The most important question for 2018 in an Australian context will be whether the economy is strong enough for the Reserve Bank of Australia (RBA) to start removing policy accommodation. That is to say, to have confidently begun a tightening cycle. This is the expectation of most market economists and indeed some continue to believe this will occur in the first half of the year.
At this stage, this seems optimistic in our view and a second-half hike seems more plausible. That said there seems to be little reward for the RBA to go early so we would be unsurprised if it only intimated a tightening cycle was imminent in late 2018 before acting in early 2019.
Important to timing of domestic policy tightening will be the pace of hikes in the US. This is because the RBA are still concerned about a materially higher Australian dollar. Any undue appreciation at this stage would be unwelcome and crimp the growth narrative from services exports in particular that has been strong in 2017.
Will the baton now be passed from housing to infrastructure?
Perhaps the key question on growth outside the ongoing services expansion is whether the growth and jobs that have been driven by residential construction will be transitioned to the infrastructure and non-residential building cycle. This is as the residential construction cycle inevitably weakens. We have already observed this in New South Wales and Victoria to some extent – both states that were willing and able to take advantage of the Commonwealth government’s asset recycling program to facilitate a strong public spending agenda. We expect this to support both growth and, importantly, jobs in these states. The latter is almost more important considering the sheer size of the labour force exposed to the construction cycle. In the absence of rate hikes the dwelling investment cycle, that already seems past its peak, should continue to trend lower. However a rate hike would likely accelerate this cycle and is a reason why we think that ongoing jobs strong growth is required to warrant a rate rise in the year.
The other aspect of this residential cycle will also be important, that is the property market. Dwelling prices have been weaker in the resources states already and now are softening in the previously strong non-resources states also. This includes the cities with the strongest growth this cycle – Sydney and Melbourne. This is in response to only a modest tightening of conditions in the investor space. Should this price softness continue, or indeed be exacerbated by a rate rise, this will be a test for the household sector. That is because Australian households have capitalised both structural declines and now cyclically low interest rates into dwelling prices over an extended period. Even the partial reversal of this trend will see downward pressure exerted on prices.
A downtrend in prices may negatively impact households’ desire to spend - the ‘wealth effect’ has been touted as supporting consumption growth on the way up it may equally have a negative impact on the way down. Declining prices are also a problem for negatively geared investors, particularly newer ones. As it may become clearer if we are in for an extended period of flat or modestly declining prices, investor confidence may be shaken.
Further there is the direct income effect that higher rates will have on disposable income. Australian households are amongst the most highly indebted in the world with a debt-to-GDP ratio nearing 125%. Consequently, even incremental rate rises will get significant traction and impact that sector’s ability to consume.
Therefore wages growth becomes as important in the Australian context for monetary policy as it is elsewhere – if not more important given the weight of debt on household balance sheets. It will define not only future inflation but also growth – with Australians’ ability and appetite to run down their rate of savings increasingly questionable.
Yet it is likely to be the case in Australian that wages growth is even more elusive. Firstly, for the reasons cited previously in the global context, but also because of Australia’s unique lack of competitiveness that deteriorated markedly as wages rose strongly through the resources boom. The nominal exchange rate has not fallen enough to repair this. Consequently, an elongated period of soft wages growth may be required to become more competitive or indeed sustained improvement in productivity that would lower unit labour costs.
What about underemployment?
And lastly, there is also Australia’s underemployment problem. We remain dubious that this can be addressed fully by accommodative monetary policy alone. Indeed, it is the choice of individuals and perhaps more importantly the business sector that has and is driving the higher rate of part-time employment – that is employment that is likely to have significantly less wage bargaining power.
Therefore the labour market may need to be significantly tighter and the unemployment rate lower, well below 5%, to elicit consistent wage growth. This is because the natural rate of unemployment (or NAIRU) or the rate is again likely to be lower, as it is in other developed economies. As wage growth is delayed, inflation returning to the mid-point of the RBA’s target will require rates to be on hold for a longer period of time. Indeed the RBA itself does not have the rate of inflation returning to even the lower bound of its target until 2019. The concern has been for some time and will continue to be that running rates too low for too long is simply building imbalances elsewhere and household debt is already a risk to the economy. The RBA’s balancing act in this regard will continue.
Also important in the growth narrative will be whether the resources states of Western Australia and Queensland (and Northern Territory) can continue to stabilise and shake off the worst of the reversal in the commodities down cycle. As this may give the RBA confidence to normalise policy.
What is also evident from recent communications is the expectation that productivity growth and innovation will play a part in future growth. We are in complete agreement, we cannot and should not rely on ‘lazy’ growth reliant on expanding the population.
With regard to infrastructure investment, we do think there is a productivity dividend. However, we also need fiscal/ government policy innovation and reform to generate productivity and this may prove optimistic. The political process seems again to be mired in uncertainty with no strong narrative emerging. A continuation of this may indeed undermine current high levels of business confidence to the detriment of the economy. Business tax cuts may be supportive if passed and the government has also recently touted personal income tax cuts. This is to redress the bracket creep that has eroded household income growth for some years. But it also is a clear ploy to garner favour ahead of the coming Federal election that is to take place in 2019