New forecasts, new risks...and some familiar themes

Last Friday, the RBA released its February Statement on Monetary Policy which showed the central bank is now more downbeat on the near-term outlook than it was back in November, due to the twin impacts of the bushfires and the coronavirus. But the RBA remains confident in its medium-term view that the economy will return to a more robust growth performance in the second half of the year and beyond. Business confidence and consumer sentiment both remain subdued although the volatile global environment doesn’t appear to have taken a major toll on expectations, at least for now. As the number of cases continues to climb, economists are rethinking their forecasts for the likely economic costs to the world economy.

This week’s readings include the economic and political outlook for Australia, the ‘dismal kingdom’ of economics, and the debate over the future of economic growth.

I’m away from the office attending a course next week, so the next edition will be a more minimalist take on the week’s developments. Apologies. But normal service should resume the following week.

What I’ve been following in Australia . . .

What happened:

The NAB monthly business survey showed business conditions unchanged in January at plus three index points while business confidence increased slightly to minus one index point. Both indices remain below their long-term averages, however.

Why it matters:

NAB characterised the results as ‘more of the same’, with the subdued conditions that marked the private sector at the end of 2019 carrying over into the first month of this year, an outcome consistent with ‘very little / to no growth in the private sector.’ Which means that these survey results are still not picking up the RBA’s gentle turning point.

January’s survey also detected some impact from the bushfires, with ‘notable declines in conditions’ in NSW and Victoria and in recreational and personal services over the month, although the overall, national hit to business conditions and confidence from the fires appears to have been modest relative to some of the more pessimistic assessments. Next month’s survey should start to show the impact of the coronavirus on business sentiment, although February’s consumer sentiment reading (see below) suggested the impact on household confidence to date has been small.

What happened:

The ABS reported that new loan commitments for housing rose by 4.4 per cent over the month in December (seasonally adjusted) to be up 14.4 per cent over the year. The value of new loan commitments for housing has now increased by more than 20 per cent from the recent low of May 2019.

The driver of that turnaround has been loans to owner occupiers, which were up 5.1 per cent over the month and 17.9 per cent over the year. The recovery in loans to investors has been much more subdued, with the series up 2.8 per cent in monthly terms and 4.9 per cent in annual terms.

Lending for personal fixed terms loans rose 3.5 per cent over December and was up 7.9 per cent relative to December 2018.

Why it matters:

This was the strongest monthly result for owner-occupiers since 2015 and the best annual result since 2017. The turnaround in the housing market is now prompting quite strong growth in demand for mortgages by home owners and there has also been a smaller rise in activity for investors. That in turn implies continued upward pressure on house prices and underpins hopes for a recovery in dwelling investment by year-end.

What happened:

The Westpac-Melbourne Institute Index of Consumer Sentiment rose (pdf) from 93.4 in January to 95.5 in February, although that still left the index in pessimistic territory and below its long-run average of 101.4.

Why it matters:

After January’s decline in the index – likely a reflection of the impact of the summer’s terrible bushfires – this month’s reading brought a recovery in sentiment. Westpac economics points out that the week of the survey saw widespread rains, news that several large fires had been contained, and a relatively upbeat message from the RBA, all of which appear to have improved the mood of consumers.

At the same time, there also appears to have been only a very limited impact on consumer sentiment from the coronavirus outbreak, although with the economic fallout from disruption to tourism, education and other sectors set to continue, that could of course change in coming months.

What happened:

Last Friday, the RBA published its February 2020 Statement on Monetary Policy. The forecasts are a mixture of the new (assessments of the impact of the bushfires and Covid-19) and the familiar (a continued focus on households and the labour market). On the same day, Governor Lowe and his team appeared before the House of Representatives’ Standing Committee on Economics, with testimony that offered some additional insights into the Martin Place’s current thinking on the economy.

In the short term, the RBA sees the economy navigating a ‘soft patch in growth’ which it now thinks is likely to extend through the early part of this year, due to the ongoing drought, the effects of the bushfires, and the impact of the coronavirus outbreak.

The RBA sets out its views on the impact of the bushfires and the drought in a special box in which it estimates that the direct effects of the fires will be to reduce GDP growth across the December 2019 and March 2020 quarters by around a (cumulative) 0.2 percentage points, while adding that there is quite a bit of uncertainty around this estimate. In addition, the central bank notes that after that initial impact, the effects of government spending, insurance payments and reconstruction activity will all start to take effect, which means that by the end of this year ‘it is likely that the recovery will have broadly offset the decline in GDP due to the immediate impact of the bushfires.’ However, the RBA also cautions that the short-term impacts could be greater than its estimates, with the possibility of indirect effects from the loss of productivity in major cities due to smoke pollution, disruptions to regional supply networks, and the possible damage to consumer and business sentiment.

Drought is another economic headwind discussed in the Statement, with the RBA pointing out that farm GDP has declined by 22 per cent since early 2017 and is expected to decline by a further 7 per cent over the remainder of 2019/20. That would take the cumulative decline to around 30 per cent. The drought is estimated to have subtracted about a quarter of a percentage point from GDP this year (following on from similar-sized effects in 2018 and 2019).

A third drag on growth in 2020 is the impact of the coronavirus, which the RBA judges will lead to lower GDP in the second quarter (in her testimony to the House, Dr Luci Ellis, said the RBA ‘put in a minus 0.2 per cent in the March quarter for the effect of the coronavirus outbreak on tourism service exports’), mainly through fewer overseas students and tourists, although this negative impact is likely to be at least somewhat offset by a rise in the share of Australian holidaymakers choosing to stay closer to home. Other economic risks include reduced Chinese demand for Australian resource and agricultural exports and hence lower commodity prices, along with the risk of disruption to supply chains. The assumption here is that the impact of the virus on the Australian economy will be more severe than that of SARS (where we escaped relatively unscathed) but that the hit to growth will have faded by the second half of the year.

Once again, however, the Statement includes the important qualification that these forecasts are subject to a great deal of uncertainty, dependent as they are on the duration and severity of the virus outbreak and the measures taken to control it. There is also the possible impact of any offsetting stimulus from the Chinese authorities and the consequences of any Australian dollar adjustment to be considered.

Setting aside these short-term downgrades to the outlook, the RBA continues to expect the same sort of gradual improvement in Australia’s medium-term economic prospects that it was predicting in November’s Statement, with GDP growth increasing to an annual rate of 2.75 per cent by the end of this year and then averaging three per cent across 2021. That recovery in activity is predicated on several familiar factors:

1. The stimulus from lower interest rates and tax cuts is expected to contribute to a gradual increase in consumption growth as households complete the process of balance sheet repair (aided by rising house prices) and switch their focus from repaying debt to spending.
2. Business investment is likewise expected to recover somewhat from its recent slump. A large part of this story relates to mining investment which is ‘expected to pick up noticeably over 2020 and 2021 as work commences on a number of sustaining and expansionary projects’ while non-mining investment is also expected to rise, albeit only modestly.
3. Although dwelling investment is forecast to continue to fall over coming quarters, the RBA has pencilled in the trough in residential construction for the second half of this year, and thereafter the turnaround in the housing market is anticipated to prompt a recovery in investment through 2021.
4. Public demand growth is projected to remain strong in the near term, with further increases in public investment, including in the form of rebuilding efforts associated with recovery from the bushfires.

The forecast pickup in growth is assumed to be enough to take the unemployment rate down to five per cent by the end of this year and 4.75 per cent by December 2021, but this gradual tightening in labour market conditions is not set to spark any increase in wage growth, with the RBA calculating that the rise in the superannuation guarantee scheduled to take place between 2021 and 2025 will largely offset any boost to wages from the decline in labour market spare capacity. As a result, inflation is forecast to rise marginally over the next couple of years, only reaching two per cent by the end of December next year.

Why it matters:

The main message from February’s Statement is that – for now at least – the RBA is inclined to look through the near-term impacts of both the bushfires and coronavirus which ‘are currently expected to be relatively modest and short-lived’ and leave its broadly upbeat view of the underlying economic trends intact. Hence the new set of forecasts combine downgrades to the near-term outlook with little change to the medium-term projections that were set out in November.

The Statement also set out the conditions for another cut in the cash rate, stating that ‘if the unemployment rate were to be moving materially higher and there was no further progress being made towards the inflation target, the balance of arguments would tilt towards a further easing of monetary policy.’ In this context, it’s worth noting that the forecasts outlined above are conditioned on the assumption that the cash rate will move in line with market pricing, which when the RBA was penning the Statement implied one 25bp cut in the cash rate around the middle of this year.

Finally, there several points worth noting to come out of the RBA’s testimony to the House Standing Committee on Economics.

1. The RBA acknowledged that its forecasts last year were undermined by two big surprises. The first of these was the speed of household balance sheet adjustment (as low wage growth and falling house prices pushed households to repay debt, and with the impact of lower interest rates and tax refunds serving to encourage those same households to accelerate their debt repayments rather than boost spending) which triggered a large downward adjustment in household consumption. And the second was an unexpectedly large rise in labour market participation, which made it difficult to create a tight labour market despite healthy employment growth.
2. Governor Lowe is sceptical of arguments that the RBA should consider a lower inflation target, saying ‘I think it would be inappropriate to lower our target just so that we could say we met it. We don’t really shift the goalposts!’
3. He also pushed back (again) against the argument that last year’s rate cuts were bad for consumer confidence, arguing that ‘household confidence is weak because income growth is weak and housing prices have fallen and we’re responding to that. So, these two things – interest rates and confidence – are measured at the same time and they move together, and people say, “It’s the cut in interest rates that has damaged confidence,” but I don’t think that’s the case. It’s low wage growth and falling housing prices that have damaged confidence.’
4. The governor is also worried that the Australian economy is becoming less dynamic, pointing out that we are currently experiencing ‘lower rates of investment, lower rates of business formation, lower rates of people switching jobs, and in some areas lower rates of R&D expenditure.’

. . . and what I’ve been following in the global economy

What happened:

As the number of identified cases of the new coronavirus disease (or Covid-19) continued to climb, economists have been scrambling to update their estimates of the potential consequences for the world economy.

Why it matters:

As explained back in the first note of this year, the initial benchmark for the likely impact of Covid-19 on the world economy was the 2003 Severe Acute Respiratory Syndrome (SARS) pandemic. That experience suggested that a decent baseline assumption would be for a sharp but temporary economic shock that would likely be particularly damaging for the international tourism and education sectors, as well as for the retail sector in the most affected economies. And even with that relatively common baseline, private sector estimates for the likely impact on the Chinese economy to date have ranged from downgrades of 0.1 per cent to 1.2 per cent to 2020 growth.

That same piece also warned that there were reasons for thinking that the SARS comparison came with some important limitations attached. Increasingly, that appears to be the consensus view. Several factors sit behind that assessment.

1. While there is still some debate over the quality of the data Covid-19 is significantly more contagious than SARS (certainly, many more people have now been infected than during the SARS pandemic) although apparently less deadly.
2. The Chinese population is much more mobile today than it was in 2003, making containment more difficult (although some optimists make the case that Beijing has been able to draw on lessons from the 2003 experience to be more effective in its response than it otherwise would have been).
3. The Chinese economy is much larger than it was in 2003. On IMF data, its share of global GDP (measured on a purchasing power parity basis) has risen from 8.7 per cent in 2003 to an estimated 19 per cent last year. Regional – and global – exposure to Chinese consumers and to Chinese demand for commodities is correspondingly that much greater.
4. China is now far more central to global supply chains. According to estimates from Bloomberg Economics, about one fifth of all global imports of intermediate manufactured products come from Chinese factories. The rest of the world’s reliance on these inputs for production has doubled since 2005. And for regional economies the dependence is even greater: Bloomberg reports that about 40 per cent of all imports of intermediate manufactured products consumed in Cambodia, Vietnam, South Korea and Japan came from China in 2015. According to press reports, car manufacturers have already said they are struggling to source key parts from Chinese suppliers.
5. At the same time, China’s growth performance is much less robust today than it was back then. Even with the impact of SARS, real GDP growth in 2003 was around 10 per cent. Last year, growth was 6.1 per cent, its weakest pace since 1990 (albeit on a much larger base).
6. Related, the structure of the Chinese economy has changed, with a much greater role for (the relatively more vulnerable to virus-related effects) service sector in economic output.
7. Cognisant of all the above, financial and commodity markets are now much more sensitive to China-related shocks.

As a result, although the underlying lesson from the SARS experience – a sharp but temporary economic disruption is the most likely outcome – continues to underpin most economic forecasts of the impact of Covid-19, estimates of the likely scale of that disruption are now being revised up.

What I’ve been reading

CEDA’s economic and political outlook for 2020 has been released.

A speech from Productivity Commission (PC) Chair Michael Brennan on private health insurance contains some interesting facts on the relative performance of the Australian health system. For example, according to Brennan, Australia’s overall health system is in pretty good shape, delivering high and healthy life expectancy for a relatively low level of spending relative to GDP, such that ‘Australians live on average about half a year more than would be predicted from our health spending. The average American lives 6 years less than would be predicted from their very high spend as a share of GDP.’ Again, ‘Australia delivers among the highest volume of services, third only to Germany and the US, who are of course spending nearly twice as much as Australia as a share of GDP.’ The PC puts the annual cost to the Australian economy from people sitting in doctors’ waiting rooms at around $1 billion.

ANZ Bluenotes chart Australia’s housing market.

AMRO (the ASEAN + 3 Macroeconomic Research Office) has released an assessment of the impact of Covid-19 on China and the regional economy. It estimates that China’s GDP growth this year will be lowered by about half a percentage point after taking offsetting government stimulus measures into account, and that ASEAN+3 growth overall will be down by about 0.2 percentage points.

From the FT, is the coronavirus China’s Chernobyl moment?

A revised and updated innovation system monitor is now up on the Department of Industry’s web site.

In the New Yorker, John Cassidy asks if it is possible to have prosperity without growth, running his eye over the sects of ‘degrowthers’, ‘slow growthers’ and ‘green growthers’ as well as those who argue demographics and the shift to services are leading to an inevitable slowing in the pace of economic expansion. Related (but not recent), here (pdf) is Benjamin Friedman setting out the moral case of economic growth, proposing that many people have been too quick to frame economic growth in terms of material considerations versus moral ones while neglecting the fact that growth can foster ‘greater opportunity, tolerance of diversity, social mobility, commitment to fairness and dedication to democracy.’ I’ve linked to Friedman before, but I think it’s an important argument.

Dan Drezner on the dollar and the other Thucydides trap: by successfully weaponizing the US dollar, has Washington made it more likely that countries will turn to other alternatives, or does the dearth of the latter keep the greenback secure? His answer appears to be, yes and yes.

Interesting piece in the WSJ looking at the rise of ‘chain production’ in services in the United States. The theme is that there has been an industrial revolution in services allowing standardisation and (hence) productivity gains that has seen large service provides grab sizeable market shares in a way that has parallels with the earlier wave of consolidation driven by consolidation in manufacturing. The article links to the authors’ paper, here, which argues that rising industry concentration in the United States is largely a product of this revolution in three sectors: services, retail and wholesale.

A review essay by Paul Romer on the ‘dismal kingdom’ of economics. Romer warns that ‘a system that delegates to economists the responsibility for answering normative questions may yield many reasonable decisions when the stakes are low, but it will fail and cause enormous damage when powerful industries are brought into the mix.’

The Congressional Budget Office (CBO) presents an overview of the US budget and economic outlook for 2020 to 2030. Based on the technical assumption of no change to the current laws governing federal taxes and spending, it estimates that the federal budget deficit will rise from an estimated 4.6 per cent of GDP (US$1.0 trillion) this year to 5.4 per cent of GDP by 2030. Over the same period, federal debt held by the public would rise from 81 per cent of GDP to 98 per cent of GDP. Underpinning those forecasts is an assumption that the economy will grow at an average annual rate of 1.7 per cent over the next ten years.

Daniel Markovits explains his view that McKinsey - and management consultants more broadly - destroyed the US middle class. He blames the abolition of middle management and the replacement of lifetime employees with short-term, part-time, and contract workers. So, not a fan of Mayor Pete.

Bloomberg examines what it takes to be a member of the global top one per cent.

A Bruegel paper on the shift from globalisation to deglobalisation.