Statement 3: Economic Outlook
This statement presents the economic forecasts that underlie the budget estimates. |
The stronger world economy will provide a renewed source of growth for domestic economic activity in 2004-05, leaving Australia well-placed to build on the current economic expansion. Solid economic growth is forecast for 2004-05, with higher export growth largely offsetting lower growth in domestic demand (as measured by gross national expenditure). Employment growth is forecast to remain solid, holding the unemployment rate near 23-year lows, while inflation is forecast to fall to below the bottom of the 2 to 3 per cent target band reflecting moderate growth in labour costs and the higher exchange rate.
Overview
In 2003-04, economic growth in Australia is forecast to be 3¾ per cent, unchanged from the forecasts presented in the Mid-Year Economic and Fiscal Outlook 2003-04. Gross national expenditure (GNE) is forecast to grow by 6 per cent for a second consecutive year, with household consumption being boosted by increasing wealth from higher house prices and investment growth driven by increasing construction activity in both the residential and non-residential sectors. Farm production is forecast to grow strongly in 2003-04, contributing ½ of a percentage point to gross domestic product (GDP) growth. Strong consumption growth helped the economy to ride out the challenges presented by the severe drought, a patchy world economy, Severe Acute Respiratory Syndrome (SARS) and continuing international security concerns, which saw net exports make a large detraction from GDP growth in 2003-04.
In 2004-05, economic growth is forecast to be 3½ per cent, with growth in GNE easing to a more sustainable 3¾ per cent, partly offset by a smaller detraction from net exports. Employment is forecast to grow by 1¾ per cent in 2004-05, which should be sufficient to maintain the unemployment rate at around 5¾ per cent. Inflation is forecast to decline to around 1¾ per cent through the year to the June quarter 2005, influenced by low prices for imported consumables and moderate labour cost pressures. The current account deficit is expected to narrow to 5 per cent of GDP in 2004-05, primarily reflecting an improvement in Australia’s terms of trade.
Growth in all of the major components of GNE is forecast to slow in 2004-05. A decline in the construction of medium-density buildings is forecast to contribute to a contraction in dwelling investment activity. Construction of detached housing is also forecast to fall in 2004-05, while investment in alterations and additions is forecast to grow by less than in 2003-04. Growth in household consumption and business investment is forecast to ease towards trend rates in 2004-05, following very strong growth in recent years.
Net exports are forecast to detract ½ of a percentage point from economic growth in 2004-05, as imports continue to grow a little more quickly than exports in response to the still solid levels of domestic spending. Nevertheless, and despite the appreciation of the currency over the past two years, 2004-05 should see a significant improvement in export growth compared with the previous two years. The stronger world economy will provide support for exports of non-rural commodities, manufactures and services. The large grain harvest in 2003-04 has contributed to a build up of farm stocks, which will provide continuing support to rural exports into 2004-05, although the prospect of continuing dry conditions in parts of rural Australia is a risk to the outlook for activity in aggregate.
The recovery in the world economy has strengthened significantly since last year’s Budget. World growth was strong in the second half of calendar 2003, supported by expansionary monetary and fiscal policy. The durability of the world economic recovery has been aided by the broadening of growth, with strong growth in the United States (US) and East Asia, a firming recovery in Japan and modest growth in Europe.
World economic growth is expected to be brisk throughout 2004, resulting in above trend growth for the year as a whole. Monetary and fiscal policy will likely remain broadly expansionary across a wide group of economies. Despite higher oil and commodity prices, world inflationary pressures are generally low.
In the domestic economy, the very strong growth in household consumption expenditure over the past year was supported by robust growth in real after-tax incomes, rapid increases in wealth, and continuing high consumer confidence. These factors, in addition to the Government’s Budget initiatives, will continue to support consumption growth in the near term. However, an assumed slower pace of wealth accumulation flowing from a flattening in dwelling prices and slightly lower employment growth are expected to see consumption growth moderate to around 4¼ per cent in 2004-05.
After three years of strong growth, dwelling investment is forecast to fall by 3 per cent in 2004-05, with the slowing in activity expected to begin around mid-2004. While the dwelling sector has maintained momentum through 2003-04, the long-anticipated slowdown has begun in some markets, although its extent remains uncertain. Oversupply is most pronounced in pockets of the medium-density sector, particularly for apartments near major city centres. Falls in prices are widely expected and lower construction activity is forecast in this component of the housing sector through 2004-05 and beyond. A more modest downturn is forecast for detached housing, reflecting the relatively more robust conditions in that sector. Partly offsetting the declines in new building activity, renovation work is forecast to continue to grow, but at a slower pace than in recent years.
Growth in business investment has been exceptionally strong in recent years, despite the uncertain world environment, but is expected to slow toward trend rates in 2004-05. Business investment conditions remain favourable, with strong profit growth in sectors exposed to the domestic economy, low interest rates, and corporate balance sheets in a generally sound position. Business surveys point to high levels of both business confidence and capacity utilisation.
In line with these positive fundamentals, and supported by lower prices for imported capital goods, new machinery and equipment investment is forecast to grow by 8 per cent in 2004-05. New non-dwelling construction is forecast to grow by 6 per cent in 2004-05 after very strong growth over the past two years. The lower growth forecasts reflect increasing commercial vacancy rates and a slowing in commencements of major new infrastructure projects. However, construction activity is forecast to remain at very high levels as a share of GDP as work on existing projects continues.
While private final demand growth is expected to ease from 6½ per cent in 2003-04 to 4 per cent in 2004-05, growth in public final demand is expected to increase from 2¾ per cent to 3½ per cent. Over the past two years, public finances have been supported by strong economic growth, while State government revenues have benefited particularly from activity in the housing market. Economic growth will continue to support the forecast increase in public demand through 2004-05.
Export growth is expected to increase to 8 per cent in 2004-05, reflecting improved conditions in the rural sector and the more positive outlook for the world economy. Increased production capacity in Australia for non-rural commodities is also expected to boost export growth, but the appreciation of the Australian dollar over the past two years will remain a constraint on export growth more generally. Import growth is forecast to moderate to 9 per cent in 2004-05, in line with the expected easing in GNE growth. Taken together, the trade forecasts imply that the external sector will detract ½ of a percentage point from economic growth in 2004-05, a significantly smaller detraction than was recorded over the past two years.
The terms of trade are forecast to increase strongly in 2004-05, driven by increased prices for a number of Australia’s non-rural commodity exports, and further declines in many import prices, particularly for information and communication technology (ICT) goods. This improvement in the terms of trade underpins a forecast narrowing of the current account deficit to 5 per cent of GDP in 2004-05.
Employment growth is forecast to ease slightly to 1½ per cent through the year to the June quarter 2005, reflecting the slight moderation in forecast economic growth for 2004-05. Employment growth at this rate would be sufficient to hold the unemployment rate near 23-year lows of around 5¾ per cent through 2004-05.
The inflation outlook remains benign, underpinned by moderate growth in labour costs and the substantial appreciation of the Australian dollar over the past two years. Inflation is forecast to gradually decline to around 1¾ per cent through the year to June 2005, as the effect of the drought on food prices diminishes, the rate of increase in project home prices moderates and the lagged effects of the exchange rate appreciation continued to feed through to retail prices. In addition, tradables prices will benefit from tariff reductions on motor vehicles and textiles, clothing and footwear from 1 January 2005.
The key risk to the economic outlook relates to developments in the housing sector, particularly the future path of house prices and the associated wealth effects on consumption. Dwelling investment is forecast to moderate over 2004-05 and the rate of increase in nominal house prices is expected to flatten in aggregate, with some market segments seeing price falls. The assumed slowing in house price growth is forecast to lead to a slowing in household wealth accumulation and consumption growth. However, there is a risk of a more widespread fall in house prices that, if realised, would amplify the slowing in wealth and consumption growth, and have broader implications for aggregate economic activity.
Medium-density apartments, particularly in areas near major city centres, have clearly seen significant over-building in recent years, public warnings of the dangers notwithstanding. A more dramatic fall in prices — even if contained to particular market segments or geographic areas — would introduce additional risk to the outlook.
That said, the dwelling sector has consistently surprised on the upside, and a further boost to aggregate activity from dwelling construction cannot be ruled out.
Increasing levels of household debt also present a potential risk. Household debt-to-income ratios have increased over the past decade, partly in response to low interest rates, moderate rates of inflation and financial market innovation. While there is no evidence that current levels of debt are proving onerous for households in aggregate, higher levels of debt have increased the vulnerability of households to adverse shocks, particularly shocks that might be associated with a deterioration in labour market conditions.
The forecasts are predicated on an assumption that average seasonal conditions will prevail in 2004-05. A continuation of very dry conditions in the south-east, or lower than average seasonal rainfall across broader areas of Australia over the coming year, presents a risk to the prospects for a full recovery in the farm sector and poses a downside risk to the forecasts for farm production and exports in 2004-05.
The risk to the domestic outlook from developments in the world economy appears to have abated significantly since the 2003-04 Budget, with strong growth in the US and East Asia, a firming recovery in Japan and modest growth in Europe. Uncertainties remain, however, about the evolution of the world economic recovery. The recovery has surprised with its strength, suggesting some upside risk to world growth, although questions remain about the unwinding of imbalances in saving and investment flows, and the impact of high and volatile oil prices.
Table 1: Domestic economy forecasts(a)
- Percentage change on previous year unless otherwise indicated.
- Calculated using original data.
- Chain volume measures.
- Excluding transfers of second-hand assets from the public sector to the private sector.
- Percentage point contribution to growth in GDP.
- For presentational purposes, forecast changes in inventories held by privatised marketing authorities are included with the inventories of the farm sector and public marketing authorities.
- The estimate in the final column is the forecast rate in the June quarter 2005.
Source: Australian Bureau of Statistics (ABS) Cat. No. 5206.0, 5302.0, 6202.0, 6345.0, 6401.0, unpublished ABS data and Treasury.
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