Five questions on the Australian economy
About the author:
- Author name:
- By Michael Knox
- Job title:
- Chief Economist and Director of Strategy
- Date posted:
- 18 January 2021, 2:05 PM
The first question is how was growth last year and what is happening this year? We expect strong Australian growth of 4% in calendar 2021. We have upgraded our estimates for growth in the Australian economy at the end of 2020. We previously thought it would fall by 3.7% then we thought it would fall by 3.5%. Now we think the fall in 2020 was 2.2%. The reason is that we think the final quarter grew almost as rapidly as the very strong growth in the third quarter. We think that is because hours worked in the employment survey increased at the same very rapid rate as Victoria came back to full engagement with the rest of the Australian economy.
The next question is, was quantitative easing a mistake from the RBA and have they used up their policy ammunition? The answer is no, it wasn’t a mistake and no, they’re a long way from using up their ammunition. We think of both the RBA Term Funding Facility (TFF), as well as the Australian and semi-government bond-buying program as part of quantitative easings. Both programs are necessary.
The TFF has been enormously supportive of the capitalization of Australian banks and their ability to lend to Australian businesses in the situation of a weak international market for funds. That program needs to continue at least for the next three years. Quantitative easing of the bond market is also very important to support our market for Australian Ten-Year and semi-government bonds. We’ll come back to that later when we talk about the exchange rate.
Where would we be without quantitative easing? Our model of Australian short rates tells us that the cash rate would have to fall to an impossibly low -64 basis points if there was no quantitative easing. That’s literally impossible. This tells us that both quantitative easing and fiscal stimulus will remain necessary until unemployment is at much lower levels, perhaps in three years’ time or more.
The RBA still has plenty of ammunition. On the 9th of December 2020, the RBA balance sheet seems to be only 16.2% of Australian GDP. That’s tiny in comparison to the Federal Reserve which, in their September statement, said that their balance sheet was 35% of US GDP. The Bank of Japan says its balance sheet is over 100% of Japanese GDP, so we have enormous space to expand the RBA balance sheet and an enormous amount of time to do it in.
The next question is what about house prices? We think house prices will still be rising in 2021 and that the recovery in house prices is healthy. It has years to run as full-time employment recovers over the next few years with the coming business cycle. We don’t believe that the RBA will achieve its level of target inflation until unemployment gets below 5%. It will take years to achieve that level of unemployment. It is very unlikely that inflation is going to be a problem during this period. Our view is that full employment in the Australian economy is at 4.5%. We think it’ll take not less than four years for growth to get unemployment down to that level.
Trade with China
What about the current trade confrontation with China? We think this current trade confrontation with China is a beneficial challenge for the Australian economy. For example, our largest market for thermal coal is not China, but Japan. We have other markets. By the end of this decade, the Chinese economy will slow down to a growth rate of no more than 2% per annum by 2030. The reason that happens is that the one-child policy has finally hit the growth in the labour force, and it doesn’t seem that the Chinese population wants to increase that from that rate of natural growth.
Because of that very slow growth in the Chinese labour force, what you’ll see is by the end of this decade, the economies of India, Indonesia and Vietnam will all be growing faster than China because their labour force is growing more rapidly. So those are the kind of markets that we should now focus on to get the growth for our exports. It’s time for us to diversify to other markets that give us higher market growth prospects. That is what we should be doing, and this is a great opportunity to do it.
Now, what can the RBA do about the Aussie Dollar? We think that the RBA will attempt to slow the rise of the Australian dollar this year by buying Australian bonds and semi-government bonds, keeping our long-term interest rates low, relative to U.S. bonds. In theory and in practice, it’s long-term interest rates, not short-term interest rates, that actually drive where the real exchange rate will be.
What’s happening here is not so much the Australian dollar going up; it’s the US dollar going down. The RBA can’t stop the US dollar from going down. The falling US dollar is caused by an enormous expansion of the US Budget deficit to 15% of GDP, which is the largest Budget deficit since WW2. This is over 10% higher than the deficit was the previous year. That’s an enormous increase in the flow of bonds onto the international market. In order to clear the market for these bonds, the real value of the US dollar has to fall and the Aussie dollar go up.
What the RBA gains for the Australian economy, by intervening in the bond market firstly, may be that it can slow the rise of the Australian dollar, but not prevent it. By buying Australian bonds, this increases the money base in Australia which increases the money supply. Therefore, there’s the flow of credit in Australia which increases non-mining investment and that drives employment.
We’ll have a stronger domestic economy and faster domestic growth because of what the RBA is doing. Still, the Australian dollar has to rise. It is the US dollar going down that is making the Australian dollar go up.
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