Troubling issues, but not for monetary policy

Reviewing the recent experience of the Australian economy last Tuesday the Reserve Bank board can only conclude it could hardly be better. Even three months ago there could have been some doubt as to the resilience of Australian and global growth, but there can be very little now. Export values picked up strongly in April and the increase was sustained in May, unemployment moved further down to a new 28 year low in June and the bulk of the record 370,000 jobs created since June of last year are full time, retail sales picked up in April after several flat months, the downswing in housing continues but housing construction approvals have now flattened out and lending for new home construction is once again increasing, and business investment remains at high levels and will be supported by major new projects in minerals, energy and infrastructure.

With low unemployment and a formidable trade deficit the RBA would not want to see domestic demand expanding too vigorously, and it won’t. The continuing decline in housing construction assures that, and so does the moderation in consumer spending. Domestic demand growth has slipped from 5.9% in the year to March 2004 to 3.4% in the year to March 2005. Export volumes increases will account for most of the additional output growth over this year and into next, which is exactly what is required to begin to narrow the trade deficit.

Yet despite low unemployment and accumulating evidence that overall output growth is slowly picking up from the 1.9% rate to the first quarter of this year, inflation remains moderate. Last week’s 0.5% gain in the second quarter consumer price index was lower than we expected, and lower than we had any right to expect given increases in petrol prices and in import prices more widely. At 2.5% for the year to June the headline measure was at the exact mid point of the target band. The RBA’s weighted and trimmed mean underlying measures were a bit higher and took the annual rate in both those series to 2.4% compared to 2.1% four quarters ago, but the rate of increase is sufficiently measured to suggest that headline inflation will increase only slowly as the petrol price stabilises.

We think rising import prices will over time push up the headline rate, which will anyway be kicked up this quarter as another low number drops out from the same quarter ago. Even so, inflation has been consistently less than we expected and we recognise the likelihood that some of the general increase in import prices will once again be absorbed into importers and retailers margins.

It’s an encouraging set of circumstances for the board to contemplate, and all the more so because by now the RBA is likely to be convinced that there is little danger of a sharp downturn in global growth. The US economy is expanding at an annual rate a little over 3.5%, and doing so persistently quarter after quarter. We would all feel more comfortable if US house price growth and new housing construction slowed, but the US is also seeing useful export growth and strong business investment.

A year ago we were concerned by the risk of a dramatic slowdown in China. Through to the June quarter China has slowed only imperceptibly, however, and while the pace can and should marginally slow there is no compelling reason to expect a big downward shift in growth over the remainder of this year and into next. Japan has picked up after the downturn in the second half of last year, and while we don’t expect much we do expect persistent output growth over 1% this year and next. We are still concerned about Europe, but even France and Germany have shown signs of life in recent data.

The numbers suggest there is wisdom in RBA Governor Ian Macfarlane’s observation, expressed in mid June, that the global economy is in the early stages of an expansion. These are most certainly not circumstances that call for a cut in the 5.5% Australian cash rate, but they don’t at this point call for an increase either. The RBA board will certainly endorse the RBA official’s recommendation to leave cash unchanged. That decision is easy. It will be tougher for the RBA staff to draft next Monday’s Statement on Monetary Policy.

The aim is to express a reasonable degree of satisfaction with current circumstances without sounding complacent or wanting in bankerly vigilance. Part of the problem for the RBA is that the Australian economy is posed with at least two very serious challenges, neither of which is within the reach of monetary policy.

The secret of Australia’s record breaking fourteen years of uninterrupted growth has been persistently high labour productivity growth. But over the last year and to the most marked extent in nearly twenty years, labour productivity growth has fallen. It is highly likely only the simple arithmetic outcome of temporarily slow GDP growth and temporarily fast employment growth. As GDP growth picks up and employment growth slows from what is clearly an unsustainable pace, labour productivity will once again increase. Until it does however Australian business will be caught between the pressures of highly competitive markets, and rising labour costs per unit of output. Sufficiently prolonged it will see either falling profits or rising inflation or more likely both.
There is nothing more certain to terminate Australia’s long run of success than stagnation in labour productivity, particularly at a time when labour force growth must inevitably sharply slow from the 3% annual rate of recent quarters. (The promised changes to the industrial relations system are unlikely to help productivity growth and on the contrary are likely to slow it. The central idea is to lower real minium wages, which might well increase employment but only by hiring additional employees whose marginal productivity does not warrant employment at current wages. The certain result is lower average productivity, which is what happened when New Zealand made similar changes over a decade ago.)

The other big problem for Australia is the persistently large current account deficit, which has seen net foreign liabilities increase from 55% to 65% of GDP since the middle of the last decade. Sooner or later the growth of foreign liabilities compared to GDP will have to be arrested, and it will only happen when Australia is able to run a small but persistent trade surplus. That will require many changes, one of which will be a major depreciation of the currency. The RBA would probably welcome a sharp depreciation of the Australian dollar, which would help redirect output into exports and allow the central bank to gently raise the cash rate to help the transition along.

The market does not seem to have the least intention of delivering a big depreciation of the currency, however, and there is no way the RBA can bring it about other than by a sharp cut in the cash rate. Given the strength of the economy Mr Macfarlane cannot take the Australian cash rate down towards those of the major economy central banks. If the Australian dollar is to come under serious pressure, he will have to wait until they move up closer to his rate.