With the economy 'on a knife edge', a former treasury boss has backed the government's balanced approach

Former treasury secretary Ken Henry said the government should not use its budget to cut spending. (ABC News: John Gunn)

Former treasury secretary Ken Henry has called for a “neutral” federal budget next week, warning against spending cuts while the economy is “on a knife edge”.

The comments lend weight to Treasurer Jim Chalmers’s declaration earlier this week that his third budget would not take a “slash and burn” approach to spending amid persistent inflation.

“It would not be wise [to cut spending] when people are doing it tough and when the economy is soft,” Mr Chalmers said on Monday.

Dr Henry, whose decade in charge of Treasury included the 2008-09 Global Financial Crisis, told the ABC he agreed.

“We have to be careful in our use of fiscal policy [budgets] to try to achieve an inflation target,” he said.

“That was a lesson that we learned a long time ago … certainly by the time that we came out of the recession of the early 1990s, the very broadly based consensus among economists was that monetary policy [interest rates] was the better tool to use to try to control inflation.”

Other economists, including the International Monetary Fund, have called on federal and state governments to consider spending cuts and tax increases to take money out of the economy to help the RBA in its inflation-fighting efforts.

Economist Chris Richardson said on Sunday inflation was the “everything of this budget” and said spending cuts and tax increases were “the right thing for the government to do”.

Dr Henry said this view was “understandable … After all, the budget is not in good shape. So it’s natural to ask the question whether a tighter fiscal stance might not help the Reserve Bank in its job of trying to control inflation.”

But he said signs of economic softening meant it was more appropriate for the government to “wait and see” how the economy would respond to the RBA’s 13 interest rate increases.

In its third meeting for the year on Tuesday, the RBA Board left interest rates on hold but took a more pessimistic view of the persistence of inflation. Yet, at the same time, it was concerned about “very weak” household spending and warned there was a risk of a “significant deterioration” in the jobs market and a broader economic downturn.

“I can understand why the Reserve Bank board decided to pause yesterday, because we are on this knife edge,” Dr Henry said.

“Have a look at what’s happened to hours worked in the Australian economy. Total hours worked in the Australian economy are lower now than they were 12 months ago. There’s clearly a softening there.

“I think, right now, a neutral stance [for the budget] is the appropriate stance, neither adding to demand nor substantially detracting from it.

“That doesn’t mean fiscal policy is off the hook. What it does mean is that you don’t want fiscal policy working against monetary policy … What the Reserve Bank is really worried about is a nasty surprise [in the budget] to make their job more difficult.

“There’s no sign of that, I don’t expect that.”

Treasurer promises a ‘calibrated’ budget

On Wednesday, Mr Chalmers said the government would have a “primary focus on inflation in the near term” and would show “spending restraint.”

“The budget’s got an important role to play and making sure we get it into much better nick, and we’ve made some really good progress getting debt levels down, delivering the first surplus in 15 years. All of this has been an important part of the inflation fight.

“There will be help for people with the cost of living, but we’ll make sure that that cost-of-living help is part of the solution and not part of the problem when it comes to inflation.”

In its first two budgets, the government has saved most of the large tax ‘windfalls’ it has received thanks to high commodity prices and high employment.

This allowed it to deliver a budget surplus in 2022-23, and likely another in 2023-24, despite adding money to the economy via new spending.

Its inflation-related measures have mostly been targeted at individual prices, including energy bill relief and child care subsidies.

Dr Henry said he did not believe these measures made a meaningful difference to inflation.

“It is possible for a government to change prices of goods and services in the economy by the use of taxes or subsidies … But when you’re considering whether in net terms the budget puts upward pressure or downward pressure on prices, what [you] would be looking at is the overall stance of the budget … is the budget deficit getting smaller or is the budget surplus getting larger?”