On the face of it Australia’s economic report card looks good. Real GDP growth was running a touch above potential growth at 3.3% y-o-y in Q2 with an unemployment rate at a three-year low 5.6% in August. National income helped by a brief burst of higher commodity prices took a stronger turn too in Q2 and annual wages growth while still very low at 2.1% y-o-y in Q2 may be basing after the decline of the past two years. Housing activity is holding up for the time being and while growth in household consumption spending is on a fade, it is not too worrying a decline just yet. Falling mining investment spending, the biggest detraction from economic growth over the past two years, may be about to fall at a less pronounced pace over the next year. Please continue below or on the attached PDF.
The Federal Government and the RBA, the pullers of the two main macroeconomic policy levers – budgetary and monetary – seem prepared to accept that what appears to be happening in the economy may continue and that they can leave policy settings where they are for the time being.
Proposals in May Budget in a state of flux
In the case of the Federal Government, its budgetary policy setting from the May Budget was initially proposed to be a tiny fraction the contractionary side of neutral in its impact on economic growth in 2016-17 with containing growth in government debt over the medium-term the main focus. The proposals in the May Budget are currently in a state of flux in the new Parliament where the Government has to bargain its legislation even within its own party before dealing with the constraints of a wafer-thin lower house majority and the wide interests of the big Senate cross-bench. 2016-17 budgetary policy is being re-shaped it seems in this bargaining process slightly to the expansionary side of neutral setting, but not by government design. The Government is struggling to put a clear stamp on budgetary policy in the current difficult Parliament and that is unlikely to change.
RBA likely to hold
Meantime, the RBA is showing signs that it will leave its comparatively easy monetary policy setting on hold for some time. The minutes of recent RBA policy meetings and speeches of senior RBA officials all point to belief that Australian economic growth will continue and over time accelerate and that the current monetary policy setting is about right to meet the RBA’s objectives. In regard to the RBA’s objectives the contract written between new RBA Governor Lowe and the Treasurer is very similar to contracts with Governor Lowe’s immediate predecessors with small tweaks to recognise the importance of financial stability plus a change in timing for meeting the 2% to 3% inflation target from over the course of the cycle to over time. The additional flexibility in the timing of meeting the inflation target coming when inflation looks set to travel under target range for some time would seem to imply flexibility for the RBA to leave the cash rate unchanged, even if inflation comes in very low as it may with the next quarterly reading due in late October.
By design it looks like the RBA will be doing nothing to the cash rate for some time. By constraint it looks like the Government will be unable to do anything with budgetary policy for some time. Doing nothing, however, is not the same as saying that macroeconomic policy settings will actually have no effect on economic growth. In the case of the RBA, deciding not to lower the cash rate further for the next few months could lead to actual monetary conditions becoming less growth accommodating. There is a risk in a world where temporarily there is a touch of upward pressure on government bond yields and perhaps credit spreads too that funding cost pressures on Australian banks build, even though the RBA’s cash rate is stable at 1.50%. Higher bank funding costs would probably lead banks to lift their lending interest rates. In effect, a period of cash rate stability becomes the equivalent of a tightening of monetary policy as far as borrowers are concerned.
Australian dollar strength
The monetary policy tightening effect may also be compounded if the Australian dollar trades stronger because of the stability of the cash rate. There may be some tentative signs that this is already starting to occur. After briefly trading lower against the US dollar and on trade-weighted basis as talk in financial markets turned a few weeks ago to the possibility of another US Fed rate hike approaching, the Australian dollar seems more recently to be regaining strength.
The Federal Government, in contrast, being unable to pursue the full extent of its planned budget savings is lending an expansionary bias to budgetary policy – possibly running as much as 0.3 percentage points of GDP in 2016-17 on what has been announced so far from the bargains that seem to have been struck in Parliament. A drift easier in budgetary policy combined with a drift tighter in monetary conditions probably amounts to not much impact at all on the growth outlook.
Almost no effect from macroeconomic policy settings on growth in 2016-17 would be fine if what we have seen with Australian growth and unemployment so far this year persists. This is where what is happening below the surface of the headline numbers matters. Getting real GDP growth up to 3.3% y-o-y has depended on what appear big one-time contributions to quarterly growth rates in the first half of 2016 from net exports in Q1 and government spending in Q2. The more consistent and smaller contributions to growth from housing and household consumption spending both look less robust over the year ahead - much softer quarter-to-quarter than where they were travelling through the second half of 2015 and in early 2016. This base effect implies that annual real GDP growth will retreat quite sharply in coming quarters from the 3.3% high point set in Q2 2016.
Unemployment to drift higher
Also the 5.6% unemployment rate in August looks unsustainably low given that employment change month-to-month has been relatively soft with full-time employment down by 51,200 since the end of 2015 and with paid hours work done over the same period down by 3.4 million hours or by 0.2%. Most likely, soft employment conditions will show through in a higher unemployment rate before long. The unemployment will start to drift higher over coming months in our view.
These signs of softer GDP growth ahead with a possible drift higher in the unemployment rate indicate to us a period when policymakers should be busy doing something, not planning or being forced to do nothing, as seems likely to occur.