Treasurer Wayne Swan has confirmed, in his speech to the Australian Business Economists, that the government will deliver a strong contrationary bias to public demand in the budget. This contraction will not just be concentrated in 2012-13 but will continue into 2013-14, an important fact for the market and RBA board members to contemplate.

Of huge significance, Swan’s very clear message to the RBA is that it can easily cut interest rates knowing that government demand will be dampening demand and inflation pressures over the forecast horizon.

This message is now filtering through to foreign investors in Australian markets which is seeing the Australian dollar take a few steps lower as the carry trade loses some of its appeal. Here is some of what Swan said:

“Our fiscal strategy ensures we won’t be adding to the price pressures of a strengthening economy experiencing a once-in-a-generation investment boom …”

“The IMF also acknowledges a surplus, and I quote, ‘will increase fiscal room and take pressure off monetary policy and the exchange rate’.”

See the logic? It’s a near perfect application of economic policy: tighter fiscal policy which builds savings, giving even great fiscal flexibility for the future, allows for a lower interest rate structure and therefore a lower Australian dollar.

Recall the alternative is an easy budget with on-going deficits, higher interest rates and an even higher Australian dollar. Lovely.

It is often forgotten that government demand makes up around 20% of GDP.  As such, it is four times bigger than all housing investment; it is not much smaller than all of retail sales combined. What happens to government demand has a big impact on the overall growth performance of the economy.

The budget measures will confirm Australia has a recession in government demand. This will free up resources to allow the private sector to grow and expand. The private sector will be aided by lower interest rates and a more competitive exchange rate. The government sector’s demand on workers, finance, resources will be lower with tight fiscal settings, which allows for those resources to be taken up by the private sector.

There are some commentators suggesting that the economy is so soft or vulnerable that the government should abandon its economic objective of returning to budget surplus. These calls are embarrassing for the proponents as they underscore a lack of appreciation of the policy objectives.

They must recall that the cash rate in Australia is 4.25% — a long way from the zero bound in so many other countries at the moment. There is plenty of scope for the cash rate to be lowered. The RBA could cut to 3.5%; 2.5%; 1.5% if needed. What’s wrong with this as a measure to support activity?

Those arguing for the budget surplus objective to slip are implicitly arguing for higher interest rates and an even higher Australian dollar. I suppose that is fair enough if they acknowledge the consequences of their suggestion, but given the terms of trade are falling and the Australian dollar is still high, such a move would drive an even greater imbalance within the economy.

If I was recommending market trading strategies — and I’m not in this instance — I would be getting set for the RBA to be cutting interest rates aggressively in the next few months. A 3.5% cash rate remains on the cards.

In this climate of what are currently unanticipated rate cuts, the Australian dollar is long overdue for a fall. With the carry trade losing some of its carry as the RBA cuts rates, a nice 5 to 10% fall in the dollar could be seen by year end.

*Stephen Koukoulas is Managing Director of Market Economics, a macroeconomic, policy and financial market advisory firm. This item was originally published on his blog.