Shift in public sector growth may complicate central bank's policy decisions
Australia’s recent economic performance has surpassed expectations, with inflation returning to target levels and unemployment remaining relatively low. Reserve Bank of Australia (RBA) governor Michele Bullock highlighted this progress, stating, “Australia has done remarkably well.”
“Who would have said two years ago we would be sitting here now with inflation at two something and unemployment at 4.1%?” she said. “Not many people.”
Much of the improvement is attributed to the easing of earlier supply disruptions. However, the expansion in public sector demand has also played a significant role, supporting the labour market without substantially adding to inflation. This dynamic has allowed the RBA to focus on controlling inflation while maintaining employment levels.
The RBA’s monetary policy decisions have a direct impact on mortgage rates across the country. The RBA sets the official cash rate, which is the interest rate on overnight loans between banks. This cash rate serves as a benchmark for the interest rates that banks and other lenders charge their customers, including for home loans. As a result, shifts in the RBA’s policy stance can influence borrowing costs for households and businesses alike.
“The huge expansion in public sector demand has supported the labour market more than it has added to inflation, allowing the RBA to focus on taming inflation without having to look over its shoulder at a deteriorating labour market,” said Jameson Coombs (pictured), economist at Westpac.
“The RBA’s focus is now, rightly, on preserving this success by ensuring at-target inflation is sustained and the gains in the labour market are retained. However, this may prove difficult.”
The RBA now faces the challenge of managing a slowdown in public sector demand, which could complicate its efforts to balance inflation and employment objectives. The economy’s sensitivity to monetary policy may also be diminishing, further complicating the central bank’s task.
Public sector demand has outpaced private sector growth in recent years, expanding at an annualised rate of 4% since late 2022, compared to 1.5% for the private sector. This surge has been driven by increased spending in the care economy and cost-of-living support, while private sector activity has been dampened by high inflation, increased taxes, and elevated interest rates.
Most job growth over the past two years has come from non-market sectors such as healthcare, education, and public administration. “Non-market sector job creation, propelled by the expansion in public demand (particularly in the care economy), has prevented a material increase in unemployment, as would normally be expected given recent weak GDP growth outcomes,” Coombs said.
Despite concerns that rising public demand could fuel inflation, its impact has been limited. Many of the services funded by the government are not included in the Consumer Price Index, and subsidies have helped reduce headline inflation. However, the increased demand for labour in the non-market sector has strained resources in the market sector, and infrastructure investment continues to draw on private sector capacity.
The outlook is changing as governments scale back support and the care economy’s growth slows. Private demand is beginning to recover, aided by rising household incomes, tax cuts, and lower interest rates. However, a reduction in public demand could weigh on overall economic activity and limit job creation, especially as the market sector is less labour-intensive.
A slowdown in public sector growth is unlikely to immediately lower inflation, as much of the earlier increase in public demand was in areas not captured by consumer price measures. The withdrawal of government subsidies may even temporarily push headline inflation higher.
“The asymmetric impact of slowing public sector growth is a tricky combination for central bankers. Instead of a world where the RBA has headroom to attend to one side of its mandate, the RBA could be faced with a scenario where they increasingly clash,” Coombs said.
“The challenge imposed on the RBA from a worse trade-off between inflation and labour market outcomes is likely to be compounded by the fact that monetary policy will be working on a smaller share of the economy.”
The RBA may need to provide more monetary support if the labour market weakens further, but is expected to prioritise its inflation target until employment conditions deteriorate. This approach is likely to result in less predictable policy decisions in the near term.
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