Thursday, June 6, 2013


Economic growth: the economy’s production of goods and services (real GDP) grew by a below-trend 2.5 pc over the year to March. Non-mining business investment spending is weak, home-building and public spending are flat, but consumption is growing at below trend and net exports (exports minus imports) are growing strongly. Mining investment may have peaked. Production is forecast to grow slightly below its trend rate at 2.75 pc in 2013-14.

Inflation: the underlying inflation rate was 2.4 pc in the year to March, down from a peak of 5 pc in the year to September 2008, immediately before the GFC. It’s been back in the target range of 2 to 3 pc for three years and in the bottom half of the range for one year, suggesting no threat from inflation.

Unemployment: using trend estimates, the unemployment rate was 5.5 pc in April, having crept up from 5.1 pc over the previous year, though with the participation rate unchanged at 65.3 pc. Thus the economy has not been growing quite fast enough to hold unemployment steady. And with its growth forecast to stay a little below trend in 2013-14, the unemployment rate is forecast to continue creeping up to 5.75 pc by June 2014. But note that this unemployment rate is not much above the NAIRU, our lowest sustainable rate.

Current account deficit: CAD was $9 billion for the March quarter, or 2.2 pc of GDP. For the year to March, the CAD totalled $49 billion, made up of a trade deficit of $13 billion and a net income deficit of $36 billion. As a consequence of the high CADs in earlier years, the foreign debt has risen. At the end of March the net foreign debt was $764 billion, or 51 pc of GDP. The CAD is below its trend level of about 4.5 pc of GDP because although national investment (mining construction spending) has been stronger than usual, national saving (households and companies) has risen by more, while staying less than national investment.

Now let’s take a closer look at the state of the economy. This is a particularly interesting time to be studying the Australian economy because we have spent the past decade coping with the biggest commodity boom in our history since the gold rush, with the global financial crisis and its aftermath thrown in just to make things interesting. The boom has had big implications for the exchange rate, for change in the structure of the economy and, of course, for macro management.

Resources boom: The boom started in 2003, but was briefly interrupted by the GFC. It arises from the rapid economic development of China and India, which has hugely increased the world demand for energy and the main components of steel. This demand may stay elevated for several decades until the two most populous countries complete their economic development. The boom has involved three overlapping stages:

First, hugely increased prices for our exports of coal and iron. These caused Australia’s terms of trade to reach their most advantageous level in 200 years by June 2011, but they have since fallen back by 17 pc. Even so, we are still receiving significantly higher prices for our exports of coal and iron ore. Prices shot up as demand outstripped supply, but as Australia and other commodity exporters increase their production capacity prices are falling back.

Second, an unprecedented boom in investment in new mines and natural gas facilities as miners take advantage of the great global demand for minerals and energy. This investment spending has been a major contributor to growth for the past few years, but it is now expected to reach a peak in 2013 and, thereafter, begin subtracting from growth as it falls back. Note that, even though spending will decline from one quarter to the next, there is still considerable spending to come.

Third, significant growth in the volume of our exports of minerals and energy as new investment projects come on line. This volume growth will make a positive contribution to GDP growth and also to the trade balance and the CAD, even as falling export prices act to worsen the CAD.   

Exchange rate: As a commodity-exporting country, Australia’s exchange rate always tends to rise or fall in line with world commodity prices and our terms of trade. So our exceptionally favourable terms of trade left us with our strongest exchange rate for 30 years. The dollar is also being kept high by foreign purchases of Australian government bonds and the indirect effect of the developed countries’ use of ‘quantitative easing’ to stimulate their economies.

The higher dollar has reduced the international price competitiveness of our export and import-competing industries. Exporters are earning fewer $As from their overseas sales in $USs, while domestic industries are losing market share to now-cheaper imports. This adversely affects all industries in our tradeables sector (including the miners and the farmers), but particularly disadvantages our manufacturers and key services exporters, tourism and education (international students). These industries’ profits and their production are reduced.

Structural change: Economists argue that the long-lasting change in the rest of the world’s demand for our mineral (and rural) commodity exports necessitates change in the structure of our industries, with relatively more resources of labour and capital going to mining, and relatively fewer resources going to all other industries, but particularly manufacturing and service exports. Economists further argue that the high exchange rate is the market’s painful way of helping to bring about this structural change. They say that using government subsidies or other forms of protection to help our industries resist change reduces the efficiency with which the nation’s resources are allocated. Mining production now accounts for about 10 pc of GDP (though only about 2 pc of total employment).

Retailing is another industry facing structural change as consumers shift their preferences from goods to services, and as the internet gives consumers access to overseas markets where retail prices are lower. This change is not related to the resources boom, but is related to the end of a long period when consumption grew faster than household income.

Monetary policy: MP is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Since monetary policy is the primary instrument used by the managers of the economy, its history encapsulates their efforts to cope with the various stages through which the resources boom has passed and also with the GFC. We can divide the RBA’s management of monetary policy over the past decade into five distinct phases:

First, inflation worries. When it became clear after 2003 that we were entering a huge resources boom, the RBA worried that it might lead to a surge in inflation as many commodity price booms had in the past, with them often ending in policy-induced recessions as the authorities struggle to control inflation pressures. These worries were compounded by the RBA’s belief the economy was not far from full capacity, with the unemployment rate not far above the non-accelerating-inflation rate of unemployment (NAIRU) - our lowest sustainable rate of unemployment - thought to be about 5 pc. So the RBA progressively tightened monetary policy, lifting the cash rate to a very contractionary 7.25 pc by early 2008.

Second, the GFC. But with the financial crisis reaching a peak with the collapse of Lehman Brothers in September 2008, the RBA realised the inflation threat had evaporated and been replaced by the threat of our economy being sucked down into the Great Recession. It quickly slashed the cash rate, lowering it to a highly expansionary 3 pc by April 2009.

Third, resources boom resumes. By October that year, however, the RBA realised the emergency had passed, we’d avoided serious recession, the resources boom had resumed and the dollar had gone back up. It thus resumed its worries about inflation. It began tightening in steps of 0.25 percentage points. By November 2010 it had returned the cash rate to 4.75 pc, a level it considered to be just a fraction more restrictive than neutral.

Fourth, high dollar starts to bite. By November 2011, however, the RBA realised the inflation threat had passed. The economy was being hit by two conflicting external economic shocks. One, the positive shock of the resources boom, which had boosted real incomes and mining investment spending. And, two, the related negative shock of the high exchange rate, which was cutting import prices directly, but also reducing the international price competitiveness of our export and import-competing industries. This was reducing their production and squeezing their prices and profits. So the RBA began cutting the cash rate, lowering it to 2.75 pc, its lowest level in the history of the RBA. This makes the stance of policy highly stimulatory in order to offset the contractionary effect of the continuing high dollar.

Fifth, the transition to normal growth. With the terms of trade now deteriorating and the mining investment about to pass its peak, we need to make a transition from mining-led growth to growth led by its normal forces: consumption, housing and non-mining business investment. But this transition is being hindered by the continuing high dollar, which has not (or not yet) fallen in line with the decline in the term of trade. The longer it takes before the non-mining sector takes up the running, the more growth will fall below its 3 pc trend rate and unemployment will rise. A fall in the dollar will help ease the transition. Failing that, the RBA stands ready to cut the cash rate again and make monetary policy yet more stimulatory.