell to 3.0 per cent of GDP in 2011-12.

Today’s MYEFO confirms that government spending, in real terms, will fall by a record 4.4 per cent in 2012-13. By itself, the Commonwealth government fiscal measures will cut around 1 per cent from GDP. In 2012-13, nominal government spending will fall by around $7.8 billion, the first time there has ever been a such a decline. The government is using the return to trend growth as a reason for it cutting expenditure so sharply.

Importantly, there will be a budget surplus in 2012-13 and in all of the years of the forward estimates.

In the three years before the GFC, government spending averaged 23.5 per cent of GDP. Over the last 20 years, the government spending to GDP ratio averaged 24.7 per cent. In 2012-13, after the MYEFO measures, government spending will be 23.8 per cent of GDP, which is back to the sorts of levels prevailing when the economy was booming and will be well below the long-run average.

But it is not just 2012-13 where the fiscal discipline is evident. The forward estimates confirm that the government spending to GDP ratio will average 23.8 per cent out to 2015-16 with real growth in spending between 2012-13 and 2015-16 averaging a miserly 1.1 per cent per annum. Clearly fiscal policy is contractionary.

There are few surprises in the updated economic forecasts. The outlook for GDP growth has been trimmed by 0.25 per cent; employment growth has also been shaved marginally, while there has been a sharp downward revision to the terms of trade which are now forecast to drop 8 per cent in 2012-13. There is nothing in the revised Treasury forecasts that is controversial – they may even be a little too pessimistic but that is for another day.

In the immediate aftermath of the MYEFO, the futures market is pricing in a cash rate at a record low below 2.5 per cent in the middle of 2013, with it placing about an 88 per cent chance of a 25 basis point cut in November. The Australian dollar is softer at 1.0310 but it could fall further once the market fully comprehends just how tight fiscal settings are.

The trade off between tight fiscal settings and easier monetary policy settings are well understood and are being factored into the markets.

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