RBA) Malcolm Edey - Economic and Political Overview 2008



(RBA) Malcolm Edey - Economic and Political Overview 2008
Talk to CEDA Economic and Political Overview 2008
Malcolm EdeyAssistant Governor (Economic)
Committee for Economic Development of Australia (CEDA)Economic and Political Overview 2008Sydney - 19 February 2008
Thanks to CEDA for the invitation to speak here today.
Since the last time I spoke at this event, the RBA has taken a number of steps to increase the amount of information it makes available to the public, both about its policy processes, and its thinking about the economy. We now issue a monthly statement after each Board meeting, setting out the reasons for the latest decision, whether or not the interest rate is being changed. Minutes of the Board meetings are now also published, and they give additional detail on the matters that were considered and the reasoning behind the decision. And those of you who follow these things closely would know that we've increased the level of detail in the economic forecasts set out in our quarterly Statement on Monetary Policy.
So there's a lot of material out there for financial markets and Reserve Bank watchers to get their teeth into. Today I won't be trying to add anything new to that, but rather, I'll base my presentation on our latest Statement, which was released last week.
The challenge in assessing the economic outlook at the moment is to weigh up the effects of contrasting domestic and international forces. Over the past few months the run of new information coming from abroad, at least in the major industrial economies, has been mostly bad. One important aspect of that is the deterioration in global equity markets, and the ongoing strains in credit markets. I'm not going to focus on those things today, but instead I'll focus on the evolving economic data.
Naturally, a lot of attention has focused on the United States (Graph 1). The fourth quarter national accounts confirmed a sharp slowdown in the US, and most expectations now are for a period of further weakness in the first half of this year. Some observers are saying the US is about to enter a recession, or is already in one.
Graph 1
What's driving the weakness most significantly is the downturn in the housing market. Housing starts are down by more than 50 per cent from their peak two years ago (Graph 2). Even though housing is typically only about 5 per cent of the economy, falls of this magnitude are a significant drag on growth. It's interesting to note that expenditure on US GDP excluding housing construction was still growing at a rate of 3½ per cent through the latest year (Graph 3). The problem is that a divergence of this size between the housing sector and the rest of the economy can't persist indefinitely, because the housing slowdown feeds back into employment, incomes and other forms of spending. Adding to the contractionary impact is a downturn in established house prices which, according to one major index are down about 9 per cent from their peak, and still falling (Graph 4). These forces, and the ongoing fall-out from the sub-prime crisis, could continue to dampen the US economy for a while yet.
Graph 2
Graph 3
Graph 4
On the other hand, it's important to note that there are some forces supporting growth. The US export sector is getting the benefit of a lower dollar; there's a significant fiscal package in the pipeline, which will add more than 1 per cent of GDP to private spending power; and sharp cuts have been made in US official interest rates, with financial markets expecting more to come. So the overall course of the US economy will depend on the net impact of all these forces. Opinions still differ as to how severe the US slowdown will be.
In varying degrees, the other major industrial economies are also experiencing a period of weakness. The important question is to what extent the weakness in the major industrial countries will affect China and the developing world. Up to now, the available indicators show the Chinese economy still growing strongly, at 11 per cent over the year to the December quarter (Graph 5). Chinese export growth did slow towards the end of last year, but only from around 30 to around 25 per cent, and, in any case, the bulk of China's growth is being driven by domestic demand. I note in passing that, on the latest data we have, the Indian economy is also growing well, though we don't yet have fourth quarter figures. And of course, both these strongly growing economies are now a bigger share of world and trading partner GDP than they were in previous business cycles.
Graph 5
Elsewhere in east Asia, conditions seem to have remained firm through to the end of last year. Growth in industrial production picked up during the course of last year, as did export growth, probably a result of rising Chinese demand (Graph 6).
Graph 6
Despite these continuing signs of strength, it's still likely that a generalised slowdown in the major industrial countries will have some dampening effect on the Asian region, and on other parts of the developing world. The most obvious channel for this to happen is through trade linkages, but these effects are probably not large enough on their own to generate a sharp slowdown in the developing world. Bigger effects would be seen if there were direct spillovers from recent events into developing-countries' financial systems. But while there has been some spillover of equity market weakness, the difficulties in credit markets at this stage have been mainly confined to the industrial countries.
Drawing all of this together, the RBA is forecasting that growth in Australia's trading partners will slow to a below-trend rate this year and next (Graph 7). This incorporates very weak growth in the G7 economies, comparable to the rates seen in the early part of this decade. Growth in our other trading partners is also forecast to slow down from last year, but unlike in the G7 countries, we expect their growth rates to stay relatively strong. Overall, trading partner growth is forecast at just under 4 per cent for each of the next two years, which is down from the 5 per cent pace seen in 2007. This outlook is a little softer than the outlook published by the IMF in late January.
Graph 7
The other important aspect of the international environment is the outlook for commodity prices and Australia's terms of trade (Graph 8). For the last four years, our terms of trade have risen at a rate of about 8 per cent per annum. This is the largest cumulative run-up since the 1950s, and a big source of stimulus to domestic incomes and spending. Developments over the latest year have been more mixed. Base metals prices have come off their peaks, by an average of about 30 per cent, though they're still high compared to earlier history. On the other hand, markets for coal and iron ore have tightened further, and big rises in this year's contract prices are widely expected. Rural prices have also been rising. Based on these developments, we expect Australia's terms of trade to rise by another 5 per cent or so this year, but to fall gradually thereafter (Graph 9).
Graph 8
Graph 9
As I said at the outset, the striking thing about the current situation is the contrast between domestic and international conditions. The Australian economy to date has stayed robust, and the main domestic challenges are those of strong demand, tight capacity and inflationary pressures. I'll outline some of the main features of all that and then finish up with the RBA's domestic forecasts.
The latest national accounts are now a bit dated, but they show a high rate of growth, over the year to the September quarter, of just over 4 per cent (Graph 10). Growth of domestic spending was even higher, at 5½ per cent. It's often the case in reading economic data that we get conflicting signals that make it hard to judge the overall pace of the economy. We had a period like that a year or two ago, when GDP growth was estimated to be quite low but other indicators, like business survey results and employment growth, were pointing to stronger outcomes. But in the more recent period we're getting a fairly consistent picture of strong growth, at least up to the September quarter.
Graph 10
More recent indicators seem to point to further growth. Retail sales posted a big rise in the December quarter (Graph 11). The value of sales over the latest year was up by 8 per cent, which was the fastest rate since 2004. Employment growth in the past few months has continued at an above-average rate, and the job vacancy rate rose further. Spending on imports has picked up, which can be taken as a general sign of strong demand. And most of the business surveys reported good trading conditions in the December quarter. An average of the results from the major surveys shows conditions were moderating in the second half of last year, after a strong first half, but they were still at a high level at the end of the year (Graph 12).