WEEKEND ECONOMIST: Will it work?

This week policy-makers stepped up the fight. The RBA cut its official interest rate by a further 100 basis points to a 44-year low of 3.25 per cent while the government announced new fiscal spending worth $42 billion, or 3.5 per cent of GDP. Moreover, the Government revealed that, in the three months since November, government revenues for the next four years have collapsed by $75 billion, mainly due to a weaker corporate tax take. As a result, the government is now expected to run a cumulative budget deficit of $118 billion from 2008-09 to 2011-12, averaging almost 2.5 per cent of GDP.
The Government's growth forecasts have been revised down sharply, to 1 per cent in 2008-09 and 0.75 per cent in 2009-10. But with the government claiming the stimulus package will add 0.5 percentage point to growth in 2008-09 and 0.75-1 percentage point in 2009-10, the implication is that without this policy action growth would have been flat to negative next financial year. This suggests the Government believes its fiscal policy will avert a local recession.

How realistic is this? Certainly, there is now a lot of stimulus in the economy. Rates have fallen four percentage points in the last six months, reducing consumer debt interest paid in this period by almost 30 per cent. All up, the government has thrown $68 billion at the economy since the budget. This is 5.8 per cent of (estimated) 2008 GDP and is large by international comparisons. The US has committed 7 per cent of GDP, the Euro-zone 1.5 per cent of GDP and the UK 1.4 per cent of GDP. Indeed, the Australian response is bigger, in a relative sense, than the total global response of 4.7 per cent of global GDP.

This week's retail sales data shows the first part of the government's response – the $8.7 billion handout to households in December – provided good support to the economy. Retail sales jumped 3.8 per cent in the month with spending on many discretionary items up around 5 per cent. Lower interest rates and the increased first home owners grant is also supporting confidence in the demand side of the housing market. Housing finance approvals have turned slightly positive and are expected to rise solidly again in December (this data is out next week with ANZ expecting a rise of around 7 per cent). This tentative confidence should be helpful in avoiding any significant fall in house prices.

In our judgement, the government's fiscal spend will do a lot to soften the severity of the downturn in the economy in the short-term. Even if a good portion of the government's next set of handouts (worth $12.7 billion) are saved, it should still boost consumer spending as the payments are distributed over March and April. Likewise, it should continue to put a floor under consumer confidence and provide good support for overstretched households, again helping to avert any substantial fall in house prices.

The short-term stimulus now in the system may give the RBA room to become a little more measured in the pace of easing. While we expect rates will fall to 2.5 per cent, we would be surprised if this happened as early as next month. Markets have also scaled back expectations for further aggressive rate cuts; the OIS market is now pricing a rate cut of around 66 basis points in March, down from nearly 100 basis points earlier this week. More on the RBA's likely strategy should be revealed when the Bank's latest forecasts are outlined in the Quarterly Statement on Monetary Policy tomorrow. We suspect the Bank's outlook is unlikely to differ too much from the Government's.

Too much, too soon?

The major issue we have with the Government's fiscal response is that about half of the total spend is centred on the short term. Yes, this should put some
floor under the fall in fourth quarter activity and the first half of this year. Given the calamitous collapse in activity in other parts of the world, the benefits of this should not be underestimated.

But as the household payments are one-off, the boost to consumption will also be one-off, not permanent. Hence, the nature of the package raises the risk of a very poor second half of 2009 (and in particular the third quarter), as households adjust once more to a lower level of income. And while the government's intended spend on infrastructure over 2009-10 is welcomed, it may well not be enough to avert the expected sharp fall in business investment.
It will also do little to soften the impact from a deteriorating export outlook; data this week showed export volumes collapsed by around 5 per cent in the fourth quarter with further falls, particularly in commodities, now assured. Nor will the fiscal package prevent a further rise in the unemployment rate, which on the Government's own estimates will rise to 7.0 per cent by mid-2010.

Hence, the fiscal package has prompted us to only make a small upward revision to growth in 2009 (although economic activity is still likely to be broadly flat) and no change to our 2010 outlook. Given the amount of money the government has now thrown at the economy, it is a shame that only a small portion of the spend will be available to fight the significant risks Australia faces in the second half of 2009, including (and not limited to) a collapse in private business investment as few new projects commence to replace existing projects that roll off, and the risk of a sharp response in the labour market.

Katie Dean & Riki Polygenis are economists at ANZ Bank.