Tag Archives: inflation

It (still) all comes back to productivity

Amidst all the discussions of this week’s interest rate rise and the outlook for inflation, wages and growth, one crucial factor has been largely overlooked: productivity.

It’s an ugly word and can be very tricky to measure.

But it is likely to play a crucial role in how high interest rates go and how well-off we all become.

Productivity is basically a measure of how much is produced for a given level of input (labour, capital and other resources).

When he was Treasury secretary, Ken Henry regularly referred to productivity as one of the three Ps crucial to growth (the others being population and participation).

Productivity is especially important in a high-inflation environment like we have right now. The more that can be produced using a given amount of labour and capital, the cheaper it is to produce.

If there is sufficient competition, this will tend to put downward pressure on prices.

The big problem is that for the 25 years productivity growth in Australia has been mostly weak.

Analysis by the Australian Bureau of Statistics shows that in that time both labour productivity and so-called multifactor productivity (that is, productivity including labour, capital and everything else) has mostly been below 2 per cent.

The last time it reached above that was in 2014-15.

This brings us to the Reserve Bank of Australia’s latest assessment of the economic outlook, which came out on May 6.

In it, the central bank lays out its central case for how it thinks things will turn out.

Broadly, it expects inflation to rise to 6 per cent by the end of the year and only gradually ease back to 3 per cent by mid-2024.

It thinks unemployment will remain low (3.5 per cent), forcing wages and other inducements like bonuses and overtime payments to accelerate to around 5 per cent by mid-2024.

This will support household consumption and growth.

This is what the RBA thinks is the most likely scenario.

But the central bank’s quarterly outlook always includes a section that looks at all the things that could go wrong.

Right now, it is quite a long list – another serious COVID-19 outbreak, ongoing disruptions to global supply chains and tumbling house prices, to name but a few.

But one of the crucial unknowns is productivity.

If it improves significantly, inflation could ease more quickly and real incomes (adjusted for inflation) could grow, boosting prosperity.

There is some cause for optimism here.

Business confidence has increased in recent months and firms are ratcheting up their investment plans. Capital investment has been the most important driver of productivity growth in the most recent cycle, according to the ABS, so the increased willingness of businesses to buy new equipment and technology could deliver an important productivity boost.

But there is ample scope for things to go wrong, as the RBA has acknowledged.

“It is possible that some of the recent changes in spending and production patterns are long-lasting and that these constrain the efficient allocation of resources and, in turn, productivity,” it said.

If that turns out to be the case, then “any given rate of growth could be more inflationary than before the pandemic”.

And if wages increase in the absence of an improvement in productivity, the consequent boost to household spending will likely result in “inflation being sustained at a higher rate than currently anticipated”.

That would inevitably mean that interest rates have to go higher for longer.

So boosting productivity will be key if the nation is to avoid high interest rates and cost-of-living pain.

There are plenty of things that governments can do to help achieve this, like ensuring a welcoming environment for investment (local and international), encouraging greater workforce participation through measures like improving access to affordable child care and investing in education.

For the past decade, progress on any of these has been woeful, and in several cases has gone backwards.

Whoever wins the election needs to make enhancing productivity a top priority.

Our future prosperity depends on it.

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Interest rates Australia: the outlook for 2019

This post was first published in In The Black on 8 March 2019 at https://www.intheblack.com/articles/2019/03/08/interest-rates-australia-outlook-2019

When the Reserve Bank of Australia (RBA) last changed interest rates Malcolm Turnbull was still prime minister, Donald Trump had yet to seize the White House, the UK had just voted for Brexit and house prices were booming.

During all the subsequent turbulence locally and abroad, the RBA cash rate has been a rare constant. In two and a half years it has not budged from a record-low 1.5 per cent.

However, markets and economists increasingly believe this period of policy stability is coming to an end, though views diverge sharply on whether the next move will be down or up.

The Reserve Bank recently indicated that it has shifted from a bias towards increasing interest rates to a more neutral stance. Governor Philip Lowe said in a recent speech that “over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be more evenly balanced.”

Unemployment falling

CommSec senior economist Ryan Felsman.

Some, such as CommSec senior economist Ryan Felsman (left) and ANZ’s co-head of Australian economics, Cherelle Murphy, think the time is coming when the RBA will be able to raise interest rates.

Despite weakening house prices, the employment rate was steady at 5.1 per cent in January, supported by strong participation in the labour force, according to the Australian Bureau of Statistics. The trend ratio of employment to population rose to a 10-year high of 62.4 per cent.

Felsman says the central bank will look past the continued slide in house prices and unexpectedly soft growth in the September quarter to developments in employment.

“The labour market is the key indicator going forward as far as interest rates are concerned,” he says.

Demand for workers has been building – about 284,000 jobs were created in 2018 and the unemployment rate has dipped to 5 per cent – and Felsman expects this pressure to gradually force wages higher and enable households to increase their spending.

Eventually, he expects wages growth to reach 3.5 per cent, which would be consistent with an inflation rate of about 2.5 per cent – the mid-point of the Reserve Bank’s 2 to 3 per cent target band – “which the RBA has previously identified as a level they would like to get to before they lift interest rates”.

Interest rates to rise in November?

ANZ’s co-head of Australian economics, Cherelle Murphy.

 

Felsman thinks this point will most likely be reached in November, convincing the central bank to lift the cash rate to 1.75 per cent.

Murphy (right) shares Felsman’s upbeat outlook for the economy but foresees a more gradual improvement.

She does not expect the RBA to lift the cash rate until August next year, followed by another increase in November 2020 to take the cash rate to 2 per cent.

Murphy says national income is holding up. Businesses are being buoyed by good profits, encouraging them to invest and hire, and feeding more company taxes into government coffers.

Just as important, tighter credit conditions are working to cool the once-rampant property market without triggering widespread mortgage defaults.

While homeowners may see a peak-to-trough fall of 20 per cent in house values before the market stabilises, Murphy says the fact that mortgage rates are stable means few are being forced to sell.

“This helps explain why consumer confidence has not fallen in a hole, and instead has stayed at pretty high levels,” she says, along with the strong jobs growth.

Given the importance of private consumption for economic activity (accounting for almost 60 per cent of GDP), this is an important plus for growth.

Further interest rate cuts

AMP Capital Markets chief economist Shane Oliver.

 

AMP Capital Markets chief economist Shane Oliver (left) and Market Economics principal Stephen Koukoulas are much gloomier about the economic outlook and believe tepid growth, elevated global risks and inflation that is stubbornly below target will leave the Reserve Bank board with no choice but to cut official interest rates in 2019. Oliver tips the rate to drop to 1 per cent by the end of this year; Koukoulas reckons it will hit a record low 0.75 per cent.

Both forecasts are more aggressive than financial market estimates which, which nonetheless have fully priced in a rate cut to 1.25 per cent by the end of the year.

Concerns about growth, falling house prices, stagnant wages and soft household spending have been underlined by the release of figures showing underlying inflation has been below the RBA’s 2 to 3 per cent target range for most of the past four years.

China’s slowing economy

Internationally, China – Australia’s largest export market – has slowed. In the 12 months to the December quarter it expanded by 6.4 per cent, its weakest pace in almost three decades as consumers eased the pedal on major purchases such as cars. The unresolved US-China trade war has deepened concerns about Chinese growth.

Against this, the Chinese Government has pledged to support the economy and is expected to unveil tax cuts and relax bank cash reserve requirements.

Nonetheless, the International Monetary Fund (IMF) expects the US economy to soften in the next two years as the effects of the Trump tax cuts fade, recent Federal Reserve rate hikes bear down on activity and the trade war with China rumbles on.

These developments are buffeting other economies. In Europe, the IMF expects Germany to be hit particularly hard. The euro zone’s largest economy is heavily reliant on exports to the US and China, and the Fund has sharply downgraded its growth prospects, forecasting it will expand by just 1.7 per cent this year.

Slowing European growth

Add to this mix the Brexit fiasco, and the IMF thinks the euro area as whole will struggle to grow by just 1.9 per cent in 2019 – and that is assuming Britain and the EU reach agreement on an orderly exit.

While these issues have been on the Reserve Bank board’s radar for some time, Oliver says the way they have evolved in the last few weeks will have it worried.

“I think they would be feeling more nervous about things than they were in December when they last met,” he says. “We have seen another round of volatility in markets, and a lot of the issues around that haven’t been resolved. Locally, the housing downturn has worsened, [and there are] more concerns about tight credit conditions.”

Despite this, Oliver does not expect the central bank to be in a rush to cut the cash rate and will instead want to see spending measures in the April Federal Budget and the promises made by both the major parties in the lead-up to the federal election before moving.

Amidst such uncertainty, the RBA and its counterparts around the world appear poised to act meeting to meeting, examining data in forensic detail for the faintest hints of how key aspects of the economy are faring.

As Felsman says, “Every policy meeting is now live.”

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Why what happens in Washington matters in Canberra

Among the economic indicators Treasurer Scott Morrison needs to keep an eye on, the US labour market should be toward to the top of the list.

As the US Federal Reserve begins to gradually edge up its funds rate, Chair Janet Yellen has indicated the tightness of America’s market for workers will be an important factor in shaping the central bank’s thinking on how quickly to proceed with tightening monetary policy.

The state of the US labour market matters because as it gets tighter, so the bargaining power of workers is likely to increase and wages rise, helping force inflation up.

The higher inflation goes, the more the Federal Reserve will feel compelled to raise interest rates.

This matters for Australia because the higher official US interest rates rise, the greater the downward pressure on the Australian dollar (though this relationship should not be overstated).

As the Australian economy tries to establish sources of growth outside the boom-and-bust resources sector, a lower dollar helps by making exports and locally-made goods and services more competitive.

In the past year, the $A-$US exchange rate has slipped down more than 10 cents to 71.2 cents, a far cry from the above-parity levels reached earlier this decade, when massive mining investment was sucking in huge amounts of capital.

Given that the US unemployment rate has already dipped to 5 per cent, it might come as a surprise that the Federal Reserve has only just begun to increase interest rates.

But behind the headline number, data shows that many of the jobs created in the last few years have been casual or part-time. This suggests that there is considerably more slack in the labour market than a 5 per cent unemployment rate would ordinarily imply.

Recent soft income growth underlines the point. In the year to September, US wages grew by 3.66 per cent, virtually half the long-term average of 6.33 per cent.

This is being reflected in consumer spending – US retail sales grew by a modest 1.7 per cent in the year to November.

The Federal Reserve held off embarking on a tightening cycle until it was confident that the US recovery from the global financial crisis was well-established, so its decision earlier this week to raise interest rates, even by a meagre amount, is seen as a vote of confidence in the world’s largest economy.

As he contemplates the sea of red in the Commonwealth’s financial accounts, Scott Morrison can only hope that this is the case.

Despite his bizarre denialism on the matter, the Federal Government does indeed have a revenue problem. Collapsing commodity prices and soft income and corporate tax collections account for a lot of the deterioration in the Budget position.

And the government’s own forecasts suggest there is not going to be a quick turnaround. Earlier predictions that the economy would expand by 2.75 per cent this year have now been pared back to 2.5 per cent, and next year it is expected to grow by 2.75 per cent rather than 3.25 per cent.

Estimates of business investment, household spending, the terms of trade and private final demand have all been downgraded.

As Reserve Bank of Australia Governor Glenn Stevens observed last month, a rebalancing in the sources of growth is underway, but it is a little rockier than might have been hoped for.

With the economy poised between the drag caused by tumbling resources investment and support coming from a nascent recovery in non-mining activity – particularly services – now would seem a bad time to be adding to the weight on activity by cutting into government spending.

To his credit, Morrison has so far eschewed the sort of bloodletting Joe Hockey pursued in his first Budget.

But the cuts he has outlined – crackdowns on welfare ‘rorts’ and the axing and reduction of bulk billing incentives for pathology and diagnostic imaging services, in particular – make little economic sense.

Both sets of measures, collectively worth more than $2 billion, will mean consumers have less money to spend.

As the country’s experience through the GFC has shown, this is significant. Arguably the most effective measure taken by the Federal Government when the GFC hit in late 2008 was to deposit money directly into the bank accounts of millions.

While much of this money was saved, enough was spent to keep shop tills ticking over, shielding thousands of retail and services sector jobs.

This was especially the case among lower-income households, where a higher proportion of income has to be spent rather than saved.

The bulk of Morrison’s cuts will fall on just such households.

At a time when retailers and service providers are trying to find their feet after several years of lacklustre conditions, this is hardly helpful.

Such unhelpful tinkering by governments all too common.

Economists often lament that government interference prevents an economy’s ‘automatic stabilisers’ (floating currency, swings in tax collections and welfare payments) from working effectively, making a difficult situation far worse.

But it is totally unrealistic to expect governments in such situations to do nothing – after all, they have usually been elected on a platform to ‘do something’.

As Ross Gittens suggests, they could do much worse than to devote their energies into devising a path to surplus that kicks in once a recovery is established, and to work out how to better handle future prosperity.

 

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RBA locks in 2.5 per cent cash rate – for now

Don’t expect interest rates to go up any time soon but, equally, don’t expect them to go down – that was the clear message from the Reserve Bank today.
In unusually direct language, RBA Governor Glenn Stevens has moved to lay to rest interest rate speculation for the next few months, saying the most prudent course for the central bank to take was likely to be “a period of stability in interest rates”.
That is central bank speak for everyone – those predicting imminent rate rises, and those calling for rate cuts – to take a Bex and calm down.
As mortgage holders ponder the pros and cons of fixing part of their loan, and investors do their credit sums, the Reserve Bank has tried to give some reassurance by flagging official rates are not likely to move for some time yet.
As widely tipped, the RBA has decided to hold the official cash rate at 2.5 per cent this month.
What many may not have anticipated though, was the central bank’s unusual willingness to flag its interest rate intentions.
Following the Reserve Bank Board’s first meeting for 2014, Mr Stevens released a statement that showed the RBA is in no rush to change its policy settings.
“On present indications, the most prudent course is likely to be a period of stability in interest rates,” he said.
The Reserve Bank sees no compelling reasons yet for either a rate increase, or a rate cut.
Unexpectedly strong inflation growth in the December quarter (underlying inflation grew by 0.9 per cent to be up 2.6 per cent from a year earlier), along with the falling exchange rate and increased housing activity, had prompted some to speculate that the RBA would soon have to consider raising the c ash rate.
But while Governor Stevens admitted monetary policy was “accommodative”, interest rates were “very low”, and house prices have surged, there was as no yet sign of a dangerous build up in indebtedness. In fact, household credit growth is moderate.
On inflation, the central bank so far does not seem to be phased by the jump in prices in December, some of which it attributed to importers and retailers quickly passing through to consumers much of the increase in costs caused by the easing exchange rate.
Mr Stevens said that although inflation was stronger than the central bank had predicted when it released its most recent Statement on Monetary Policy late last year, it was “still consistent with the 2 to 3 per cent target over the next two years”.
Those arguing the case for a rate cut have pointed to the nation’s anaemic growth rate (2.3 per cent in the 12 months to the September quarter 2013), a plunge in mining investment and weak labour market (the economy shed almost 32,000 full-time jobs in December and the unemployment rate is expected to rise above its current 5.8 per cent) to show the need for more support for activity.
But to this line of argument, Mr Stevens said monetary policy was “appropriately configured” to foster growth in demand (ie don’t expect them to go any lower).
Of course, the RBA might be considering the possibility (raised by Deloitte Access Economics director Chris Richardson) that commercial banks will lower their lending rates as they secure cheaper sources of funding on international markets. The Governor’s statement gives no hint on this front, except to say that long-term interest rates and risk spreads remain low, and there is adequate funding available through credit and equity markets.
As the economy gropes toward sources of growth to replace the sugar hit from resources investment, conditions are likely to stay rocky and uncertain.
In this shifting economic environment the RBA has moved to provide consumers and investors with one welcome point of consistency, at least for the next few months.

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