How strong is the Australian economy really, and what does this mean for interest rates?
This is the debate now being waged by financial market economists across Sydney dealing rooms, and there’s no clear consensus. Goldman Sachs thinks the economy is picking up, and the RBA is on balance likely to raise rates by year-end. JP Morgan, meanwhile, thinks the economy will soften and the RBA will be cutting interest rates by the first half of 2018.
The diversity of views and difficultly in judging who will be right is not helped by the conflicting range of economic signals on the economy. As reported last week, we enjoyed only modest 0.3% GDP growth in the March quarter, with sub-par 1.7% growth over the year. Adding to the woe, the Westpac/Melbourne Institute index of consumer confidence has slipped in recent months to below-average levels and household income growth remains very weak. All this is consistent with weak growth in retail sales.
So far so bad. Yet the May employment report revealed a healthy 42,000 job gain in the month, and 2% employment growth over the year. After threatening to break through 6% again a few months ago, the unemployment rate in the past few months has dropped back to a somewhat more comfortable 5.5%. After a subdued start to the year, retail sales at least bounced back a feisty 1% in April.
Another stark divergence stems from the fact that the National Australia Bank monthly business survey remains unrelentingly upbeat. The all-important business conditions index eased back to +12 (from +13) in May, but remained well above its long-run average of around +3. The survey also reveals the strength in business conditions if fairly broad-based across industries, with all sectors reporting positive business conditions – and even in the weakest sector, retailing, business conditions seem better than they were six months ago.
As seen in the chart below, the divergence between the NAB measure of business conditions and annual trend growth in GDP is particularly wide at present.
Meanwhile, however, the recent improvement in the unemployment rate is consistent with long-established strength in hiring indicators, such as ANZ Job Advertisements and the NAB measure of business hiring intentions.
What can we make of all this? Sadly, the NAB business conditions index seems at best a coincident indicator of the economy, so it does not necessarily suggest the soggy GDP numbers will improve anytime soon. Indeed, we know that Cyclone Debbie at least, will hold back GDP growth in the June quarter due to disrupted exports and agricultural output.
That said, the NAB employment index – and to a degree ANZ job ads – do appear to lead the unemployment rate somewhat, and so both suggest there’s reduced risk the unemployment rate will threaten 6% again in coming months, and might even drop further. That alone will be enough to keep the RBA on the sidelines.
All up, I think to a degree we should discount the dodgy GDP numbers, especially as they’ve been hit over recent quarter by weather events, and so we should accept the economy is currently travelling reasonably well – most other indicators point in this direction. In turn, that’s consistent with the strength in commodity prices over the previous year and the ramping up in mining export volumes – which has been a notable improvement in the NAB measure of mining business conditions in the past six months. Tourism is also improving, areas such as health and education continue their secular growth, and housing construction activity remains at a high level.
There are valid reasons why the economy presently appears OK.
That said, this still leaves open the question where the economy will head over the coming six months to one year. With housing activity peaking, iron ore prices in sharp retreat, and wage growth likely to remains quite low (as international evidence suggests a low unemployment rate is not enough to put more money in consumer pockets), I’m still inclined to be more downbeat than upbeat. I’d change my mind if the Australian dollar dropped a lot further, perhaps on the back of commodity price weakness and higher US interest rates – but it remains stubbornly range-bound for now.
All up, this suggest the RBA is unlikely to touch interest rates for at least the next three to six months or so. Further out, I still see more downside than upside to the interest rate outlook.