Tight fiscal policy = easy monetary policy = electoral support for government

There's a flood of judgment and opinion in the last few days suggesting that the government should not move for a further (even slight) tightening in fiscal settings as it works to meet its commitment of a Budget surplus in 2012-13. It seems that this assessment is based on a view that with the economy growing only at a trend pace and unemployment ticking up, more fiscal tightening would threaten to undermine the whole economy.

I note only in passing that some of these same commentators were scathing of the Budget noting it didn't tighten enough! Anyway.

The error in the "forget the 2012-13 surplus" analysis is a lack of acknowledgement of policy levers other than fiscal, most notably monetary policy. Monetary policy always has and always will complement what is happening on the fiscal side. If fiscal policy is too tight, the RBA can set interest rates lower. Conversely, if fiscal policy is too loose (as in the period 2005 to 2007), the RBA will set interest rates higher than would otherwise be the case.

I don't know anyone who would seriously and credibly argue against this truism.

So now, as policy makers look into 2012 and 2013, a firm hand on fiscal policy from the government and the maintenance of the budget surplus objective will allow the RBA to set interest rates lower than otherwise. Plain and simple.

And if you want any proof of the political benefits of these actions, look at the recent opinion polls which suggest a 3 or 4 point move back to the Government in the last month, a time when lower interest rates were discussed and then delivered.

I'd be willing to bet that if the government stays tough on fiscal policy and delivers that surplus in 2012-13, the RBA can set interest rates around 100 bps lower than now. That alone might be enough to see the Government regain the political high ground as the election in late 2013 gets nearer.