Is the Australian economy on the brink of recession?

“An opinion piece written countering an argument that Australia is on a brink of a recession”

A recession is a period of temporary economic decline during which economic activity is suppressed, often identified by two consecutive quarters of negative Gross Domestic Product (GDP) growth.

(GROSS DOMESTIC PRODUCT, Volume measures: Seasonally adjusted (Australian Bureau of Statistics, 2018)

The Australian Bureau of Statistics data for the most recent periods of reporting show 6 consecutive quarters of GDP growth in Australia while remaining stable within the targeted growth range set by the Reserve Bank of Australia. A recession is quantified by negative GDP growth across two consecutive quarters. Hence the June quarter 2018 GDP announcement cannot become the start of a recession and the statement “The Australian economy is on the brink of a recession” cannot be considered correct.

There are many underlying fundamental variables throughout the economy affecting GDP that will shape the macroeconomic environment in the long term. The GDP figure is, in fact, a consequence of their effect on the macroeconomic environment. GDP is also a lagging indicator as it can only be calculated and reported post end of quarter creating a significant time-lag making the GDP figure a less accurate predictor of recessions.

John Maynard Keynes argued in 1936 in his publication ‘General Theory of Employment Interest and Money’, that aggregate demand should be the determinant for the level of economic activity. Hence a resulting loss in aggregate demand leads to the tipping point in the business cycle, where irrational behaviour will cause a market contraction/recession (Amadeo, 2018).

Based on Keynes’s theory, aggregate demand and the components that make up the GDP can be investigated as potential leading indicators.

Circular Flow Model:

The circular flow model explains the resource flows between households and firms and can be used to derive aggregate demand which is equivalent to the GDP figure at equilibrium.

Circular flow model

In this model, aggregate demand is generated when household income is converted to consumption of goods and services produced by firms. Governments will collect income tax from households and spend it on investments in infrastructure and public goods and services. Finally, the net overseas spending, which is the net value of imports to exports, contributes to the aggregate demand (Economics online, 2018).

The lack of consumer confidence leads to decreased consumption and increased savings. If consumers adopt this strategy, aggregate demand will collectively decrease causing a retraction in GDP.

A decrease in aggregate demand can cause a ripple effect leading to businesses employing less staff contributing to a higher unemployment rate. Manufacturers in return are also more likely to decrease the manufacturing volumes due to lower demand, eventually leading to a domino effect that cascades throughout the economy contributing to a start of a recession.

Hence the need for central banks to intervene and restore consumer confidence and attempt to increase aggregate demand.

The Reserve Bank of Australia (RBA) has adapted a monetary policy that targets inflation through the manipulation of interest rates with the objective to stabilise inflation in the 2–3% band. This, in turn, reduces the volatility of the GDP growth and results in lower chances of recessions.

The following macroeconomic indicators apply to different resource flows in the circular flow model and can be used to evaluate if “Australia is in the brink of a recession”.

GDP Trends:

The Australian GDP is among the highest in the world as published by the OECD. As the GDP figure is a broad quantitative measure of a country’s total economic activity, it can be said that Australia currently enjoys a high monetary value for goods and services that are produced within the nation’s borders.

Additionally, the real-GDP forecast by the OECD indicates that the Australian GDP is currently healthy and is expected to trend higher in 2018 to a growth rate of 2.93% followed by 2019 to a growth rate of 3.04 (tradingeconomics, 2018).

Since 2010 there have only been 2 separate quarters of negative GDP growth indicating consistent and steady growth in the size of the economy over time.

In the most recent quarter, the economy advanced 1 per cent above market consensus over the previous quarter reflecting the steady growth rate, attributing to a boost in export volumes (tradingeconomics, 2018).

National Australia Bank has forecasted an increase in mining activities alongside public and private sector investments indicating that business confidence is at its strongest levels as well (Oster, et al., 2018).

Overall the current GDP position among the OECD countries and the forecasted growth is a sign that household consumption and goods and services production by firms will see an increase.

Household Income:

Australian household disposable income is among the lowest in the OECD countries. (OECD.org, 2016). The increased cost of living plus weak growth in wages adds further risk to the economy combined with the low disposable income (CBA, 2018).

Household income growth is forecasted by the CBA to start rising based on their Tax Flow Indicator which measures tax payments flowing through CBA accounts (CBA, 2018). As the household income starts to increase as forecasted the pressure from high debt levels and cost of living will reduce and improve consumption leading to economic growth.

Household Savings:

According to OECD reports, Australian household savings showed a sharp increase in 2007 and continued past the global financial crisis until 2014

(OECD.org, 2016). Household consumption is expected to be more conservative in uncertain economic environments with most spending concentrated towards autonomous spending.

Household savings, which is considered a ‘leakage’ in the circular flow model, has declined since 2014 and the OECD forecast for Australia is for this to further decrease contributing to a positive outlook on economic growth and increased consumption.

However, CBA claims that there is no evidence of an increased flow towards consumer spending. They have explained this observation in terms of debt servicing costs where many interests only loans that were issued previously are now being switched to principal and interest-based loans as shown by CBA’s offset account balances (CBA, 2018).

Although the drop in savings may not be directly increasing household consumption, it is still contributing to the circular flow model where the savings flow towards finance and in return is injected back into the economy as investments.

Household Debt Levels:

Household debt levels in Australia is the fifth highest among the OECD countries (OECD.org, 2016) adding concern to the sustainability of household consumption levels.

However, the growth in the household debt levels are slowing down and converging towards income growth instead, potentially fuelled by the tight lending criteria of the banks (CBA, 2018). The convergence to income is a positive indication for the GDP growth from the cyclical flow model perspective.

House Pricing:

The major cities of Australia have seen a fall in house prices, sales and auction clearing rates. Residential property prices have fallen in the last two quarters, which has been the largest decline in property prices since 2011 (Australian Bureau of Statistics, 2018). NAB forecasts a decline in prices in 2018 and 2019 leading to an even weaker outlook.

A decrease in housing prices during a recession is often a sharp drop triggered by interest rate hikes and a rise in unemployment. However, the reduction in house prices is forecasted to be more gradual on this occasion, potentially attributed to ‘tight credit’ as the biggest constraint, with a “shift” of blame towards APRA and stringent requirements (Oster, 2018).

Consumer Confidence:

The recent political environment is somewhat unstable with ongoing leadership challenges that has been in occurrence to each new prime minister since 2007. The most recent leadership spill was followed by a 2.3% month on month decline in the consumer confidence as per Westpac bank. However, the general direction of consumer confidence index above shows a rising trend the last 12-month period (Trading economics, 2018), showing a positive outlook to the household consumption in the circular flow model.

Unemployment:

The unemployment rate in Australia currently sits at 5.4% which is a 6-year low. Australian unemployment rate is also among the lowest in the OECD countries.

NAB expects continued growth in employment, leading to further declines in the unemployment rate even though the growth in job numbers has slowed down.

A reduction in unemployment will collectively increase household income flow allowing for increased consumption outflow leading to economic growth in the cyclical flow model.

Retail Sales:

Retail sales of non-essential items are generally the earliest to decrease as household incomes fall under pressure in a recessionary environment.

Australian retail trade has risen by 0.4% in June for the sixth straight month, implying sustained improved consumer confidence and increased household consumption.

This rise in retail trade has reflected a rebound in sales for cafes, restaurants and takeaways (0.9 percent from -0.7 percent). Additionally, a further increase in retail sales was reflected in food retailing, household goods, clothing footwear and personal accessories, showing household spending on non-essential retail goods are on the rise.

Wages Growth:

Australia currently enjoys a position in the top ten wage earning countries among the OECD countries. The wage price index indicates that the rise in wages across all sectors was only 2.1%, which is equivalent to the Q2 inflation rate. Hence an inflation-adjusted wage increase of ‘zero’ (ABS, 2018).

Although the wage growth is currently stagnant there is some consensus to a potential wage increase above the inflation rates in the near horizon.

The wage price indicator of CBA forecasts wage growth in Q2, and the RBA business liaison also reports ‘more firms are expecting a pickup of wage growth’.

This expected wage growth would improve the household disposable income leading to higher spending outflows contributing to economic growth.

Capital Expenditure:

Capital investments by firms are an essential component of the cyclical model that ‘inject’ into the economy contributing to the growth in GDP. However, Investment expenditure in both mining and non-mining sectors have been decreasing in the previous years.

NAB forecast for the underlying business investment is a rise in 2018 followed by an acceleration 2019/20 due to the large pipeline of planned infrastructure investments.

The mining sector capital expenditure has also stopped decreasing, due to the growth of LNG exports leading to increased infrastructure spending in the sector (CBA, 2018).

Exports — Commodity Prices:

A higher than expected iron ore and coal prices, as well as a ramp-up in LNG production, are nudging commodity prices higher contributing to a rise in the terms of trade ultimately resulting in a trade surplus (de Garis, et al., 2018). These higher prices are contributing to an increased capital inflow into Australia, directly improving the economic outlook of the country as can be seen on the exports resource flow on the cyclical flow model.

PMI | Imports | Exports:

The manufacturing purchasing managers index (PMI) in Australia has averaged at 50.50 from 2001 to 2018. Throughout this time, it reached an all-time high of 63.10 in March of 2018 (Trading economics, 2018).

A PMI index value above 50 per cent indicates a positive development. Thus, the current PMI of more than 50 indicates expansion of the manufacturing sector (Guruprasad, 2017). This shows that the firms are anticipating increased household consumption and are preparing to deliver higher volumes of goods and services to meet the anticipated demand.

Infrastructure Investments:

Policymakers are emphasising the shrinking budget deficit to send positive outlook messages. Additionally, increased infrastructure spending is also a feature of the government fiscal policy further improving aggregate demand (NAB, 2018) in the cyclical model via government spending as an injection.

Australian Fiscal Policy:

The federal government has indicated the intentions to leave the tax take at 23.9% of GDP, along with forecasts of growth and budget surpluses. This indicates a series of tax cuts to follow in the future leading to an anticipated increased household disposable income. However, a tax cut could potentially become a leakage in the cyclical resource flow model if the increased disposable income from the tax cuts flows onto savings instead of being spent by households.

Based on the CBA’s Tax Flow Indicator (TFI) the tax payment flow is also on the rise correlating with increased income tax revenues received by the Government.

The current account balance is also shown to be on increase heading towards the zero (RBA, 2018).

Cumulative budget deficit to April was recorded at $12 Billion, the smallest since 2009 indicating a surplus achievement is a high probability in the 2018/2019.

Collectively the above effects of the fiscal policy will contribute to economic growth, improved sentiment and a higher propensity for consumption.

Annual Inflation, CPI and Interest Rates:

(IMF, 2018)

Australian inflation rates remain low and within the targeted band of 2–3%. The most recent inflation rate announced was at 2.1% which within the lower band of the targeted inflation range set by the RBA monetary policy (RBA, 2018).

The interest rates are also at an all-time low whilst the reserve bank cash rate remains at 1.5%. RBA has announced ‘patience’ and the forecast by the major banks are a rise in the cash rate to follow the increased Federal reserve rates in the USA. However, this increase is forecasted to commence in February 2019 (CBA, 2018) leaving the interest low for some while.

The interest rates remaining low alongside the inflation rate is perceived positively by households leading to increased spending and decreased savings levels contributing to economic growth.

Financial Markets:

The current cash rate set by the RBA of 1.5% is less than the US federal reserve rate of 2%. It is often expected that the Australian interest rates to be higher than the US rates to offer a higher yield for investors to invest in Australian government debt over the US government debt. However, it has now become the opposite implying that an investor is paid more to invest in US government debt than Australian government debt.

Although the above theory may limit the investment in government debt, the resulting low-interest rate encourages businesses to borrow and invest in expansion activities due to lower cost of capital. It is also favourable to exporters as the value of the Australian dollar should decrease improving net exports.

Global Outlook:

Globally the major central banks are moving towards a tighter monetary policy. The ECB has indicated that it will taper the Quantitative Easing program in Q4 indicating anticipated economic growth.

The tariff war initiated by the US president against China is also creating unrest among other nations due to concerns of a global trade war.

However much the concerns, the major advanced economies are anticipating stronger economic growth (Oster, 2018).

China is an important trading partner of Australia with a significantly large purchasing account. The recent Australian political leadership spill and accusations of interference by the Chinese government has placed this relationship under stress. However, policymakers are mending this relationship suggesting the likely continuance of this relationship for the benefit of economic growth in Australia.

Conclusion:

The monetary and fiscal policies of Australia are both well aligned to promote economic growth. Whilst the cash rate is at its lowest level the RBA has not indicated any intentions to raise the rate in the near term. The fiscal policy outlines government investments in infrastructure development and a series of tax cuts to maintain the tax take on GDP at a constant level and boost the household disposable income and increase employment figures.

Several widely used economic indicators such as the PMI, consumer confidence, retail sales, inflation, CPI and wage growth are all indicating economic growth.

The household income flow outlined by income, savings and debt levels also support economic growth in the longer term. In the shorter term, however, a weaker more stagnant outlook can be expected due to weaker wage growth and high debt levels due to inflated property prices.

With unemployment at its lowest levels and increased capital expenditure by firms contributing to investment, all resource flows of the cyclical flow model indicate a positive outlook with expectations of economic growth.

The financial markets favour Australia with its low-interest rates, and the global outlook is also positive with inflation under control. Economic growth is forecasted throughout Asia and Europe, while the European Central Bank tapers down the quantitative easing program. Combined effects of these will become positive for Australian economic growth.

As the evidence is biased towards positive economic growth, it is difficult to agree with the statement that “The Australian economy is on the brink of recession.”

In fact, the more accurate statement may be to conclude that “The Australian economy is NOT on the brink of recession.”

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