Statement 3: Economic Outlook
Part IV: Uncertainties
The uncertainties surrounding both the international and domestic economic outlooks have generally declined since late 2001 and are now more evenly balanced, although there is still uncertainty about the pace of the world recovery.
On the international front, the recovery in the US is expected to be moderate because of the absence of pent up demand, over capacity in some sectors, various financial constraints and lingering global weakness, particularly in Japan. It is possible, however, that these factors will be less of a drag on growth than currently anticipated. Still high prospective returns on technology investments and process innovations may see stronger investment than currently expected with positive flow on effects to other parts of the economy. The current accommodative monetary and fiscal settings may also provide a stronger stimulus to the economy than currently anticipated if current uncertainties were to dissipate quickly.
There are also some downside risks to the US economy. Ongoing weakness in corporate profitability and heightened uncertainty surrounding corporate governance issues in the wake of the Enron collapse could delay the expected recovery in investment. In addition, an increase in uncertainty, due for example to the impact on employment security of adverse labour market developments or a resurgence of international tensions, could see spending falter and a weaker recovery than currently anticipated. Higher than expected oil prices could also slow recovery. There is also a risk that some of the imbalances built up in the 1990s, including household and corporate sector debt and highly-valued equity prices may need to be unwound, slowing the pace of recovery. There also remains an ongoing issue of the sustainability of the US current account and, by extension, the stability of G-3 (US, Japan and Euro area) exchange rates.
Economic conditions in Japan have worsened over the past year and a further period of weakness is anticipated in the forecasts. However, continuing deflation, writedowns of bank capital and uncertainties about the extent of non-performing loans have added to the risk that the financial system will be unable to adequately cope with further weakness in the economy. Monetary and fiscal policy options are limited. While the most likely outcome for Japan is that it will slowly work through its current problems without a major financial crisis, there is a risk that a further deterioration in economic and financial conditions will put additional pressure on fragile banking and corporate sectors, increasing financial system instability.
The possibility of a weaker recovery in the US and/or financial instability in Japan poses a substantial risk to the East Asian region. Strong trade and investment linkages would transmit the weakness to the East Asian economies, and increase the possibility of financial instability in the region.
Turning to domestic economic activity, there is some uncertainty around the expected depth of the downturn in the dwelling sector. While a sharp decline in new dwelling construction is expected in 2002-03, as the additional FHOS is phased out and the stock of excess supply in some segments of the market is reduced, overall conditions remain supportive of solid growth in alterations and additions. Nevertheless, there is a risk that activity in alterations and additions could moderate as new dwelling construction declines, leading to a larger decline in dwelling investment than presently forecast. This in turn would have negative implications for employment growth and household consumption, particularly for the consumption of durable goods.
On the other hand, the business investment intentions data reported by the ABS in the latest capital expenditure survey point to some upside risks to the forecasts for business investment and in turn import growth in 2002-03.
The stronger domestic economic environment, combined with reduced competition in some markets (such as insurance, telecommunications and airlines), could also create an opportunity for firms to re-build margins following the decline in the exchange rate over the last two years. Should this occur, particularly in conjunction with other short-term price pressures, it could have an impact on underlying inflationary pressures.
In addition, the recent increase in oil prices to well over the assumed price of $US23 per barrel underlying the forecasts, which is being driven mainly by concerns about the conflict in the Middle East, also presents risks to both the international and domestic forecasts. If the oil price remains well above the assumed level for an extended period of time, then confidence both domestically and internationally could decline, and other more discretionary expenditures may be lower than forecast. In addition, there is a risk that if higher petrol prices were sustained, it could feed into ongoing inflation.
