Looking beyond the horizon
The macro outlook is unchanged from our view of recent months. Two years of slow growth could result in economic slack, with inflation ultimately undershooting the RBA’s target. What forces could emerge to offset this?
This week we released fresh forecasts in our Market Outlook publication. The national accounts came in broadly as we expected, and the narrative is unchanged. We continue to expect slow growth in the first half of 2024, with some improvement in the second half of the year. The tax cuts coming from July will help reverse the squeeze on household incomes. Lower inflation will also help restore households’ purchasing power.
The impending tax cuts can be seen as largely restorative and a necessary rebalancing. The share of household income going to income tax payments was exceptionally high in the second half of 2023. Without the give-back inherent in these tax cuts, that tax take would continue to increase and the drag on growth in household disposable income would continue.
Likewise, the cuts in interest rates that we expect later in the year could be regarded as restorative. Monetary policy is currently restrictive. If a restrictive stance of policy is maintained for long enough, inflation continues to decline and ultimately exits the target range on the low side. Some normalisation of policy will therefore need to happen at some point.
Even with these pivots in policy, if our forecasts or something like them turn out to be true, Australia will have had two consecutive years of output growth around 1½% – the 1.5% result over 2023 and (we expect) 1.6% over 2024. This is well below trend. It is also well below the population growth recorded over 2023 and still a little below our expectations for population growth in 2024. Unemployment will be rising, wages growth slowing, and the economic experience of households more broadly will still be uncomfortable.
According to Westpac Economics’ forecasts, Australia will end this year with the unemployment rate at 4½%. As the RBA has emphasised recently, there is more to achieving full employment than just the unemployment rate. The sustainable rate of labour market slack – including unemployment – that keeps growth in labour costs stable and consistent with inflation at target, is not directly observable. But as best as anyone can tell, a 4½% unemployment rate is likely to be a little above this sustainable level. Some evidence for this assessment can be seen in the tipping over in growth in the leading edge of wage determination, individual agreements, already evident with an unemployment rate around 4%. If this assessment is correct, at least some parts of the domestic economy will be exerting downward pressure on inflation over the period ahead, and especially from 2025.
Looking beyond 2025, then, there is a risk that – without at least a period of above-trend growth and falling unemployment – domestic inflation continues to fall. The gap between actual unemployment (implied in our forecasts) and the full-employment level of labour market slack will be small, however, and hard to detect in the data. If it is indeed a gap, though, there will be a tendency for inflation to undershoot the RBA’s target beyond 2025.
When we look beyond 2025, the question therefore arises: what forces would bring about a period of above-trend growth to eliminate emerging economic slack and allow inflation to stabilise?
One obvious possibility would be that the RBA ends up reducing the cash rate to a level that is mildly stimulatory, rather than converging to a more neutral stance as is often assumed. This might not be a conscious strategy. Rather, the RBA might end up there simply because neither they nor anyone else knows exactly where the ‘neutral’ cash rate is. In feeling their way to neutral in the face of fiscal headwinds and labour market slack, they might end up a little below where neutral actually is.
In this context, one can interpret the Westpac Economics forecast for the cash rate at the end of 2025 of 3.1% as either neutral, with a neutral real rate a bit below 1%, or slightly below neutral with a higher neutral real rate. Given the uncertainties around both the outlook and the level of the neutral rate in any one period, we are agnostic about which interpretation turns out to be the right one. It might be that one will never be able to tell the difference.
Another alternative way for a period of above-trend growth to occur is that business investment might pick up. Our forecasts for business investment growth over 2024 and 2025 are running ahead of GDP growth for the same periods, but not enough to drive a period of above-trend output growth overall.
One scenario that would spur a further pick-up in this space would be a concerted response to the climate challenge, perhaps starting in 2026. The considerable required investment in renewable energy generation and transmission would be a large part of this. Other areas that could be involved would be the electrification of the commercial vehicle fleet and rail network, and development of biofuel alternatives for the legacy stock of internal combustion engine vehicles. The energy efficiency of buildings and building materials are another aspect of the transition, especially considering the elevated rate of non-residential building and infrastructure work underway.
The rest of the world will also be highly engaged in energy transition and climate mitigation. It is therefore possible that global investment is elevated in the period ahead, relative to the years between the Global Financial Crisis and the pandemic. This has implications for the likely structure of interest rates globally in coming years. Recall that the so-called ‘neutral’ risk-free interest rate is simply the rate that balances global saving and global investment. It is an outcome of the system, not something imposed as an external force. If desired global investment picks up relative to the pre-pandemic period, for climate or other reasons, that would tend to lift the rate that produces that equilibrium.
The deeper question is whether bond markets, and fiscal authorities, have planned for that possibility.
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