WEEKEND ECONOMIST: Rates reticence

On Wednesday, Australia's National Accounts for the December quarter were released. They showed the economy finished 2010 on a mixed note. In the quarter, the Australian economy grew by 0.7 per cent/quarter, 2.7 per cent/year, in the fourth quarter.

Domestic demand growth was only 0.3 per cent in the quarter, with consumer spending 0.4 per cent, housing -0.4 per cent, business investment 0.5 per cent and public demand increasing by 0.7 per cent.

Inventories provided a major boost in the quarter, rising by 0.7 per cent to add 0.7 percentage points.

Net exports were neutral, with export volumes increasing by 3.0 per cent in response to strong global demand.

This result provides further evidence of the major challenge for the Australian economy.

Housing activity and household spending are clearly much weaker than would be expected for an economy basking in the sunshine of the highest level of its terms of trade since the 1950s.

Business investment is also soft, although equipment investment increased solidly in the fourth quarter. The weakness in infrastructure investment in the period is surely a timing issue. However, the issue remains as to whether those businesses focused on servicing the household sector may reduce their investment plans while the household sector remains subdued.

If we dissect the investment data we note that services investment represents around 57 per cent of total investment compared with 25 per cent for mining; 12 per cent for manufacturing and 6 per cent for agriculture. Within the services category, much of the investment could be classified as being focussed on domestic demand: real estate services (11 per cent); retail and wholesale trade (7 per cent); finance and professional services (8 per cent); construction (5 per cent); transport (7 per cent); and communications (5 per cent). Some of these sectors such as trade; finance; and real estate could be expected to be almost entirely dependent on the household sector whereas professional services; transport; and communications may benefit indirectly from the mining sector.

The boost to equipment investment in the December quarter and the CAPEX survey of investment intentions for 2010-11 provides some positive indications that firms may be looking through the weak household sector and adding capacity. However, that is not entirely clear given the soft indicators from business surveys.

An extended period of steady interest rates, which we confidently expect, may revive household activity. But this will only really be clear by the second half of 2011.

The strong contribution from inventories to growth in the December quarter is likely to turn into a major drag in the March quarter with the loss of activity in mining and agricultural production due to floods and cyclones raising the likelihood of a negative growth quarter.

Overall, the prospects for a resurgence in confidence and activity in the household sector and the response of firms servicing this sector will shape the growth and interest rate profile for 2011.

The ongoing mining boom and high terms of trade will not be enough in their own right to lead to strong growth and the significant increases in interest rates which are generally expected.

For our part, we only expect one interest rate increase at most in 2011 as time will be required to resolve the complex interactions in the economy in 2011.

Here the prospects for the savings rate and the labour market will be key. In 2010 we saw very strong growth of around 7 per cent in nominal labour incomes, reflecting wages growth of around 4 per cent and employment growth of 3 per cent. Spending growth was more subdued as households increased their savings. The savings rate has now reached around 10 per cent. It is reasonable to expect that households should be satisfied with that rate of savings. If nominal labour incomes continue growing at 7 per cent, then household spending growth can be expected to pick up as households do not seek to raise the savings rate any further.

However, there are risks around employment growth. Those industries such as finance, retail, business services and construction are, along with the non-cyclical health and education sectors, the major employers. With employment growth running faster than production, productivity has been poor. There must be a significant risk that these household focussed employers reassess their labour needs, thus lowering employment and labour income growth. Households might offset that slowdown by cutting savings. However, the key driver behind the decision to raise savings – concerns about household debt and house prices – are very unlikely to ease in 2011.

In 2012, the picture will be clearer. Surveys show the mining boom is expected to gain more momentum. Households should be buoyed by a year of relatively steady rates and in real terms, housing will be more affordable. An easing in the savings rate is likely in 2012.

Rates are likely to move higher under those circumstances.

Bill Evans is chief economist at Westpac.