Our economy is the envy of the world, but the locals are restless

Years of prosperity have raised expectations, writes Clancy Yeates.

Years of prosperity have raised expectations, writes Clancy Yeates.

Two starkly different views of Australia's economy were on display this week.

One suggested trouble was around the corner. "Emergency lows" was the catch-cry of market pundits and media outlets on Tuesday after the Reserve Bank cut the cash rate to 3 per cent, a level not seen since the depths of the global financial crisis.

Clouds over the outlook darkened further after Wednesday's sluggish economic growth figures sparked fresh criticism of Labor's plan to return to surplus during a slowdown.

Global investors, however, appeared to take a different view. For all the excitement about the lower cash rate, international currency markets that determine the dollar's value pushed it sharply higher after the Reserve's decision.

BlackRock's global chief investment strategist, Russ Koesterich, has coined the acronym CASSH to describe the lucky countries - Canada, Australia, Switzerland, Singapore and Hong Kong.

Clearly, there is a significant gap between the view from overseas and the gloomy economic "mood" within Australia.

This is partly human nature. A director at Deloitte Access Economics, Chris Richardson, says people tend to compare things with what they're accustomed to, rather than with conditions overseas.

"When we've been way out in front of the pack for so long, to move closer to the pack is painful," he says.

At the same time, the economy is in an awkward phase, as we grapple with what follows the mining investment boom.

There are tentative signs some sectors are starting to pick up the slack, but no one knows if this will be enough to keep growth ticking along at the pace Australians have become used to. Deep public spending cuts are also starting to bite, which could require interest rates to do more of the heavy lifting.

So is the economy in a funk, or are things better than we realise? It depends who you ask.

The financial position of many households is improving, thanks to a series of rate cuts and increased savings. Businesses, however, are facing a tough environment that shows little sign of improving, and this could soon be a worry for employment.

The Reserve's deputy governor, Dr Philip Lowe, this week described how our expectations for what is "normal" had been inflated by a string of one-off events over the past 20 years.

There was the permanent shift to lower interest rates that came from the deregulation of the financial system in the 1980s; the subsequent boost to home values; and the huge jump in export prices over the 2000s.

These all caused wealth levels to rise rapidly, which funded higher consumption. But they were temporary forces - and certainly not "normal".

"Twenty years of good economic performance and rising asset prices raised our expectations of what is normal and many in the community are a little disappointed that these higher expectations are not being met fully," Lowe said.

"I suspect that this is one factor that explains why the public mood has been a bit flat over recent times, despite many observers outside our country viewing the Australian economy with some envy."

It is a message the Treasurer, Wayne Swan, is also pushing. He is bluntly telling consumers they will not be seeing the blistering pace of spending growth enjoyed before the financial crisis, when consumption sometimes grew at two or three times its long-term average.

"People were borrowing a lot more, putting more on their credit cards, doing all these sorts of things which had impacts across various sectors. We're not going back to that world," Swan said in Canberra.

But although consumers may be disappointed they are not going back to the "good old days" of turbo-charged spending, household finances are in better shape today than previously.

Since 2007, when the Reserve Bank had pushed up interest rates to 7.25 per cent, households with a $300,000 mortgage have been paying about $100 a week less in interest. Half of all borrowers are ahead of their mortgage repayments schedule.

Earlier this year there was a fear households would face a squeeze in income from a fall in commodity prices. However, the UBS chief economist Scott Haslem says rate cuts have meant the worst of the cashflow squeeze is now probably in the past.

"If you look at actual take-home pay for households, with the cash rate cuts and a little bit of jobs growth and wages growing at about 3 per cent, we're probably past the worst as far as the household sector is concerned, subject to us not getting a big jump in the unemployment rate," Haslem says.

After a string of recent lay-offs, households are deeply pessimistic about the jobs market. But this may not be as bad as people fear, either.

A Westpac index of unemployment expectations is 17 per cent above its long-term average - pointing to a jobless rate of about 6 per cent. However, this week the Australian Bureau of Statistics reported that unemployment fell in November to 5.2 per cent, although the number was affected by fewer people looking for work.

Citi's chief economist, Paul Brennan, says this is just one example of how people are more gloomy than the figures suggest they should be - a hangover from a decade of rapidly rising asset prices.

"People are quite fearful about their jobs but the reality, according to the ABS, is that unemployment is quite low," he says.

So far, it appears households have been directing much of the windfall from interest rate cuts into higher mortgage repayments, rather than splashing out at the shops. But there are some tentative signs consumers may also be starting to loosen their purse strings.

House prices rose in every capital city except Melbourne last month, while car sales jumped by 10.9 per cent in the year to November. The Westpac-Melbourne Institute index of consumer sentiment has also bounced back so that optimists outnumber pessimists.

While it is early days, Haslem says there could be "early signs" consumers are responding to lower interest rates.

For businesses, however, it's a different story.

Despite an interest rate cut in October, business conditions hit a three-year low last month, with a particularly weak outlook for manufacturing.

High on the list of business complaints is the high dollar - which continues to squeeze big exporters like manufacturing, tourism and education.

At the same time a wide range of domestic industries - including finance, retail and real estate - are being hurt by households' more frugal attitude.

Indeed, the national accounts published this week showed the only non-mining sectors to make a positive growth were social and healthcare services and, surprisingly, manufacturing. Retail, professional services and farming all contracted during the quarter.

With such widespread weakness, many experts doubt non-mining sectors can pick up the slack left when resources investment slows.

JP Morgan's chief economist, Stephen Walters, says it is difficult to think of areas that would come close to filling the gap left by mining, as consumers seem happy to save most of the gains from interest rate cuts.

"As domestic activity continues to lose momentum, the risks of the economy hitting an air pocket next year, once mining investment peaks, are rising," Walters says.

Though spending by miners is still at huge levels, plans to invest and hire in the future are being scaled back. Planned investment was cut by $6 billion in the September quarter, while the ANZ's index of job advertisements fell for its eight month in a row in November.

In August, before the extent of the investment slowdown was known, Deutsche Bank's chief economist, Adam Boyton, posed the question if Australia would face a recession next year due to the mining slump.

While he does not necessarily predict a recession in the narrow sense of two quarters of negative growth, he says things will feel worse for households. Mining investment has driven half our economic growth recently, and he is doubtful other sectors can match this contribution.

"For a country that's had a long and uninterrupted experience of growth, as Australia has had, it's going to feel very different next year," Boyton says.

Unemployment could hit 6 per cent, he says, which will make the economy feel much softer than most Australians are used to.

To avert this outcome, it is hoped other industries such as housing will be buoyed by lower interest rates. The Reserve says there are some signs of improvement in residential building.

But so far, lower interest rates appear to have done little to boost borrowing in the corporate sector. The latest RBA figures show business credit decreased in October by 0.3 per cent, suggesting firms remain deeply reluctant about taking on debt to fund expansion.

The crucial missing ingredient is confidence, says the head of business banking at NAB, Joseph Healy.

"It reflects confidence - there's no constraints in play in terms of being able to provide credit to businesses."

Tuesday's rate cut on its own is unlikely to be a trigger to restore confidence, he says, arguing that a "glass half-full" mindset is what the economy needs. So far, however, this seems to be lacking among the nation's business people.

If private households and businesses remain reluctant to reignite activity, the government appears to hope further interest rate cuts might help.

Indeed, analysts say it is actively encouraging further rate cuts from the independent Reserve by dragging down the overall rate of economic activity.

The RBA's Lowe suggests that if the dollar remains "uncomfortably" high, interest rates may remain lower than they have been for the last two decades.

"It is possible that normal lending rates will be somewhat lower for a period owing to the combination of global factors and the legacy of the credit boom," he says.

But while this may sound appealing to mortgage holders, the strategy also has plenty of critics. For one, people with savings, such as self-funded, retirees face lower returns, with one-year term deposit rates falling from more than 6 per cent to about 4 per cent. The yield from shares is now significantly higher than what is offered by term deposits, but few are willing to take the greater risk so far.

HSBC's chief economist, Paul Bloxham, also points out that the Reserve will be reluctant to use up too much of its interest rate ammunition where there remains the prospect of a meltdown in Europe.

"The trouble is that the RBA is already at 3 per cent. There's a bit of room left but you don't want to take away all the room to move, because you would need that if there were a negative shock from abroad," he says.

Labor's pledge to deliver a $1.1 billion surplus this financial year is also controversial. By tightening the budget at a time when businesses and households are cautious, there are concerns the government could make the transition from the mining investment boom harder than necessary.

While Swan says he remains committed to the surplus goal, there are suggestions Labor may abandon the pledge if growth drops below its long-term trend rate of about 3 per cent in the December quarter.

Ultimately, the government may have little say in the matter. A bigger-than-expected slowdown would probably eradicate its razor-thin surplus by eroding tax revenues and pushing up welfare payments.

Richardson, a former Treasury official, also points out there is no passage in the budget rule book that says we must have a surplus 2012-13, especially if things are weakening.

For all the challenges facing the economy and individual industries, however, Richardson concludes there is still reason to believe the glass is "half full".

To make his case, he points to what economists call the "misery index" - the inflation rate plus the unemployment rate. Australia's score on the index is 7.2, compared with 10.1 in the United States and 13.9 in Europe.

"It's very close to its lowest level since the 1960s. We should be calling it the happiness index," he says. SOURCE: RBA, HSBC, CBA

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