The big question mark hanging over the RBA's outlook

The Reserve Bank remains optimistic about prospects for the household sector, but considerable uncertainty about the collapse in mining investment continues to cloud its vision.

According to the Reserve Bank of Australia, there will be little relief for Australian households and businesses, with the economy set to rise at a below trend pace for another couple of years. But there is considerable uncertainty surrounding its outlook -- particularly for the mining sector -- which could prove disastrous if not managed effectively.

The Reserve Bank of Australia released its Statement on Monetary Policy today, which showed that the outlook for the Australian economy has eased over the past three months.

Following a much softer June quarter, led by falling exports and household spending, the RBA downgraded its outlook by 0.25 percentage points over the year to June 2015 and June 2016. This follows a similar downgrade at the May SMP.

Growth is expected to ease considerably over the next year before heading back towards trend in 2016. The darker blue interval indicates that the RBA is 70 per cent confident that growth will fall within those parameters.  

Graph for The big question mark hanging over the RBA's outlook

The RBA also lowered its forecasts for headline and underlying inflation. The main change since the May SMP is the repeal of the carbon tax.

The RBA’s forecasts have incorporated modelling by Treasury, which suggests that the removal of the carbon tax will reduce annual inflation by around 0.75 percentage points over 2014-15. The effect on underlying inflation is expected to be more modest at 0.25 percentage points. 

Graph for The big question mark hanging over the RBA's outlook

Understanding the RBA's forecasts requires consideration of the assumptions it makes. For example, the forecasts assume that the cash rate and exchange rate will be unchanged over the outlook. Compared with the May SMP, the exchange rate is a little higher but the overall effect on the outlook should be negligible. 

The risks to the dollar are primarily on the downside due to softer commodity prices. The Australian dollar has proved surprisingly resilient to changes in our terms-of-trade -- which definitely surprised me -- but historically the two move in step. While a downward shift in the dollar is inevitable, the timing of this adjustment is unknown, which creates considerable uncertainty for the Australian economy.

The RBA is upbeat about the prospects for the household sector, with “consumption growth … anticipated to pick up to a slightly above-trend pace by 2016, supported by moderate income growth and increases in household wealth”. Its conclusion is curious since real wages are falling and wage growth is set to remain “significantly below its decade average”.

Clearly the RBA has high hopes for property and shares but with housing affordability almost at breaking point and housing finance near its peak, I find it difficult to share its optimism. If anything the current state of the property sector (and its associated indebtedness) continues to weigh on household spending and poses financial stability risks, as suggested by the Murray inquiry last month.

The biggest immediate challenge for the Australian economy remains the collapse in mining investment. The RBA dedicates considerable column inches to discussing that issue and conditions in the resource sector.

First, the RBA notes that “there is no guarantee that the rebalancing of spending will be a smooth process”. This process could prove to be highly disruptive to the Australian economy, resulting in either “excess demand for, or supply of, particular labour skills or types of capital”. 

Recently ANZ and NAB estimated that the resource sector could cut between 75,000 and 100,000 jobs over the next couple of years, which could lead to structural unemployment as the economy struggles to absorb the excess supply of workers -- many of whom share similar skill-sets and experience.

This is particularly troubling since our economy is already finding it difficult to absorb our rapid population growth, with the unemployment rate rising to a 12-year high and the youth unemployment rate at almost 14 per cent (Disastrous jobs data will create more work for the RBA, August 7).

Second, the RBA notes while it is certain that mining investment still has a long way to fall, ‘it is unclear by just how much, and how quickly this will occur”. This is an important point and one that will shape the RBA’s decision-making and the Australian economy over the next few years.

In the past I have suggested that mining investment could create a hole in real GDP of around 4 to 5 percentage points. Such a hole would prove difficult to fill, which is a large reason why I have been pessimistic regarding the outlook. But there is mounting evidence that the resource sector over-invested during the boom, which could necessitate mining investment falling to below its long-run average.

New production has flooded iron ore and coal markets and, in response, prices have fallen sharply. According to the RBA, “at current prices, there is a sizable amount of coal and iron ore production that is unprofitable”; furthermore “the outlook for prices will depend on what proportion of these mines is shut down”. That is a clear sign of over-investment and a sign that the collapse in mining investment may be greater than commonly anticipated.   

The Australian economy slowed considerably during the June quarter but the RBA has revised its outlook only modestly. Nevertheless, the economy continues to face several years of below-trend growth and an outlook that is plagued by considerable uncertainty.

In my opinion there is enough doubt about our prospects to warrant a further rate cut but the RBA may want more information on mining investment before it takes that step. Later this month the ABS will release a revised set of capex expectations for the next couple of years, which could prove a game-changer for policy in both directions.

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