May 2019
In Josh Frydenberg’s recent budget speech, he referred to our “strong economy” no less than 14 times. Turns out the Morrison government is using the claim that it has delivered a strong economy as its main argument that it should be re-elected at the federal election on May 18. Unfortunately for Scott Morrison, the release of recent key economic indicators of the health of the economy have caused many economists to abandon their view that the economy is reasonably strong and about to get stronger.
The first upset came in early March, with the national accounts for the December quarter of last year showing a second successive quarter of surprisingly weak growth, which lowered the growth in real GDP over 2018 to just 2.3 per cent. The second data upset came in late April, with the CPI showing no overall change in prices in the March quarter of this year, thus causing the annual rate of inflation to fall to 1.3 per cent – way down from 1.8 per cent the previous quarter and way below the bottom of the Reserve Bank’s inflation target of 2 to 3 per cent on average. This news of weak economic growth and an inflation rate moving further below the target range has greatly increased the pressure on the RBA to add to the monetary stimulus acting on the economy by cutting the overnight cash rate, after having held it steady for more than two and a half years.
To see how disappointing this recent news is, consider this. In Morrison’s own budget this time last year, he forecast that the economy’s growth (real GDP) in the financial year just ending would have accelerated to 3 per cent. In this year’s budget Mr Frydenberg cut this forecast to 2¼ per cent. Last year Morrison forecast an inflation rate of 2¼ per cent in the financial year just ending; now Frydenberg has cut it to 1½ per cent. Morrison forecast wages growth of 2¾ per cent; Frydenberg cut it to 2½ per cent.
The fact is that, for most of the time since the global financial crisis, Treasury and the RBA have been forecasting that the economy would soon return to growing at its “trend” or “potential” rate - which they calculate to be 2¾ per cent a year – and even a bit faster while the economy uses up idle production capacity, know as the “output gap”, before reaching full employment of labour and other resources. Full employment is estimated to be growth of 2¾ per cent and a NAIRU – non-accelerating-inflation rate of unemployment - of about 5 per cent. This would involve inflation returning to the centre of the RBA’s target range, 2½ per cent, and wage growth increasing to 3½ per cent.
Budget forecasts: Treasury has forecast that this acceleration would begin each year for the past seven years. And each year, when it has failed to happen, Treasury has repeated the forecast of an early return to the “old normal”, just moving it forward a year. Surprisingly, despite the recent evidence of a sharp slowing in the economy in the financial year just ending, in this year Treasury persisted with forecasting that the economy will soon return to the “old normal”. Indeed, it sees the economy speeding up in the coming financial year, 2019-20, returning to potential growth of 2¾ per cent, staying at the NAIRU of 5 per cent, inflation back in the target range at 2¼ per cent and wage growth strengthening to 2¾ per cent, implying real wage growth of about ½ per cent. And things get even better in the following year, 2020-21, with real wage growth increasing to ¾ per cent, then 1 per cent in each of the following years. It would be wonderful to see these forecasts come to pass, but they are increasingly hard to believe.
Why the economy’s weakness hasn’t been evident until now: There are four main reasons why the economy’s continuing weakness hasn’t been evident until now. First, we’ve been preoccupied with the ups and downs of the decade-long resources boom: the rise and then fall in mineral export prices and our terms of trade, and then the rise and fall of mining investment spending.
Second, our rates of growth have compared well with other advanced economies because we have had much higher rates of population growth than they have. Over the 6½ years since mid-2012, real GDP has grown by 17 per cent, whereas GDP per person grew by less than 6 per cent. In other words, most of our growth was explained by a fast-growing population, not by higher productivity and growing prosperity. The economy was bigger, but not a lot better. Measured by GDP per person, our growth has not been a lot faster than the other rich countries.
Third, in 2017, our growth in employment was about twice as fast as usual, and since then it has been faster than usual. Over the past 2¼ years the unemployment rate has fallen from 5.8 per cent to 5 per cent – which is impressive. Even so, it’s now only a fraction lower than it was in mid-2012. Similarly, the under-employment rate has fallen over the past 2¼ years, but is still quite a lot higher than it was in mid-2012.
Fourth, much of what growth we’ve had in the economy, and in employment, has come from the public sector, not the private sector. Of the 2.3 per cent growth in GDP over 2018, increased government consumption and investment spending accounted for more than half. Similarly, most of the growth in employment has come from the rollout of the National Disability Insurance Scheme and from increased spending on infrastructure by the states, as well as in health and education. The point here is not that there is something bad about government spending, but just that, when you take it away, you find the private sector economy – the biggest part of the economy - isn’t strong.
The key role of wages: Much of the economy’s weak growth and weak prospects of faster growth can be explained by weak growth in real wages. It’s not surprising that nominal wage growth has been low when consumer price inflation has also been low, but there has been almost no real wage growth for the past five years. In the past, a healthy economy has seen real wages growing by a per cent or more each year, roughly in line with growth in the productivity of labour. An economy with no growth in real wages is an economy in which real economic growth is likely to be weak. This is because wages are the main source of growth in household disposable income, household disposable income is the main source of growth in consumer spending, and consumer spending accounts for about 60 per cent of GDP. What’s more, firms are unlikely to invest much in expanding their business if demand for their products isn’t strong. And it’s firms replacing their equipment with the latest model than does most to increased productivity by spread new technology through the economy. Treasury and the RBA have been forecasting a recovery in real wage growth for five years or more, but it still hasn’t happened. The union movement and some labour economists have argued that the decentralisation of wage fixing has shifted the balance of bargaining power in favour of employers and robbed workers of their ability to ensure their real wages keep rising. Whatever the true cause of weak wage growth, it’s certainly hard to see the economy returning to strong growth until real wages are growing strongly.
Now let’s turn to how the two arms of macroeconomic management – monetary policy and fiscal policy - have been responding to this story of disappointingly weak growth in wages and GDP.
The monetary policy “framework”
Monetary policy - the manipulation of interest rates to influence the strength of demand - 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. Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over time. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.
Recent developments in monetary policy
Because of the six consecutive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc to 1.5 pc between the end of 2011 and August 2016. For more than 2½ years after that, it left the rate unchanged – a record period of stability. It’s not hard to see why it left the official interest rate so low for so long: the inflation rate has been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy has yet to accelerate and has plenty of unused production capacity, and the rate of unemployment shows little sign of falling below its estimated NAIRU of 5 pc. For many months, the RBA governor, Dr Philip Lowe, kept saying that, though the next move in the cash rate, when it came, was likely to up, a rise was some way off. Earlier this year, however, he switched to saying that the next move was just as likely to be down as up. And now, with the recent bad results on growth and inflation, he is under pressure to start cutting the cash rate.
Fiscal policy “framework”
Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Morrison government’s medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”. This means the primary role of discretionary fiscal policy is to achieve “fiscal sustainability” - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.
Recent developments in fiscal policy
Until recently, 2017-18, the Coalition government (and the Labor government before it) had seen the growth in the economy being repeatedly less than forecast, meaning the government has made slow progress in returning the budget to surplus and halting the rise in its net debt. Even so, it has focused on the medium-term objective of fiscal sustainability, not the secondary objective of helping monetary policy to get the economy growing faster. The long period of policy stimulus has come almost wholly from lower official interest rates.
In the year to June 30, 2018, however, the underlying cash budget deficit proved a lot lower than expected - thanks mainly to an improvement in export commodity prices and higher company tax collections for other reasons. The improvement in export prices continued in bolster company tax collections in the financial year just ending, 2018-19, producing another big fall in the budget deficit. How can the budget be improving rapidly when economic growth has been weak? Because of the unexpected improvement in the terms of trade and thus mining company profits and tax payments.
Since this year’s budget rests on Treasury’s continued assumption that the economy is about to return to the strong growth of old, Mr Frydenberg is forecasting a return to a modest budget surplus of $7 billion (0.4 pc of GDP) in 2019-20, with the surplus continuing to grow in future years.
This forecast improvement in the budget balance means that, when expressed as a proportion of GDP, the federal government’s net debt is now expected to peak at 19 pc in June 2019, and then fall back to zero by June 2030. Again, it will be a great thing if it happens. It also means the budget balance is expect to continue improving despite the budget’s centrepiece, a doubling of last year’s plan for tax cuts in three stages (July 2018, July 2022 and July 2024) over seven years, with a cumulative cost to the budget of a remarkable $300 billion over 10 years. This is possible because of plan’s slow start.
Judged the RBA’s way, by its “fiscal impact” (the expected direction and size of the change in the overall budget balance), the “stance of fiscal policy” adopted in the budget is mildly contractionary. However, judged the Keynesian way (which focuses on the expected direction and size of the change in just the structural or discretionary component of the budget balance) the stance is mildly stimulatory, thanks to the doubled immediate first stage of the tax cuts.
