• The Governor’s opening statement forecast that growth of 2‑3%pa is the most likely outcome for 2014/15 and inflation to remain consistent with the 2% to 3% target.
• Economic growth could be higher but there are significant forces restraining activity.
• There are signs of a pick‑up in non‑mining investment but investment intentions are mixed and dependent on the domestic growth outlook. Australians have become more risk averse since the GFC.
• The unemployment rate could stay near present levels and not fall significantly until 2016.
• The AUD remains high because of comparatively attractive yields in Australia. The USD is unusually weak. The RBA is not keen on market intervention to weaken the AUD.

RBA Governor Stevens and other officials appeared before the House Economics Committee in Brisbane this morning.  While the recent Statement on Monetary Policy (SMP) seemed to emphasise the downside risks to growth, the Governor was a touch more positive yesterday. The Governor was willing to contemplate some upside growth risks and noted that recent forecast changes didn’t really indicate a shift in thinking. Assistant Governor Kent muddied the waters a little by suggesting that the labour market outlook was little changed from earlier thinking as well, with a turning point in unemployment a little sooner than suggested in the SMP. The comment certainly suggests a reluctance to cut rates. But equally, the Governor made it clear that the RBA had not thought about raising rates lately.

The opening statement repeated some of the themes evident in the detailed media interviews and speeches in recent months. Namely, in terms of the world economy, growth is continuing at a “moderate pace”.  Importantly for Australia, major trading partner growth is running around its long‑run average rate.  China’s growth has been close to the official target of 7.5%.  The Governor noted the low volatility across global financial prices which is partly a reflection of the “exceptional” accommodative monetary policy that has been conducted across the world.

In terms of the Australian economy, GDP growth looks set to be between 2% and 3% in 2014/15 which is below its trend rate. The forces restraining growth are well known. The current fall in mining investment could be a bit larger than previously expected. The Australian dollar (AUD) remains relatively high, especially when compared to the level and direction of bulk commodity export prices. The USD, unusually, appears to be relatively weak given its firming growth and interest rate outlooks. Consumer spending is unlikely to lift significantly and could rise in line with modest income growth.

Offsetting these domestic weaknesses there is clear evidence of stronger activity in the interest‑rate‑sensitive areas like housing and other construction. The labour market reflects the conflicting forces in the real economy. The RBA expects the unemployment rate to stay high for a considerable period, until 2016. June quarter GDP growth is likely to be relatively weak compared to the strong QI figure.

The Governor’s testimony indicates that other issues, besides monetary policy, are holding growth back from its potential rate. Namely, a consistent and sustained lift in business confidence is required which would lead to higher non‑mining business investment. The shift to more risk aversion by households and business restrains economic growth.

The unemployment rate could stay near present levels until well into 2016. While forward indicators are positive there are other issues, like strong population growth, which impede a marked reduction in the unemployment rate.The highlights of the Q&A session include:

•  The high AUD reflects strong inflows of capital seeking higher yields, as well as a weak USD.
•  The RBA is keeping direct currency intervention as “part of the toolkit”.  So far, the Governor believes that it was been the “right call” not to intervene in the currency market.
•  Low wages growth is a product of elevated job concerns but it will help the economy adjust to a more competitive position and support jobs growth.
•  Productivity trends appear to be improving but more efforts are required to replicate the 1990s gains.
•  The RBA’s inflation target has a priority in policy deliberations over the setting of the cash rate.

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• The RBA maintained its guidance that “the most prudent course was likely to be a period of stability in rates”.
• The tone was in line with previous Board minutes, highlighting the “significant degree of uncertainty” about the growth outlook.
• Trading partner GDP growth was expected to be slightly above its decade long average. But bulk commodity prices had fallen in the June quarter because of new supply from Australian producers.
• Firmer US activity and the US Federal Reserve’s reduction of financial assistance point to higher US interest rates next year.
• Businesses remain reluctant to commit to higher investment until they see signs of stronger demand.
• The RBA Governor will give his semi‑annual testimony to the House Economics Committee in Brisbane tomorrow.

It is worth remembering that yesterday’s August RBA Board meeting (and the minutes) preceded the more recent Statement on Monetary Policy (SMP). The SMP downgraded slightly the RBA’s GDP and inflation forecasts. It also included a relatively negative view on the labour market. Namely that the unemployment rate is likely to “remain elevated” and may not “decline in a substantial way till 2016”.

The Board minutes are very clearly “neutral” in their outlook for monetary policy. The forces acting against higher growth (like an overvalued AUD) are offsetting significant amounts of the benefits flowing from lower interest rates settings, such as a pick‑up in residential construction, and higher export volumes. The Board sees the conflicting forces operating currently as producing a “significant degree of uncertainty” around the growth forecasts. So the growth “transition” is underway. But the net effect is modest and not sufficient to lift GDP growth close to “trend” outcomes, ie 3¼%pa. More importantly domestic activity measures are well below trend.

The RBA’s views on the inflation outlook are, in our view, reasonably optimistic. They expect the “transition” to mid‑target band inflation as subdued wages growth reduces non‑tradables inflation to similar levels. It is clear that wages growth is subdued, running at just 2.6%pa in QII, the lowest in 16 years. But non‑tradables inflation remains stubbornly at 3%, which is at the top end of the inflation target band. Our take on the most likely way the economic data will evolve in coming quarters is more optimistic, growth‑wise, than the RBA. It has implications for our expectations on the most likely inflation outcomes as well.

It is worthwhile to note that financial markets are pricing in a 50% chance of a rate cut by mid‑2015. So the markets increasingly believe that the headwinds to growth will win the macro‑economic battle in coming quarters. They will be helped by a strong AUD which is negative for many sectors’ growth and employment outlooks. The restructuring forces imparted by the strong AUD are still considerable on activity levels and the inflation outcomes.

The RBA’s comments on the Australian dollar again point out the misalignment between significantly lower bulk commodity prices over the past year and the resilient AUD. Australia’s relatively high yielding interest rate securities, by international standards, are still attracting considerable offshore investor interest, despite the prospect of higher US and UK interest rates through 2015 and 2016.

We still believe that the question the RBA will be likely to debate early next year is “does it make sense to keep cash rates at record lows in an economy running near trend growth and where the desired growth transition is underway?”  We will have to wait for the next few jobs market figures to determine whether the July unemployment rate of 6.4% was an aberration or the new norm. If the unemployment rate falls back to 6% we would see it as supporting our argument.

Our somewhat ambitious call remains in place. We expect the RBA is likely to begin “normalising” monetary policy in early 2015.  The next major parts of the economic jigsaw are the QII Capex survey and, in the following week, QII GDP. Both have some downside risk. Even though the business surveys are showing higher confidence levels it is not flowing into better labour market conditions. The risk is that a sustained stronger AUD could impact on the inflation trajectory and the growth transition and therefore the timing of any ultimate interest rate move.

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The week ahead

The ECB cut rates and introduced aggressive expansionary measures to lift EZ growth.

The market reaction to tonight’s May non‑farm payrolls data is likely to set the tone across financial markets next week. A rise of around 215k in employment is expected, with the unemployment rate to rise slightly to 6.4%. Such an outcome would be within the Fed’s general expectation about growth trends. Markets also believe that a smaller jobs gain most probably would not derail the Fed’s next “tapering” adjustment at the 18 June FOMC meeting. US bond yields rose during the week, as the growth outlook improved, after reaching unusually low levels at the end of May.

The past week has had some interesting developments. The ECB delivered some reasonably aggressive changes to monetary policy settings aimed at lifting growth and lifting inflation over coming quarters. The introduction of negative interest rates for deposits at the ECB by the major banks was widely expected. But it is still an unusual measure and demonstrates the seriousness of the deflation pressures in the EZ. In contrast to the ECB’s measures, the Bank of England left their cash rate at a record low of 0.5% on Thursday.

In the US, in the past week, there was some confusion over the correction to the ISM data that ultimately showed a continued expansion in the US manufacturing sector. It was positive for the US growth outlook and helped to lift longer term bond yields up from their recent lows.

The data schedule in the US and Europe is relatively light and skewed towards the end of the coming week. In the US the major releases are the May retail sales and consumer confidence data. The focus will tend to be on the upcoming Fed meeting in the following week. In the EU there will be updates on industrial production and the international trade balance. The UK has employment data which, if stronger than expected, could have the markets pondering the timing of the BoE’s expected rate hike. UK markets have priced in a BoE rate hike in QII 2015.

In Australia over the past week we had updates on a large number of indicators. The major one was the QI GDP which came in at a robust 1.1% to push annual growth to 3.5%, the highest in the past two years. Our analysis is included inside. The major driver of the QI result was mining‑related exports. Over the past year, about two thirds of growth has come from that source. Other data showed a stumble in the monthly building approvals. But the pipeline of planned construction remains large and should keep adding to growth. April’s modest retail trade rise still left annual growth at just under its long term average of 5%pa. The small April trade deficit followed a string of strong, upwardly revised surpluses.

In Australia this week, the main release is Thursday’s jobs data which is expected to show a rise of 10k. The unemployment rate is forecast to stay at 5.8%. Conditions in the Australian labour market have improved and the forward looking indicators suggest jobs growth will rise in coming quarters.

In New Zealand, the RBNZ is expected to lift their OCR to 3.25% on Thursday as the inflation risks rise and economic growth lifts. The RBNZ could stay on the sidelines in following months, until December, and watch the flow of data before lifting rates again.

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Joe Hockey is due to deliver his first Budget next week.

The Commonwealth Budget will be handed down on 13 May.  The precise details will have to wait for Budget night.  But the Budget theme has been made very clear.  It will be of the “blood, sweat and tears” variety.  And all will feel the budget lash.

The Budget is one of the big set pieces of economic policy.  But it is fair to say that fiscal policy has taken a back seat to monetary policy in public and financial market perceptions.  This time is different.  The rhetoric has been ramped up to unprecedented levels.  And a concerted campaign has been underway for far longer than usual to prepare the ground for a tough budget.  The Treasurer, for example, talks of a “budget emergency”.  The Prime Minister points to a “Ponzi scheme of unsustainable spending”.  The more measured comments from government officials such as RBA Governor Stevens and Treasury Secretary Parkinson are along the lines of having a “national conversation” about the level of government services we want or are prepared to pay for.

The Budget & the Commission of Audit

The Commission of Audit has set the parameters.  An aging population and associated trends will ramp up government spending and erode the tax base over the next decade.  Government spending on major programs will run ahead of GDP growth and the spending share will inexorably rise.  Revenues will also rise.  But the bracket creep underlying revenue growth will have some undesirable consequences.  Treasury Secretary Parkinson, for example, notes that the average tax rate for the average taxpayer will rise from 23% now to 28% by 2023/24.  The resulting economic distortions are such that tax cuts appear certain over the next decade.

The bottom line is clear.  A “business as usual” approach would see deficits persist over the next decade.  The limited ability to influence revenues and the probability of tax cuts means the focus must be on the expenditure side of the Budget.

The Commission of Audit makes 86 recommendations that, if accepted, would balance the books by 2018/19 and deliver the government target 1% of GDP surplus by 2024.  Distilling these recommendations down, real government spending growth in this “reform” scenario must be kept to 1¾%pa.

On the Audit, the Treasurer noted that “We do not automatically accept all of its recommendations.  Some can be actioned in the short term, others will require further consideration, and some will be rejected outright”.  He described some of the proposals as “courageous” and indicated that the initial response to the Commission’s recommendations will be the Budget itself.

So there will be an element of cherry picking when it comes to what will be included in the Budget.  The pain will be shared across households, business and the corporate sector.  Based on comments by the Treasurer and Prime Minister, we can expect to see proposals for means testing, co‑payments and reciprocal obligation.  The “age of entitlement” is over!  Other areas of “pain” will be promoted as economic reforms.  The government will withdraw from areas where the private sector can adequately fulfil the function.

Scoping the Budget task

Keeping real government spending growth to 1¾%pa is a big ask.  We have done better than that for short periods.  But not over the extended time frame required in the Commission of Audit reform scenario.

Some rough figuring indicates that hitting the 1¾%pa target over the traditional four‑year forward estimates to 2017/18 would require cumulative spending cuts of $33bn relative to the business as usual baseline.

What will the Government deliver?

New Governments are typically at their bravest in Year 1.  And given the level of expectations that have been encouraged, a tough budget will need to be delivered.  Policy makers are clearly finding the going tough, however.  The possibility that tax measures such as a “deficit levy” are under consideration highlights the point.  As does the apparent decision to wind back some of the signature policies proposed by the Coalition during the Election campaign.

We expect fiscal initiatives to fall under a couple of broad headings:

(i) Delivering on Election promises

The Coalition’s election campaign was built around a small number of signature themes.  The main themes relate to improving the backdrop for business and easing pressures on households.   The package includes removing the carbon tax and the mining tax, cutting the company tax rate by 1.5ppts to 28.5%, pursuing an “affordable” version of the NBN, a generous paid parental leave scheme and lifting infrastructure spending.  Defence spending will rise over time.

Other proposals largely relate to paying for the main policy themes and shifting the focus on climate change to “direct action”.  Foreign aid, the public service and business bear the brunt of the proposed changes (eg losing carbon tax compensation, a 1.5% levy to partly cover paid parental leave).

We expect the Budget to deliver on these commitments.  But with one important exception.  The means‑testing theme from the Commission of Audit appears to mean a standardised cut off point at a family income level of $100k.  So the paid parental leave scheme will be a little less generous than previously outlined.   The Family Tax Benefit payment will be more tightly targeted.

(ii) Cherry picking the Commission of Audit

Means testing, co‑payment (or price signals) and reciprocal obligation themes from the Commission of Audit will be evident across a range of portfolios including social security and health.  Welfare payment indexation rates seem set to be shifted in a way that will contribute to slower spending growth.  There may also be some reallocation of responsibilities between the Commonwealth, States and the private sector, at least as an objective.  Privatisations are back on the agenda.

(iii)  Promoting infrastructure spending

he “positive” news part of the Budget will be an increased focus on infrastructure spending.  There have already been announcements about a second airport for Sydney, a sizeable rise in road funding and incentives for asset recycling by the States.  Asset sales will help fund these initiatives.

Reconciling short‑run requirements with longer‑run needs

The rhetoric justifying a tough Budget sits at odds with concerns about growth and labour market prospects.  And with the commitment made by the Treasurer at the recent G‑20 meeting to set a GDP growth target for Australia of 3%pa.

The rationalisation of these competing objectives lies in the new ten‑year forecast horizon that resulted from negotiations to eliminate the Commonwealth debt ceiling late in 2013.  This fiscal cycle can now be divorced to some extent from the political cycle.  The Government should no longer feel constrained to produce a Budget surplus within the traditional four‑year projection period if this is not economically desirable.  They can, however, announce measures designed to get there within a realistic timeframe.  And, if the proposals look credible, then there should be widespread acceptance of the strategy.

The reality may be that a lot of the Budget “nasties” are announced on Budget night.  But they may not take effect until a few years down the track.  The back‑end‑loaded nature of many spending commitments makes this approach feasible.  The gap between budget outcomes in the Commission of Audit’s business as usual and reform scenario is actually quite small in the early years ($1‑6bnpa over the next three years).  The approach to pension reform is an example.  The Prime Minister has indicated that any changes such as lifting the retirement age will not occur before the next election (that is, post 2016).

Medium‑term fiscal strategy

The Commission of Audit recommended that the Government adopt a high‑level fiscal strategy which seeks to achieve underlying cash surpluses, on average, over the cycle.  This is the approach in place for a considerable time now and there seems little reason to shift.

In an operational sense we expect the fiscal strategy to be set as;

·         reaching a surplus of 1% of GDP by 2023/24;

·         keeping taxation receipts below 24% of GDP; and

·         improving the government’s balance sheet over time.

The shape of the Budget economic forecasts

The Budget is likely to adopt economic assumptions similar to those that underpin the Commission of Audit.  Those forecasts have:

·         Real GDP growing by 2½% in 2013/14 and 2014/15, and 3% in the subsequent two years.

·         Nominal GDP, which drives the revenue side of the budget, growing at 3½%pa in both 2013/14 and 2014/15, increasing to 4¾%pa in the next two years.

These forecasts look conservative.  Trend GDP growth is generally put at 3%pa or a touch higher.  An assumed continued decline in the terms of trade back to 2006/07 levels by 2019/20 lies behind the weak nominal GDP forecasts.  This is a pessimistic assumption.  Commodity supply will rise.  But global demand also has some upside.  The unemployment rate is projected to remain around 6% beyond 2014/15.  This forecast is also pessimistic considering the unemployment rate has averaged 5.1% over the past decade.  And the standard forecasting assumption in Intergenerational Reports and so on is to equate full employment with a 5% unemployment rate.  So there are upside risks to the Commission’s growth, employment and revenue forecasts.

The revenue side

Assumptions/forecasts for nominal GDP growth are critical for Budget projections.  Nominal GDP is effectively the tax base.  And faster growth in the tax base should mean faster growth in revenues.

Nominal GDP growth has picked up over the past year.  Income growth at the end of 2013 was running at a 4.8%pa pace, well up on the 2.3% rise recorded during 2012.  And tax revenues are starting to respond.  The budget deficit for 2013/14 should be noticeably smaller than the $47bn estimate published in the mid‑year budget review in December.  The cumulative underlying deficit for the eight months to February 2014 was $30.2bn, some $3bn smaller than expected at the time of the mid year review in December.

Our forecasts have faster growth in nominal GDP in the out‑years as well.  Our budget model suggests the better picture for income growth could improve the starting point for the 2014/15 Budget by nearly $6bn.

 A deficit levy?

A new income tax or so‑called “deficit levy” could be part of the Budget.  Levies are not new to Australian Governments.  In the past, levies have included:

·         the “gun buy back” levy in 1996/97 (0.09% GDP);

·         the “East Timor” levy in 2000/01 (0.13% of GDP); and

·         the “flood” levy in 2011/12 (0.12% of GDP).

The impact that a levy is likely to have on consumer spending depends on its size and timing.  The “East Timor” levy in 2000/01 was applied during a period of strong credit growth and rising real incomes.  And it came into play the year that the GST was introduced.  Retail trade growth was above average over the year.  On the other hand, consumer spending growth came in below its long run average during the years when the flood levy and gun levy were both applied.  But the trend in retail trade growth at the time the levies were introduced didn’t materially change.  This minimal impact on spending was primarily due the small size of the levy.

The details of any potential “deficit levy” for inclusion in the Budget are not clear.  But any non‑trivial increase in income tax rates at a time when wages growth is weak and the economy is stuck in a sub‑trend groove may have a negative impact on consumer spending, notwithstanding the recent solid lift in retail trade.  Depending on the exact details, a 1‑2% tax on people earning $80,000 or more could be expected to raise $2‑4bn (or 0.13‑0.25% of GDP).  A levy at the upper end of that range would be a little larger than the “East Timor” and “flood” levies.

Funding the deficit

Our forecast for slightly smaller underlying deficits translates through to a smaller call on the bond market.  After accounting for existing ‘investment’ cash flow projections (such as funding student loans and the NBN) but also adding in $4bn for the expected sale of MediBank, we estimate the headline cash deficit will also narrow by $17bn in 2014/15.

Including approximately $27bn of maturities in 2014/15 gives AOFM a total funding task of around $59bn – a significant step down from peak funding of $72bn in the current financial year.  With state governments also producing improved budget results, the recent theme of demand exceeding supply is set to continue.

Along with the positive implications of fiscal tightening for the AAA/Aaa rating (see below), and the downward pressure it places on long‑term interest rate expectations, we see this dynamic as highly supportive for the back end of the steep Aussie bond curve.  We forecast the 3/10yr bond curve to flatten to around 40bp in 2014/15, and the AUS‑US 10yr spread to narrow to 110bp.

We expect AOFM to stick with bond tenders of around $700m twice a week in the first half of the financial year.  We also anticipate a new 2035 nominal bond will be issued, thus keeping a 20‑yr benchmark in place following the successful issue of the 2033 bond last November.  There is also room to fill in the space between the 2027 and 2029 bonds, or perhaps a late 2019 bond given all prior years already have two maturities.  We would also expect a new linker, though are not sure AOFM would want to go as far as 2040 yet.

Recent syndicated deals have been large and the recent $7bn 2026 transaction was particularly successful.  As we wrote in March, these larger transactions have enabled liquidity to be built quickly, thus lowering the premium that used to be applied to new issues.  Continuing down that path with 3‑4 new bonds amid a smaller issuance task implies that AOFM may have to step back from tendering twice a week once we enter 2015.  But we don’t expect them to announce such plans at this early stage.

Implications for the AAA/Aaa rating

The Budget should help underpin the AAA/Aaa rating.  The renewed focus on unsustainable spending, with more conservative revenue and growth forecasts, is a welcome development from this perspective. Overall, we’re more optimistic on fiscal risks than in 2013 (at the time of our last ratings analysis).  Within Moody’s and S&P’s ratings methodology, we see Australia holding onto relatively high fiscal scores if the reform scenario highlighted by the Commission of Audit is largely adopted.

An improving fiscal profile should also alleviate pressure on the large total economy foreign debt load.  Consistently, Australia has registered one of the largest foreign liabilities and current account deficits of all high rated countries (see chart).  This debt increases Australia’s vulnerability to shocks in foreign income and market conditions.  Looking ahead, lowering the government borrowing requirement will reinforce the transition from externally‑funded mining investment to a resource export boom currently underway.  This is expected to be a net credit positive as it should underwrite a medium term improvement in the current account balance.  Notwithstanding this progress, the external debt level will remain a source of ratings vulnerability in the years to come and will continue to underscore the need for fiscal prudence.

The slow growth and soft labour market outlook will remain challenging for revenues and tighter spending will accentuate this pressure.  The transition in growth away from resources investment will continue to be a challenge, but we think it’s manageable in the absence of a severe hard landing in China.  An increasing reliance on the housing sector throws up its own set of risks, as Australia’s households are among the most indebted in the world.  We see current household credit conditions as benign, but an undue rise in borrowing could change that assessment.  We are, however, confident that flexible monetary policy and a strong banking system (amongst the best in the world according to S&P metrics shown in the chart) will continue to offset this risk.

Appendix: Other measures

The Commission of Audit means much of the pre‑budget debate has centred on spending in the big ticket programs.  The tax side of the debate has fixated on proposals for the deficit “levy”.  There are many other options that fall on the “courageous” side of the ledger that are often raised at this time of year.  So a Budget preview would not be complete without looking at those other options.  Some of these are shown in Table 5.  Note that our cost estimates are “approximate” and use some of the published ATO data eg for the cost of tax concessions like negative gearing.

To put the list into perspective, total Federal Government revenues are around $410bn, even after the $36bn in deductions claimed by individuals.  Small changes in deductions and spending can boost the Budget bottom line significantly.  There is, however, an “iron law of unintended consequences” involving tax and spending changes.  Households and businesses plan their decisions around their tax position.  Changes to tax rates and inclusions do change spending and savings positions – superannuation is an example.

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Financial markets had a roller coaster week, thanks mainly to events in the Crimea. A referendum in that region over the weekend, and international reaction to it, could prolong the volatility for shares, currencies and bonds. The US FOMC meeting may add to market moves if they depart from current views about the tapering program.

On Thursday the RBNZ lifted the Overnight Cash Rate, which had stayed at 2.50% for 3 years, to 2.75%. The ASB Chief Economist, Nick Tuffley, analyses in an article inside, the RBNZ’s reasoning. He forecasts the OCR to rise further over 2014 and 2015. NZ QIV GDP data this week is expected to show annual growth above 3%.

Australia’s financial markets received some shocks on Thursday. The first was a startling 47k jump in February jobs, with some upward revisions, unpalatable for some, to a previously quite weak history. Bond yields and the AUD/USD jumped initially, then regained some composure as more details about the survey methodology emerged. In our view, the February spike in employment is a “statistical reversal” of previously reported weak numbers given the limitations of a survey‑based data measure. On a three‑month average basis, jobs growth is around 14K. Firm population growth means around that 18K jobs are required every month to keep the unemployment rate stable. So it is reasonable, in our view, that while the short term risk remains with a rising unemployment rate, market watchers should prepare themselves for a gradual improvement in the jobs market around mid‑year. Markets are now pricing in the next RBA rate move as a rise, in mid‑2015. In our view it is more likely to be in late 2014 given our expectations about rising inflation risks. We expect the RBA to lift the cash rate to 3.5% in late 2015.

Weaker than expected China data on industrial production and retail sales was the second shock on Thursday. It restored the faith of those with bearish views on China, Australia and commodity prices. Our view is that the January‑February data in China is unduly influenced by shifts in the timing of the Lunar New Year. Another issue relating to the direction of the Chinese Yuan, CNY could become more important for markets in coming months. The CNY, which is controlled by China’s central bank (the PBoC), has fallen recently against the USD when its usual trend of the past few years is to appreciate. A weaker CNY will help China’s exporters but lift the cost of imports and possibly, inflation.

The US data in the coming week covers industrial production, CPI, housing construction and, most importantly, the US FOMC meeting. It will be the first meeting with Janet Yellen in charge. The Fed is expected to continue its tapering of asset purchases. It is also likely to change its forward guidance on monetary policy. Namely, the general unemployment rate target may be replaced by a broader set of jobs market indicators. The Fed could also adopt an approach that discusses what they intend to achieve with an interest rate rise and whether further rate rises will be gradual.

Australia has a reasonably light data calendar in the coming week. The only major release is the RBA’s February Board Minutes. We expect the RBA to repeat its “neutral” monetary policy bias. There could be some further signs from the RBA that they believe the uptick in cyclical parts of the economy is gaining more traction. We believe that the next move in RBA cash is up in the December quarter.

CBA’s economic and financial forecasts are attached, along with the weekly and events calendar. Articles inside include an overview of the RBNZ rate rise and an overview of Queensland’s economic outlook by Senior Economist, John Peters.

Shane Workman – CBA Economics

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Population – June Quarter 2013

• Australia’s population rose by 95.7k in QII to 23.13 million.  Over the past year it rose by 407k or 1.8% which is high by global standards.
• The natural increase (births less deaths) was a record 163k in the year to QII 2013.  There were 311.4k births and 148.8k deaths.
• Net overseas migration was 244k over the past year.
• Natural increase contributed to 40% (or 163k) of the population rise over the past year and net migration 60% (244k).
• For the States, WA had the strongest annual growth rate at 3.3%pa, followed by the ACT and Qld.
• New dwelling construction is 161k annually, well below population growth, putting upward pressure on house prices.

Analysis

Australia’s population up by 0.5%

Australia’s population rose by 95.7k (0.5%) over the June quarter 2013, taking the annual population increase to 407k, the highest since September 2009.  The increase means that Australia’s population was just over 23 million in June.  The major driver of population growth has been net migration which was 244k over the past year, the highest since December 2009. Natural population growth (births less deaths) was 163k over the year.

Across the States the annual growth rates were diverse. WA’s population rose by 3.3%, ACT 2.2%, Qld 2%, Vic 1.9%NT 1.8%, NSW 1.4%, SA 0.9% and Tas 0.2%. WA’s population growth should ease over the next few years as the investment and construction phases of the resources boom deflate and are replaced by the operational phase which includes a significant rise in export volumes of iron ore and LNG. The national population figures are still likely to stay in the 1.6% to 1.8% range as Australia’s relatively attractive economic position attracts migration.

The older age groups, those above 55 years of age, have had the fastest growth rates compared to other age groups over the past twenty years. The proportion of the population over 65 years is rising gradually and is now just over 14% compared to under 12% in 1993. It means that the median age of the population has risen from 33 to 37.3 years old from 1993 to 2013. The economic adjustment to an ageing population is already underway and presents a significant challenge to Federal and State Governments. The labour force participation rate is shifting lower, as the largest of the population age cohorts, the “baby boomers” retire. Health care demand will rise dramatically in the next ten years and stay high as the population ages. In a partial counter to the ageing forces, the Federal Government has allowed a much higher migration rate. It also introduced the “baby bonus” which produced a noticeable rise in births over the past seven years. It has also given rise to much higher demands for prams and baby wear, child care, primary school places and teachers.

There is a strong link between population growth and housing demand which is worth highlighting because of the debate around the level of, and current upswing in, Australia’s house prices. Australia’s relatively high annual population growth rate of 1.8% compares to the US growth rate of 0.8%, the UK’s 0.6%, Canada’s 1.0% and China’s 0.6%. It helps explain the strength of housing demand and rising national residential rents.

New housing supply is near 150k annually, and has been running well below our estimate of underlying housing demand of 170k, for the past few years. The current upswing in house prices reflects the interplay of population pressures, constrained new housing supply and low mortgage rates. National house prices have risen by around 8% over the past year while the number of loans is about 15% higher. In our view the underlying conditions still point to some more upside on national house prices.

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Household debts high by international standards.

Australian households have housing debt levels that are high by international standards.

Australian household debt ratios are relatively high by international standards. But there are important economic and legal differences between housing markets that can sustain marked variations in housing prices. In Australia, it is also important to understand the economic and social characteristics of the households that have the debt.

This note uses the considerable amount of research into household financial positions (published by the ABS, the RBA and other groups like the Melbourne Institute’s 2012 Household Income and Labour Dynamics in Australia (HILDA) report) which provide extensive insights into these household characteristics. The data and the surveys show that household debt has increased steadily over 2002‑2010, primarily due to growth in housing‑related debt.

But the data and the surveys also indicate that the households who carry the most debt typically have stable characteristics. On average, these households are couples with good health, high educational attainment, relatively high and stable incomes and in a prime age category. On balance, Australian households are in a good position to service their housing and other debt. The net asset positions of the households are also important in judging their capacity to cope with adverse economic developments.

One of the more interesting recent trends is that households have also increased their housing debt prepayments over 2012 and 2013, by leaving their repayments unchanged while interest rates fell. It is in line with the inclination to reduce housing and credit card debt since the GFC. Combined, these more cautionary shifts provide households with an important buffer to any negative economic shocks.

Some commentary on Australian household balance sheet positions conveys the impression that household debt levels are too high, leaving many households with unmanageable debt servicing commitments. The general line is that a significant number of households are at risk of financial ruin if their economic circumstances, like employment, change adversely. The surveys, and the experience of the past few decades, does not, in our view, support those lines of argument. The experience of the post‑Global Financial Crisis (GFC) period was a “stress test” that indicated the ability of Australian households to cope well with adverse economic developments.

Some of the commentary on Australian house prices, especially from offshore based groups, argues that there is a housing price “bubble” in Australia which will eventually burst and replicate the downward path of US and UK house prices through the 2008 to 2011 post‑GFC period. In our view, the US and UK housing market outcomes reflected the severe recessions and the housing demand/supply imbalances that hit the two economies after the GFC. Fortunately, through good luck and good management, Australia did not have a recession and the most important influence on the housing market’s outcomes, the unemployment rate, peaked at just under 6%. That was significantly below the peaks reached in the US and UK where the rates are moving lower but are still around 8%.

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