To a year of trouble or safety in numbers?

As forecasts for the year ahead come thick and fast, which figures will bring Australia the best chance of economic success?

There are scores of people making their predictions for the economy and financial markets in 2013, myself included. Last week, I wrote of my 'Top 10 Big Issues for 2013'.

But rather than well-founded forecasts on where the economy might be heading in 2013 and how it gets there, it is perhaps more useful to set a series of benchmarks to judge whether the economy does well or not in the year ahead.

Before formalising those benchmarks, it is important to note the policy objectives of the two main economic policy institutions.

Treasury’s mission is "to improve the wellbeing of the Australian people”, while the Reserve Bank of Australia says its duty is to "contribute to the maintenance of price stability, full employment, and the economic prosperity and welfare of the Australian people”. While these objectives are inevitably medium-term goals, short-term management is also important.

In light of this, how should the performance of the economy be judged in a year’s time?

If annual GDP growth is 3 per cent this time next year, it will be good news. Growth at that pace is around trend, enough to ensure inflation will be within the Reserve Bank's target range and strong enough to see employment growth sufficiently solid to keep the unemployment rate broadly steady.

If GDP growth undershoots and is near 2.5 per cent or lower, it will be a poor result and the Reserve Bank will have likely made a policy error in not easing monetary policy sufficiently. If growth is this soft, the unemployment rate will likely be near 6 per cent and inflation stuck at 2 per cent or lower.

If, on the other hand, GDP growth turns out to be 3.5 per cent or more, the unemployment rate will be near 5 per cent, perhaps a touch lower, and inflation will likely be moving up towards the upper end of the Reserve Bank's 2-3 per cent target band.

Those are the broad benchmarks to judge whether the economy has done well and been well managed during 2013.

In terms of the level of official interest rates or whether the budget is in surplus or deficit at the end of the year, who really cares?

It must be emphasised again and again, that the setting of interest rates and the budget bottom line are not ends in themselves. For anyone with an understanding of economic policy and changes in the business cycle, there is no short-term optimal level or target for interest rates or the budget balance.

Interest rates will be adjusted up and down according to demand and inflation pressures in the economy. At the same time, the budget balance will swing from deficit to surplus and back again as the automatic stabilisers work and occasional doses of counter-cyclical fiscal policy changes are delivered to dampen the amplitude of the business cycle.

This returns us to the point that a 3 per cent GDP growth pace by this time next year is good news. It will imply interest rate settings are broadly appropriate and will likely end the next year near where they are now, and the budget momentum will be moving to a small surplus.

It almost goes without saying that if the economy is a little softer, interest rates will be lower and the budget will likely be in small deficit. A much weaker economy due to something like an exogenous shock from the global economy or an unexpected slowing in China will see interest rates end 2013 substantially lower and a modest budget deficit in place.

A stronger economy near 3.5 per cent or an even bigger surprise on the upside will see monetary policy tighter than it is now – and the budget will be on track for a comfortable surplus as the automatic stabilisers kick in extra revenue. 

The end point is that we should be rejoicing a scenario where GDP runs around 3 per cent through 2013. It will mean inflation will be comfortably low and the unemployment rate will be in a 5-5.5 per cent range. It will mean the budget will be hovering around balance or a small surplus in 2013-14.

It would also mean Australia entering its 23rd year of unbroken economic growth, with more than a decade since the unemployment rate was above 6 per cent. And it will mean there have been two decades of successful inflation targeting from the Reserve Bank.

And by the way, 2012 is ending with the current data set on the Australian economy showing annual GDP at 3.1 per cent, the unemployment rate at 5.2 per cent, inflation at 2 per cent and underlying inflation at 2.5 per cent.   

Frankly, that is near perfection. Let’s hope these are the numbers in play on 31 December 2013.

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