Beware sticky inflation and stickier deficits, OECD says

The OECD has warned that persistent price pressures in Australia’s services sector may mean interest rates may have to stay higher than hoped, days out from the Reserve Bank’s next board meeting.

The OECD has delivered a warning to Australia on inflation. Picture: NCA NewsWire / Luis Enrique Ascui

The OECD has warned that persistent price pressures in Australia’s services sector may mean interest rates stay higher for longer, as it urged the government to address the structural budget position by putting in place “tangible measures” to slow runaway growth in the cost of the NDIS.

The Paris-based body’s latest economic outlook predicts growth in Australia’s economy will slow to 1.5 per cent this year, from 2 per cent in 2023, before accelerating to 2.2 per cent in 2025 as cost-of-living pressures wane and households begin to enjoy real income gains.

A day after Jim Chalmers said there had been an “over-reaction” to hot consumer price figures last week, the report said “a downside risk to economic growth is that taming stubborn services inflation may require tighter monetary policy than currently assumed”.

“Price pressures will continue to ease, although inflation of some services components is anticipated to remain elevated throughout 2024,” the OECD said.

Financial markets predict an interest-rate cut is unlikely until after the next election due in May 2025.

“Monetary policy should remain restrictive in the short term to tame inflation and the fiscal deficit should be narrowed in the coming years,” the OECD said.

As the Reserve Bank battles to slow the economy enough to bring inflation under control without triggering a rapid rise in unemployment, the OECD analysis suggests budget settings – including the introduction of the revamped stage three tax cuts – are working in the opposite direction.

“Fiscal policy (in Australia) is assumed to have a slightly expansionary influence on economic activity in 2024, before there is a modest fiscal contraction in 2025,” the report says.

Amid concerns the Treasurer will increase spending in the budget, Wesfarmers chief executive Rob Scott said the government needed to be “very mindful” that policy settings didn’t contribute to cost-side inflation across the Australian economy and add to interest rate pressure.

“We are seeing rents wage costs, energy costs continue to go up quite strongly, and an area that we are concerned about is the very significant escalation in construction costs,” Mr Scott said. “And that is creating a challenge around residential home builds. I think there does need to be a degree of caution around the domestic inflationary impacts”.

Mr Scott, whose business owns brands including Bunnings, Kmart and Officeworks, said the budget should be an opportunity for the Albanese government to seize a big idea and reshape the tax system to help solve some of these inflationary problems.

“We’ve got some very ineffective taxes like stamp duty and payroll tax, that are basically making housing more expensive, making jobs more expensive without any benefits for the workers,” he said.

After the Treasurer this week flagged that the May 14 budget would still reveal substantial deficits beyond this financial year, the OECD’s policy prescriptions were that “monetary policy should remain restrictive in the short-term to tame inflation and the fiscal deficit should be narrowed in the coming years”.

“With fiscal pressures related to ageing and the climate transition ahead, reforms will be needed to promote medium-term fiscal sustainability,” it said. “These include tangible measures to slow growth in National Disability Insurance Scheme costs, potentially through better clarity on the eligibility and scope of support packages, as well as improved … administration.”

The OECD predicts inflation in Australia will drop from 3.6 per cent now, to 2.9 per cent by the end of next year – against Treasury’s prediction of 2.75 per cent by mid-2025 – and estimated three rate cuts by the end of next year, starting in the September quarter of 2024.

The RBA board meets on Monday and Tuesday to consider a fresh set of forecasts and whether the balance of risks around inflation have shifted enough to warrant a more cautious message about the prospect for rates to fall.

OECD chief economist Clare Lombardelli echoed the IMF view that “cautious optimism has begun to take hold in the global economy, despite modest growth and the persistent shadow of geopolitical risks”. She said “substantial concerns remain”, not least the potential for conflict in the Middle East to interrupt global energy supplies, causing inflation to spike and growth to falter.

The fiscal outlook for OECD countries over the medium and longer term was “worrying”, she said, and countries would have to make tough choices to “address mounting debt and rising expenditure demands due to ageing populations, climate change mitigation, and defence needs”.

Dr Chalmers said the OECD’s warning against “complacency” amid heightened geopolitical tensions was “an important reminder that governments need to strike careful balances between getting inflation under control and supporting growth”.

“While we’ve made substantial progress in getting the budget in better nick, having delivered the first surplus in 15 years with a second one in prospect, we know that pressures on the budget are building, not easing,” he said. “That’s why the May budget will continue our record of responsible fiscal management, provide cost-of-living relief without adding to inflation, and lay the foundations for growth through a Future Made in Australia.”

AMP chief economist Shane Oliver said government spending – at 26-27 per cent of GDP – was above pre-pandemic levels, too large as a share of the economy and set to swell in coming years despite the budget’s structural problem. “Structural spending is pushing higher in coming years, and there is a danger in adding to those pressures” through measures such as Made in Australia,” he said. “If that spending reinvigorates productivity, then there might be a case for it, but I’m not sure the Made in Australia stuff does that.”