Interest rates will move to the forefront of the Australian economic debate this week with housing finance and labour force figures due for release.
Of the two, the jobs numbers will be the big test on Thursday and a strong month in June, with no change in the unemployment rate (currently around 4.2 per cent in May).
Stephen Roberts, chief economist for Grange Securities, part of Lehman Brothers here in Australia,says the economy is being stretched. Here's his latest weekly comment:
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The economy has had an uncanny ability to absorb demand pressures, but it now looks very stretched. The RBA can take some time, but will likely have to hike before year-end.
As expected, the Reserve Bank of Australia (RBA) this week left the cash rate unchanged at 6.25%, extending the pause since the last rate hike to eight months.
The RBA provides an explanatory statement after the monetary policy meeting only when it changes rates, but even without a statement we judge that the RBA is moving to a tightening bias, as pressures are slowly building that are likely to impel the RBA to hike rates in Q4. The reason: the likelihood that inflation will rise above its 2-3% policy target band in 2008.
Notwithstanding a near-term dip to below 2%, price pressures are building. Sixteen years into an uninterrupted economic expansion, the inflation pressure point stems from a sharp acceleration of growth since mid-2006, stretching further what has so far been surprisingly elastic supply.
Despite softer demand-side signals so far in Q2, the risk remains firmly on the side of growth in demand being much stronger through 2H 2007.
Strong demand was led by consumption in Q1, but retail spending curiously weakened in April and May. We judge this to be temporary weakness driven mostly by a large one-off lift in personal superannuation saving contributions ahead of a tightening of annual contribution limits on 1 July.
In 2H 2007, households look set to continue spending strongly, buoyed by solid growth in employment and wages, plus government budget initiatives introduced on 1 July, including tax cuts and improved family benefits.
On top of a rebound in consumption, capital spending and exports should also strengthen in 2H 2007. Because of slow home-building activity since early 2003, when the housing boom peaked in the big-population eastern states of New South Wales and Victoria, new housing supply is now running well below demand, as evidenced by the renewed rise in general house prices.
New home-building activity has been erratic in 1H 2007, but is tensioned for strong improvement as new home supply tries to catch up with demand.
On capital spending, business investment spending is strengthening, spurred by rising sales and strong growth in profits. Governments at all levels in Australia are loosening their budget purse strings.
In particular, inadequate or ageing public sector infrastructure has been a major focus of new spending plans. While easy to fund given very low levels of public sector debt, these public spending plans will have the unwelcome impact of adding a pro-cyclical boost to an economy that is already running hot.
The overriding influence, however, taking the demand side of the economy from simmer to the boil has been the secular 40% rise in the terms of trade over the past four years.
That is the biggest terms of trade gain in half a century, which has boosted national income and quickened export growth. We see exports rising very strongly over the next 12 months helped by a big lift in capacity from very strong mining investment spending over the past three years.
Rural exports are also likely to lift strongly, helped by rising food prices and the easing of drought conditions after extensive winter rainfall.
It is not easy to judge how much the expected across-the-board demand strength in the second half will stretch capacity. While the labour market is very tight – the participation rate is at a record high (65.0% in May) and the unemployment rate (4.2%) is the lowest in almost 33 years – annual wage growth has so far only inched higher. Wages growth, at 4.1% y-o-y in Q1, remains below the 4.5% line-in-the-sand drawn by the RBA as marking the portal to wage-push inflation territory.
Several reasons have been put forward for why the labour market is stretching well beyond the point where in the past wage inflation would have been stoked. Labour market reforms have fragmented wage bargaining, ensuring that fast wage growth in areas where labour is in greatest demand, such as in mining and construction, do not cascade to other sectors.
The government is also working hard to boost labour supply by introducing various initiatives to increase the number of skilled migrants, encourage parents and the over-55s to stay in the workforce, and to incentivise those on unemployment benefits to move back into paid employment.
Whether these policy initiatives can lift already high employment growth of 3% even higher over the next 12 months, as demanded by an economy that stands to accelerate to more than 4% growth by year-end on our forecasts, is highly questionable.
The RBA must be wondering how much more stretch there is left in labour supply if demand stays very strong, and naturally the Bank is likely to become more sensitive to the strength of demand-side indicators.
Fortunately for the RBA, it has been able to bide its time in assessing when supply-side constraints may start fanning inflation, in part because of the temporary soft patch in demand, but also due to a transient dip in inflation (Figure 2).
The dip in inflation has a lot to do with base effects: there was an unusually large quarterly increase in the CPI index in 2Q 2006, fuelled by sharp rises in petrol and fresh fruit prices, which will drop out of the year-on-year calculation, the
