Where is Australia’s economy headed?
This week, we heard the economy grew by 3.6 per cent in the 12 months to June.
It was a strong rate of growth and showed some households were still happily spending money as the Reserve Bank began to lift interest rates in May.
But what will happen from here?
A slowdown in growth
Bill Evans, the chief economist of Westpac, says the RBA clearly wants to slow the economy down in the next 12 months.
He said the RBA’s objective is to slow demand to the point where inflationary expectations are wrung from the system.
And it’s using a blunt method.
It will get households to stop spending by reducing their disposable income and making them feel less wealthy.
“The channels for flattening growth in demand include a very large negative wealth effect as house prices tumble, restricted growth in household disposable income as interest rates increase, record low consumer confidence, and increased borrowing costs for businesses,” Mr Evans wrote.
“We think that objective will be achieved by steadily increasing the cash rate to 3.35 per cent by early 2023 with GDP growth eventually slowing to around 1 per cent in 2023.”
Growth of 1 per cent?
That would be a huge slowdown in economic activity.
As things stand, the RBA has lifted the cash rate target from 0.1 per cent to 2.35 per cent in five months, and Evans thinks it will lift the target by at least another 1 percentage point from here.
Inflation expectations
Questions have been raised recently about the theory that underpins inflation expectations.
But this week, RBA governor Philip Lowe said inflation expectations were still an important element in the “workhorse models” that central banks use to forecast inflation.
And he said inflation expectations had picked up a little recently, although not enough to suggest they’ve been one of the primary drivers of inflation in this cycle.
Which was a statement of the obvious. Gas and oil prices, the price of building materials and new homes, and the price of food, haven’t risen so sharply because we’ve been expecting them to.
Nevertheless, Mr Lowe said he was still concerned about the general inflation psychology in the community.
“Prior to the pandemic, it was very difficult for a business person to stand in the public square and say they were putting their prices up,” he said.
“And a common theme from our liaison was that, because most businesses had trouble putting their prices up, wage increases had to be kept modest. That was the mindset.
“Today, business people are able to stand in the public square and say they are putting their prices up, and they can point to a number of reasons why. The community doesn’t like it, but there is a begrudging acceptance.
“And, with prices rising, it is harder to resist bigger wage increases, especially in a tight labour market.”
He said there was “some evidence” that cost shocks were being passed through more quickly, with more frequent price and wage adjustments, and it was contributing to the strength of the pick-up in inflation.
“It is something to watch,” he said.
So, if we marry Bill Evans’s analysis with Lowe’s warning about the potential for inflation expectations to rise, it means the RBA is engineering a sharp slowdown in economic activity partly to discourage people from even thinking that higher inflation could set in.
What about incomes?
Westpac economist Matthew Hassan said household spending was strong in the June quarter as total wage income rose by 2.3 per cent.
But disposable income took a hit, partly from higher interest rates.
“The result meant disposable incomes declined in real, inflation-adjusted terms, down 0.5 per cent for a second quarter in a row,” Mr Hassan said.
“The combined effect took an extra $2.4 billion out of disposable incomes in the quarter.”
He said the fall in disposable income in the June quarter saw people saving less money so they could keep consuming at a high level.
And that was an important dynamic to keep an eye on, he said, because the interest rate squeeze on disposable incomes will “intensify dramatically” over the second half of this year.
“The combination of a decline in real disposable income and a solid rise in real consumer spending produced another fall in ‘new’ household savings [the portion of income unspent],” he explained.
“The savings ratio dropped to 8.7 per cent in the June quarter from 11.1 per cent in the March quarter and 13.5 per cent in the December quarter last year.
“In nominal terms, this reduced savings effort effectively ‘freed up’ $7.6 billion for spending, accounting for most of the $10.8 billion increase in spending in the quarter.
“Based on a ‘6 per cent norm’ for savings, the accumulated reserve from ‘excess’ savings over the last two and a half years now stands at around $275 billion.”
When will some households stop spending?
So, where to from here?
Mr Evans said there were a number of areas of uncertainty that could impact the interest rate path in the coming year.
But a crucial area was the degree to which households would be willing to use their accumulated savings to offset the RBA’s interest rate increases.
He said there was a risk the RBA may end up having to lift rates even more if households didn’t curtail their spending at some point.
“Unfortunately, if household spending, in particular, does prove resilient, it is likely that the RBA will extend its tightening cycle further into 2023,” he said.
And that would affect people with mortgages.
Households with fixed-rate mortgages have been largely shielded from the RBA’s interest rate increases so far.
But the majority of those fixed-rate loans are due to expire over the next two years, with the greatest concentration of loans expiring in the second half of 2023.
When they do expire, the interest rate shock will be big.
“Assuming all fixed-rate loans roll onto variable mortgage rates and new variable rates are broadly informed by current market pricing, estimates suggest that around half of fixed-rate loans would face an increase in repayments of at least 40 per cent,” RBA deputy governor Michelle Bullock said in July.
Given the lag effect from interest rate increases, it will also take a while for variable-rate borrowers to experience the coming deterioration in their spending power.
Meanwhile, renters are also seeing their post-housing disposable income eroded by a dramatic surge in asking rents.
On the flip side, there are the savers with no debts who are now enjoying better returns off their deposits and will be able to spend even more, nullifying some of the effect the RBA is trying to achieve.
There are also plenty of people who have no spare money to spend as it is, with no savings to speak of.