The outlook for the domestic economy
Key assumptions
The domestic economy forecasts are underpinned by several technical assumptions. The exchange rate is assumed to remain around its recent level — a trade weighted index of around 67 and a United States dollar exchange rate of around 82 US cents. Domestic interest rates are assumed to remain unchanged at current levels. World oil prices (West Texas Intermediate) are assumed to move in line with market expectations, and remain above US$65 per barrel throughout most of the forecast period. The farm sector forecasts are based on an assumption of average seasonal conditions in 2007-08, but take into account the current very low water storage levels.
Demand, output and income
Real GDP is forecast to grow by 3¾ per cent in 2007-08, with the partial recovery from drought expected to add ½ of a percentage point to growth (Chart 2). Farm GDP is forecast to rebound by 18 per cent in 2007-08, following a fall of 20 per cent in 2006-07, on the assumption of a return to average seasonal conditions.1 The non-farm economy is expected to grow by 3 per cent in 2006-07 and 3½ per cent in 2007-08.
Chart 2: Contributions to GDP growth(a)
- Adjusted for second-hand asset sales and includes the impact of the privatisation of Telstra.
Source: ABS cat. no. 5206.0 and Treasury.
The Australian economy continues to benefit from strong world demand, with labour and capital continuing to shift towards the mining and construction sectors in response to the increase in commodity prices. Business investment growth is anticipated to moderate, but the level of investment is expected to remain high, supported by a record amount of planned engineering construction. Strong investment growth over recent years is expected to translate into accelerating export growth. The shift in resources within the economy is expected to continue to result in State and industry divergences (Box 2).
Growth in gross national income — which adjusts GDP for movements in the terms of trade and net primary income earned overseas — was 3.3 percentage points higher than GDP growth over the two years to the December quarter 2006. Ongoing growth in national income, household wealth and employment is expected to support solid household consumption growth and a modest pick-up in dwelling investment.
Household consumption
Household consumption is expected to grow by 3½ per cent in 2006-07 and 2007-08, following growth of 2.6 per cent in 2005-06 (Chart 3). Strong employment growth, solid wage growth and tax cuts allowed consumers to maintain modest consumption growth in 2005-06 despite higher petrol prices, increased debt servicing costs and an adjustment to little or no house price growth in some markets.
Chart 3: Growth in household consumption
Source: ABS cat. no. 5206.0 and Treasury.
Box 2: Divergences among States and industries | ||
The drought, housing market and the increase in commodity prices have all had State and industry dimensions. The significant increase in commodity prices has seen a shift in labour and capital towards mining-related industries. This has resulted in some States growing more quickly than others in recent years. The resource-rich States of Queensland and Western Australia grew at a weighted-average rate of 4.9 per cent in 2005-06, compared with 1.9 per cent for New South Wales and Victoria (Chart A). Chart A: Gross State Product
Source: ABS cat. no. 5220.0. While business investment has been a major factor behind divergent State growth, household consumption growth has also diverged. For example, consumption growth in New South Wales was modest at 1.7 per cent in 2005-06, compared with 4.1 per cent in Western Australia. The commodity price stimulus has been evident in the labour market (Chart B). Construction and mining employment grew by 7.6 per cent through the year to the March quarter 2007 (an increase of 77,900 jobs). Employment in mining and services to mining represents just 1.3 per cent of total employment. Outside construction and mining, employment also grew strongly by 2.4 per cent through the year to the March quarter 2007, resulting in an increase of 213,400 jobs. Chart B: Industry employment
Note: Mid-month quarterly data. Source: ABS cat. no. 6291.0.55.003. Outside mining, businesses have benefited from strong demand underpinned by high employment. Households have benefited from higher incomes, driven by both employment and wages, and higher wealth through the housing and share markets. |
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In aggregate, the saving performance of households improved in 2005-06. This reflected a decision by households to continue to rebuild their balance sheets following a period in 2002-03 and 2003-04 when rapid consumption growth outpaced income growth. Abstracting from the impact of the sharp fall in farm incomes related to the drought, the saving performance of households continued to improve in the latter half of 2006.
Favourable conditions for household consumption are expected to continue over the forecast period. Household disposable income is expected to continue to grow solidly, supported by employment and wage growth. Consumer price inflation is expected to moderate from its recent highs, as automotive fuel prices stabilise, large rises in fruit prices unwind and underlying inflationary pressures ease.
Consumption is also likely to be supported by recent increases in household wealth. Real household net wealth has increased strongly in recent years, rising by over 15 per cent over the past two years to June 2006. The growth in wealth has come from both dwelling and non-dwelling wealth, although non-dwelling wealth has increased at almost three times the rate of dwelling wealth over the past two years. In contrast, between June 2000 and June 2004 dwelling wealth grew at more than twice the rate of non-dwelling wealth. Consumption in Australia, and elsewhere, appears to be more responsive to changes in dwelling wealth than changes in non‑dwelling wealth, suggesting that recent wealth increases will support consumption growth, but not by as much as when house prices were rising rapidly.
The risks around the consumption outlook have become more balanced in recent months. In aggregate, the housing market and consumption expenditure have adjusted smoothly to higher interest rates and higher petrol prices. In addition, household balance sheets are generally sound. However, concerns remain about the vulnerability of a small proportion of highly-geared households to unexpected changes in interest rates and incomes.
Dwelling investment
Dwelling investment fell slightly in both 2004-05 and 2005-06, after growing at an average annual rate of 12.9 per cent over the preceding three years. Dwelling investment is forecast to grow by a modest 2½ per cent in 2006-07 and 2007-08 (Chart 4). Growth is expected to be led by alterations and additions, with purchases of new dwellings picking up towards the end of the forecast period. Recent interest rate rises and low rental yields are expected to weigh on investors in the near term.
Chart 4: Growth in dwelling investment
Source: ABS cat. no. 5206.0 and Treasury.
Investment in alterations and additions is forecast to grow steadily, and to increase as a share of overall dwelling investment. This process is more advanced in New South Wales, reflecting a combination of factors. These include the limited availability of land in some locations and, in more recent years, the increased transaction costs involved with buying and selling a house. This trend has been evident in recent data, with alterations and additions having grown by 4.1 per cent Australia-wide over the six months to the December quarter 2006.
The near-term indicators of new housing construction activity remain subdued, in part reflecting recent increases in interest rates. Nevertheless, housing demand remains solid. Sustained growth in household incomes and employment, combined with increased immigration, is expected to support new dwelling investment growth in 2007-08.
Investor activity in the housing market has been discouraged in recent years by increases in the cost of borrowing, low rental yields, low growth in house prices and strong returns on alternative investments, such as shares. However, current low vacancy rates and ongoing solid demand for housing suggest that rental yields are likely to rise, largely through increases in rents (Box 3). The timing and effect of any rental yield rise is uncertain, and if yields were to rise more quickly than anticipated there could be a stronger-than-forecast increase in dwelling investment growth.
Investor activity in the housing market has been weak in recent years. Loans to investors fell sharply in late 2003 and have remained low. This reflects low gross rental yields and the reduced potential for capital gain. Between 2001 and 2003 house prices rose much faster than rents, resulting in a sharp decline in gross rental yields (Chart A). In more recent years, low house price growth has led to weak capital gains. All else equal, a lower rental yield and less potential capital gain means that property has become less attractive relative to other assets. Chart A: Gross rental yield and nominal
Source: ABS cat. no. 6416.0, Real Estate Institute of Australia and Treasury. Reduced investor activity, combined with ongoing solid housing demand, has resulted in rental vacancy rates falling to unusually low levels across Australia's capital cities. Historically, low vacancy rates (or high occupancy rates) have led to a pick up in real rent growth (Chart B). Chart B: Occupancy rate and
Source: Real Estate Institute of Australia and Treasury. Given the solid demand for housing, rents are expected to continue to rise, leading to an increase in rental yields.
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Business investment
After recording double-digit rates over each of the past four years, new business investment growth is expected to moderate over the forecast period, to be 4 per cent in 2006-07 and 7½ per cent in 2007-08 (Chart 5). Part of the forecast growth reflects Telstra's reclassification as a private non-financial corporation. The reclassification is expected to reduce public final demand and increase new business investment effective from the March quarter 2007.
Chart 5: Growth in new business investment
Source: ABS cat. no. 5206.0 and Treasury.
The business investment environment remains favourable, with high corporate profits, high rates of capacity utilisation, a relatively low cost of capital and continuing strong global demand for mining commodities. While the increase in commodity prices has boosted mining investment, it has also had a positive impact on investment in other sectors, such as manufacturing and property and business services. Over the past four years, the mining industry has accounted for around 20 percentage points of the 65 per cent growth in nominal investment. In addition, the share of non-dwelling construction undertaken by the mining industry has doubled from around 10 to 20 per cent since the beginning of this decade. However, continued solid growth in non-dwelling construction investment is at some risk from capacity constraints in key labour and capital markets.
The expansion in new machinery and equipment investment is expected to pause in 2006-07, with investment falling by 1½ per cent, before increasing by 6½ per cent in 2007-08. The Australian Bureau of Statistics' Survey of Private New Capital Expenditure and Expected Expenditure (ABS CAPEX survey) suggests widespread weakness in plant and equipment investment intentions in the period ahead. Agricultural machinery and equipment investment (not included in the ABS CAPEX survey) is also likely to fall in 2006-07, reflecting low farm production and profits. New machinery and equipment investment is expected to rebound in 2007-08, with business conditions anticipated to remain strong.
Total new non-dwelling construction investment is expected to grow by 12 per cent in 2006-07 and 7 per cent in 2007-08. New engineering construction investment growth is expected to increase sharply in 2006-07, before moderating slightly in 2007-08, supported by new projects and a record amount of work that has begun construction but is yet to be completed (Chart 6). New non-residential building investment growth is expected to moderate from recent strong rates. Commercial office, other business premises and retail construction are expected to experience the strongest growth.
Chart 6: Nominal new engineering construction
Source: ABS cat. no. 8762.0.
Inventories
Inventories are not expected to contribute to or subtract from GDP growth in 2006-07, as a rise in business stocks offsets a run-down in grain stocks. With farm production forecast to partially recover in 2007-08, grain stocks are expected to rise, with inventories contributing ¼ of a percentage point to growth in 2007-08.
Public final demand
Public final demand is expected to grow strongly in 2006-07 and 2007-08. State and local government investment is expected to increase sharply over the forecast period, reflecting a large number of infrastructure projects. General government consumption is expected to grow strongly in 2006-07, with growth moderating in 2007-08. As is the case for business investment, there is some risk to public investment from capacity constraints.
Net exports
Net exports are expected to subtract ½ of a percentage point from GDP growth in 2007-08. Exports are forecast to grow by 3 per cent in 2006-07 and 5 per cent in 2007-08 (Chart 7). The modest export growth forecast in 2006-07 reflects the impact of the drought on rural exports and moderate growth in exports of elaborately transformed manufactures and services. Export growth is expected to increase in 2007-08, reflecting stronger non-rural commodity exports.
Chart 7: Growth in exports
Source: ABS cat. no. 5302.0 and Treasury.
Rural exports are expected to fall in 2006-07, reflecting the drought-driven 20 per cent fall in farm production. However, a run-down in grain stocks is expected to soften the impact of the fall in farm production on exports. As farm production will partially rebound in 2007-08 under the assumption of average seasonal conditions, some rural exports are also expected to rebound.
Growth in non-rural commodity exports is expected to accelerate in 2007-08, after solid growth in 2006-07. The acceleration in growth reflects the huge investment of around $55 billion undertaken by the mining industry over the past five years.
Nevertheless, uncertainty remains around the timing of the forecast acceleration in non-rural commodity export growth, with the lead times in mining investment having been surprisingly long. While export growth in some commodities — for example, liquefied natural gas and iron ore — has been strong over recent years, others have not performed as well. Coal exports have grown at an average annual rate of 4 per cent over the past four years, while exports of crude oil and condensate have fallen at an average annual rate of 14 per cent. However, there are signs that mining production (including oil production) may have started to turn around. Mining production grew by 9 per cent over the six months to the December quarter 2006 and mineral fuel exports increased by 23 per cent. In addition, while coal exports have been hampered by infrastructure constraints in some supply chains, there are significant expansion plans underway.
Elaborately transformed manufactures and services exports are expected to grow modestly over the forecast period, with the relatively high exchange rate and competitive pressures expected to constrain growth. Manufacturing exports have grown at an annual average rate of 2.7 per cent since 2000-01, well below the 20‑year average of 10.5 per cent. There have been a number of factors contributing to the slow growth, including a turbulent world economy in the early part of the decade, the relatively high exchange rate, and increasing competition from industrialising economies such as China. These factors have also hindered services exports.
The increase in commodity prices is contributing to higher import growth, through a higher exchange rate and strong growth in domestic demand. Strong import growth is the counterpart of strong growth in investment and incomes in the economy. Since 2001-02, imports have grown at an average annual rate of 11.4 per cent, with capital imports growing at an average annual rate of around 20 per cent.
Imports are forecast to grow by 6½ per cent in 2007-08. Growth in capital imports is expected to moderate from its recent high rates in line with an expected moderation in business investment growth. Imports of consumption goods are expected to remain solid, in line with growth in household consumption.
Terms of trade
Following an increase of around 22 per cent over the past two years, the terms of trade are forecast to rise by 6 per cent in 2006-07, before falling by 1½ per cent in 2007-08 (Chart 8). The expected fall is largely driven by anticipated falls in non-rural commodity prices. Despite continued strong world growth, these prices are expected to fall as global mining supply comes on line. Rural prices are also expected to moderate, reflecting a partial recovery in Australian farm production in 2007-08.
The recent strength in the terms of trade has predominantly been driven by non-rural commodity export prices, which rose by around 67 per cent over the past two years. This aggregate increase was dominated by large rises in the prices of iron ore and coal, as well as mineral fuels, gold and metals. Non-rural commodity price rises also contributed to import prices rising modestly. However, import prices are expected to moderate over the forecast period. Despite increasing cost pressures and higher world inflation, the prices of manufactured imports are expected to continue to fall.
Chart 8: Terms of trade
Note: Annual data prior to September 1959 and quarterly data thereafter.
Source: ABS cat. no. 5302.0 and Reserve Bank of Australia.
There is a risk that non-rural commodity prices will not fall as expected. While there have been recent falls in oil, alumina, some coal and some base metal prices, there are still signs of strength in other prices. Illustrating the mixed results, the prices of zinc and copper fell by 8.3 per cent and 19.0 per cent over the six months to March 2007, while the prices of nickel and lead increased by 48.4 per cent and 35.5 per cent. If world demand remains strong, and the global supply response does not match its pace, prices could be higher than expected. However, commodity prices are volatile, and there is the potential for a sharp correction if there were to be a reduction in demand or a faster-than-anticipated global supply response.
Current account balance
The current account deficit (CAD) is expected to widen to 6 per cent of GDP in 2007-08 (Chart 9). It is anticipated that the trade deficit will widen, with import volumes outpacing export volumes and an expected fall in export prices. This is expected to be partially offset by a narrowing in the net income deficit (NID).
The past two years have seen a significant rise in the NID as a share of GDP following a long period when this ratio was declining. The earlier decline in part reflected a narrowing in the spread between the yields on foreign liabilities and those on foreign assets (Box 4). This differential has widened in the past two years as strong mining profits, coupled with a relatively high degree of foreign ownership in the mining sector, have underpinned a rapid increase in equity income accruing to the rest of the world. Reflecting an anticipated easing in commodity prices and corporate profits, equity income accruals are expected to moderate in 2007-08. This is expected to be partially offset by a rising stock of net foreign liabilities resulting from past current account deficits, and higher world interest rates.
Chart 9: Current account balance
Source: ABS cat. no. 5302.0 and Treasury.
From a saving and investment perspective, the expected widening in the CAD reflects expected higher investment and relatively unchanged national saving as a share of GDP. The widening in the CAD since 2002-03 initially reflected a deterioration in the net lending position of households. In recent years, the net lending position of households has improved as they have begun to consolidate their balance sheets. However, this change has been partially offset by increased borrowing by the corporate sector in order to fund business investment.
Labour market, wages and prices
Labour market
Employment growth is expected to ease to 1½ per cent in 2007-08, consistent with around-trend non-farm GDP growth and a modest rise in real labour costs. The growth in employment is expected to be underpinned by higher-than-average population growth resulting from increased immigration.
The participation rate is expected to rise to 65 per cent in 2007-08, partly reflecting the Government's Welfare‑to‑Work reforms. This is expected to contribute to a modest increase in the unemployment rate to 5 per cent. The new participation requirements for Disability Support Pension and Parenting Payment recipients are likely to lead to more people entering the labour force, increasing the unemployment rate in the short term as new entrants to the labour market take time to find jobs.
The recent strong rise in the demand for labour has been largely met by increased labour supply. The strong growth in employment has been reflected in a rise in the number of people entering the labour force, as well as a fall in the number of people who are unemployed. Around 27 per cent of the growth in employment between June 2004 and March 2007 reflected rising participation, with around 16 per cent associated with a fall in the number of people unemployed. In Queensland and Western Australia — the two States with the strongest mining industries — increased labour force participation is a reflection of the strong increase in demand for labour.
A near-record-high participation rate and an unemployment rate at 30-year lows suggest a tight labour market. Another illustration of the tight labour market is the increase in full-time jobs, which have accounted for the majority of jobs created in recent years (Box 5). Moreover, measures of labour utilisation, which adjust for the number of hours worked by part-time and full-time workers, are at near-record levels (since the monthly labour force survey began in February 1978). In fact, for those aged 25 to 54, this measure is at its highest level on record.
Box 5: Part-time and full-time employment | ||
Part-time jobs have accounted for around 30 per cent of jobs created in the past five years, compared with over 55 per cent of jobs created over the previous two decades. After rising consistently since the early 1980s, the part-time share of total employment has been steady for the past five years (Chart A). Chart A: Part-time share of total employment
Source: ABS cat. no. 6202.0. The shift away from growth in part-time employment towards full-time employment has occurred in most States. This shift has also occurred, to a varying extent, across age and gender cohorts. Further, it has occurred despite an increase in the share of older workers (55 and over) in total employment, where part‑time jobs are more prevalent. The shift towards full-time job growth is partly related to strong employment growth in the mining and construction industries. In February 2007, these industries accounted for around 11 per cent of total employment, up from around 8 per cent in 2001. Around one in eight jobs in these industries is part-time, compared with about one in four across all industries. However, there has also been a shift towards full-time employment growth within industries that are more part-time intensive. For example, after rising since the 1980s, the part-time share of retail trade employment has been steady at around 47 per cent since 2001. This industry accounts for about a quarter of part‑time workers. Future changes in the part-time share of employment will depend on economic conditions, structural changes and demographic factors. Historically, economic upturns are accompanied by slower growth in part-time jobs compared with full-time jobs. As the share of older persons in the labour force increases, the part-time share of total employment could rise further, reflecting the transition to retirement. However, as noted earlier, a rising share of older persons in total employment has not seen an increase in the part-time share of employment in recent years. |
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Wages
Wage growth is expected to moderate slightly in 2007-08, in line with an easing in employment growth. The Wage Price Index is forecast to grow by 4¼ per cent through the year to the June quarter 2007, before easing to 4 per cent through the year to the June quarter 2008. The pattern of through-the-year growth will be affected by the timing of the Australian Fair Pay Commission's 2006 Federal Minimum Wage decision, which is likely to result in stronger wage growth in the March quarter 2007.
Despite strong employment growth and continuing falls in the unemployment rate in recent years, overall wage pressures have not increased considerably (Box 6). There have, however, been localised wage pressures in those sectors most directly affected by the mining and construction industries (Chart 10). Wage growth in the mining and construction sectors was 5.6 per cent through the year to the December quarter 2006, compared with growth of 3.8 per cent for all other industries. The strength in wages in these sectors is expected to continue, and there is a risk that this may lead to more widespread wage pressures with the tight labour market.
Chart 10: Growth in the Wage Price Index
Source: ABS cat. no. 6345.0 and Treasury.
Box 6: Inflation and unemployment | ||
Over the past decade, inflation in Australia has been well-anchored, with annual inflation averaging 2½ per cent. At the same time, the unemployment rate has been falling steadily and the economy is now as close to full employment as it has been for over 30 years. The relationship between inflation and the unemployment rate over the past 30 years can be interpreted as a series of shifting short-run Phillips curves, with downward shifts reflecting lower inflation expectations (Chart A). The combination of low unemployment and low inflation has been sustained for some time, which suggests that the short-run trade-off between unemployment and inflation has diminished. This has been a consequence of credible macroeconomic policy frameworks, which have anchored inflation at low rates. Moreover, the labour market is more flexible than it was in the past. As a result, relative wages among industries now provide a stronger signal for labour to move in response to demand without creating economy‑wide wage pressures. Chart A: Phillips curves in Australia(a)
Source: ABS cat. no. 6401.0, 6202.0 and Treasury. |
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Prices
Consumer price inflation has been affected recently by significant movements in the prices of automotive fuel and fruit (Chart 11). These items subtracted 1¼ percentage points from Consumer Price Index (CPI) growth over the six months to the March quarter 2007, after contributing 1¼ percentage points in the preceding six months. As automotive fuel prices stabilise and fruit prices remain below the highs experienced in 2006, inflation is expected to temporarily fall below 2 per cent through the year to the June quarter 2007.
Chart 11: Inflation(a)
- Adjusted for the effects of The New Tax System.
Source: ABS cat. no. 6401.0 and Treasury.
In addition to these one-off factors, there have been some underlying inflationary pressures reflecting the indirect effects of higher oil prices and solid growth in nominal unit labour costs. After slowing at the beginning of the decade, growth in nominal unit labour costs picked up in 2004-05 and 2005-06 reflecting a slowdown in productivity and a modest pick-up in wages. Nominal unit labour costs are expected to ease in line with a strengthening in productivity. As a result, underlying inflationary pressures are expected to moderate.
The inflation rate is forecast to be 2¾ per cent through the year to the June quarter 2008. Behind the moderate outlook for inflation are divergent trends for the prices of different goods. The downward trend in the price of some tradeable items, such as clothing and footwear and computing equipment is expected to continue. However, as discussed in Box 3, house rental prices are expected to continue to increase. This, combined with a forecast modest increase in house purchase prices — which together account for around 13 per cent of the CPI basket — is expected to place upward pressure on inflation. Low water allocations in the Murray-Darling Basin will also add to the upward pressure on inflation through higher fruit, vegetable and dairy prices, although alternative Australian and international supply sources are expected to reduce this impact. While upward price pressures are not anticipated to lead to significant increases in consumer price inflation, they remain a risk.
1 The Mid-Year Economic and Fiscal Outlook 2006-07 contains a detailed discussion of the impact of the drought on the economy.