Sunday, May 1, 2022


 The pandemic isn’t over, but with most of our population vaccinated, we can hope that the worse of it is over and it won’t greatly disrupt the economy in future. Australia has had great success in containing the virus, and the “coronacession” has proved to be much shorter and shallower than expected. The economy has bounced back from each of the two periods of lockdown, the unemployment rate has fallen to its lowest in almost 50 years and strong growth of a bit over 4 pc is expected in calendar 2022. However, global supply-side shocks have lifted the inflation rate to 5.1 pc over the year to March, and it’s expected to go a bit higher before it starts falling back. To ensure the strong economy doesn’t cause the once-only supply-side price rises to get built into the wage-price spiral, the Reserve Bank has begun increasing the official cash rate to withdraw the “extraordinary monetary support” put in place to help the economy through the pandemic. The government is likely to come under pressure from macro-economists to tighten fiscal policy somewhat for the same reason.

Why the “coronacession” was shorter and shallower than expected

What I call the “coronacession”, which ended Australia’s record run of almost 30 years without a recession in the March quarter of 2020, proved to be much shorter and shallower that originally feared. The initial, nation-wide lockdown in the economy caused real GDP to contract by more than 7 pc in the March and June quarters of 2020. The unemployment rate peaked at 7.5 pc in July 2020, and the under-employment rate peaked at 11.4 pc in September 2020. But, to everyone’s surprise, GDP rebounded strongly in the following two quarters, to end 2020 just 1 pc below where it was in December 2019. Then followed a second lockdown in NSW, Victoria and ACT, which caused real GDP to contract by 1.9 pc in the September quarter of 2021, before bouncing back with growth of 3.4 pc in the December quarter after the lockdown ended. By coincidence, the net growth in real GDP over the two years to December 2021 was also 3.4 pc.

The latest figures for the labour market, for March 2022, show net growth in employment of more than 390,000 jobs in two years, almost all of which were full-time. The rate of unemployment had fallen to 4 pc and the rate of underemployment to 6.3 pc. The participation rate was at a record 66.4 pc, and the proportion of the working-age population with jobs at a record 53.8 pc. Remember, however, that this amazing performance was assisted by the temporary closing of our borders to “imported labour” during the worst of the pandemic. Immigration has now resumed.

Four main factors explain why the coronacession proved shorter and shallower than originally expected. First, the virus wasn’t as virulent as first feared by epidemiologists and our hospital system was stretched but not overwhelmed. We took advantage of our island status to close our borders, all states co-operated in limiting the spread of the virus, a vaccine became available and was distributed far sooner than originally expected, and we didn’t have a big problem with anti-vaxxers or people refusing to wear masks.

Second, the coronacession can’t be compared with an ordinary recession. Whereas ordinary recessions are caused by weak demand by households and firms, the corona recession was caused by a government-ordered temporary cut in supply, as federal and state governments sought to suppress the virus by closing our borders, ordering many industries to cease trading, and requiring people to leave their homes as little as possible. This meant that, when the lockdowns were lifted, people and businesses were able to resume (almost) normal activity. The JobKeeper wage subsidy program was designed to keep workers attached to their employers until the lockdown ended. The temporary JobSeeker supplement was intended to help anyone who did lose their job to keep spending. The two programs were highly effective.

Third, the rebound strategy was hugely effective in restoring employment to roughly where it was before the lockdown. However, the rate of unemployment has fallen by more than would normally happen in response to such a rise in employment. This is because the closing of our border to immigrants caused the size of the labour force to grow by about half the rate it normally does, thus making it easier for increased employment to lead to reduced unemployment.

Fourth, when you remember the massive amount of fiscal stimulus the federal government has applied – more than $300 billion, or about 15 pc of GDP - it shouldn’t be so surprising that the economy has grown so strongly. What this proves is that fiscal stimulus works.

Households have yet to spend much of the stimulus money and ordinary income they received over the past two years. Household saving as a proportion of household disposable income is an unusually high 13.6 pc, and households have an extra $240 billion in bank accounts. Because of this, and because so many people have jobs, the outlook for the economy at present is unusually strong. Real GDP is expected grow by a huge 4 pc or more in calendar 2022, but slow to a below-trend 2 pc in 2023 (because population growth won’t be back to normal). The unemployment rate is expected to fall further to 3.5 pc.

The return of inflation

Like all the advanced economies, Australia had enjoyed low inflation in the RBA’s target range of 2 to 3 pc on average since the mid-1990s. But over the past few quarters we’ve been hit by an unusual coincidence of global supply-side price shocks arising from disruptions caused by the pandemic, by Russia’s attack on Ukraine causing a big increase in oil and gas prices, and even by climate change, with restocking since the end of the severe drought causing a jump in beef and lamb prices. The “headline” inflation rate rose to 5.1 pc over the year to March, while the “underlying” rate rose to 3.7 pc. Both are expected to rise further, with the headline rate getting to about 6 pc before starting to fall back. As a consequence of this return to inflation well above the target range, and with the economy growing strongly, in early May – during the election campaign - the RBA began increasing the official interest rate.

The policy mix returns to normal

For many years, the “policy mix” was for monetary policy to be the primary policy instrument used to achieve “internal balance” – to smooth the path of aggregate demand as the economy moves through the ups and downs of the business cycle  – with fiscal policy playing a subsidiary supporting role. This worked well when the primary policy problem was seen as high inflation rather than high unemployment.

But when the economic disruption of the pandemic arrived, with its need to lockdown the economy, the policy mix reversed, with fiscal policy becoming the main instrument, and monetary policy playing the supporting role. Governments always resort to fiscal stimulus during recessions, but this was especially necessary in the response to the pandemic because the official interest rate was already down to 0.75 pc when it began, leaving little room to cut it further.

Now, however, with the econocrats’ need to ensure the surge in imported inflation doesn’t get built into the wage-price spiral, inflation has become the big worry and monetary policy has returned to primacy in the policy mix. In any case, this year’s budget papers say the government has transitioned to the second phase of its medium-term fiscal strategy which is to “focus on growing the economy in order to stabilise and reduce debt”.

Now let’s turn to the basic facts you need to know about the two arms of macroeconomic management and how they are now being used to continue the economy’s recover from the coronacession while returning inflation to the target range.

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. With the recovery from the coronacession now well under way, it has returned to being 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 seven successive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc at the end of 2011 to 0.75 pc at the end of 2019. It’s not hard to see why it kept the official interest rate low and getting lower for so long: the inflation rate had been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy had yet to accelerate and had plenty of unused production capacity, and the rate of unemployment showed little sign of falling below its estimated NAIRU of 5 pc, which the RBA revised down to 4.5 pc before the arrival of the pandemic.

Then the advent of the virus led the RBA to cut rates twice in one month, March 2020, lowering the rate to 0.25 pc. Despite its previously expressed reservations, it also joined the US Federal Reserve and other major central banks in engaging in quantitative easing, QE. It announced its intention to buy sufficient second-hand government bonds to ensure the “yield” (interest rate) on three-year bonds was about the same as the cash rate. And, to ensure the banks keep lending to small business during the recession, it announced it was prepared to lend to them at the same rate as the cash rate.

In November 2020, the RBA cut the cash rate even further to 0.1 pc, along with the target for three-year government bonds. It announced the further measure of spending $100 billion every six months buying second-hand government bonds with maturities of 5 to 10 years. Note that all the QE measures were intended to lower the interest rates paid by governments and private firms on longer-term borrowing. The RBA’s total purchases of second-hand bonds worth more than $350 billion are equivalent to it funding more than all the government’s fiscal stimulus by merely “printing money”.

In May 2022, following news that the inflation rate had jumped to 5.1 pc, the RBA announced its decision to raise the cash rate by 0.25 pc points to 0.35 pc to “begin withdrawing some of the extraordinary monetary support that was put in place to help the economy during the pandemic”. This would “start the process of normalising monetary conditions” and returning to “business as usual”. Ensuring that inflation returns to target over time “will require a further lift in interest rates over the period ahead”. If the goal were to return the real cash rate to “neutral” – that is, neither expansionary nor restrictive – at about 2.5 pc (the mid-point of the inflation target) by the end of 2023, the cash rate would have to be increased by 0.25 pc points every month or so. Note that this will involve the RBA taking its foot off the accelerator, so to speak, not jamming on the brakes. The RBA also announced that, having ended further QE bond purchases in February, it would now move to QT – quantitative tightening – by not “rolling over” (renewing) its bond holdings as they reach maturity.

Fiscal policy “framework”

Until the arrival of the pandemic, fiscal policy - the manipulation of government spending and taxation in the budget – had been conducted according to the Morrison government’s then medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”.

Since the coronacession, however, the government has adopted a two-phase strategy. Phase one, the economic recovery plan, involved huge fiscal stimulus to promote employment, growth and business and consumer confidence. It was to remain in place until the unemployment rate was “comfortably below 6 per cent”. Phase two now involves a “focus on growing the economy in order to stabilise and reduce debt”. “This underlines the commitment to budget . . . discipline and provides flexibility to respond to changing economic conditions,” the budget papers say.

Recent developments in fiscal policy

At the time of its election in 2013, the Coalition government expressed great concern about the high budget deficit and mounting public debt it inherited, resolving to quickly get on top of both. But it turned out to lack enthusiasm for either cutting government spending or increasing taxes. And the years of below-trend growth caused by secular stagnation meant the debt kept growing and the budget didn’t return to balance until 2018-19. Mr Frydenberg was expecting the budget to return to surplus in 2019-20, but this was overturned by the pandemic, which caused the budget’s automatic stabilisers to go into reverse and return the budget to a large deficit. The government’s massive fiscal stimulus has added further to the deficit and public debt.

The budget deficit reached a peak of $134 billion (6.5 pc of GDP) in 2020-21, and is expected to fall to $80 billion (3.5 pc) in 2021-22, $78 billion (3.4 pc) in the coming financial year, 2022-23, then have fallen to $43 billion (1.6 pc) in 2025-26. The budget is projected still to be in a deficit of 0.7 pc of GDP in 2032-33. The gross federal public debt is projected to reach a peak of 44.9 pc of GDP ($1.1 trillion) in June 2025, before beginning a slow decline as a proportion of national income.

With the election over, the government is likely to come under pressure from macro-economists to tighten fiscal policy somewhat and reduce the budget deficit, so as to hasten the decline in the public debt as a proportion of GDP, as well as to help monetary policy return inflation to the target range.