Economics | Australia Tom Kenny
Australia
Tom Kenny Exhibit 174. Australia: summary of Nomura forecasts
2004 2005 2006 2007F 2008F 2009F
National account (% y-y, real basis)
GDP 3.9 2.8 2.8 3.9 3.5 3.2
Private consumption 5.9 3.1 2.8 4.0 3.8 3.0 Public consumption 3.9 3.0 3.8 2.8 3.2 2.5 Gross fixed capital formation 8.0 7.9 5.0 8.4 6.6 5.0 Increase in inventory
(contribution to GDP growth rate) (0.2) 0.1 (0.6) 0.2 0.0 0.0 Net exports
(contribution to GDP growth rate) (2.1) (1.9) (1.3) (0.9) (1.3) (0.2) Exports (customs, US$, % y-y) 22.1 19.2 14.6 18.0 8.4 2.7 Imports (customs, US$, % y-y) 23.2 13.5 10.6 18.0 8.4 3.2 Trade balance (customs, US$bn) (17.4) (13.2) (11.0) (9.0) (8.0) (7.0) Current account (customs, US$bn) (40.3) (42.8) (40.6) (48.6) (52.3) (54.6) Current account (% GDP) (6.3) (6.0) (5.6) (5.4) (5.4) (5.5)
CPI (average) 2.3 2.7 3.5 2.3 3.3 2.7
Official cash rate (year-end) 5.25 5.50 6.25 6.75 7.25 6.50 A$1:US$ (year-end) 0.78 0.73 0.79 0.88 0.83 0.80 Source: Nomura Australia, ABS, IRESS, RBA
Economics | Australia Tom Kenny
Our view now versus three months ago
Inflation pressures in the Australian economy are more intense than we had envisaged three months ago. This seems largely owing to exogenous and supply factors, most notably increased fuel prices and higher food costs. As a result we have upped our forecast for the RBA’s cash rate, which we see peaking at 7.25% in 2Q08F. There is a significant risk the central bank could tighten monetary policy beyond this point.
Summary
Domestic activity has plenty of oomph, underpinned by solid household and business spending. The strength of demand continues to be more than a match for the
economy’s productive potential and so pricing pressures intensify further. Core inflation (3.5% y-y) is the highest it has been since the early 1990s, and well above the RBA’s 2-3% target band. The RBA has no room for flexibility and will probably continue to hike in reaction to strong inflation readings. The new Australian Labor Party
government has decided to join the fight against inflation and will be using both fiscal and microeconomic policy. Unfortunately, any impact the government may have won’t be felt for some time, leaving the burden on monetary policy in the interim.
Real economy developments and directions
The Australian economy sailed through 2007 with growth near 4% y-y, the fastest since 2002 and well above trend (3.25%). So far, financial market volatility has not troubled the real economy. Private spending was the main driver of growth and net exports continued to drag. One positive aspect of 2007 was the sharp recovery in the household savings rate to its highest in a decade. This was largely owing to the extraordinary growth in household disposable income (near 10% y-y).
Australia should enjoy solid growth again in 2008F — we expect GDP growth of around 3.5% y-y. The Australian economy and financial system, like those of many other countries, is vulnerable to the tightening in global credit conditions. The risk is two-pronged. First, the credit creation process is hampered, as lenders are unwilling to provide finance. Second, widening credit spreads are driving up borrowing costs, which could dampen spending and possibly cause financial stress. At this stage, neither looks to be having a major negative impact on the economy. In addition, Australia appears well placed to deal with weaker US growth as its prospects are more closely aligned with the still strongly growing economies of China and India.
Fiscal policy
On 24 November, the Australian electorate voted for the Australian Labor Party (ALP) to lead the country for the first time since March 1996. The new government has made tackling inflation one of its priorities. To this end, the Prime Minister, Kevin Rudd, announced a five-point plan for the government to reduce inflation pressures, some of which will be achieved via fiscal policy. Most notably, the government will aim to boost the Budget surplus via cost savings. In May 2008, the government intends to
announce a surplus for 2008-09F much larger than the one projected in November 2007 (A$14.4bn). In addition, the government wants to boost household savings and workforce participation via tax changes and incentives.
Unfortunately, there is little fiscal policy can do now that will alter Australia’s unpleasant inflation profile of the next year or two. That said, it is refreshing that the role of fiscal policy is being more closely analysed. For too long, the attitude to fiscal policy has been complacent, not surprising given there didn’t appear much wrong — Budget surpluses have been perennial and the government holds no debt. However, the good economic times Australia has been enjoying for so long can hide bad practices.
Inflation pressures: more intense than we envisaged
Household savings rate (2007) at its highest in a decade
Government will aim to boost the Budget surplus via cost savings
Economics | Australia Tom Kenny
Monetary policy and interest rates
Last year was one of surprises from the RBA, with the biggest being the myth-busting rate hike delivered during the election campaign — many thought it couldn’t be done owing to the political sensitivity of interest rates. Another was the central bank’s new arrangement for communications announced on 5 December. A statement will now be issued after each Board meeting (previously this was done only when policy was changed) and the Board minutes will also be released. We welcome this move and don’t concur with those that think this information has little value. Previously the gaps in RBA speak could be long, which is undesirable in times of turbulence like now.
In response to the ugly 4Q07 core CPI readings and string of robust activity (retail sales, building and employment) data, the RBA raised the cash rate by 25bps on 5 February. Heightened uncertainty surrounding global growth prospects and ongoing financial market turbulence were insufficient to persuade the RBA to err on the side of caution. On this score, the central bank is sanguine about the global outlook,
particularly for the Asian region where Australia’s fortunes are closely aligned.
The RBA said following its February rate increase that a “significant slowing” in domestic demand is required to reduce inflation. This suggests its work is not over yet.
The 1Q08 CPI data (released 23 April) will be the next critical data for the RBA. If core inflation prints strong (above 0.8% q-q), then a rate rise in May seems certain. In our opinion, this scenario is likely given that pricing and cost pressures remain intense.
The central bank may well hike past May if it continues its backward-looking approach (ie, placing significant weight on historical inflation data in its policy deliberations), as pricing pressures are set to be uncomfortably high for at least the next six months. In our opinion, such a strategy runs the risk of taking monetary tightening too far.
Forex policy and outlook
The Aussie almost hit a post-float (1983) peak in late 2007 against the greenback (US¢94.0 on 8 November) and a 20-year high versus the yen (¥107.9 on 1 November).
It was well bid in 2H07 amid: divergent monetary policy in Australia (tightening) and in the US (easing); tight commodity markets; and the ongoing weakness of the
greenback, which sunk to a post-float (1973) low against a basket of major currencies.
The currency was also volatile during 2H07 as sentiment toward risk, which became an important driver of currencies, swung sharply amid US sub-prime woes.
The forces shaping currencies’ fortunes in 2H07 will feature prominently again in 1H08F. We expect the Aussie to continue to get good support from positive fundamentals: the RBA holds a tightening bias while the official cash rate for most other industrial central banks will be steady or lower (eg, in the US); and ongoing solid emerging-market demand will keep commodity markets tight. More generally, the Aussie, like most other developed currencies, will be under upward pressure owing to ongoing greenback weakness as investors remain anxious about the depth and length of the US slowdown. In addition, the Aussie will be subject to bouts of volatility as lingering credit concerns keep markets on edge. In 2H08F, we expect credit worries to have eased and then in late 2008F for the markets’ attention to focus on Fed tightening.
This would likely see the Aussie weaken a tad, but also become less volatile.
Risks
We think inflation is the Australian economy’s greatest threat in 2008F. Demand-side inflation pressures may ease in 2008F, as higher interest rates and slower global growth dampen domestic spending. On the other hand, cost-push pressures may remain intense, particularly in the food and building industry. There is little doubt some of this will be passed onto consumers. This could be worrisome, as households spend more than 20% of their budget on food and housing. Any untoward increase in these basic costs of living could adversely affect inflation expectations and lead to higher wage claims. In our opinion, workers are in a strong position to demand more pay with the labour market so tight.
RBA raised the cash rate by 25bps on 5 February
We expect the Australian dollar to continue to get good support from positive fundamentals
Inflation: the greatest threat to Australia’s economy this year
Economics | Australia Tom Kenny