According to Peter Hartcher, markets currently put a 50% probability on the RBA raising rates at its 6 Nov meeting. And not surprisingly, many commentators are predicting that the Coalition’s tax cut package will increase that probability; though the effect of tax cuts starting on 1 July 2008 and backloaded to 2010Â can’t be massive.

But for the RBA, this is a rather tricky recursive problem. The impact of the tax cuts on interest rates should be increasing in the probability that the Coalition will be elected. But that probability will decline if they raise rates. According to the election betting markets, if the RBA does nothing, there’s about a 1/3rd chance that the Coalition will implement its tax package. If the RBA raises rates, there’s less than a 1/3rd chance that the Coalition will implement its tax package. If you were an RBA analyst, how would you handle this one?

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“According to the election betting markets, if the RBA does nothing, thereâ€™s about a 1/3rd chance that the Coalition will implement its tax package.”

Andrew, you seem to be assuming that the election betting markets are not already factoring in the probability of an increase in interest rates. Surely the betting markets are discounting all information.

Andrew – there is of course another consideration – what Labor’s response to the coalition tax policy would be. For example, if Labor says that they will implement the same package (as they did at the last budget) then the probability that the coalition is elected would be irrelevent (unless you thought the ALP would renege once in office. If instead they offered a combination of tax cuts and targeted spending in other areas such as health and education then the RBA board would have to weigh the effect of that particular package. One thing we can be reasonably sure of though is that Labor, like the coalition, will not allow the automatic stabilisers to do their work, and thus their total spending will be similar to that of the Coalition.

What Labour Outsider says – you have to assume that Labor will match them on either the tax or spending side, so the size of the fiscal stimulus will be roughly unaffected by the result of the election.

IOW whatever happens on 24/11 the fiscal stance is going to be a little looser than we’d have thought last week, so the probably of an interest rate hike is also a little higher than last week.

Er, surely the opposite – an incoming government has every incentive to go for austerity in year one so that a) rates are likelier to go down and set a good platform for all those ‘confidence’ indicators for the next few years, and b) they can then spend the next two and half being ‘generous’ as they claw back their first year harshness 🙂

Is this true though?

If Labor spends instead of cuts tax, every dollar gets put into the economy. But wealthier people are more likely to save their tax cuts, rather than spend, so by cutting tax the fiscal stimulus is less.

The point is that the main new info resulting from the government’s announcement is that the Budget surplus is gonna be a little less than we’d thought, whatever the election result. We’d have already taken such things as Patrick’s electorally anti-cyclical patterns into account – they won’t be substantially affected by the election result anyway.

It’s true there might be a tiny extra balanced budget multiplier with Labour, but given that empirically measured balanced budget multipliers are modest, and given Labor’s commitment to no new net spending promises, “tiny ” is the operative word.

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