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Economic Society of Victoria Forecasting Conference, Hotel Sofitel, Melbourne, 31 July 1997: address

One year ago, I addressed this conference. It was the lead up to the Government's first Budget.

I spoke about how our new Government saw the economy and how we would approach our first Budget.

It is timely to be back addressing you one year on and two Budgets later.

Timely, because much has changed and a great deal of progress has been made.

Today I want to reflect on some of those changes which have occurred in the last year, as well as look to the immediate period ahead,and the likely factors which will impact our economy.

A year ago the Commonwealth returned a budget deficit of $10.3 billion.

After two responsible budgets, the release of last week's updated figures, that preliminary outcome for 1997 showed we have now cut the deficit in half to around $4.9 billion. As a percentage of GDP, the Commonwealth deficit has fallen from around 2.1 per cent to under 1.0 per cent.

In last year's address I was able to say home mortgage rates had fallen by one full percentage point, half the result of competition between the banks and half the result of one cut in official interest rates. I told you that this amounted to a saving of $80 a month for thee average home buyer.

Today, the cumulative reduction in home variable rates is around 4 per cent, with 2.5 per cent resulting from cuts in official interest rates.

The interest saving for the average Australian home buyer is $330 a month, around $4,000 a year.

Low interest rates and a concrete and responsible fiscal plan are important cornerstones which underpin our future growth and employment prospects.

Today, I intend to talk about the state of the economy and prospects for 1997- 98, discussing and interpreting the information which has become available since this year's budget was bought down in May.

I will also discuss the farm sector and the possible weather conditions affecting farm production.

In addition, I will talk about recent outcomes in inflation and the labour market, concentrating on how these compare with historical trends and what they imply for the economic outlook.

Finally, I intend to say a few words on how Government's outlook compares with that of private-sector economists.

Economic Activity

Since Budget, the March quarter 1997 National Accounts have been published. the Accounts showed that the economy grew strongly in the March quarter of 1997, after slowing during 1996.

Real GDP(A) grew by 0.9 per cent. Whilst 2.4 per cent though- the- year growth in GDP may seem low, it simply reflects some low quarterly figures in 1996 which will kick out when the June quarter is released.

Slower GDP growth in 1996 represented a temporary easing in the pace of growth during the current economic upswing. In particular, this reflected the tighting of monetary policy (2 3/4 per cent) in the later part of 1994.

Whilst the economy has continued to expand since the 1990/91 recession, has been the case with past economic upswings, the pace of growth from year to year has varied. In the current upswing, GDP growth eased in 1996- 97.

In 1997- 98, economic growth is expected to accelerate, with GDP growth of 3 3/4 per cent forecast, up from around 3 1/4 per cent in 1996- 97.

This positive outlook is underpinned by a range of favourable economic influences, including a supportive international environment, low inflation, the impact of the five reductions in the official interest rates in the past year and the structurally sound position of the household and corporate sectors.

Faster economic growth in l997-98 should result in an improvement in the labor market, while inflation should remain low, but I will come back to the labour market and inflation later.

Faster economic growth is expected to result from stronger growth in private final demand combined with continued modest growth in public demand and a small detraction to growth from net exports.

The signs since Budget are that this set of forecasts is on track.

Private demand growth in the March quarter was 2 per cent, up from 1/4 per cent in the previous quarter. Every component of private demand grew strongly in the March quarter, and partial indicators to date suggest that private demand remained strong in the June quarter.

Private consumption growth slowed in 1996, with the retail sector feeling the pinch more than the services sector, as consumers wound back their spending on retail goods by more than their spending on services.

However, in early 1997 there was a recovery in retail sales which boosted total consumption growth. Despite retail sales data out today showing that constant price retail sales fell by 0.5% in the June quarter, private consumption growth remains on track to modestly accelerate in 1997- 98 to around 3 1/2 per cent.

Households are also investing more in dwellings, with clear evidence from a range of building statistics that the modest housing recovery which commenced in late 1996 is continuing.

This investment is being stimulated by a record level of housing affordability- house prices have risen only modestly, household income has continued to grow and mortgage interest rates are at very low levels. For example, average bank variable mortgage interest rates are at their lowest level since the 1960's.

Competition amongst lenders combined with falls in long- term interest rates has put downward pressure on mortgage interest rates, so that mortgage originators such as Aussie Home Loans are offering lending rates lower than some of the banks.

However, I should point out that the current housing recovery is not expected to be like the last one.

The last housing cycle was an unusual one by Australian standards, not just because of the very large number of dwellings built during the cycle, but more importantly because it was characterised by builders supplying many more houses and units tha needed to match the underlying demand for housing.

Consequently the last housing cycle to the largest excess supply of housing on record, and it was the slow process of eroding this excess supply which contributed to the length and severity of the recent housing downturn.

In fact, some packets of excess supply of housing remain, suggesting that the current recovery is likely to be uneven across Australia.

More broadly, the construction sector should be buoyed by another year of rapid double- digit growth in non- residential construction investment.

Rapid growth in non-residential construction should underpin strong growth in business fixed investment of around 8 per cent in 1997- 98.

Plant and equipment spending is expected to record more moderate growth in 1997- 98, after the very strong growth estimated to have occurred in 1996- 97.

This outlook is shared by businesses, with the latest set of surveyed investment intentions for 1997- 98 pointing to continued strength in non- residential construction and modest growth in plant and equipment investment. Finance and leasing commitments data are also at high levels, indicating that businesses are matching their intentions by gearing up.

Non-residential construction investment in 1997- 98 should include mining, private infrastructure projects and new projects related to the olympics games in Sydney. Offer building is also expected to contributed to growth, with a gradual pick up in investment in offices expected in response to lower vacancy rates in some capital cities.

More generally though, the favourable outlook for business investment is consistent with current investment fundamentals which remain very positive.

For instances, over the past twelve months, the price of investment goods has fallen by around 7 per cent, while the price of non- residential construction investment has recordered no growth at all. At the same time, nominal business interest rates are low. Also, the profit share and the net rate of return on the capital stock remain very positive.

Inventory investment by business is more difficult to forecast than business fixed investment. While the reasons for the run down in stooks recorded in the March quarter national Accounts remain unclear, it is not a threat to the growth outlook.

Even if businesses stock levels remain unchanged in the June quarter, stocks will contribute over 1 percentage point to GDP growth in the quarter.

Turning to the external sector, both export and import growth in 1997- 98 is expected to be strong. However, growth in imports is likely to be stronger so that net exports should detract modestly from GDP growth.

Strong import growth should be sustained by strong private demand growth, while export growth is expected to be supported by a favourable outlook for world growth and expanding Australian capacity.

To date partial indicators are in line with this forecast, although we know that export growth in the June quarter will be significally stronger than expected, skewed by the sale of gold by the Reserve Bank and the sale of an ANZAC frigate.

These are temporary boosts which will have no effect on GDP growth because they will be matched dollar for dollar by a run- down in public and private stocks. They will, however, result in a significantly lower current account deficit for both the June Quarter and 1996- 97 as a whole compared with the Budget estimate.

Finally, before moving on to the labour market, I would just like to mention an emerging risk to the Budget forecast for gross farm product growth in 1997- 98. The Budget forecast for farm output assumed that normal seasonal conditions would prevail. Now, however, one of the largest risks surrounding the forecast for farm production is the development of below average rainfall.

The Bureau of Meteorology recently announced that the EI Nino climatic event associated with dry seasons became further entrenched in June. Weather conditions data also indicated that the event is the strongest since the episode of 1982- 83, a period of widespread drought in Australia.

Lower than forecast farm product would lead to lower GDP growth in 1997- 98, but it is too early too change the forecasts because the timing, distributed and amount of rainfall over the next few weeks will be critical in determining the farm production ultimately achieved.

Labour Market

ln the first half of 1997, employment was relatively flat while there has been little change in the unemployment rate over the past twelve months, with the exception of June when the rate fell to 8.5 per cent.

The recent weakness in the labour market appears to be a lagged reaction to the easing in economic growth in 1996. Strong real wage growth appears to have compounded the problem by raising the cost of hiring additional employers.

We know now that the pace of economic growth picked up in the first half of 1997, so this should stimulate the demand for labour, as firms will need to hire more employees in order to meet rising sales.

slower real wage growth in 1997- 98 is likely to assist this process.

Considering these two influences, the Budget forecast for employment growth through- the- year to the June quarter 1998 is achievable, although year- average growth in 1997- 98 will be lowered by the weak outcomes in the first half of 1997.

This interpretation of the labour market is backed up by trends in job advertisements which are a leading indicator of near- term employment growth. Analysis shows that the number of ANZ job advertisements over recent months have been consistent with weak employment outcomes, with the series now pointing to a modest recovery in employment, having sharply turned around in the first half of 1997.

The ABS job vacancies series, which is broader in scope than the number of job advertisements, has proved a less reliable guide to employment outcomes, but also indicates that firms are signalling their intention to hire more staff, with the trend numbers of vacancies rising strongly over the past three quarters.

A resumption of employment growth will no doubt lead to more people entering of re- entering the labour force to seek work, so that the expected rise in employment during 1997- 98 will not translate into one- for- one fall in the number of unemployed.

With this in mind, a gradual fall in the unemployment rate to around 8 per cent by the June quarter 1998 is forecast.


Turning to inflation, the release of the June quarter CPI two weeks ago confirmed Australia's status as a low inflation country.

Underlying inflation was 0.3 per cent in the June quarter, or 1.7 per cent in through- the- year terms. This was the lowest annual inflation rate since the start of the series in 1972.

Headline inflation was negative in the June quarter, with the CPI falling by 0.2 per cent to be only 0.3 per cent higher than a year earlier, mainly reflecting the impact of lower mortgage interest changes.

These are exceptionally good outcomes by Australian standards and very good outcomes by international standards.

To the extent that inflation in Australia is lower than inflation overseas, then this can provide a competitive boost to Australian exports.

More generally, low and stable inflation allows businesses to plan their investments more carefully, ensuring funds are put to their most productive use.

The high inflation of the late 1980s encouraged considerable speculative investment in assets whose prices were rapidly rising. That asset price boom was undesirable and ultimately unsustainable.

Low inflation is a prerequisite for achieving sustained productive investment leading to the strong economic growth required to deliver permanent reductions in the unemployment.

In terms of the outlook,this is exactly what is in prospect.

During 1997- 98, underlying inflation is expected to be around 2 per cent, the bottom of the Reserve Bank's Medium- term monetary policy target range.

This good outlook reflects both the lagged effect of the exchange rate appreciation last year and relatively steady growth in nominal unit labour costs.

Wage growth is expected to be relatively steady during 1997-98, while labour productivity growth should remain strong.

In isolation,the recent depreciation in the exchange rate would add a little to inflation, but good labour productivity growth in early 1997 should dampen this influence via its effect on nominal unit labour costs.

Ongoing competitive pressures should also ensure that inflation stays low.

Although private sector economists and firms have been quick to recognise the low inflation of the l990s, households have been slow to revise their inflation expectation. Recently, however, there has been a marked step- down in surveyed consumer inflation expectations from around 4 per cent to just over 3 per cent as consumers belatedly recognise the low inflation outcomes date.

At close to 3 per cent, consumer inflation expectations are now at their lowest level since they were first surveyed in the early 1970's.

To the extent that inflation expectations feed into the wage bargaining process, lower expectations should result in wage claims which more closely match labour productivity improvements. ln this way, lower inflation expectations in combination with a forward- looking monetary policy should cement in low inflation over the medium term, thereby helping ensure that strong, sustainable economic growth is achieved.

Higher inflation has a distorting impact on saving and investment decisions. These distortions become particularly pronounced under a highly nominal system of taxation such as we have in Australia.

Higher inflation is an easy way out for Governments. The interaction of inflation- driven wage increases with the progressive tax system leads to increases in the real tax burden on personal income tax payers without the government doing anything. Bracket creep, being a de facto tax increase, also encourages bad fiscal policy. As the IMF has noted, fiscal consolidated based on tax increases has a tendency to be reversed, as the higher revenue gets syphoned off into higher spending. That is why our Government has relied predominantly on spending restraint to achieve fiscal consolidation.

Experience has shown that inflation expectations can be slow to adjust downwards, but when they do, they lower the cost of keeping inflation low.

Higher inflation expectations and a loss of monetary policy credibility would also lead to substantially higher market interest rates, increasing the cost of borrowing, with adverse implications for activity and employment. Need I remind you that benchmark 10 year bond yields were as high as 10 1/2 per cent as recently as October 1994 before low inflation expectations had been fully entrenched and the benchmark is now as low as 6 1/2 per cent.

The Reserve Bank has a target range that is not too heavy that it risks making the economy inflexible nor too light to create significant distortions. Low and stable inflation will provide the basis for strong, sustainable economic growth.

Private Sector Forecasts

Finally, I would just like to comment on how the Government's view of the outlook compares with that of the private sector.

As is to be expected, there is a wide range of views on what will happen in 1997- 98. Neverless, there are some surprisingly common features of the large number of private sector forecasts available and the Budget forecasts.

In particular, the Budget and most private sector forecasts incorporate an acceleration in GDP growth in 1997- 98, underpinned by strong business investment growth, strengthening consumption growth and a marked upswing in dwelling investment growth. Although, there is a range of private sector forecasts for GDP growth, the average is around 4 per cent, slightly higher than the Budget forecast of 3 3/4 per cent.

Given that the Budget and private sector forecasts for activity are so close, it follows that the respective forecasts for the labour market are also close, although some private sector forecasters expect the unemployment rate to be slightly higher by the end of 1997- 98 than the Budget forecast.

For inflation in 1997-98, private sector forecasts are a little higher than the Budget forecast, but most of these forecasts were prepared before the latest CPI was published. In light of the low outcome for the June quarter, some of these forecasts seem a little pessimistic.

The current account deficit forecasts also differ, with the Budget forecasts being lower than most private sector forecasts, reflecting the impact of a further forecast improvement in the terms of trade which should raise the value of Australia's net exports.


But without doubt, the outlook is a positive one, with stronger economic growth, an improvement in the labour market and low inflation forecast.

This favourable outlook is shared by the private sector, and should be sustained with support from Government policies.

The latest data indicate the forecasts for 1997-98 are on tack.

Economic growth appears to have accelerated in the first half of 1997.

Inflationary pressures are adequately contained.

Low inflation should lay the foundation for continued strong, sustainable economic growth.

And as I said earlier, strong, sustainable economic growth will deliver lasting reductions in unemployment.

Thank you.