The Australian economy is expected to grow by 2½ per cent in 2006-07, significantly slower than the Budget forecast of 3¼ per cent. The downward revision to GDP growth largely reflects the severe drought being experienced across large parts of Australia (see Box 1). GDP growth is forecast to accelerate to 3¾ per cent in 2007-08. Non-farm GDP is expected to grow by 3 per cent in 2006-07 and 3¼ per cent in 2007‑08, while the farm sector is assumed to recover on the basis of a return to average seasonal conditions.
Prospects for world economic growth remain favourable. World GDP growth is forecast to be 5¼ per cent in 2006, ¼ of a percentage point higher than at Budget. In 2007 the world economy is expected to grow by 4¾ per cent, in line with the 2006-07 Budget outlook. The improved outlook for the world economy reflects stronger growth in the euro area and China.
Ongoing strong world economic growth and the continued high level of Australian business investment are expected to support a gradual shift in the composition of economic growth towards exports. Business investment as a share of GDP in 2005-06 was at its highest level for 32 years. As noted at Budget, this expansion in productive capacity is likely to result in strong non-rural commodity export volumes growth in 2006-07 and 2007-08.
Domestic incomes continue to be supported by high commodity prices, with the terms of trade reaching their highest level since the early 1950s. The surge in the terms of trade has seen domestic income grow substantially faster than GDP. Real gross domestic income increased by 5.0 per cent in 2005-06, well above the GDP growth rate of 2.9 per cent. Real gross domestic income is expected to again increase faster than real GDP in 2006-07, supported by continued commodity price growth.
The stimulus from commodity prices has been most pronounced in the resource-rich States of Western Australia and Queensland. Economic growth in both States has been substantially stronger than the rest of the economy. Gross State Product in both Western Australia and Queensland increased strongly in 2005-06, by 4.9 per cent, well above GDP growth of 2.9 per cent. This divergence in growth is expected to ease modestly over the forecast period.
Household consumption growth is expected to remain moderate in 2006-07 and 2007-08 as the household sector continues to consolidate its financial position. Following a period of rapidly increasing household debt, consumers have taken the opportunity in recent years to begin to rebuild their savings. This consolidation has been supported by strong household income growth, personal income tax cuts and increased support for families. Recent interest rate increases are expected to constrain consumption growth.
Dwelling investment has shown signs of a modest recovery during 2006, following a mild downturn in the past two years. This recovery is expected to continue into 2007-08, largely driven by owner occupiers, with recent interest rate increases and modest rental yields expected to weigh more heavily on investors.
The performance of the labour market has been stronger than expected at Budget, with more rapid employment growth and the unemployment rate falling to a 30-year low of 4.6 per cent. Employment growth is expected to moderate over the forecast period, in line with around trend non-farm GDP growth. The unemployment rate is expected to be around 5 per cent in 2006-07 before rising slightly in 2007-08 — in part reflecting the impact of the Government's Welfare to Work reforms.
Inflation has been higher than anticipated at Budget, largely reflecting the jump in petrol prices in mid-2006 and the one-off effect of Tropical Cyclone Larry on fruit prices. Taken together these two effects have contributed half of the increase in inflation since the March quarter 2006. Inflation is expected to fall temporarily below 2 per cent when these factors unwind in 2007. Underlying inflationary pressures are also expected to moderate over the forecast horizon, with inflation expected to settle in the middle of the target band by 2008.