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Economic Research: Australia Can Avoid A Hard Landing

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Economic Research: Australia Can Avoid A Hard Landing

Australia's economy is holding up well. We expect a soft landing in 2024, supporting our 'AAA' sovereign rating. That's despite slowing global trade, rising interest rates, and pockets of weakness this year. We recently revised our fiscal 2024 growth forecast slightly higher to 1.2% (or 1.4% on a calendar year basis; see "Economic Outlook Asia-Pacific Q1 2024: Emerging Markets Lead The Way," published on RatingsDirect, Nov. 27, 2023).

In particular, we forecast the labor market to remain sound, with unemployment averaging about 3.9% in fiscal 2024. The unemployment rate is very low, in a historical context, at 3.7% in October. Amid a tight labor market, Australia's wages growth picked up to 4% for the year to September 2023, and inflation momentum rose again to an uncomfortably high pace for the Reserve Bank of Australia (RBA). Annual wage growth is at its highest level since the mining boom prior to the 2008 global financial crisis. We think it is near its peak.

To Curtail Inflation Faster, Rates Must Rise

We forecast the cash rate will increase further in early 2024 to 4.6% before Australia gets on top of inflation. Domestic inflation is higher than the U.S., eurozone, and the U.K., despite peaking at a lower level (chart 1). In our view, inflation will average about 4.4% for fiscal 2024--well above the RBA's official target.

The broad-based nature of inflation and the increase in service-driven inflation forced the central bank to raise the official cash rate by 25 basis points (bps) in November 2023 to 4.35%. According to the RBA, inflation is increasingly homegrown and demand-driven, rather than stemming from supply-side constraints. The next monetary policy board meeting on Feb. 5-6, 2024, will allow officials time to assess spending patterns and inflation trends over the festive season.

The RBA has rapidly increased the cash rate to curtail domestic demand. However, the central bank's rate rises have lagged other advanced economies in terms of pace and magnitude (see chart 2). The RBA also paused rates earlier than several advanced economies. This may be because Australia's monetary policy transmission (i.e., the speed that mortgage repayments reprice) is usually faster than many other countries, according to economists and policymakers. Australian homeowners much prefer variable-rate mortgages than fixed-rate mortgages. Even with mortgage payments adjusting quickly, Australia's inflation is sticky and may remain above the RBA's target for another two years.

Chart 1

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Chart 2

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Higher Interest Rates Mean Slower Growth

We forecast growth to slow to 1.2% in fiscal 2024. Real GDP will derive support from low unemployment, and slowing, but still positive, investment and consumption growth. Very high migration is masking underlying weakness. The economy is already in a per capita recession, and real disposable income is contracting at the fastest pace in the Organization for Economic Cooperation and Development (OECD) in 2023. It is worth noting that Australia's real disposable income grew aggressively during the pandemic and is back to 2020 levels, and other OECD countries suffered corrections in 2022.

We don't expect a large rise in unemployment over the next two years. Because of this we believe any economic, financial or credit fallout from a slowing economy and rising rates should be manageable.

Higher Inflation Means More Revenue For Governments

Between fiscal 2023 and 2026, we anticipate that general government revenues will surpass those of the four years before the pandemic by more than 2.3% of GDP. High commodity prices have resulted in strong mining profits and therefore company taxes. Central government revenues are A$17.4 billion (or 12%) higher in the September 2023 quarter than the previous year, while expenses are A$9.4 billion (or 6%) higher. In 2022, taxes collected across all tiers of governments in Australia rose 15.2%, according to the Australian Bureau of Statistics.

Strong employment growth and growing wages combined with fixed income tax brackets have resulted in rising personal income taxes. Australia isn't alone in so-called bracket creep: a 2018 IMF study found that 131 of 160 countries didn't regularly adjust their brackets. Of the 29 that regularly adjusted their brackets, only nine referred to inflation adjustments, including Austria, Canada, Denmark, the Netherlands, and the U.S. Unlike many countries, Australia relies heavily on income taxes. According to the OECD, Australia is the second most reliant OECD member on income taxes, trailing only Denmark.

In contrast, Australia has the third lowest reliance on consumption taxes (i.e. the goods and services tax, or GST) as a proportion of its tax take. While the GST rate is half of that in the eurozone, high inflation and rising nominal prices of goods and services still support GST revenues. GST revenues rose 11% in fiscal 2023, but is slowing, reflecting soft consumption.

Fiscal Policy May Be Dulling The Effectiveness Of Monetary Policy

Government spending may be boosting domestic demand. The central government has returned most recent revenue windfalls to the bottom line (i.e., turning a projected headline fiscal deficit into a surplus). However, spending is still higher as a proportion of GDP than it was pre-pandemic. Further, states have paid less attention to fiscal consolidation, particularly around the time of elections, in our view. States haven't tightened their belts since the midst of the pandemic when interest rates were near zero and there were unanimous calls for them to spend and invest.

We estimate Australian governments (both central and subnational governments) are spending an extra A$50 billion a year, after adjusting for the growth in the economy, than they were leading into the pandemic. That means spending is about 2% of GDP higher than it was pre-pandemic. When adjusted for higher interest payments on borrowing, governments are still spending an extra 1.4% of GDP (or A$36 billion a year) during fiscal years 2023-2026 than the four years leading into the pandemic. Central government spending accounts for about 0.75 percentage point of GDP of the uplift, with the remaining 0.65 percentage point of GDP due to state governments (see chart 3).

We forecast state governments, at the non-financial public sector, to run deficits of about 2.1% of GDP in fiscal 2024. This is 50% higher than last year as commodity royalties (particularly coal) normalize, and some states increase cost-of-living support. Our expectation of state deficits in fiscal 2024 is only 0.5% of GDP lower than their pandemic peak of 2.65% in 2021. This highlights the relaxed approach many states are taking to fiscal consolidation.

Chart 3

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Government spending seldom affects inflation as measured by the consumer price index (CPI)--governments don't generally buy goods and services in the CPI basket such as bread and milk or have haircuts. Some government policies, such as energy and childcare subsidies, lower CPI directly. For example, electricity contributes 2.2% of CPI and childcare 0.8%. Therefore, policies that reduce energy and childcare bills will lower CPI.

We note, however, that subsidies, cost-of-living measures, and higher government payments (whether through wages, new policies, or welfare) put cash in people's pockets. This can counter the government and RBA's efforts to reduce CPI, depending on if, and where, people spend these funds. For example, if people use these savings to eat at restaurants (which contribute 4% of CPI) or take domestic holidays (2.4% of CPI) it could mean CPI is higher than it would have otherwise been.

Another way government spending injects cash into the economy that can increase prices of products and services is via infrastructure spending. A record government infrastructure pipeline is contributing to higher input prices and wages. This is despite the Commonwealth's recent pledge to cut 50 projects. Input prices are captured in the producer price index (PPI; see chart 4), not the CPI.

Chart 4

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The governments' infrastructure spending isn't the only driver of PPI but is adding to pressure, in our view. The enlarged government infrastructure pipeline is squeezing the construction sector's capacity and may be crowding out private investment. The PPI has risen by 30% since the March 2021 quarter, with timber up 35%, and ceramic products (such as bricks), cement products, and steel up 30%. Some of these price movements reflect global demand-and-supply dynamics, including pandemic-related supply constraints.

We forecast state infrastructure spending will reach A$80 billion (3.1% of GDP) in 2024 up from A$37 billion (2.3% of GDP) in 2015. The independent government advisory body Infrastructure Australia estimates that the demand for workers from public infrastructure has been outstripping supply since late 2021 (see chart 5). Infrastructure Australia projects this imbalance will continue until early 2025. We believe this will likely drive strong wage outcomes and increases in input prices.

Chart 5

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In our view, the Australian economy will overcome downside risks. And this will continue to support our 'AAA' sovereign rating, and our 'AAA' to 'AA' credit ratings on the Australian states. But while we believe the economy will see a soft landing, hardships will persist. A stronger recovery isn't yet in reach.

Editor: Lex Hall

Related Research

This report does not constitute a rating action.

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