Key Takeaways
- It is possible, but not certain, that the economy can manage a "soft landing", with inflation decreasing to the Reserve Bank of Australia's target range without a major downturn and substantial rise in unemployment.
- While our baseline forecast is somewhat less optimistic than consensus on growth and inflation, we expect continued expansion in 2023 and 2024 and unemployment to rise moderately.
- The key risk is that inflation is more sticky than expected and the RBA has to hike interest rates more strongly, triggering a sharper economic downturn and larger rise in unemployment.
The Australian economy has held up, despite slowing global trade and higher interest rates to rein in inflation. The quarter-on-quarter GDP expansion has slowed from an average of 0.7% in 2022 to 0.2% in the first quarter of 2023. But the fact that growth has remained positive speaks to the domestic resilience.
In particular, the labor market has been strong. Job growth has continued through the second quarter and the unemployment rate has remained low at 3.5% in June (see chart 1).
Resilience in the service sector has been key to labor market strength. Manufacturing production momentum and sentiment have weakened since mid-2022. The momentum in service sector output eased as well in the second half of last year, as did confidence; but both picked up again in the first half of 2023. This matters since the sector contributed two-thirds to GDP in 2022 and employed 79% of workers. The labor market tightness may also reflect some labor hoarding, as firms worry they may not easily find new employees if they let some go.
Our Base Case Is For A Soft Landing
We forecast weak economic growth in 2023 and 2024 and, therefore, a rise in unemployment. Some of the impact of the interest rate rises so far is still in the pipeline and growth in the U.S. and Europe will slow. From Australia's perspective, China's recovery dampens the impact of the slowdown in the West but cannot offset it, given the continued weakness in China's commodity-intensive real estate sector.
The big question is how much Australia's unemployment will rise. A significant increase in unemployment would strain the economy and the financial system, including via higher defaults.
If the rise in the unemployment rate can be limited to around one percentage point, the economic and financial fallout should remain manageable.
How inflation can be reined in is key. To reduce inflation, the economy needs to cool to bring demand better in line with supply. The current bout of inflation was initially triggered by rapid increases in energy and food prices and global supply chain strains. But core inflation--underlying price increases after stripping out energy and food prices--has risen as firms pass on cost increases and workers demand higher wages. Core inflation was still 5.8% in the second quarter (see chart 2). Demand momentum needs to cool to bring down core inflation. Typically, the process to bring demand in line with supply after a period of overheating and inflation brings about a recession or contraction.
Chart 1
Chart 2
It is in principle possible for the economy to see a soft landing, with excess demand reduced not via a recession but through a period with actual growth lagging potential growth.
This is what the RBA is aiming for. In that context, it has slowed its policy interest rate increases recently, leaving the cash rate at 4.1%. In our view, it wants to see the impact of interest rate rises already implemented. Amid signs of a slowdown, it doesn't want to trigger a recession by lifting rates too much, given a reasonable chance it can avoid that without unduly compromising the inflation reduction.
Such a soft landing is also our base scenario. Our forecast is somewhat less optimistic than the RBA's on how fast inflation can come down: we expect it to ease to 3.6% by end-2024. Our growth forecast--1.4% for 2023 and 1.2% for 2024--is slightly lower than that of consensus and the RBA. But we expect that, because of resilience in the domestic service sector and with potential GDP growth higher than in the U.S.--amid higher population growth--Australia's economy can continue to grow modestly this year and in 2024. This is in spite of the headwinds from global demand and high global interest rates.
In this base scenario, we see unemployment going up only modestly. We forecast the unemployment rate will average 4.6% in 2024.
In the U.S., with which Australia shares similarities regarding the inflation and growth outlook, the odds of a soft landing have improved. Until recently most observers thought that a "soft landing" in the U.S. was unlikely. But a combination of somewhat better-than-expected inflation data and signs that the economy is holding up well have raised markets' expectations that inflation can be reined in without an economic contraction. This is why financial markets have rallied in recent weeks.
Downside Risks While a soft landing is the most likely scenario in Australia, there are substantial risks of a less benign outcome, with very low or negative growth. First, inflation may be more sticky, either because of renewed increases in prices for global energy (or other commodities) or, more problematically, due to persistent core inflation amid strong pass-through and wage growth. This would require more interest rate increases and thus a sharper downturn. Second, there could be other downward pressures on growth, for instance from deteriorating consumer confidence.
This report does not constitute a rating action.
AUSTRALIA
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| Primary Credit Analyst: | Louis Kuijs, Hong Kong +852 9319 7500; louis.kuijs@spglobal.com |
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