Last call for rate cuts as local growth surges

The Australian economy is poised to end 2013 with a surge in activity. Such is the momentum that GDP is on track for 3.8 per cent growth in 2014. This lift in growth should see the unemployment rate drop to 5 per cent or a little less by the end of that year while the inflation rate will edge higher, probably moving to the upper half of the Reserve Bank’s target band.

The reasons are straightforward.

Most importantly, global economic conditions are slowly improving. The US housing sector is lifting which will support activity and household consumption. In China the situation remains positive, with growth forecast to remain solid as policy makers aim for stronger activity. No doubt the eurozone remains problematic but even there, some tentative signs are emerging that growth will at least stabilise by the end of the year before edging up in 2014.

Add to that stronger growth (from a low base) in Japan and India and it is easy to see why global growth is widely expected to be 4 per cent or more in 2014.

In Australia, the transition from the mining investment boom to household consumption and dwelling investment is starting to show. Retail spending is trending higher, as is housing finance and the number of dwelling approvals. At the same time, export volumes are growing at a solid pace and the drag on GDP growth from tight fiscal policy is starting to unwind and should be turning to a positive contribution by the end of 2013.

The specific forecasts for each part of the economy add up to GDP growth just below 4 per cent in 2014.

Household consumption is forecast to rise 3.5 in 2014, which will account for around 2 percentage points of the 3.8 per cent GDP growth rate I am forecasting. The household sector’s finances are in rare shape. Debt levels as a share of income have been falling, savings have been increasing and wealth rising in line with the solid rise in share prices and moderate lift in house prices.

These favourable structural issues, added to the fact that real incomes continue to grow and that the current low level of mortgage interest rates is reducing debt servicing costs by tens of billions of dollars per annum, make it easy to construct a case where consumption growth lifts to an above trend pace.

Dwelling investment is poised for a strong gain, with low interest rates, pent up underlying demand and a jump in alterations and additions all favourable drivers. A rise of 10 per cent is forecast for dwelling investment, a growth rate that would add around 0.5 percentage points to GDP growth in 2014.

Business investment is likely to weaken over the next 12 to 24 months, although a lift in non-mining investment will cushion the decline in mining investment. The Australian Bureau of Statistics capital expenditure survey was reasonably upbeat on investment plans for 2013-14. Based on a likely scaling back of investment plans from these levels, it seems reasonable to forecast zero growth in business investment in 2014, which of course will add zero to GDP.

Public demand will be something of a wild card for the economy in 2014. As things stand, public final demand is likely to rise by around 1 per cent in 2014. This will contribute a further 0.2 percentage points to GDP growth. This small contribution to economic growth, after several years of weakness, is based on the judgment that the fiscal tightening at both the federal and state government levels will have been exhausted. That said, this is probably where there are some of the greatest risks to the growth outlook with a federal Coalition government possibly undertaking cuts to spending. At this stage, this a risk and is not something that can be factored into these forecasts.

Net exports are forecast to make a powerful 1.2 percentage point contribution to GDP, with export volumes forecast to rise a strong 10 per cent while import volumes will rise just 1 per cent.  The surge in exports is linked to the stronger global economy, mentioned above, but also the mining sector moving to the production and export phase as the investment boom matures. The lower Australian dollar will also support strong growth in export volumes across the board.

Import growth is likely to be subdued with the softening in business investment seeing a weakening in capital goods imports, although this will be partly offset by higher import volumes as household consumption growth accelerates.

The inventory cycle is forecast to be neutral – that is, make no contribution to GDP growth.

The bottom line of all this is a GDP growth forecast of 3.8 per cent for 2014, a strong rate of expansion that would see job creation accelerate and unemployment fall. Crunching the numbers from this GDP scenario suggests the unemployment rate will ease back to 5 per cent or less, but that inflation will lift a little.

The policy implications are clear. The monetary policy easing cycle is almost over. While one more rate cut is still on the agenda, the Reserve Bank may hold its nerve and wait for the earlier cuts plus the fall in the Australian dollar to see growth lift.

It will lock in a 23rd year without recession and should all but guarantee the triple-A credit rating remains intact. The strong economy is also set to lift government revenue and see the budget surplus projections for 2015-16 and beyond easily achieved.