The Reserve Bank demonstrates 'masterly inactivity'

The global growth cycle has peaked

The world economy grew by about 5 per cent last year - its strongest performance since 1976 - despite continuing geo-political uncertainty, rising US interest rates and a sharp and sustained rise in oil prices.

Global growth momentum peaked around the third quarter of last year, and seems likely to slow to an average of around 4 per cent this year, on the assumptions that US interest rates continue to rise gradually and that oil prices average around US$40 per barrel. The US and China will together again account for some 40 per cent of total world growth, while Europe and Japan will once more be drags on the global chain, each growing by less than 2 per cent.

The most important development in the world economy in 2005 is likely to be the extent of the fall in the US$. Although the US$ has started the year on a surprisingly firm footing, the underlying trend is still expected to be downwards for much of 2005, especially against the euro and other freely floating currencies, reflecting the reluctance of private sector investors outside the US to supply the more than US$2.5 billion required each working day to finance the US current account deficit.

At some point, Asian central banks - which for much of the past two years, have been filling the void left by private sector investors, purchasing more than US$400 billion per annum in an attempt to prevent their currencies from appreciating - will probably decide to allow their currencies to rise. The decision will be led by China, and will come at a time that best suits China’s strategic and economic interests, not in response to US (or financial market) pressure.

2005 may well be the year in which China decides to allow somewhat greater flexibility in the yuan’s exchange rate, most likely by moving to a (still closely managed) float against a basket of other currencies: but even in that event, a large revaluation of the yuan seems improbable. Until then, a falling US dollar - especially if the decline becomes disorderly - will tend to dampen global growth. That’s because central banks in Japan and Europe can’t, or won’t, cut interest rates in order to offset the negative effects of a rising yen and euro on their growth rates: while governments in Japan and Europe are constrained from using fiscal policy to boost growth by their already large budget deficits and rapidly ageing demographic profiles.

US$ weakness poses a dilemma for the RBA

The prospect of further appreciation of the A$, at least against its US counterpart, creates a dilemma for the Reserve Bank.

With domestic economic growth still strong, not least because of the $60 billion (equivalent to more than 1.5 per cent of GDP), which the Federal Government threw at it in the lead-up to last year’s election, and resources (of both labour and production capacity) becoming scarcer, the Bank still has a “bias” towards raising interest rates. But with the currency likely to spend much of this year above US80 cents, it will be difficult for the Bank credibly to project inflation rising towards, or above, the upper band of their 2-3 per cent inflation target range, which is their usual trigger for raising rates. Indeed, inflation could well be under 2 per cent for a good deal of 2005, thanks to the impact of a stronger currency on the prices of imported and import-competing goods and services.

However the Bank will be reluctant to cut interest rates in the face of sub-target inflation, for fear of re-igniting the property bubble, which it adroitly deflated, with almost no damage to the rest of the economy, during 2003-04. Hence it seems quite possible that, for the second year running, the Reserve Bank will leave the cash rate untouched - which would constitute an unprecedented period of “masterly inactivity” on their part.

Will exports continue to disappoint?

Another year of steady and, by historical standards, low interest rates combined with robust employment growth, rising real wages, another round of income tax cuts beginning July 1, and strong corporate profits, should ensure that any slowdown in domestic spending is quite modest, despite the softening in housing activity, which is now well under way.

The most serious concern with regard to the outlook for economic growth is the persistently poor performance of Australian exports. For the past two years, now, both government and private sector forecasters have looked to a pick-up in exports to offset the expected slowing in domestic spending. To date, neither has happened.

To be sure, global demand for many of Australia’s most important exports - minerals and energy commodities in particular - is stronger than it has been for many years, largely thanks to the emergence of China as a major purchaser of a wide range of these products.

Strong global demand has been reflected in sharp increases in the world prices of many of our more important non-rural export commodities. But the volume of Australian exports of these commodities has fallen in five of the past six, and in nine of the past twelve, quarters - largely the result of inadequate investment in production capacity in recent years, and bottlenecks in State government infrastructure.

Meanwhile, non-commodity exporters have been struggling with the effects of a strong currency, adverse geo-political developments and a more profitable domestic market, so that non-commodity exports now represent a smaller proportion of GDP than at any time since 1999. One result of these trends has been that Australia now accounts for just 0.9 per cent of total world exports, our lowest “market share” since at least 1948, and well below our share of global GDP (which has been rising in recent years) of 1.5 per cent.

Another result, of course, in conjunction with the rapid growth in imports associated with the strength of domestic spending, is that Australia’s current account deficit once again exceeds 6 per cent of national income.

So far this has been financed quite comfortably, partly because financial markets can see that Australia’s deficit owes more to increased investment than to diminished saving (with falling household saving being offset by increased corporate and government saving), in contrast to the drivers of the widening US current account deficit; and partly because of the substantial yield premium which offshore financiers of Australia’s deficit in recent years have enjoyed.

However, although export growth should pick up this year, the risk is that it will continue to fall short of optimistic expectations. As such, with domestic spending likely to grow by less than 5 per cent this year for the first time since 2001, overall economic growth in 2005 could be a touch under 3 per cent, on average, compared with the likely 3.6 per cent outcome for 2004.

The combination of unchanged Australian interest rates and progressively rising US rates will gradually erode the large interest rate premium which, along with buoyant commodity prices, is currently supporting the Australian dollar despite Australia running a current account deficit which, relative to the size of our economy, is even larger than America’s.

Against that background, the closing months of 2005 will likely see the Australian currency begin to decline once more. With domestic labour and other costs likely to be rising more quickly as 2005 progresses, that sets the stage for higher interest rates in the first half of 2006.