Search for the economy’s silver lining

The economy is likely to keep on struggling for some time yet.

There is a strange confluence of events occurring at the moment with strongly recovering housing prices and a soft real economy. Picture: Bloomberg

The outstanding feature of the current economic situation is the juxtaposition of a soft real economy with rising asset prices, particularly housing. Just this month, we learned housing prices in Melbourne and Sydney are rising at their fastest rate in 30 years. The stock exchange also has recorded historically high levels.

However, the recent figures on gross domestic product growth, the broadest indicator of how the real economy is travelling, have shown relatively anaemic, albeit positive, growth, well below what is regarded as the trend rate of growth of about 2.75 per cent.

In the year ending in the June quarter, GDP grew by only 1.6 per cent and Wednesday’s figures showed a very slight uptick to 1.7 per cent. Bear in mind, however, the ongoing drought affecting parts of Australia is subtracting about 0.25 percentage points from that figure.

The GDP growth obviously pleased Scott Morrison: “That continues to put us in a very strong position relative to all the major developed countries in the world today,” the Prime Minister said.

“Just on the quarterly figures alone, second only to the United States. When you take it through, we are equal to Canada, which is second.”

The fact the Reserve Bank on Tuesday decided to keep the cash rate at 0.75 per cent — there have been three cuts this year, each of 25 basis points — is consistent with the interpretation of the economic situation as being soft but not deteriorating. This said, there is widespread expectation the cash rate will be further reduced early next year.

 

Global forces at work

One of the conundrums facing analysts of recent economic developments is separating out cyclical from secular influences. There are clearly some cyclical effects playing out in relation to the impact of ongoing trade tensions — mainly the US-China trade relationship but also some broader trade issues. World trade growth has effectively stalled, which affects the Australian economy indirectly.

The Australian figures also point to some cyclical factors at play. Both business investment and new housing approvals have slumped in recent times, indicating that the impact of the lower cash rates has been minimal or the lags in the system are longer than were anticipated.

While it is too early to tell, there are also some tentative signs of weakness in the labour market, with the most recent figures showing weakening employment growth and rising unemployment. The rate of underemployment continues to record relatively high readings. At the same time, there is the possibility some of the economic forces at play are actually secular, meaning they are part of longer-term trends that won’t necessarily reverse themselves when the economy picks up.

Encapsulating these secular trends are the productivity figures. Alarmingly, the most recent labour productivity figure showed negative annual growth of minus 0.2 per cent. (The Australian Bureau of Statistics also released a quality of jobs adjusted figure for labour productivity of minus 0.8 per cent.)

The broader indicator of multifactor productivity, which takes into account labour, capital and other inputs into output, also recorded negative annual growth of minus 0.4 per cent.

To be sure, productivity does have a cyclical component, but if we look at how productivity has moved during the past two decades or so, it is clear there has been a marked decline in the rate of improvement across that period.

It’s why former Productivity Commission chairman Gary Banks thinks the main game is about reforming the economy rather than providing short-term sugar hits via government spending or interest rate cuts.

Keep on spending

At this stage, the two key variables underpinning the growth of GDP are net exports (the value of exports minus imports) and government spending. Just this week, another whopping current account surplus was recorded, reflecting the strength of our export performance as well as relatively high commodity prices.

The largest single component of GDP is consumption, or how much people spend, making up for around 60 per cent of output. The slow or zero growth of consumption is a key factor that explains the poor GDP growth figures over the past year or so.

In fact, the weak growth of consumption is another illustration of the distinction between the cyclical and secular characterisation of recent trends. Is it possible that larger proportions of households are deliberately turning their backs on high rates of discretionary spending? Or do poor retail sales, for instance, mainly reflect the escalating costs of non-discretionary consumption — think electricity, gas, rates, childcare fees, school fees — which effectively squeeze many household budgets?

The detailed breakdown of expenditure in the national accounts data on Wednesday shows a “clear cutback in discretionary spending”, according to Westpac economist Matthew Hassan. Overall consumer spending rose just 0.1 per cent for the quarter and 1.2 per cent for the year — both the weakest figures since the global financial crisis.

There is also the related issue of the very high rate of household indebtedness, which has reached close to 200 per cent of GDP, putting Australia as one of the most privately indebted countries.

It is too early to assess whether there are longer-run influences bearing on spending that will have ongoing consequences for GDP growth. The recent surge of retail sales associated with Black Friday perhaps points to a degree of strength.

What about jobs?

One of the recent economic puzzles has been the coexistence of relatively weak economic growth with a strongly performing labour market. The employment-to-population ratio — the best overall measure of the strength of the labour market — is close to a historical high. The labour force participation rate is also strong, with the rate of female labour force participation at a historic high.

There is evidence, however, that labour market conditions are weakening. In October, the seasonally adjusted rate of unemployment was 5.3 per cent, compared with 5.2 one year previously. The rate of underemployment was 8.5 per cent (this captures employed people who want to work more hours), which was 0.2 percentage points higher than a year ago.

While the number of employed people rose by 2 per cent in the year ending in October, there was a decline of 19,000 in their number across the month. On balance, the early indications are that the labour market has come off the boil, in part reflecting a slowing in the growth of public sector employment, including in Queensland and Victoria, as well as of National Disability Insurance Scheme-related jobs.

In this context, it is interesting to note that the Reserve Bank has recently reassessed its estimate of the so-called non-accelerating inflation rate of unemployment — the NAIRU. Rather than being around 5 per cent, the bank now puts that figure as closer to 4.5 per cent. In other words, it should be possible for unemployment to reach the low figure of 4.5 per cent without triggering a bout of inflationary pressures that would force the bank to raise the cash rate.

Hip-pocket nerves

This reassessment of the unemployment rate has been made partly as result of the ongoing weakness of wage growth. The traditional view is that lower unemployment leads to higher wage growth as employers compete for workers and bid up wages to attract and retain them. What seems to have occurred is some sort of disruption to this relationship, a disruption not unique to Australia.

While it is the case that there has been some slight recovery in wage growth — annual growth in the Wage Price Index had been below 2 per cent but is now slightly higher on recent figures — the Reserve Bank has concluded that low wage growth is the “new norm”.

This matters for several reasons including the underpinning of consumption growth and determining consumer sentiment but, importantly, in determining in part the flow of income tax revenue, which is the largest single source of revenue for the federal government. Until this point, the strong growth of employment has offset the slow growth of wages — captured by the National Accounts figure of wages, salaries and supplements — meaning that growth of income tax revenue has been reasonable.

A combination of slower employment growth and ongoing weak wage growth is deadly for the federal budget and was not factored into the budget handed down in April. Recall that in this budget it was expected the Wage Price Index would increase by 2.75 per cent in 2019-20 and unemployment would come in at 5 per cent. Both these forecasts are looking very optimistic at this stage.

Housing prices

The point was made above that there is a strange confluence of events occurring at the moment with strongly recovering housing prices and a soft real economy. In one sense, this is hardly surprising because the lower cash rates imposed by the Reserve Bank are much more likely to affect asset prices than the real economy, in particular private investment, at least in the short term. This fact has been acknowledged by RBA governor Philip Lowe, who also believes the economy has seen a “gentle turning point”.

While it is true there had been a surge in the building of new housing, including many new high-rise dwellings, the recent figures point to extremely sluggish growth on this front. The combination of ongoing strong population growth — the key figure of net overseas migration, which takes into account both permanent and temporary migrants — of around 250,000 a year continues to underpin strong demand for housing.

And given that most of these new migrants head to Melbourne or Sydney (a reasonable number also go to southeast Queensland), it is hardly surprising that the new housing price pressures are mainly being experienced in these cities. Given the low rate of new housing construction, the price increases are mainly for existing dwellings.

In a slightly perverse way — rising housing prices make life very difficult for young people wishing to break into the housing market — the RBA’s hope is that rising housing prices will generate a wealth effect. This works by making people feel better by virtue of the rising value of equity in their homes and going out to spend on goods and services. Bank research has confirmed the existence of the wealth effect but the timing and its strength are not fully known.

The economic outlook

It is now reasonably clear that the government’s budget GDP forecast of 2.75 per cent for 2019-20 will not be met. This is also true of the reasonably chipper Reserve Bank, which at least has the advantage of being able to ratchet down its forecast as the year progresses.

Its most recent statement is along the following lines. “The Australian economy is gradually coming out of a soft patch. GDP growth has been recovering since its low point last year; it picked up a little in the first half of 2019 and moderate growth is expected over the remainder of the year. Growth is expected to reach 2.75 per cent over 2020 and around 3 per cent by the end of 2021.”

In effect, both the government and the bank see economic developments as essentially cyclical; we have gone through a soft patch but things are going to pick up. To be sure, the latest figures on productivity are a concern but the government shows little sense of urgency when it comes to instituting the needed supply-side reforms, particularly on the deregulation front.

With the mid-year economic and fiscal outlook expected in a fortnight or so, it will be interesting to see how the government has revised its forecasts for the coming four-year period. The expectation is that the surplus will be slightly lower than the one forecast at budget time of $7.1bn for 2019-20.

It seem likely the relatively optimistic surplus figures for the other three years of the forward estimates — $11bn, $17.8bn and $9.2bn, respectively — will be scaled back.

Going into Christmas, it would be nice to declare the economy is at a Goldilocks point — not too hot, not too cold. Unfortunately, it is clear the private sector economy is weak and, were it not for the strength of exports, the overall economic situation would be quite dire. Some improvement is possible next year but it’s unlikely to be spectacular.