Lacklustre economic growth fails to take pressure off interest rates

It wouldn’t be at all surprising if politicians and other commentators who have never seen an increase in interest rates that they thought was warranted seized on last week’s June quarter national accounts as grounds for criticising the Reserve Bank's decisions to lift interest rates in May and again last month.

After all, yesterday's figures show that the Australian economy grew by a mere 0.3 per cent in the June quarter, the smallest increase in three years, and by just 1.9 per cent since the June quarter last year, the smallest annual increase in four years.

Yet, as was also the case with the attention-grabbing 4 per cent increase in the consumer price index over the same period, it's important to look behind the "headline" figure in order to understand what the numbers are really telling us about the state of the Australian economy.

The key number in yesterday's national accounts is that final domestic demand (that is, spending on goods and services by Australian households, business and governments) grew by 1.2 per cent in the June quarter (or by 3.8 per cent from a year earlier). Demand from foreigners (that is, exports) also grew by 1.4 per cent in real terms.

However, less than one-quarter of this increased demand, from Australians or from foreigners, was met by increased Australian production of goods and services (which is what is measured by "real GDP") during the June quarter. More than half of it was in fact met by taking off the shelves things that had been produced in earlier quarters - that is, by a run-down in inventories or stocks. And nearly one-third of it was met by increasing imports (goods and services produced by foreigners).

It would thus be quite wrong to conclude from the weak "headline" number for economic growth during the June quarter that the Reserve Bank had made a mistake in raising interest rates last month, or that the likelihood of another increase in rates later this year had appreciably diminished.

Rather, what the June quarter national accounts show is that demand continued to grow strongly, notwithstanding the increase in interest rates in May (one-third of the way through the quarter) and generally rising petrol prices; but that Australian private and public enterprises found it difficult to meet that demand by increasing output.

In the absence of any compelling evidence that the constraints on the capacity of the supply side of the Australian economy to meet demand during the June quarter were merely temporary, this combination of strong demand and constrained supply suggests that underlying inflation is more likely to rise than to fall.

And since underlying inflation is already very close to the upper end of the Reserve Bank's 2-3 per cent target band, that in turn suggests that interest rates are more likely to rise than to fall over the months ahead.

Of course, the June quarter national accounts tell us absolutely nothing about how the economy has been affected by the August interest rate rise. Indeed, apart from the sharp fall in consumer confidence which followed that move, we have yet to see any hard evidence, one way or the other, as to the reaction of households and businesses to it.

However, we do have at least some evidence to suggest that the tax cuts which took effect from the beginning of July - and which, in aggregate, more than outweigh the impact on household finances of the two increases in interest rates and the rise in petrol prices so far this year - have boosted household spending.

The Reserve Bank will therefore be watching closely the flow of official and private sector data over the next few months to ascertain whether domestic demand slows in response to the most recent increase in interest rates, thus making it harder for firms to pass on higher labour and other input costs to their customers in the form of higher prices for goods and services; or whether the tax cuts and other positive influences on real incomes and spending outweigh the effect of higher interest rates so that domestic demand remains strong, allowing underlying inflation to rise further.

All of which means that the Reserve Bank is unlikely to raise interest rates at its next meeting in October, but that a rise in November remains a distinct possibility.