The Lazarus Economy

The national accounts show that GDP grew 1.3% in the June quarter after rising 0.5% in the March quarter to be 2.6% above the level of a year ago. In the first half of 2005, the anualized GDP growth rate was compared with 1.6% in the second half of 2004 and 2.0% in the first half of 2004.

In the June quarter, the key contributors to growth were business investment, household and government consumption and dwelling investment. Net exports subtracted 0.2 percentage points from GDP growth, while inventories skimmed 0.1 percentage points off the GDP result.

What a rebound! The economy has powered back to life to shock the pants off markets that until yesterday were primed for two interest rate cuts by the middle of 2006. This clearly isn’t likely with the economy recovering and inflation pressures building. Indeed, a cold hard look at the economic data and performance of the corporate world suggests that the case for an interest rate increase is strong. If the data over the next month or two confirms further labour market tightness (August labour force data are released tomorrow), ongoing wage pressures, higher inflation and robustness in the global economy, the RBA will be compelled to hike interest rates. We feel the risk of a rate hike before year end has increased over the past few weeks to a point where it is now more likely than not.

To the national accounts. There is no doubt that the economy has picked up considerable momentum after sliding into the doldrums in 2004. The mix in growth is now quite impressive – we have booming business investment, surging corporate profits, rapid growth in household incomes and a rebound in dwelling investment. And all this is occurring while net exports are yet to make a positive contribution to growth and the inventory cycle has tended to be a damper. Add to that the government sector spending at a rapid clip and the growth rebound can be explained.

Key Points:

• Household savings remained negative for the 12^th straight quarter.
• The inventory to sales ratio remains at record lows, suggesting now unwelcome inventory accumulation.
• Nominal GDP rose 7.3% in the year to the June quarter which for those who follow the Taylor Rule suggests the 5.5% cash rate is very low.
• Revisions have cancelled each other out – down in March quarter, up in September quarter.
• The 1.3% growth rate in the June quarter is the strongest since late 2003.

Looking forward, once the net export contribution turns positive, which it almost certainly will from here on in, GDP growth will be accelerating towards 4%. It could hit this growth rate by the first half of 2006. With the economy operating at full capacity, policy needs to be tightened. With the government easing fiscal policy, some heavy lifting from the RBA is now required to ensure the economy does not overheat and inflation pressures build to blow the inflation target out of the water.

That heavy lifting can be in the form of an interest rate rise. If the RBA is of the view that the sustainability of economic growth appears well entrenched including with absurdly optimistic consumers, the stock market at all time highs, exporters rolling in cash and business investment growing rapidly, it may move to increase rates before year end.

I would recommend selling the short end of the yield curve on the expectation that an easing is priced out and a tightening is priced in. [3 year bonds are currently 5.05%]. It is a scenario where the A$ is also likely to gain ground, especially if the RBA does in fact hike rates to 5.75%.

Stephen Koukoulas is chief economist of TD Securities and a former economic journalist with the Australian Financial Review.