Economy holding up but fiscal policy support still needed

There remains uncertainty around the timing and extent to which state borders might reopen even when vaccination rates pass 70 per cent. Picture: Jane Dempster

Last year when the initial waves of Covid-19 swept the globe, financial markets seized up, adding to the supply shock to economies from lockdowns.

A notable difference today, despite the emergence of the highly transmittable Delta variant, is the resilience of financial markets, led by continued risk appetite.

This resilience, if it is sustained, is one reason to be cautiously hopeful that the economic downturn in Australia, centred on the lockdowns in southeastern states and the ACT, will be less damaging than during the first Covid wave last year.

Indeed, the latest June quarter national accounts showed strong momentum in domestic spending ahead of the lockdowns.

In particular, the development of vaccines and their subsequent availability in richer nations has allowed major economies with relatively high vaccination rates to remain open.

This has supported risk appetite, allowing global markets to look ahead to continued growth in profits, despite the rebound in infections with the spread of the Delta strain. For example, share prices in the US and Europe are at record levels.

A further differentiating factor is that unlike when the pandemic hit in 2020, monetary and fiscal policies in most economies today are already at emergency levels of stimulus.

With continued gains in financial and asset prices, household and business balance sheets have been fortified while ultra-low interest rates, large dividend payments by companies, and financial injections from governments have backstopped incomes and spending.

In Australia’s case, the lower vaccination rates have meant it has not been possible to avoid lockdowns in jurisdictions where there have been new waves of infections caused by the Delta strain.

Large case numbers, particularly in NSW, have placed significant pressure on the health system, while households, communities and businesses most exposed to lockdowns, restrictions and the closed international border have suffered renewed financial stress.

The September quarter in Australia will see a large drop in production and a sharp rise in underemployment. GDP could fall by 2 to 3 per cent, a recession on any objective measure, and underemployment, which takes account of the reduced hours being worked, could rise to 10 to 11 per cent in the next few months.

Fortunately, there are some early signs that the downturn is not accelerating. Financial conditions have remained highly accommodative, share prices rose further in July and August, albeit at a slower pace than in the US and Europe, and the weekly reads on consumer sentiment have steadied after falling in late July/early August. Further, information from purchasing managers also points to a steadying in service sector activity this month after a sharp drop in July, and at levels well above those during the first wave. Consistent with this, capex plans by companies in service sectors have held up during July and early August.

That said, it is probable that the expected rebound in the final months of the year, as vaccination rates hopefully rise to 70 to 80 per cent, will only partially recover the ground lost during the downturn. This is because lockdowns and restrictions in NSW, Victoria and possibly the ACT are likely to persist into at least part of the December quarter.

Even in NSW where the vaccination rate has jumped sharply, daily case numbers have continued to rise and the 70 per cent vaccination target nominated by Premier Berejiklian to afford some easing of restrictions is not projected to be reached until next month.

There is also uncertainty around the timing and extent to which state borders might reopen even when vaccination rates pass 70 per cent.

Doherty Institute modelling indicated that even with a 70 per cent vaccination rate, if there is ongoing community transmission, contact tracing, isolation and quarantine will only be partially effective in managing cases within the capacity of the health system.

As a result, the modelling showed that strict or moderate lockdowns would be required until the vaccination coverage is assumed to have reached 80 per cent in those jurisdictions with ongoing community transmission.

This means that there could still be a drag on the recovery during at least some of the December quarter of around $1bn per week. The experience of rapid recoveries from previous lockdowns may only partially be the relevant template this time.

Therefore, it is important that direct income support for affected households and businesses is not ended prematurely.

Indeed, the dialling up of additional but temporary support by the federal and state governments as lockdowns and restrictions were reimposed in the past two months was entirely appropriate.

By targeting those most in need and taking advantage of the record low level of funding costs, it also is a more effective response than relying on further monetary policy measures.

Indeed, at last month’s meeting the RBA board acknowledged that fiscal policy is the most appropriate instrument to deal with temporary reductions of income.

It is unlikely to change this view at next Tuesday’s meeting given that rising vaccination rates are still on track to allow the lockdown states to ease lockdown restrictions ahead of the end of the year.

Paul Brennan is the chief economist at Suncorp.