Is Australia headed for a recession?

The rumours are swirling. The US economy might be headed for a recession. And what happens in the international market significantly impacts Australia.

Many commentators are concerned that we too might be headed for a recession. But is this an accurate prediction, or are there ways Australia can weather the storm?

Host Kat Clay is joined by Trent Wiltshire, Deputy Program Director, Migration and Labour Markets, to see if the rumours are true.

Transcript

Kat Clay: The rumours are swirling. The U. S. economy might be headed for a recession, and what happens in the international market significantly impacts Australia. Many commentators are concerned that we too might be headed for a recession. But is this an accurate prediction, or are there ways Australia can weather the storm?

I’m Kat Clay, and here to talk about the potential for an Australian recession, I’m joined by our new Deputy Program Director for Migration and Labour Markets, Trent Wilshere. Trent, this isn’t your first time at Grattan though.

Trent Wiltshire: Hi Kat. No, it’s not. So, I’ve come back to Grattan after about four years of, working in the Victorian government and at the Domain Group as an economist there.

So, you know, I spent three years at Grattan, a great three years, a few years ago, and I’m very excited to be back.

Kat Clay: That’s fantastic to have you here. And I’m really glad we can do this podcast today. So, one thing I’ve, Kind of want to know, because I’m not sure that we all know, what actually is a recession?

Trent Wiltshire: The most common measure of a recession, but not necessarily the best, is when GDP, and that’s gross domestic product, which is a measure of how much output Australia produces, falls for two consecutive quarters. We’re not in a recession at the moment, actually far from it. So, GDP growth has actually been pretty strong the last couple of quarters, grew by 0.

7 percent in the March quarter and 0. 9 percent in the June quarter. So, the last recession we had was during the, the debt, the dark days of COVID back in March and June 2020. There’s another way you can measure a recession as well, and that’s known as the SARM rule, and that focuses on what’s happening in the labour market.

So that’s when the three-month average of the unemployment rate rises by 0. 5 percentage points or more relative to its low point. so again, Australia is nowhere near that point at the moment. Our unemployment rate is very low. It’s at 3. 5%. It’s actually fallen from 4. 5 percent a year ago. So, at the moment we’re a long way from a recession, but it’s the outlook that’s a little bit worrying.

Kat Clay: Yes, and we’ll get into talking about our unemployment rate, later in the podcast. The first thing I want to talk about is should we be worried about what’s happening in the U. S.? I mean, if the U. S. goes into recession, is it inevitable that Australia will follow?

Trent Wiltshire: Well, there’s an old saying that, when the U. S. sneezes, the world catches a cold. It’s still relevant, maybe less so than, a couple of decades ago, but definitely what happens in the U. S. does matter to Australia. First, I’ll just maybe give a rundown of what’s happening in the US economy. So, US is actually in a technical recession. So just what I referred to before, their GDP has fallen over the past two quarters.

but that sort of narrow definition hides probably a much stronger economy. So, their unemployment rate is very low. employment growth is still pretty good. household spending is strong. So even though they’re in a, what’s known as we say like a technical recession. it’s not quite the case that their economy is struggling, but the outlook is for growth to slow there quite dramatically.

And that’s really being driven by interest rates rising rapidly there. So, the Fed, which is the U S equivalent of the reserve bank has increased rates from 0 percent in February up to 3 percent last week. And rates are expected to go above 4 percent by the end of this year. They also got very high inflation, much higher than ours.

so yeah, the Fed’s raising rates rapidly to bring inflation back down to their target of around 2%. What’s happening in the U S matters for two reasons. First on interest rates. when the Fed raises rates much faster than what’s happening here, that drags down the, the Australian dollar when rates are higher in the U S, that makes investments more attractive there.

Okay. Brings money into the US, makes the Australian dollar fall. Why does it matter for us? Well, a weaker Australian dollar means that imports are more expensive. So, if we buy from overseas with a weaker dollar, things cost more. And that pushes up our inflation rate, which then the RBA has to respond to.

So, the more the, the Fed, raises rates typically means the RBA is more likely to raise rates further, and that’s more likely to slow down our growth. So that’s one channel. the other channel is just directly by the U. S. being such a big economy, we trade with them. So, if they’ve got, if they’re slowing down, their economic activity slowing, that means our exports will slow down as well.

Then indirectly, Obviously, China is a big trading partner of the U. S., so if the U. S. slows down, that slows down Chinese growth. We export a lot to China, so if they’re slowing down, that slows us down as well. So, it’s sort of through the financial markets as well as directly and indirectly through trade and economic activity.

Kat Clay: And you see that’s happening right now. I mean, the Australian dollar’s at a low, the RBA is talking about raising the cash rate again. I mean, what is the RBA talking about here and what are they forecasting?

Trent Wiltshire: The RBA is not forecasting a recession, unlike, say in the UK, where the, the central bank there has just come out and said, we think the economy is in a recession, even though, the data is not quite showing it yet.

but the RBA is forecasting the economy to slow. So, in August, the RBA put out a set of forecasts and said they expect GDP growth to slow to 1. 7 percent in 2024. I think the unemployment rate is going to rise from around the three and a half percent markup towards the four percent mark in a couple of years, and I think inflation is going to remain elevated as well.

So, currently inflation is at about six percent. Underlying inflation, so taking out the big movements, like petrol particularly, that’s about five percent, and Phil Lowe, the governor of the ABA, is forecasting inflation to hit eight percent about at the end of this year. Like I just mentioned for the US, the RBA is also raising interest rates quite rapidly, as you would have seen in the news, and that’s really aimed at bringing down inflation and also inflation expectations.

So, so currently right through 2. 35%, most forecasters think that’ll probably be the case. Being to the mid to high threes, the financial markets actually think rates are going to rise to above 4 percent and that’s really jacked up over the past week or so too. So that’s where the RBA thinks the economy is heading.

Kat Clay: Yeah. I feel like there’s not a week goes by without another mortgage rate increase and, and the cost of living is just increasing so much. I mean, you see it in the supermarkets, in your bills, in You know, the mortgage repayments. I mean, given these rising costs of living right now, I mean, what’s worse here, high inflation or a recession?

Trent Wiltshire: It’s something that Australia hasn’t really had to deal with for a long time. So, the inflation targeting regime, which was introduced in the 1990s, where the RBA’s focus was to target inflation to. To have inflation averaging about two to three percent over the business cycle over the medium term. It’s been really successful in keeping inflation low and stable.

There was a bit of a spark before the GFC, but typically inflation’s been very low. So, we’ve really been worried about unemployment, but now actually, yeah, we’ve, we’ve got to worry about both. We’ve got inflation high and expected to rise further. Unemployment rate, thankfully very low. Like we did a great job during COVID to bring that employment rate down.

It’s lower than most people forecast, but now it’s sort of the battle of the two things that really people care about. So, I think you can think about inflation is bad for pretty much everyone means cost of living is going up. So real wages. So that’s, Wages less inflation have been negative, for the past four quarters.

So compared to a year ago, people can buy less with their money. That’s what inflation does, erodes the value of your earnings. So pretty much for everyone rising inflation is bad, particularly for low-income earners who spend a lot of their money on essentials. we’ve seen essentials. Rising price rapidly, particularly petrol, but also food as well.

That’s why inflation is bad. And we’ve seen consumers really hate high inflation. So, consumer sentiment, surveys show that confidence plummeted from sort of early this year. nearly down to the depths of COVID, nearly where it was in the GFC. even though unemployment rate is very low, that inflation, because it affects everyone, really does, yeah, affect consumers.

In contrast. a recession, which, you know, I’ll talk about. The main sort of consequence there is rising unemployment. What that means is there’s particularly a smaller cohort are really badly affected. So as an example, unemployment rates about three and a half or three and a half percent. Now, if that rises to 4.

5%, that’s about 150, 000 more Australians out of work. When people lose a job, It’s really, it’s really bad for a number of reasons. So, it’s bad for income. Grattan research has found that people who typically have a job, if they lose their job, we’ll have an 11 percent lower income for five years after, you know, even just a three-month spell of unemployment.

So, it hits your incomes. Makes it hard to pay your mortgage or rent. It has big impacts on mental health as well. And it makes it harder to find a new job too, even if you just have a short spell of unemployment. So, for those that lose their job in a, an economic downturn or a recession, you know, that’s really bad news for.

a lot of parts of their life and really affects wellbeing. Other grant research also shows that when the broader labour market slows and unemployment rate rises, the unemployment rate actually rises further for disadvantaged groups. That’s low skill, low-income people, young people, and other disadvantaged groups as well.

So yeah, that’s why we really care about. Unemployment rising. The challenge of the moment for the Reserve Bank is that inflation’s high. So, we’ve got to bring that down to that sort of target level of 2 to 3%. But in doing so, that’s likely to cause unemployment to rise. So, the Governor Phil Lowe has talked about there being a narrow path ahead where the RBA can successfully raise rates enough to slow down the economy to bring inflation down without causing the unemployment rate to rise too significantly.

Kat Clay: So, we mentioned it at the start of the podcast, but would a recession mean the end of full employment?

Trent Wiltshire: Full employment is where, in sort of non-technical languages, when the economy’s operating at capacity, we’ve got as many people employed as possible, and inflation’s at that sort of two to three percent range, so low and stable inflation.

So pre COVID, most economists thought that full employment was around when the unemployment rate was around four and a half percent. we’ve actually seen post COVID, the unemployment rate falls quite significantly well below four percent. So, it’s been around three and a half percent for a couple of months now.

There’s potentially been a situation where we have to reassess what full employment is, which is promising. It means we can get unemployment rate down lower than what we thought. The economic model suggests that when unemployment falls below that full employment range, Wages growth will start to take off and inflation will start to take off.

we are seeing signs of that, particularly with inflation. Inflation is becoming more broad based. It’s picking up in areas where it’s more sensitive to, to wages. We are seeing wages growth pick up, but really not too much just yet. There’s, probably there’s some more science of the RBA’s liaison program has pointed to wages growth picking up in some areas, but it’s really not a broad pick up in wages.

So, I’d say we are below full employment, but perhaps not as far below as we thought pre COVID. So, you know, my guess would be that full employment, unemployment rate is around the 4 percent mark now. Yeah, a recession will likely mean. a decent rise in the unemployment rate up into the four to maybe five percent range.

So temporarily it might mean the unemployment rate rises above, but that’s that narrow path that I mentioned before, being able to slow down economic activity enough that inflation comes down without unemployment rate rising too much.

Kat Clay: I mean, do you think that employers would be reluctant to increase wages at a time when recession is potentially on the horizon?

Is that, is that something that we might see that the inflation continues to grow, but wages growth doesn’t kick off?

Trent Wiltshire: It’s pretty clear that employers have been reluctant to lock in higher wages. So, there’s been evidence that employers are looking at using non-wage measures to, to boost pay and attract staff without locking that higher wages for the future.

So that seems like a bonus payments, flexible working arrangements, extra leave, things like that, that firms have had a very much a mindset of cost cutting and and keeping wages. down for a while now and it’s, it’s really taken a while for them to adjust to a higher wage environment. As mentioned before, they are seeing some areas where wages are rising, so say construction’s looking a bit stronger as well, but it’s really not flying through the broader wages growth just yet.

Kat Clay: Now a little bit of an esoteric question for you because one of the things I’ve been thinking about with all these predictions and seeing the future of the economy, I mean, are these predictions fraught? Can economists actually predict what’s going to happen next?

Trent Wiltshire: Economists try to, but yes, it’s, it’s very fraught to try and predict the future.

I think we’ve seen that over the last few years that Predictions can go wildly astray. So just a couple of examples. You think start of COVID a lot of people thought, including myself forecast house prices to fall quite considerably. I’ve actually seen a massive rise over the past couple of years. The RBA has come out and apologize for its commitment to keep interest rates around zero until 2024.

Although I think. That sort of got lost up in the, in the media sort of mix it up. It was a conditional forecast that if things played out as expected, they would keep if, if things were weak for a while, they’d keep rates low, but that sort of got lost in investing that people took it as a commitment to keep rates low regardless.

Pretty much most forecasters have been completely surprised at how fast the economy has rebounded from the COVID impact. So, from 2021 onwards, a lot of the focus was still on jobs. how can we get the economy picking up again by early 2022? No, a switch has flicked until I know we’re actually in an environment where inflation is taking off, demand is too strong.

We have to, we have to pull it back. So, economists do their best at predicting the future, but can certainly. get it wrong.

Kat Clay: You’re not psychics, at least not all of you.

Trent Wiltshire: Definitely not.

Kat Clay: One last question for you. And I think it’s an important one. How do you recession proof the economy or at least put in some buffers that can help Australia weather this storm?

Trent Wiltshire: The key one and the experience of COVID over the past couple of years is, how important monetary policy is in terms of, keeping the economy operating close to potential. So, the Reserve Bank’s responsibility is managing demand in the short term, short to medium term to, to keep the operating, to keep the economy operating as close to potential as possible with inflation, low and stable at around two to 3%.

So that leads to, I think, one of the most important things is to have a high-quality central bank that operates really good monetary policy that flows into, you know, there’s currently a review of the Reserve Bank underway at the moment. I think really important that the Reserve Bank does, you know, have the best governance possible, have the best management possible.

The tools at its disposal are right. The target of monetary policy, so that’s the statement and conduct of monetary policy, is all at best practice. We learn from what’s happening overseas. So, this review that’s underway is a really wide range of review. looks at policy tools, culture, et cetera. The role of the Reserve Bank has been shown to be so important over the past couple of years, in times when the economy’s hit by a big shock.

So, I think that’s number one. Number two, you want the government to be able to react quickly as well. So, the other main macro lever, fiscal policy, we’ve seen that’s important as well. I think it’s, it’s a secondary behind monetary policy, but it does play a role in, in times of crisis. And we saw that Happen, with things like JobKeeper, and other big loans that were made out.

So, a strong budget position makes it more likely the government will step in and spend or cut taxes or do some sort of demand, expansionary policy where possible. It’s, it’s not, not necessary to have a really strong budget position, but I think it will certainly help governments to, to make that commitment.

another one is that that have the RBA And the government and fiscal policy mantra probably working together rather than against each other. So, if you look at the UK at the moment, it’s actually working against each other. So central bank there is raising rates to slow down the economy. The government’s just come in and brought in a huge, huge tax cuts, really expansionary policy.

So, when they’re working against each other, that makes the economy. recoveries from crises even harder. So, we’ve been pretty good in Australia recently in terms of the RBA and the government acting together, but not always the case. Some other things that it can also help with, making us recession proof or limiting the damage of a downturn, things like a flexible labour market.

So, a big feature of the Australian economy. At the past probably two decades is a shift to in times of weaker economic activity, firms tend to cut hours rather than cut jobs in terms when there’s a slowdown occurs that limits the damage for people who so fewer job losses, but more hours lost. So that sort of spreads the damage a little bit more.

So that relies on having a flexible labour market and a key one for Australia as well was what’s happening with commodity prices. So typically, we’ve been very lucky in that in times of, in times of. Weak economic conditions, commodity prices, and as we’re a net exporter of commodities, often boosts our national income.

That’s happening at the moment. Commodity prices are really high, sort of helped by Russia’s invasion of Ukraine. There’s been a weird side effect there that commodity prices have shot up and that sort of insulated the damage or the impacts from overseas. So, we’ve seen that in the budget position recently has been boosted by.

strong tax, tax intake.

Kat Clay: Thank you so much, Trent. It’s a topical issue that we’ll probably look at again in the coming months as the economy progresses. If you’d like to read our research on this particular topic or find out more, please visit grattan.edu.au. All our research is available there for free.

If you’d like to talk to us on social media, please find us on Twitter at Grattan Inst and all other social media channels at Grattan Institute. As always, please take care and thanks so much for listening.