Economic and financial market update

What is normal?

Summary:

• The economy has been buffered by long-lasting significant events;
• Some of those events have largely ended, some are current, some will be with us for some time;
• These events are having offsetting impact in how the economy will evolve;
• A key to the economy and interest rate outlook is how far income growth will be above the rate of inflation.

Australia was less impacted by the GFC than most other developed economies. But a backdrop of a weak global economy and declining structure of world interest rates meant that interest rates in Australia also declined sharply. The negative impact from the GFC has largely passed. This means that one factor that has been holding back the domestic economy and interest rates over recent years is no longer in play.

The end of the mining boom played an important role in an extended period of Australian economic underperformance in the years prior to the pandemic. By 2018 the fallout from the end of the mining boom began to diminish. The terms of trade started to improve and mining capex spending started to increase.  State Governments’ have ramped up their infrastructure spending. 

Pandemics have historically resulted in lower economic growth, inflation and interest rates. The economics have been different in this pandemic. Demand has still been weak. But Governments’ and central banks have been able to substantially offset any income declines. Online shopping has enabled the demand for goods to continue. Lockdowns and rising consumer caution have hit the supply of goods and services. The result has been higher inflation and therefore higher interest rates. 

Wars almost always lead to higher demand and lower supply. They result in higher inflation (and therefore higher interest rates). Russia and Ukraine’s importance as commodity exporters has led to significant rise in commodity prices. By itself this will lead to higher inflation and hurt importing commodity countries (notable Europe, China, Japan and Korea). Commodity exporters (such as Australia) benefit. To me the short-term economic growth impact of the disruption caused by the war is unclear. In the medium term (longer than 1-2 years) demand is likely to be higher due to higher defence spending. 

In recent years there has been growing recognition that climate change will have a significant impact on the economy and society. The result has been increasing investment in alternative energy and more spending to mitigate the cost of the climate change that has already happened. From an economic standpoint that means higher demand (greater investment). 

Global population growth is both slowing and aging. This means that growth in the global labour force will be slower and will likely lead to slowing growth in demand. An older population also requires more government spending on income support (pensions) and health. An aging and declining population was first called out as a possible issue for Australia about twenty years ago.  But the subsequent strong immigration growth meant that Australia experienced a period of strong population growth. And because immigrants were younger than resident Australians it reduced the immediate concern about an aging population. This underlines the importance of a return of strong immigration growth. 

High debt levels typically reduce demand. A large amount of debt can be a problem in very low inflation times (particularly if there is deflation). It is less of a problem during periods of rising inflation (and wages growth) as borrowers have greater capacity to repay debts. Crucial is what happens to interest rates relative to wages and profit growth (or more precisely, disposable income growth). The strength of disposable income growth will play an important role in how high interest rates will go in coming years.

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