Australia's budget deficit returns: expert analysis on interest rates and economic outlook

The Federal Budget 2025⁠–⁠26 delivers short-term stability but risks long-term vulnerabilities, according to CommBank economists. Here, they break down how delayed tax cuts, returning deficits, and global uncertainty will influence inflation, interest rates, and Australia's economic outlook.

The Federal Government's latest budget successfully sidesteps significant short-term risks but leaves longer-term challenges unaddressed, according to Luke Yeaman, Chief Economist, CommBank.

Breaking down what the budget means for businesses and the Australian economy on a webcast debrief, Yeaman observed, "There was a real risk sitting at the heart of this budget, a big spending, pre-election budget that could undermine the path to lower interest rates. The government has overall avoided that in the short term."

The budget aligns with CommBank's macroeconomic assumptions, suggesting improving economic conditions. "On the positive side, the economy is picking up, the labour market remains stronger, and inflation is coming down," Yeaman explained. "At this stage, we still expect to see three more interest rate cuts this year, meaning a total of 100 basis points of interest rate relief over the course of the rest of this year."

However, he added a note of caution, pointing out there was a lost opportunity for the government to bank revenue gains from a strengthening economy. "Overall, the budget position longer-term remains a real challenge, and we think it also makes the budget more vulnerable to external shocks," said Yeaman.

While there are some incremental budget measures for businesses to monitor, the real insight for business leaders stemmed from Treasury’s macroeconomic assumptions and what those metrics will mean for inflation, interest rates and Australia’s economic health. 

Cost-of-living tax cuts: why phasing matters

“There's always one surprise in a budget, and the Treasury did a good job of keeping the tax cuts under wraps until budget night,” Yeaman said.

The CommBank Global Economic and Markets Research team (‘the economic research team’) outlined budget initiatives targeting household relief, chiefly, its centrepiece allocation of $17.1 billion over five years to deliver an income tax cut for all taxpayers. Specifically, the marginal tax rate for the bottom bracket will decrease from 16% to 15% from 1 July 2026, and further to 14% from 1 July 2027, granting an average wage earner an additional $268 in 2026–27 and $536 in 2027–28.

Yeaman highlighted the delayed rollout as a critical factor in reducing inflationary concerns. “The downside is that the tax cuts don't start straight away,” he explained. “The fact that the tax cuts are delayed helps take pressure off inflation in the near term and prevents this from being a stimulatory budget.”

There are a number of other measures targeting cost-of-living pressures like $8.4 billion over four years of healthcare spending to increase doctor’s incentives and boost bulk billing rates in Australia. The budget also extended existing energy bill rebates at a cost of $1.8 billion. The rebates are expected to reduce headline CPI inflation by half a percentage point in late 2025, however, these rebates as announced will only continue for six months rather than a full year. 

Back in the red

According to the economic research team, these substantial spending initiatives are offset in large part by reduced spending growth in areas such as disability support and tax receipts.

"There's around $35 billion of improvements in tax receipts and reductions in spending because of a stronger labour market and economy," Yeaman said.

"The government had a choice about what to do with that money. It could have saved it and put that towards budget repair and helped to reduce the deficit and the debt, but instead, on the eve of an election, not surprisingly, they chose to deliver further support to households."

Yeaman described the budget as relatively restrained though deficits are set to return after two years of surpluses. Treasury estimates an underlying deficit of $42.1bn (1.5% of Gross Domestic Product), which the economic research team noted, is an improvement since the Mid-Year Economic and Fiscal Outlook (MYEFO) estimate of $46.9bn and the May 2024 estimate of $42.8bn.

The economic research team sees the structural budget position continuing to deteriorate over the medium term and increases the risk that the deficit will widen further in coming years if assumed savings and higher revenue do not eventuate.

"This creates some vulnerabilities in the budget,” Yeaman said. “We know there are long-term structural pressures, and this budget probably worsens those pressures and adds to the budget task in the longer term. It also makes the budget more vulnerable to international shocks."

"The government had a choice about what to do with that money. It could have saved it and put that towards budget repair and helped to reduce the deficit and the debt, but instead, on the eve of an election, not surprisingly, they chose to deliver further support to households."
– Luke Yeaman, Chief Economist, CommBank

Consumer spending and inflation

The budget paints quite a positive picture of the economy in the coming years, closely aligned with CommBank’s view Yeaman explained. The economic research team said economic growth, currently around 1.5%, is forecast to rise to 2.25% next year and 2.5% the following year, driven largely by stronger consumer demand as interest rate cuts begin to take effect and inflationary pressures ease. Yeaman noted that consumer spending remains an important factor for business leaders to watch.

On inflation, Yeaman said that Treasury had grown more confident, bringing forward its expectation of sustainably lower inflation by approximately six months and flagging easing pressure in key areas such as housing, rents, insurance, and services.

Commenting on newly released monthly Consumer Price Index (CPI) data, the economic research team said annual headline CPI inflation eased to 2.4% per year in February. “The headline number and the underbelly of the data add to the evidence that inflation is continuing to moderate.”

“February's data gives us more confidence the underlying inflation pulse remained

relatively benign,” the economic team said, noting there was once again better news on housing inflation, with new dwelling costs in deflation and recording its third monthly price fall in the past four months. However, emphasised there remains pockets of elevated inflation, “but these look now increasingly concentrated in administered price changes where outcomes are largely indexed (whether directly or indirectly) to past inflation”.

One notable positive in the budget's economic assumptions is an improved outlook for the unemployment rate, that Treasury says is forecast to peak at 4.25% (a quarter of a percentage point below the MYEFO estimate). "They're essentially saying the labour market doesn't need to weaken as much as previously thought to sustainably lower inflation," Yeaman explained.

The RBA reaction

The Reserve Bank of Australia (RBA) is expected to maintain its current course following the latest federal budget, suggesting the budget won’t have a significant impact on monetary policy, according to Yeaman.

He noted that the government's choice to spend its revenue gains rather than save them leaves little scope for the RBA, whereas if the government had banked the potential upgrade, “that would've potentially created a little more room for the RBA," Yeaman explained. "Given they've spent it all, we come out basically even at the end of the day."

Yeaman flagged that while electricity rebates included in the budget would mechanically lower headline inflation, the RBA typically overlooks such temporary factors, focusing instead on core inflation measures like the trimmed mean CPI.

On 1 April, the RBA decided to leave the cash rate target unchanged at 4.10%, as CommBank and most other forecasters expected. In its 1 April update, the economic research team said its base case looks for the RBA to deliver a 25 basis points decrease at its May, August and November meetings.

Trump’s tariffs

Belinda Allen, Senior Economist, CommBank, said that global trade uncertainty and the interest rate outlook, rather than the federal budget, will primarily shape Australia’s economy in the near term.

The US announced on 3 April that Australia’s goods exports to the US will be subject to a 10% tariff rate. Other countries including China will be subject to a much higher tariff rate. Australia's trade deficit with the US made it a smaller tariff target, sectors such as beef remain exposed. The larger risk to the Australian economy, Allen emphasised, comes from potential indirect effects of escalating US-China tensions, particularly given Australia's dependence on Chinese demand for iron ore.

Allen warned, “The risks are building, and the greatest impact could come through the confidence channel [surveys measuring business confidence and sentiment], changing business investment decisions and consumer expectations.”

“The risks are building, and the greatest impact could come through the confidence channel, changing business investment decisions and consumer expectations.”
– Belinda Allen, Senior Economist, CommBank

As the trade tensions continue to evolve, it’s become clear that the era of trade liberalisation, free market reforms, deregulation and fiscal discipline (the Washington Consensus) is “officially dead and buried”, according to Yeaman. “In a few weeks, President Trump has reversed a century's worth of US trade liberalisation,” he wrote in the Trump, Tariffs and Trade: A Different Kind of Wall economic update published on 9 April.

Yeaman noted that the US administration is committed to its tariff plan and won't be easily deterred by economic and political pain. “This is a long-term project, not merely a negotiating play, so expect a protracted trade war. Tariff rates could yet go higher.” He emphasised that global and US growth will be lower in 2025. Positively, Yeaman said it would take a lot to de-anchor inflation expectations and weaker economic growth will suppress broader price pressures.

“Australia is relatively well-placed to weather the storm, but we won't be unaffected. Our fundamentals are sound, and our direct trade exposure is small,” he explained. “A protracted trade war will hurt China and Asia, with flow on effects to Australia. A lot rests on potential Chinese Government policy responses.”

The Australian dollar

Allen believes Australia's flexible economy, including its floating currency and central bank's ability to lower interest rates, will help cushion it from global shocks, although she notes the Australian dollar is particularly sensitive to international uncertainty.

While geopolitical developments, such as increased defence spending in Europe, have recently weakened the currency, CommBank expects the Australian dollar to decline slightly this year before recovering by late 2026. However, Allen warned a severe global trade war would represent the biggest downside risk, but if tariffs ease quickly, the currency could benefit.