Words by Professor Richard Holden

There’s considerable uncertainty about who will govern Australia next year. Labor has a slim majority but could be elected to a second term. Recent polling suggests a Coalition return to government isn’t out of the question. A minority government of one sort or another remains the most likely outcome.

Whichever major party holds power in Canberra next year, they will face significant economic challenges.

Inflation

Chief among those is persistently sticky inflation. According to the Australian Bureau of Statistics, underlying (trimmed mean) inflation for the September quarter came in at 3.5%. That’s a full percentage point above where the Reserve Bank of Australia (RBA) wants it to be.

The RBA forecasts not returning to that 2.5% level until the end of 2026 – more than two years away.

This is partly a consequence of our RBA being less decisive in raising interest rates to combat post-pandemic inflation. Rates in peer countries were raised well above Australia’s 4.35%. The US peaked at 5.25–5.5%, New Zealand 5.5%, the UK 5.25%, and Canada 5%. That’s why inflation is under control in those countries and why they are starting to cut rates. Not so in Australia.

Budgets

It's also partly a consequence of extremely expansionary budgets at the federal and state level in Australia. The last two federal budgets each expanded net spending by around a full percentage point of GDP, and state budgets in Victoria and Queensland were also highly expansionary.

As I wrote recently in my Australian Financial Review column, the neutral cash rate – that which is neither expansionary nor contractionary – is likely 3.5–4%. When interest rates do start to fall, they don’t have far to go. This is good news for savers but bad news for borrowers.

Obviously, that includes households with large mortgages. However, it’s often forgotten that we are moving into an era where the cost of borrowing for businesses will be substantially higher than the 2008–2020 period, which spanned the financial crisis and start of the pandemic. This has big implications for the level of investment in the Australian economy and all that follows from that.

Productivity

Productivity remains a major problem. We’re not alone among advanced economies in facing a productivity slowdown: only the US has robust productivity growth. But Australia has an acute problem with productivity that has literally gone nowhere in the past five years. Nobel Prize-winning economist Paul Krugman’s 30-year-old aphorism that “a country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker” is as true today as ever. If we don’t solve our productivity problem, then living standards won’t budge.

To do so will mean not just improving education and training – crucial though those are – but also focusing on specific sectors. Service-sector productivity (like in aged care and health) can largely only be achieved through increased automation and productivity in the construction sector has fallen by a staggering 18.1% over the last decade. Fixing that will require some hard choices about work practices in the construction sector.

Structural Deficit

Finally, as commodity prices retreat from record levels, the structural deficit in the federal budget will once again become clear. The best estimates are that it’s around 2% of GDP, or A$50 billion a year. Spending pressures from the NDIS and defence put upward pressure on that structural deficit, and again require tough political choices to be made.

It’s far from clear who will occupy the Treasury benches in Canberra come June 2025, but whoever it is will have plenty of economic challenges with which to grapple.