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Australia has been the strongest performer among developed economies post-Covid, with the broadest measure of economic performance, real GDP, about 7½% higher now than it was just before the outbreak of Covid way back in the December quarter of 2019. That’s about 2 percentage points (ppts) better than the US, 5½ ppts better than the euro area, 6 ppts better than Japan and a whopping 8 ppts better than the UK (which is yet to recover to its pre-Covid level of GDP). But Australia’s growth outlook is weakening. Just like the US, euro area, the UK and many other countries around the world (the main exceptions being China and Japan), Australia is facing the twin headwinds of ongoing elevated and sticky inflation rates and high interest rates, with potentially more rate hikes to come.
Higher inflation and interest rates are now eroding the purchasing power of Australian consumers and growth in real household disposable income, which peaked in FY2020/21 but has turned negative in FY2022/23. Fiscal policy is also shifting from a tailwind to a headwind, with the Federal Budget set to register a sizeable surplus for 2022/23 and a small deficit, or even be in balance, in 2023/24. This is following on from the massive stimulus packages of the Covid years 2019/20 and 2020/21, which saw the Budget deficit blow out to 6½% of GDP. Three questions about the outlook that economists are asked most frequently are: how quickly will inflation fade, how high will interest rates go, and will the economy fall into recession? Let’s start with inflation. Inflation peaked in the December quarter 2022 at 7.8%, but high inflation rates will persist for another year at least, particularly under the pressure of rising wage growth. Although the increase in goods prices is abating quickly, increases in the prices of services are rising as a strong labour market, rising wages and a post-Covid rebalancing of consumer spending in favour of services drive both demand and costs higher in the services sector.
It is precisely this nexus between strong demand for the labour-intensive services sector fuelling a tight labour market that pushes wage growth higher, with the potential for businesses to pass on wage costs to consumers in the form of higher prices (that is, a good old 1970’s style wage/price spiral) that is of most concern to the RBA. While services inflation remains on an upward trajectory, we can remain sure that the RBA will continue with rate hikes – most likely with a 25bp rate hike at their August meeting, with a potential follow-up at their September meeting. The twin headwinds of inflation and interest rates are pressuring household budgets and FY2023/24 will see another weak outcome for real household disposable income, which we are forecasting to experience no growth over the financial year despite the pickup in wage growth and ongoing employment growth. The ongoing weakness in disposable income over (particularly) the first half of FY2023/24 (second half of CY2023) calls into question the prospect of a consumer recession, and hence, a recession in the economy.
Our view is that, notwithstanding the weakness in household disposable income, consumer spending, whilst slowing, will avoid recession. There are three main reasons that we hold this view. First, there is the size of excess accumulated savings built by households over the Covid years of 2020 to 2022, which can be drawn on to support spending during a period of weak real income growth. Over the Covid years, Australian households managed to accumulate around $280 billion of excess savings, which are now being deployed to support spending as real disposable income growth declines. From its peak level in the September quarter of 2022, households wound back just $20 billion of these excess accumulated savings by the March quarter of 2023. Based on a continuation of that trend, households will still have $190 billion of accumulated savings at their disposal by the end of CY2024. Second, the resurgence in migration is leading to unprecedented growth in population and the labour force. Migration is adding to both the demand and the supply sides of the economy, further supporting consumer spending as well as adding to the productive capacity of the economy; hence, limiting the inflationary impact of the additional spending. Third, the Federal government’s Stage 3 tax cuts will provide further support to the household. While the tax cuts don’t come into force until the second half of CY2024, some spending will be brought forward into the first half of CY2024 in anticipation of tax relief. The total value of the Stage 3 tax cuts is large, equal to around 1.3% of disposable income over FY2024-25 and FY2025-26, rising to 2% of disposable income in FY2027-28.
So, what does the new financial year look like? Of the cons, we can expect inflation to remain stubbornly high and still above the RBA’s target band of 2% to 3% by this time next year. Consequently, we can expect the RBA to lift the cash rate from 4.1% to 4.6% before 2023 is over. Growth will slow and household disposable incomes will remain under pressure and spending will slow to substantially below trend rates. Employment growth will ease and the unemployment rate will lift gradually to just over 4% by this time next year. Of the pros, the ability of households to support spending from accumulated savings and the contribution to spending and production by migrants will help the economy avoid recession. This will keep the unemployment rate from rising sharply and will continue to allow a shift higher in wages, which can be absorbed by businesses without creating a wage price spiral or a severe collapse in profitability. FY2023/24 will be a year of transition from the Covid to the post-Covid world. While it is our conviction that the Australian economy can successfully navigate this coming year of transition, the shape of the post-Covid world remains uncertain. At least two key problems of adjustment will not be resolved over the coming financial year. The very high cost of housing and the rising cost of energy. Solutions (or lack thereof) to these twin problems will shape the Australian post-Covid economy.