A mini budget soon after the election could reset Australia's economic outlook

On the positive side, unemployment nudged below 4 per cent to reach a 48-year low of 3.9 per cent. It seems pretty likely this is the maximum capacity of the labour market at this time.

This is unquestionably a positive. Without wanting to downplay the cost-of-living challenges facing families as a result of rising inflation, one of the most consistent indicators of enduring poverty is long-term unemployment.

The challenge of making ends meet is exponentially harder for those marooned on government benefits; even if those benefits are indexed to inflation, when wages are not. In the past, unemployment this low has not been sustainable. Instead, the hot labour market is likely to translate into higher wages.

Of course, in an apparent contradiction, this week saw not a rise in wages, but a fall. In fact, real wages fell by 2.7 per cent on an annual basis - the largest fall in more than 20 years. Coming hot on the heels of inflation of 5.1 per cent, it was always incredibly unlikely that wage data would show anything other than a fall in real wages.

Of course, nominal wages growth has not exceeded 5 per cent since the modern Wage Cost Index series began in the late 1990s. For years, wage growth has bounced around the 2 per cent to 2.5 per cent level, a decline from the 2000s when wages growth of 3.5 per cent to 4 per cent was much more common.

When inflation was at or below 2 per cent - as it was for almost the entire period between 2014 and mid-2021 - this meant small increases in real wages. With inflation at 5 per cent and growing, workers are going backwards. Fast.

This is bad news for a government already under fire on cost-of-living pressures. However, it is worth keeping this (somewhat) in perspective.

First, large spikes in wages are actually bad for the economy. They tend to lead to uncertainty and unemployment. If wages were already climbing prior to the inflation spike, which has been driven at least in part by COVID-supply side shocks, this would be pretty troubling news indeed.

Even if a 70s-style wage-price spiral is less likely in an open economy with a floating exchange rate, wages remain a major cost for business. Significant wage increases, especially in the current environment, would be inflationary.

Second, unlike prices that can rise relatively quickly, movements in wages tend to be far slower. Most workers have a pay review once a year. Minimum wages are also changed once a year, as are award wages linked to the national minimum wage.

Workers on multi-year workplace agreements will have staged pay increases across the life of the agreement. These are only adjusted once the agreement expires.

This means wages may already be primed to rise - as the RBA believes. Regardless, if inflation is sustained anywhere near its current level for a period of time, this will almost certainly flow through into higher wages over the next year.

This represents a real and immediate challenge for the next government.

A comparison with 2008, when inflation was also at 5 per cent, makes this clear. In 2008, the economy was strong: wages were growing at 4 per cent, the budget surplus was almost 2 per cent of GDP and the RBA had increased interest rates by 3 per cent over the previous 6 years.

The current inflation spike, in contrast, has been driven by excessive stimulus by the government and the RBA; partly in expectation the pandemic would be worse than it was and partly because of poor policy choices (notably design flaws in JobKeeper).

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The government, in particular, has not withdrawn its fiscal stimulus anywhere near as fast as it should have, an often-repeated flaw of fiscal policy. The main question now is who 'pays' the price for this fiscal folly.

To put it another way, all this extra money in the economy has raised demand above the sustainable productive capacity of the economy. This imbalance will be corrected one way or another - in fact this has already started - which means living standards must fall.

If neither the RBA nor the government were to act to fix this problem, it will probably only continue to get worse, especially inflation. Essentially, inflation represents a direct fall in living standards, and its impact falls most heavily on those on lower and fixed incomes.

The new government could rebalance fiscal policy - for example, through a mini-budget not long after the election. Such a budget would be deeply unpopular; shelving promises, cutting spending and increasing taxes. It's hard to see the current crop of politicians having the courage or conviction to take that step. Budgets have become a handout festival, not a time to deliver tough fiscal reality.

After almost 10 years in opposition, would Labor jettison its promises to fix the economy? As for the Coalition ... well they helped make this mess in the first place.

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If the government does nothing, leaving the budget massively in deficit or increasing the deficit as the opposition leader has suggested, the RBA will raise rates higher and faster than they otherwise would.

This will get inflation back under control but it will cut economic growth and create unemployment. It will also tank house prices and create significant mortgage pressures for home owners, especially those who have purchased recently. This, too, will rebound negatively on the government.

There is a chance such a short, sharp correction is impossible. Even if the RBA does act decisively, there will be pressure on the government to 'cushion the blow'. This suggests our flirtation with unemployment below 4 per cent may be far briefer than our trip above 4 per cent inflation.