Energy prices and interest rates growing as risk to national economy

Soaring energy prices and a steep increase in official interest rates to keep inflation at bay will drag household spending down to near-recessionary levels by the end of next year as the globe’s economic clouds darken.

The new 2022-23 budget released by Treasurer Jim Chalmers on Tuesday shows the situation could get even worse if inflation edges higher than feared over coming months either here or overseas, pushing up unemployment and dragging the economy to a standstill.

High inflation, and the interest rates used to bring it down, is likely to stop consumers in their tracks.Credit: Ashleigh McMillan

Chalmers said inflation was the single biggest factor affecting the budget, with risks of higher price pressures more likely than a softening in cost hits to households and businesses.

He said the events across Ukraine, coupled with a decade of poor energy policy and recent natural disasters were all putting upward pressure on consumer prices.

“While we intend to avoid the worst of the turbulence from overseas, we cannot escape it completely. Global challenges, along with high inflation and higher interest rates, will have an impact,” he said.

“A bigger and bigger part of our inflation challenge is going to be electricity prices combined with the impact of these natural disasters in some of the best food-producing land in the world.”

Treasury is forecasting inflation to peak at about 7.75 per cent in the December quarter this year, only easing to 3.5 per cent through 2023-24.

Retail electricity prices alone are expected to rise an average 20 per cent by the end of this year, and then another 30 per cent in 2023-24. Gas prices are expected to climb by up to 20 per cent over both years.

Combined, the increase will add 0.75 percentage points to inflation this year and a full percentage point in 2023-24.

Higher inflation will eat into the buying power of consumers, who will also face higher interest rates from the Reserve Bank as it attempts to tame price pressures. The RBA has already lifted the official cash rate to 2.6 per cent from 0.1 per cent at the start of May, and financial markets are tipping it could reach 4 per cent by the middle of next year.

Soaring energy prices and rising interest rates are predicted as economic clouds darken.Credit: Janie Barrett

Household consumption, which accounts for about 60 per cent of economic activity, is tipped to slow from 6.5 per cent this year to 1.25 per cent in 2023-24. That would be the slowest rate of household spending since the COVID pandemic hit in 2020, and the first year of the global financial crisis in 2008.

“Many indebted households will come under greater pressure in response to higher interest rates,” Treasury said. “In particular, low-income households will face pressures as essentials – such as housing costs and energy – make up a larger share of their expenses.”

Treasury has modelled the impact of inflation reaching 8.75 per cent by the end of this year. If that occurred, it would expect overall economic growth – forecast to be 3.25 per cent – to be a quarter percentage point lower and then just 0.75 per cent in 2023-24.

Unemployment would then reach about 5.25 per cent by the middle of 2024, 0.75 percentage points higher than what is currently expected.

Consumers would actually try to save money, reducing their expenditure, to deal with higher inflation.

“Under this scenario more persistent inflation is assumed to lead to a higher peak in interest rates than currently expected. Higher inflation and interest rates would lower real household disposable income,” Treasury noted.

The impact of higher interest rates and inflation is evident in housing construction, with the government now expecting a 2 per cent drop this year followed by a 1 per cent drop in 2023-24.

Higher interest rates may not just come in response to domestic inflation pressures. Treasury said a number of countries would fall into recession if overseas central banks push up their interest rates more than expected to deal with their own inflation risks.

That would drag down global growth, which would in turn would result in Australia’s economic growth slowing to 0.75 per cent in 2023-24 rather than the 1.5 per cent forecast at present.

Australia’s unemployment rate, now at 3.5 per cent, would rise to 5 per cent by the middle of 2025 if this was to occur.

Mining investment is expected to lift due to the higher commodity prices that are supporting the overall budget bottom line.

Chalmers cautioned that commodity prices are increasingly volatile.

Iron ore, which in the March budget was assumed to average $US134 a tonne before falling to its long-run average, is now assumed to average $US91 a tonne. Metallurgical coal is expected to fall from $US271 a tonne to $US130 a tonne after being tipped to hit $US510 a tonne before easing.

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