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Economic update: payment due? Some thoughts on 2004 and beyond.



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Outlook 2004 Speakers papers

Speaker Michael Blythe

Chief Economist Commonwealth Research Commonwealth Bank of Australia

Title Economic Update

Payment due? Some thoughts on 2004 and beyond

Session Economic Overview

9.45am Tuesday 2 March National Convention Centre, Canberra

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Economic Update ABARE OUTLOOK 2004

Payment due?

Some thoughts on 2004 and beyond

• Economic momentum should ensure a good start to 2004.

• The real issue is whether that momentum can be sustained into 2004/05.

• Favourable fundamentals to dominate in H1 2004. Financial risks an issue for H2.

Summary

The economy reached the end of 2003 with a considerable amount of momentum behind it. The growth positives remain in place. And some of the growth negatives loosened their grip. Together with stronger global growth, that momentum should ensure a good start to 2004. Growth approaching the Government’s 3.75% forecast looks easily achievable in 2003/04. The real issue, though, is whether the economy can sustain that trajectory during 2004/05.

Any checklist based on the economic fundamentals that will drive the economy in 2004 balances out on the favourable side. The traditional income drivers are supportive. Wages are running ahead of inflation. Strong output growth and weak labour cost growth are labour-market friendly. A rising terms of trade means any increase in output is producing a bigger rise in income than in the past. Residential construction may slow. But a high level of underlying demand for new dwellings and relative price movements favouring alts & adds mean that any downturn could be quite mild. Business investment fundamentals are also generally favourable. Stronger global growth and an easing of the drought will boost exports.

Any checklist based on the financial factors at work over the next year or so however, balances out on the negative side. These financial factors include the interplay between household debt and interest rates, house prices and household wealth, and the AUD. Many households have built up a sizeable buffer against interest rate rises. So the impact of rising rates may take longer than expected to filter through. But prospective rises in debt servicing mean that household spending could slow sharply as we move through 2004. Households are also more exposed to shifts in asset prices. The key asset price for households is housing. Any fall in house prices would require some adjustments to household balance sheets. And there are plenty of recent examples showing just how painful balance-sheet

adjustments can be. The other unknown is the how the impact of the unstoppable Aussie will play out. An overvalued currency will neuter part of the impact of a stronger global economy. It will also tighten financial conditions. Our monetary conditions index is now on the restrictive side of neutral. Pricing power is low. Businesses remain at risk from any squeeze on profits. Any squeeze would encourage firms to economise on their use of labour and/or defer their capital spending plans. Watch retail trade. It should provide the first indication of when the financial risks are a starting to outweigh the positive economic fundamentals

The economic fundamentals are likely to dominate in the first half of 2004. The financial risks are more of an issue for the second half of the year. The RBA is unlikely to view its job as finished against that sort of backdrop. The cash rate is likely to peak at 5.5%. Bond yields may also move a little higher. And the AUD should breach the USD0.80 barrier later in the year.

2 February, 2004

Michael Blythe Chief Economist (612) 9312 4135

michael.blythe@cba.com.au

Important Information: is advice has been prepared without considering your ectives, financial situation or eds, and before acting on the

vice, you should consider its appropriateness to your circumstances.

w.research.commbank.com.au www.ecommcorporate.com.au

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2004: a good place to start

The end of 2003 proved to be much better than the start.

The end of 2003 proved to be much better than the start. Concerns at the start of the year about the sluggish global economy, the risk of deflation, the war in Iraq and the SARS outbreak were all replaced at year end by a sunny

The growth positives remain in place…

…and some of the growth negatives eased.

optimism that the way ahead was clear.

Domestically, the QIII national accounts indicated that the Australian economy bounced decisively out of its mid-year pothole. Growth outcomes reflected a continuation of some of the growth positives and an easing of some of the growth negatives. Domestic spending was very strong, the reduction in net exports

slowed and there was a big lift in farm production.

Data in the final months of 2003 were encouraging. The global recovery strengthened and broadened. Australian economy-wide indicators (such as employment and credit) remained resilient. Perhaps the best indication of that resilience was the

decision by the RBA to

remove some of the stimulus from monetary policy settings.

So the economy reached the end of 2003 with a

considerable amount of momentum behind it. Togeth-

RURAL & GLOBAL DRAG (contribution to growth)

- 2

- 1

0

1

2

Sep-92 Sep-94 Sep-96 Sep-98 Sep-00 Sep-02

% %

Farm sector

Net

exports

EMPLOYMENT &CREDIT (annual % change)

- 1 0

0

1 0

2 0

Jan-90 J a n - 9 3 J a n - 9 6 J a n - 9 9 J a n - 0 2

- 5

0

5

1 0

% %

Credi (lhs)

Employment (rhs)

Can the good growth trajectory be sustained into 2004/05?

er with stronger global growth, that momentum means a good start to 2004.

Growth approaching the Government’s 3.75% forecast looks easily achievable in 2003/04. The real issue, though, is whether the economy can sustain that trajectory during 2004/05 and beyond.

2004 checklist: favourable fundamentals

Any checklist based on the economic fundamentals that will drive the The traditional consumer spending drivers are favourable.

economy in 2004 balances out on the favourable side.

Australian consumers have been spending with their ears pinned back. And, in terms of the t r a d i t i o n a l spending drivers at least, there appears little to stop consumers

spending:

• wages growth is running ahead of inflation so real incomes are rising;

• jobs growth has bounced back from its mid-2003 pause;

INCOME DRIVERS (% change)

- 1

0

1

2

3

Sep-89 Sep-92 Sep-95 Sep-98 Sep-01 - 3

0

3

6

9

% %pa

Wages (OTE, rhs

Employment (qtly % ch (lhs)

QIV (e)

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The key drivers of labour demand are pushing in the direction that favours continued employment growth.

A rising terms of trade is boosting domestic incomes.

• the key drivers of labour demand - output growth and labour costs - are pushing in the direction that favours continued employment growth;

• similar mixes of strong output growth and low labour cost growth in 1994 and 2000 were

accompanied by solid employment growth;

• jobs growth in the 15-20k per month range, as

seems likely, would

eventually push the

unemployment rate below current 22-year lows;

• favourable labour market trends pushed job security concerns to relatively low levels and confident

consumers will keep spending.

Another traditional income driver that will be very

important in determining spending trends is our terms of trade. Convention has it that commodity-exporting-manufactured-good-importing countries like Australia have declining terms of trade. But that convention is being increasingly challenged. With 2 0 / 2 0 h i n d s i g h t , t h e

downtrend levelled out in 1987. And a sustained

uptrend has been evident since 1999. That rise is

important because it means that any increase in output is generating a bigger increase in income than in the past. Real GDP is now 13.0% higher than in mid 1999. But the real income generated by

LABOUR DEMAND DRIVERS (annual % change)

- 4

0

4

8

Sep-90 Sep-93 Sep-96 Sep-99 Sep-02 - 4

0

4

8

% %

Non-farm GDP

Real

labour costs

JOB CONCERNS & SPENDING

- 2 0

6

3 3

5 9

8 5

J u l - 9 0J u l - 9 2 J u l - 9 4 J u l - 9 6J u l - 9 8 J u l - 0 0J u l - 0 2

- 2

1

3

6

8

*Source: Melbourne Institute

% %pa

Consumer spending (rhs)

Job concerns*

(net % exp unemployment to (inverse, lhs)

INCOME & PRODUCTION (QIII'99=100)

1 0 0

1 0 6

1 1 2

1 1 8

Sep-99 Sep-00 Sep-01 Sep-02 Sep-03

1 0 0

1 0 6

1 1 2

1 1 8

Index

Gross Domestic Income

GDP

Index

that production is up by 16.2%. That wedge essentially represents a transfer of income from the rest of the world to Australian households. And those households have had little trouble in spending that additional income.

A stronger global economy is boosting global commodity prices. The all conquering Aussie dollar is muting the impact on our export prices. But the AUD is also accentuating the downward pressure on import prices triggered by global excess supply and deflationary influences. So our terms of trade is set to rise further.

Residential construction activity will turn down. A downturn in residential construction has been part of the economic script for a long time now. “Never change a good forecast” has long been a

forecasting article of faith. But, based on the fundamentals, the risks seem to lie with any downturn in construction being quite mild.

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But the economic fundamentals say this downturn might be quite mild.

Part of the reason that construction activity has surprised is that we’ve all underestimated underlying demand for new dwellings. On some estimates, immigration is running at around 150k per annum at present (one of the highest rates in fifty years). And the mix of that migration is skewed towards those that add straight away to the demand for housing. Allowing for this, current construction activity is running only a little above underlying demand. The excess supply of dwellings is not at the sorts of levels that have precipitated large downturns in new construction in the past.

UNDERLYING DEMAND

- 1 0 0

0

1 0 0

2 0 0

Sep-78 Sep-83 Sep-88 Sep-93 Sep-98 Sep-03

- 1 0

0

1 00

2 00

Underlying demand

Dwelling commencemen

' 0 00 ' 0 00

Pent-up demand

Excess supply

MOVE OR RENOVATE? (annual % change)

- 3 0

3 0

9 0

1 5 0

2 1 0

Sep-81Sep-85 Sep-89 Sep-93 Sep-97 Sep-01 - 40

- 20

0

2 0

4 0

Moving c o s t s * (rhs)

Alts & add costs (rhs)

Alts & adds spending (lhs

%

%

*based on ownership transfer cost

At the same time, relative price trends (cost of moving vs staying put) strongly favour renovating existing dwellings. Alterations & additions activity (40% of construction) is set to remain at high levels.

Business investment fundamentals remain generally favourable.

The business investment fundamentals remain gen-erally favourable.

The strength in investment spending over the past year or two has pretty much filled in the “hole” that was there in terms of capital:labour and capital:output ratios. But capacity utilisation is running at historically high levels.

Based on these fund-

amentals, the most likely outcome is one where capex spending holds at high levels

CAPITAL RATIOS

2.50

2.75

3.00

3.25

3.50

1 9 7 9 / 8 0 1 9 8 4 / 8 5 1 9 8 9 / 9 01 9 9 4 / 9 5 1 9 9 9 / 0 0 0.13

0.15

0.18

0.20

0.23

Capital:labou (rhs)

Capital:output (lhs)

over the next year or two. But the contribution to GDP growth will wane.

A stronger global economy will help (at least for a while).

The other key economic fundamental determining bottom-line economic growth is the strength and durability of the global recovery.

Prospective growth rates for our major trading partners are consistent with a sharp pick-up in Australian export

volumes. An easing of the drought will ensure that rural exports make a big con-

tribution to this pick up.

But we retain some lingering concerns about what sort of

TRADE & GROWTH (annual % change)

- 1 0

0

1 0

2 0

1 9 7 9 1 9 8 4 1 9 8 9 1 9 9 4 1 9 9 9 2 0 0 4

- 4

0

4

8

% %

Australian exports (lhs)

Major tradin g

partner grow (rhs) CBA ( f )

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After some initial encouraging moves, the external sector may make a smaller contribution to growth than the consensus would have.

contribution the external sector will make to growth. We have argued for some time that there is a question mark over the durability of global recovery over the medium term. It is becoming increasingly clear that the recovery in rural production reflects the lucky timing of some rains rather than the definitive ending of the drought. And a strong domestic economy will put a floor under import volumes.

All up, after some initial encouraging moves, the external sector may make a smaller contribution to growth than the consensus would have. And progress in winding back the current account deficit might be slower than anticipated.

Other growth drivers are likely to have a relatively neutral impact.

Other growth drivers are likely to have a relatively neutral impact:

• Public spending has grown strongly in recent years. Defence and national security issues boosted spending at the Federal level. Health and law & order boosted spending at the State level. The

commencement of some State infrastructure projects will keep spending at high levels.

• Inventory movements are unlikely to have a significant influence on growth outcomes. Inventory:sales ratios are pretty much in line with longer-run trends.

2004 checklist: unfavourable financials

The economic fundamentals are generally favourable. The economic fundamentals are generally favourable. But any checklist based on the financial factors at work over the next year or so balances out

on the negative side. These financial factors include the interplay between household debt and interest rates, house prices and household wealth, and the AUD.

But any checklist based on the financial factors at work over the next year or so balances out on the negative side.

The flow of funds (or net

lending and borrowing

between different sectors of the economy) provides a good snapshot of how these

financial factors are playing out. In the flow-of-funds

framework, shifts in net lending in one sector will necessitate equal and offsetting shifts in other sectors. In turn, these financial shifts have some obvious implications for the real economy.

The Australian flow of funds traditionally involved net lending by households, net borrowing by the government and business sectors, with the balance made up from

borrowing from overseas.

Households have become large net borrowers at a time when the business sector demand for funds has started to increase. A switch to net lending by government in 2002/03 partly accommodated these shifts. But the heavy lifting was done through a greater use of overseas

- 1 5

- 1 2

- 9

- 6

- 3

0

3

6

- 9

- 6

- 3

0

3

6

9

1 2

% %

Households (lhs)

Business (rhs)

AUSTRALIA: NET LENDING BY SECTOR (% of GDP)

- 1 5

- 1 2

- 9

- 6

- 3

0

3

6

1 9 8 01 9 8 3 1 9 8 61 9 8 9 1 9 9 21 9 9 5 1 9 9 8 2 0 0 1 - 3

0

3

6

9

1 2

1 5

1 8

Government (lhs)

Rest of World (rhs)

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The household sector looks most at risk. sources of funds. The widening current account deficit was the mirror image of this reliance.

Looking ahead, the provision of funds from the rest of the world is about as large as it ever gets. With the USD on the nose and a very favourable interest-rate differential, we can probably rely on foreign savings for a while yet. The AUD will rise further as a result. But a reduction in that reliance will have to occur at some stage. And that reduction will have to come via the household sector.

Higher interest rates will encourage adjustment in the household sector. The unknown in the outlook is the speed and extent of that adjustment.

Higher interest rates will encourage adjustment in the household sector. The unknown in the outlook is the speed and extent of that adjustment.

Every economist’s favourite chart at the moment is the one that looks at the trajectory of household debt servicing ratios in an environment of rising interest rates.

The circles on the chart

opposite show the impact on that ratio of each 25bpt rise in interest rates.

The two rate rises to date will push that ratio above the peak levels recorded in the late 1980s/early 1990s. The economy slowed sharply at

H/H INTEREST PAYMENTS (% of income)

3.0

4.5

6.0

7.5

9.0

Sep-87 Sep-90 Sep-93Sep-96 Sep-99 Sep-02 3.0

4.5

6.0

7.5

9.0

that time.

The way households manage their balance sheets has changed significantly over the past couple of decades. So a better way to look at how shifts in household cashflows will influence household spending is to look at the change in debt servicing rather than the level.

Many households have built up a sizeable buffer against interest rate rises. So the impact of rising rates may take longer than expected to filter through.

DEBT & CONSUMER SPENDING

- 4

0

4

8

Sep-79 Sep-84 Sep-89 Sep-94 Sep-99 Sep-04

- 3 .0

- 1 .0

1.0

3.0

%pa Ann

ch

Consume spending ( l h s )

H/hold interest paym (% of income, inver (adv 5 qtrs, rhs

DEBT & CONSTRUCTION

2 0

3 0

4 0

5 0

Sep-79 Sep-84 Sep-89 Sep-94 Sep-99 Sep-04

- 3 .0

- 1 .0

1.0

3.0

' 0 00

Ann ch

Dwelling

commencements (lhs)

H/hold interest paymen (% of income, inverte (adv 5 qtrs, rhs)

But prospective rises in debt servicing mean that household spending could slow sharply during 2004.

Many households have built up a sizeable buffer against interest rate rises by paying their home loans off at a faster-than-necessary pace. So the impact of rising mortgage rates may take longer than expected to filter through. But as the charts above show, prospective rises in debt-servicing commitments raise the possibility that consumer spending and residential construction activity will slow sharply later in 2004.

Households are more exposed to shifts in asset prices.

Cashflows are not the only channel to worry about. Changes in the structure of household balance sheets (debt and assets) mean that households are more exposed to shifts in asset prices. The key asset price for households is housing. A key threat to the outlook would be falling house prices. We think generalised price falls are unlikely. But there are some commentators

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who believe that house prices are overvalued by up to 20%. If prices did fall for any reason, then some of the balance sheet changes of the past twenty years would have to be unwound. And there are plenty of examples over the past few years of just how painful balance-sheet adjustment can be.

Table 1: House Prices & Household Balance Sheets

Ch in house prices (%) -5 -10 -15 -20

Ch in h/hold wealth (%) -3 -6 -9 -12

Required ch saving ratio (%pts) +1.1 +1.6 +2.4 +3.2

Ch in h/hold spending (%) -1.2 -1.8 -2.7 -3.6

WEALTH & SAVING

3 0 0

4 4 0

5 8 0

7 2 0

8 6 0

1 0 0 0

1 9 7 91 9 8 21 9 8 51 9 8 8 1 9 9 11 9 9 41 9 9 72 0 0 02 0 0 3 June

- 4

0

4

8

1 2

1 6

% %

Wealth (% of income (lhs)

Saving ratio

(inverse, rh

Contrib to GDP (%pts) -0.7 -1.1 -1.6 -2.1

Any fall in house prices would require some painful adjustment to household balance sheets.

The table above shows our back-of-the-envelope calculations on the impact of falling house prices. Choose what sort of house-price fall you think likely and read down the column for the associated balance-sheet changes and economic implications that would follow. A 20% fall, for example, would:

• reduce household wealth by 12%;

• require a 3.2ppt rise in the saving ratio;

• meaning consumer spending would have to drop by 3.6%; and

• GDP would decline by 2.1%.

Of course, house prices do not have to fall for there to be an economic impact. They just have to stop rising. The rapid house-price growth and associated rise in household debt over the past few years allowed consumer spending to run well ahead of income growth. Our estimates indicate that each 10% rise in real house prices adds 1% to consumer spending in the long run. That icing on the cake is unlikely to be there over the next few years.

The other unknown is the how the impact of the unstoppable Aussie will play out. Based on the “traditional” currency drivers, our current estimates for The other unknown is the how the impact of the unstoppable Aussie will play out.

AUD fair value are TWI=58 and USD0.73. A rising AUD is to be expected given the global backdrop. But the Aussie is now a little above fair value vs the USD and well into overvalued territory on a TWI basis. The degree of overvaluation on a TWI basis is now at a record high. And the rise is not finished yet. Our currency forecasts

envisage the AUD breaching the USD0.80 mark later in 2004.

THE AUD

(deviation from fair value)

-30

-15

0

1 5

Sep-86 Sep-90 Sep-94 Sep-98 Sep-02

-30

-15

0

1 5

TWI

USD

% %

There is a strong negative relationship between the real exchange rate and net exports

There is a strong positive relationship between global growth and Australian exports. But there is also a strong negative relationship between the real exchange rate and net exports. Our analysis implies that each 5% rise in the real TWI (relative to trend) is accompanied by a 1% decline in net export volumes. The real TWI is now about 30% above its long-term trend, the most severe divergence in thirty years. This rise saw a reduction in net

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exports cut output by around 5%.

Currency movements change financial conditions. 0.7

0.9

1.2

1.4

Jun-70 J u n - 7 7 J u n - 8 4 J u n - 9 1 J u n - 9 8

Real TWI

(detrended, invers (lhs)

- 6

- 3

0

3

THE EXCHANGE RATE THREAT

Net exports (% of GDP) (rhs)

%

MONETARY CONDITIONS (Jan'88=100)

8 0

9 0

1 0 0

1 1 0

1 2 0

1 3 0

Jan-90 J a n - 9 3 J a n - 9 6 J a n - 9 9 J a n - 0 2

8 0

9 0

1 00

1 10

1 20

1 30

Terms of trade adjusted MCI

Index Index

1 9 9 3 - 2 0 average

Our monetary conditions index is now on the restrictive side of neutral.

Currency movements change financial conditions. So a stronger AUD is akin to a rise in interest rates. Our analysis concludes that a 3% change in the real TWI has the same economic impact as a 1% change in the real cash rate. The Aussie should, of course, move higher given background economic conditions. So in some ways it is only that part of the Aussie’s rise above that justified by the fundamentals that tightens financial conditions. Nevertheless, even after allowing for that effect, our monetary conditions index is now on the restrictive side of neutral.

A loss of competitiveness and a tightening in financial conditions will, at the very least, offset some of the positives flowing from global recovery.

Any squeeze on profits would encourage firms to economise on their use of labour and/or defer their capital spending plans.

On the business front, our profit squeeze indicator moved sharply lower in 2003. This fall is an

indication that growth in sales prices has slipped behind growth in

p r o d u c t i o n costs. It is not our

central case, but any squeeze on profits would encourage firms to economise on their use of labour and/or defer their capital spending plans. For example, our analysis shows a reasonable correlation between shifts in the cyclical

component of our profit-squeeze indicator and employment growth. And between our indicator and the realisation ratio that drives the conversion of capex spending from planned to reality.

Not all of the financial factors in play are working against growth. The rate of return from investing in the capital stock, for example, is running at a forty-year high at present. And the market is valuing additions to the capital stock more highly that the cost of adding to that stock. Both of these factors will encourage

business investment spending.

PROFIT SQUEEZE & JOBS

- 3

0

3

6

1 9 7 9 - 8 01 9 8 4 - 8 51 9 8 9 - 9 01 9 9 4 - 9 51 9 9 9 - 0 0 - 2 .0

- 0 .5

1.0

2.5

%pa %

P r o f i t squeeze indicato (rhs)

Employment (lhs)

* Deviation from trend

PROFIT SQUEEZE & CAPEX

0.90

1.03

1.17

1.30

1 9 7 9 - 8 01 9 8 4 - 8 51 9 8 9 - 9 01 9 9 4 - 9 51 9 9 9 - 0 0 - 2 .0

- 0 .5

1.0

2.5

Ratio %

P r o f i t squeeze indicato (rhs)

Realisation ratio (lhs) * Deviation from trend

2004 checklist: what to watch

So how will the balance between favourable fundamentals and unfavourable financials play out? The former should mean that there are still some good

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financials play out? The former should mean that there are still some good times ahead. The latter should mean that headwinds will build as we move through 2004/05. At the very least, it means that the balance of risks is more skewed to the downside than the consensus would have it.

Retail trade is the data to watch.

It should provide the first indication of whether the financial risks are a starting to outweigh the positive economic fundamentals

So what should we watch to judge how the trade-off between the fundamentals and the financials is playing out? And when monetary policy is finally biting?

One answer lies with the distribution of household debt. If low interest rates have allowed more households to access the credit market, some for perhaps the first time, then a significant part of the increase in debt may have occurred at the lower end of the income range. Data on home purchasers does show a significant increase in the proportion at the lower end of the income range over the past decade.

The available data also shows that debt repayments account for a much larger share of income for low-income groups. These same groups spend a much larger share of

income on retail-type items. Higher interest rates should affect the retail-spending ability of low-income groups more quickly (and possibly quite heavily).

So retail trade is the data to watch. It should provide the first indication of whether the financial factors are a

DEBT REPAYMENT LEVELS (% of h/hold income, Sep'03)

0

1 0

2 0

3 0

<30 3 1 - 5 0 5 1 - 7 0 7 1 - 1 0 0 >100

Income ($'000pa

0

1 0

2 0

3 0

% %

Source: Melbourne Institute

HOUSEHOLD SPENDING RATIOS (by income quintile)

0

2 5

5 0

7 5

1 0 0

Lowest 2 0 %

2nd 3 r d 4th Highest

2 0 % Income quintile

0

2 5

5 0

7 5

1 0 0

Retail spending as % of H/H incom

Share of retail spendi

% %

Source: HES, 1998/99

starting to outweigh the economic fundamentals.

2004: inflation

Price pressures are contained.

The RBA’s preferred statistical measures show underlying inflation tracking at 2_%pa at present. Price pressures are limited to areas of clear economic strength, such as housing. These pressures are being largely contained by the beneficial influences of the rising Aussie. Fluctuations around the generally benign trend largely reflect random swings in the volatile items such as petrol and fruit & veg prices.

How the gap between (weak) tradables and (strong) non-tradables inflation is closed will determine the longer-run inflation path.

Recent RBA commentary has made much of the divergence between (weak) tradables and (strong) non-tradables inflation. The longer-run path for overall inflation will depend on how that divergence is closed. The RBA believes that a stronger AUD “cannot be relied on to control inflation over the medium term; that requires domestic pressures to be properly contained”. For that reason they believe that inflation risks are starting to tilt to the upside.

The labour market is certainly “tight” on any historical comparison. And we are at the point where wage/price pressures could be reasonably expected to emerge. Business surveys do report labour shortages in some areas. But indications that these pressures are having some upward influence on wages growth are tentative at best. Unit labour costs, for example, fell on the latest reading. A cyclical slowing in productivity growth from here may see growth in unit labour costs pick up. But any increase seems set to be modest.

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Upstream price pressures appear virtually non-existent. Prices (domestic and imported) at the preliminary and intermediate stage of production are flat or falling at present. Existing price pressures (eg from the red-hot construction sector) will probably ease. All up, surveys suggest that business costs (materials, labour, overheads) are growing only slowly at present.

CONSUMER PRICES (annual % change)

- 2

0

2

4

6

Sep-91 Sep-94 Sep-97 Sep-00 Sep-03

- 2

0

2

4

6

% %

Non

Tradeables

Tradeables (exc petrol & foo

Source: RBA

0

4

8

1 2

Sep-78 Sep-83 Sep-88 Sep-93 Sep-98 Sep-03

- 5

5

1 5

2 5

%

%

Hourly labour costs (%pa, rhs)

Unemployment rat (inverse, lhs)

LABOUR COSTS & UNEMPLOYMENT

There is also the issue of just how much pricing power businesses have at present. The flip side of the environment that has delivered low inflation over the past decade is low pricing power. Recent falls in import prices have probably partly been absorbed into margins. But the environment remains very competitive. Looking at business surveys and comparing actual price changes with the outcomes expected in earlier surveys suggests some deterioration in pricing power during recent quarters.

RBA inflation concerns look a little overdone. The influence of the AUD is also an interesting issue. The RBA view has long been that the influence of the currency on inflation (positive and

negative) is best viewed as a “wave” that rolls over the surface, leaving ongoing inflation largely unchanged once the effect has passed.

RBA thinking implies that global influences are cyclical in nature. They tend to cancel each other out over the course of the cycle. From our perspective, this conclusion ignores the structural influence that global price trends have exerted. These structural influences were one factor behind the step down in inflation rates in the 1990s. And they are a factor that suggests that the slowing trend in tradables inflation reflects more than just the transitory influence of a stronger AUD.

Inflation could dip below 2%pa in the near term.

THE IMPORT PRICE "WAVE" (contrib to underlying inflation*)

- 2

0

2

4

Sep-93 Sep-95 Sep-97 Sep-99 Sep-01 Sep-03

%pa

Contrib from AUD

Contrib from other factor

*Ex GST

PRICES & WAGES (annual % change)

- 3

0

3

6

9

Sep-89 Sep-92 Sep-95 Sep-98 Sep-01 Sep-04 - 3

0

3

6

9

% %

CBA ( f )

CPI

AWOTE

WCI

On our figuring, inflation is set to dip below 2% in the early part of 2004, before slowly returning to the lower half of the RBA’s 2-3% target range.

Payment due?

Prepared for ABARE OUTLOOK 2004

12

2004: monetary policy and interest rates

The RBA is unlikely to view its job as finished The economic fundamentals that will drive the economy in

2004 are skewed to the

favourable side. The financial risks are skewed to the

downside. The economic fundamentals are likely to dominate in the first half of 2004. The financial risks are more of an issue for the

second half of the year.

Strong growth and a

perception that longer-run inflation risks are tilting to the upside mean that the RBA has further work to do. The cash rate is likely to peak at 5.5% in the early part of 2004. But that will be it for the time being. The expansion of household debt means that a given change in interest rates should have a larger impact on household cash flows and spending intentions than in the past. Put another way, if you have a certain end point in mind, then a smaller rate rise than previously will get you there.

THE REACTION FUNCTION (Australian cash rate since 1990)

3

4

5

6

7

8

- 1 2 - 6 0 6 1 2 1 8 2 4 3 0 3 6

Months from last cut

3

4

5

6

7

8

% %

1 9 9

1 9 9

Current

RBA INFLATION FORECASTS

0

1

2

3

4

Sep-93 Sep-96 Sep-99 Sep-02 Sep-05

0

1

2

3

4

Projection at the tim

Core inflation

% %

1st rat rise

They will get rates back to “neutral”. We suspect that it will be a case of get interest rates back to the point where they are no longer adding stimulus to the economy (5.5% is the bottom end of

the RBA’s “neutral” zone). And then sit back to evaluate the effect before deciding whether another lift is necessary.

And then sit back to evaluate the effect.

The direction of longer-term interest rates remains largely dependent on global events. US data will continue to point to a strengthening US economy for some time yet. And as long as global growth surprises on the high side, bond yields can head higher. But the upside is probably quite limited. Debt markets have already priced in a premium for higher inflation, even though significant excess capacity remains in the US. And investor belief in the US recovery is high.

Looking past the first half of 2004, the key issue for financial markets is the sustainability of the US economic upturn. We believe that the level of US household debt will make it difficult to sustain strong spending levels. And US budget / current account imbalances will need to be resolved at some stage. The resolution of these imbalances will quite likely involve slower growth and low inflation. A scaling back of policy stimulus in the second half of 2004 is shaping up as a potential pothole for the US growth profile. Yields could move lower as a result.

2004: the Aussie Dollar

A standout feature of the past year was the relentless rise of the AUD.

A standout feature of the past year was the relentless rise of the AUD. The Aussie initially became the darling of international investors because of our AAA rating and high interest rates. Later on, the AUD became an avenue to take advantage of commodity strength. And it remains an Asian currency play ahead of expected rallies there.

Payment due?

Prepared for ABARE OUTLOOK 2004

13

The broad theme for 2004 will be further US Dollar weakness.

The broad theme for 2004 will be further US Dollar weakness. A falling USD has far-reaching implications for all currencies. But the implications look

particularly marked for Asian currencies and the AUD.

The attention of US policy makers is firmly fixed on Asia. Asian central banks have spent enormous sums holding down their own currencies relative to the USD. They are now under pressure to let their currencies strengthen.

Rising Asian currencies, particularly if the Chinese re-value the Renminbi, (which we expect to occur in the first half

S&P 'AAA' & INTEREST RATES

0 2 4 6

A u s t r a l i a

Singapore

Canada

U S A

A u s t r i a *

Denmark

F i n l a n d *

F r a n c e *

G e r m a n y *

I r e l a n d *

L u x ' b g *

N ' l a n d s *

N o r w a y

S w i t z

UK

%

Cash

10 y

bonds

*EUR members

There is a good chance that the Aussie’s march continues past the USD0.80 mark.

of 2004), will give the AUD another boost. Ten of Australia’s top thirteen trading partners are in Asia. And the AUD is already a recipient of strong capital inflows in its capacity as a liquid proxy to the Asian currency rally. We believe there is a good chance that the Aussie’s march continues past the USD0.80 mark around mid year.

In trade-weighted terms, the Aussies rise is likely to be very muted. While the AUD has further to go against the USD, we are likely to track sideways against our Asian trading partners as the Asian currency bloc strengthens.

Several factors will ultimately slow the Aussies ascent.

There are several factors that will ultimately slow the Aussies ascent:

• Higher prices are attracting additional supply (eg gold and base metals) and that should begin to weigh on commodity prices later in 2004.

• Interest rate spreads will begin to narrow as global central banks tighten interest rates.

• Large amounts of Japanese bond investments in AUD will mature in the first half of 2005, further weighing on sentiment.

Those factors will see the AUD head lower in late 2004, and retrace towards US0.74 by the middle of 2005. Further out, we expect the currency to return to its long-term fair value around US 70 cents.

Our key forecasts are summarised in the table below:

Table 2: Commonwealth Bank Key Forecasts

2002/03 (a)

2003/04 (f)

2004/05 (f)

2005/06 (f)

GDP (% ch) 2.8 3.7 3.4 3.5

Employment (% ch) 2.5 2.1 2.0 1.9

Unemployment (%) 6.1 5.7 5.9 5.7

CPI (% ch) 3.1 2.2 2.2 2.6

Wage Cost Index (%ch) 3.5 3.5 2.9 2.9

Current Account ($bn) -$41.1bn -$43.6bn -$39.8bn -$39.7bn

AUD/USD (end yr) 0.6674 0.78 0.70 0.70

Cash rate (end yr) (%) 4.75 5.5 5.5 5.5

10-yr bonds (end yr) (%) 5.01 6.0 6.0 6.0

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