Why Australia’s inflation problem is like a spoiled, overtired child

The economy has sent the Reserve Bank an unambiguous message: it cannot take even mild demand stimulus without overheating.

You’d be forgiven for assuming Australia’s inflation problem is the result of global geopolitics or protectionist trade policies. Outside of jewellery prices, it isn’t. Some substantial imports, including gas and petrol, even became cheaper over last year.

While the world is grappling with wars and protectionism that push up costs, there’s little evidence that these forces are meaningfully inflating Australian prices.

In fact, the appreciation of the Australian dollar, which is at least partly a reflection of overseas events weakening the US dollar, is helping put downward pressure on Australian prices: the Aussie is up 12 per cent against the US dollar, and 10 per cent on a trade-weighted basis over the past year.

Which brings us to the uncomfortable truth. Australia’s inflation is overwhelmingly homegrown. That is both good and bad news. Good, because domestic problems can be solved at home. Bad, because it means we allowed inflation to take root under our noses.

In the very short term on Tuesday the Reserve Bank is likely to lift the cash rate from 3.6 to 3.85 per cent, along with another increase later this year. It’s a remarkable shift from three months ago when further rate cuts were expected.

The economy has since sent the Reserve Bank an unambiguous message: it cannot take even mild demand stimulus without overheating. Rather like a spoiled, overtired child, a hint of sugar can induce a tantrum.

A cash rate of 3.6 per cent, dropped from a peak of only 4.35 per cent, looked broadly neutral. It turns out neutral may be higher, and the economy needs tighter settings to stay within its supply limits.

We only have ourselves, the indulgent parents, to blame.

Let’s start on the demand side. The first rule of inflation is don’t overstimulate the economy. So monetary policy bears some responsibility. But public spending deserves a closer look.

Government expenditure across local, state and the Commonwealth governments now sits at more than 28 per cent of gross domestic product, very close to a post-war high. And it keeps climbing. The Commonwealth’s mid-year budget update in December added $66 billion in expected spending between 2025-26 and 2035-36. Some of that spending is unquestionably necessary. But is all of it?

In a demand-deficient world, a government building a new bridge is helpful. In today’s economy, it means private sector activity is impacted. The labour, concrete and steel used are the same scarce inputs needed to build apartments or mining equipment. When the public sector bids aggressively for them, the private sector pays the price, literally.

Even more concerning is the economy’s limited ability to supply. Continuing the parenting analogy: perhaps we haven’t raised a robust child. One capable of growth, adaptation and, ideally, broccoli appreciation.

Some forms of public spending don’t just fuel demand, they distort supply. Poorly targeted expenditure builds unhealthy expectations that governments can solve every problem. Fiscal projections across the Commonwealth and most of the states make it clear, they cannot.

When supply can’t keep up with demand, we don’t just see inflation. We see housing shortages, overcrowded emergency departments and longer commutes. As Australia’s population ages, healthcare needs rise and climate transition demands intensify, these supply constraints will worsen without serious structural reform.

The OECD’s recent survey of Australia lays out a sobering, but constructive, to-do list. It is focused on competition, housing, tax, climate and energy transition policies, as well as better co-operation across governments to lift productivity growth.

On housing, it recommends easing land use restrictions, permitting greater density and replacing stamp duty with broad-based land taxes. With these changes, it says Australia could expand its stock of social housing, which is about half the OECD average.

Tax reform is also highlighted by the OECD. It encourages broadening the GST and raising the rate of the GST, while removing distortionary taxes on income. Compensating lower income households will also be needed. To that, we’d add the need to lower the 30 per cent company tax rate, which is well above the OECD average. It was pleasing to see a renewed focus on tax reform by the treasurer over the weekend.

Governments can also lift their own productivity by using technology to target spending more precisely. Given they are responsible for more than one in every four dollars spent across Australia, this matters.

Digital IDs can improve citizen verification, blockchain can track government funds to cut waste and fraud, and AI can analyse spending patterns to direct resources to the highest-impact welfare programs.

Discipline, innovation and constraint in policy development are therefore, clearly, essential. On the demand side, unnecessary government spending should be constrained. On the supply side, overdue reforms that lift productivity and expand the economy’s capacity can allow it to absorb more demand.

Inflation’s domestic sources mean the solutions are in our hands. The sooner we embrace them, the sooner we can restore stability, resilience and growth.