Some reflections on last week's March quarter national accounts

Australia's economy contracted in the first quarter of 2011, only the fifth time that real gross domestic product (GDP) has declined since the recession of the early 1990s. (As an aside, the Statistics Bureau now reckons that real GDP contracted – albeit by just 0.02% – in the September quarter of 2000, which means, given that it also declined in the December quarter of that year, that Australia's most recent recession, by the most commonly-used 'rule of thumb' for designating one, was just over a decade ago: but perhaps that says more about that 'rule' than it does about what was actually going on at that time).

Unlike each of those four previous occasions (and two other quarters besides, either side of the quarter of negative growth which followed the collapse of Lehman Brothers in September 2008), the contraction in the March quarter of this year was driven entirely by the supply side of the economy, following a series of floods and cyclones that affected various parts of the country, in particular Queensland, during the first few weeks of the year. The volume of exports fell by 8.7%, the largest decline in 37 years, largely reflecting a 27% slump in exports of coal and an 8% fall in exports of other ores and minerals. By itself, the fall in exports sliced 2.1 percentage points off total output in the March quarter. A run-down in inventories, which was probably also prompted by the series of natural disasters, reduced total output by another half of one percentage point.

Overall, mining industry output dropped by 6.1% in the March quarter, the biggest quarterly decline in 25 years. Farm output, which was also affected by floods and cyclones, fell by 10.0%. Parts of the services sector were affected too: for example, the accommodation and food services sector contracted by 1.1%, probably as a result of people cancelling holidays in Queensland, while the (private) administration and support services sector (which is as large as farming) shrank by 2.4%, probably as a result of the inability of many workers in Brisbane (Australia's third largest services sector) to get to work for between several days and two weeks during January.

Yet other aspects of the March quarter national accounts released last week suggest that, notwithstanding the travails of the housing, retailing and manufacturing sectors, the underlying trend in the Australian economy remains strong.

In marked contrast to the supply side, the demand side of the Australian economy remained very robust in the March quarter. Final domestic demand, which is the sum of spending by Australian households, businesses and governments, rose by 1.3%, the largest increase since the December quarter of 2009. Households saved 11.5% of their disposable income – the highest proportion in 25 years, apart from the two quarters of the Rudd Government's 'cash splashes' in response to the global financial crisis. But that income grew by 2.4% in real terms, enough to allow consumer spending still to grow by 0.6%, only just off the pace of the two previous quarters. Housing investment was up by a surprisingly strong 4.6%, and business investment by 2.8%; while (tighter fiscal policy, according to the government, notwithstanding), public sector spending rose by 1.1%.

The likelihood is, then, that as the supply side of the economy recovers from the natural disasters that afflicted it in the March quarter, and allowing that it is taking longer than expected for production at many Queensland coal mines to return to normal levels, recorded GDP growth will bounce back in the June and September quarters. 2

One aspect of the national accounts that the Reserve Bank is likely to find particularly disturbing is the picture it paints of building inflationary pressures. In its most recent quarterly Statement on Monetary Policy, issued four days before last month's Federal Budget, the Reserve Bank identified as 'the greater risk' to the outlook for the Australian economy as the possibility that, as the mining boom continues, 'companies compete aggressively for labour and other inputs, leading to more pressure on wages and other costs than is envisaged in the central forecast' – a forecast which, as it was, envisaged the 'underlying' inflation rate breaking out of the top end of the Bank's 2-3% target range by 2013.

Although the standard measures of wage inflation (the Statistics Bureau's wage cost index, and measures of average weekly earnings) don't point yet point to any serious acceleration (beyond the reversal of the slowdown in wages growth that occurred during the financial crisis), the national accounts' measure of average 'compensation' (pay and benefits) per non-farm employee rose by a rather more striking 5.7% over the year to the March quarter. That figure will reflect any increase in average hours worked (and paid for), as well as increases in hourly rates of pay. But it has occurred during a period in which output per hour worked (that is, labour productivity) fell by 1.8% - the largest decline in 25 years. Measured productivity was probably also affected by the series of natural disasters, to the extent that people were turning up for work but unable to do any: but annual productivity growth had also been negative in the September and December quarters of last year, so floods and cyclones are unlikely to have been responsible for all of the decline in labour productivity during the March quarter.

The combination of accelerating employee 'compensation' and falling labour productivity has resulted in a sharp acceleration in non-farm unit labour costs – that is, labour costs per unit of goods and services produced – to 7.4% over the year to the March quarter. That's the highest rate since the June quarter of 1990. And given the role which unit labour costs play in almost all models of inflation, it's a figure which is bound to have rung alarms bells at the Reserve Bank.

The statement following yesterday's Reserve Bank Board meeting suggests that those alarm bells yet ringing loudly, with the Board concluding that 'the current mildly restrictive stance of monetary policy remained appropriate'. But when they go on to say that they will 'continue to assess the evolving outlook for growth and inflation', we can be fairly sure that they will be paying close attention to any indications that these inflationary pressures are intensifying.