Australian Recessions

We have lived through more than 12 months of the advocates for an immediate central bank interest rate cut saying that if we don't get a rate cut this month, the economy will enter a recession.  So far those advocates have been wrong. It reminds me of the Paul Samuelson joke: “the stock market has predicted nine out of the last five recessions”.

When we think about recessions. many people adopt the definition of a technical recession: two or more quarters of negative GDP growth (Q on Q). It's a useful rule of thumb, but it can miss significant economic contractions that are interrupted by a quarter of smallish growth. Focusing on technical recessions can also elevate short, slightly negative events that are not as serious. The working definition I use is that a recession is an extended period of economic contraction and an associated decrease in the number employed and a substantial increase in the unemployment rate.

While Australia's economic growth is in the doldrums, the economy is some way from a recession. And our labour market performance has been strong. On average, a recession happens about once a decade. Naively, without considering the economic fundamentals, the probability of a recession in 2025 is around 10 per cent. 

Using the above definition, I have looked at six factors that could indicate a recession. They are: 

• GDP Technical Recession, 
• Negative Annual GDP Growth,
• GDP per Capita Technical Recession,
• Rapid Unemployment Growth,
• Employment Technical Recession,
• Negative Annual Employment Growth,

The charts for these indicators follow.

Individually, there is a lot of noise in the above charts. To overcome this, I have looked at those periods of time where three or more of the above six indicators are positive. This yields a clearer picture of when the economy has been in recession: the early 1960s, the mid 1970s, the late 1970s, the early 1980s, the early 1990s, and most recently in 2020. In each case (but one), the recession saw a year over year decline in both the size of the economy (GDP) and the number of people employed. Other less severe events in terms of the Australian economy include the 2008 global financial crisis, the dot-com bubble of 2000, and a slowdown in the early 1970s. 

Only three recessions over the past 65 years have seen all six triggers activated. 

Note: I last looked at Australian recessions in 2012. In this exploration, I have come to slightly different conclusions.

Inflation update

Context

Inflation in Australia (and the rest of the world) took off after the COVID pandemic, after an almost 30-year period of lowish inflation.

It was initially stoked by lockdowns (which reduced spending and increased savings) supported by government payments to mediate the economic impact of the pandemic. It was further exacerbated by supply constraints associated with restarting global supply chains and the war in Ukraine (a large global food producer). 

Australia has seen two phases to this inflation story. Initially, it was hit by increasing goods prices (related to global supply constraints). Subsequently services prices increased as price increases were built into the input costs of the (largely domestic) services sector. Services sector inflation remains elevated. [Note: The most recent print of goods inflation in this chart is affected by measurement issues discussed below].

Internationally, Australia was (perhaps 6 months) late to the post-COVID inflation peak. We have been further behind the US curve when it comes to its decline, and return to target. 

Uniquely, and at the urging of the Government, the Australian central bank took a softly-softly approach to tackling inflation. Interest rates were raised later and not as hight as comparable countries, The objective was to minimise the impact on the labour market of fighting inflation (ie. to protect jobs). As a result, core inflation remains well above the target range. Australia is the only Anglosphere nation not to have reduced interest rates after the current inflationary cycle.

The Australian inflation story is further complicated by recent policy initiatives by state and Federal governments that impact on the measurement of inflation, without impacting on the price levels themselves. In Australia, inflation is measured from the perspective of the out-of-pocket costs to the household. Government subsidies to households for electricity costs (for example), have substantially affected the headline measurement of price increases. These subsidies also impact on the measurement of core inflation; nonetheless, underlying inflation in Australia remains above the 2-3 per cent target band.

Prognosis

Going forward, my baseline expectation is that price growth will continue to slowly moderate back to the target range by the middle of the 2025. This is consistent with the view of the Australian central bank in their latest statements on monetary policy (SOMP).

My expectation is that we will see two central bank policy rate reductions, each of 25 basis points, from the current 4.35 per cent to 3.85 percent (which would leave interest rtes on the slightly restrictive side of neutral). I expect these will occur in May and August, but there is some likelihood (say 30%) that the first rate cut might occur in February 2025. There is also a small chance (say 30%) we will see a third 25 basis point reduction towards the end of 2025, leaving interest rate policy close to a long-run neutral setting (which I have around at 3.5%, around 100 basis points above the long-run inflation target). 

However, there are risks to this inflationary and interest rate prognosis, and they are mostly on the upside. These risks (discussed below) are:

• low productivity growth
• reduced population growth
• low GDP growth and stagflation
• international uncertainties

Productivity growth

Productivity refers to the outputs that an economy produces for a given set of inputs. Productivity growth over the long run puts downwards pressure on inflation and allows for wage growth to exceed inflation. It underpins an improved standard of living. At the moment, we are in a productivity growth slump. GDP per hour worked in Q3 2024 is much the same as it was in Q3 2016.

The consequence of a productivity slump is less headroom to accommodate wage increases without causing inflation. So what does wage growth look like? With the Wage Price Index (WPI) growing at 3.5 per cent per year (3.2 per cent annualised), in the context of low productivity growth, it is worth keeping an eye on. 

Reduced population growth

The labour market is tight and may be tightening. The latest print has the unemployment rate at 3.9 per cent. Although I would be cautious with taking this latest print as confirming a trend, it is worth keeping an eye on.

Why keep an eye on it? First, there is a short-run relationship between the unemployment rate and inflation known as the Phillips curve. So far it has been heading in right direction for inflation to return to the target band. However, a tightening labour market could see inflation increase.

Second, we have maintained a low unemployment rate - around 4 to 4.1 per cent - over the past year in the context of record population growth. If the rate of population growth slows now, it might make the labour market even tighter (putting upwards pressure on inflation). Unfortunately, the different measures of population growth from the ABS have conflicting stories.

Low GDP growth

Growth in the Australian economy is stagnating. Apart from the pandemic, it lower than it has been since the beginning of the post 1990s low inflation era. 

While we are not experiencing 1970s style stagflation, we are are facing some of the same policy conundrums. Some people want lower interest rates to restart the economy. Others are concerned about inflation, and believe we should be cautious about lowering rates (and perhaps even raise rates for a period). It is the same conundrum that left interest rates too low for too long in the 1970s and 1980s. Again, something to keep an eye on. 

International uncertainties

Inflation in Australia is correlated with global inflation. In this context, it is worth noting the US 10-year bond has risen a percentage point since early September. The bond market expects interest rates to rise under Trump (implicitly, they expect higher inflation). The global inflationary head-winds may prove challenging in 2025.

In the last 3 months of 2024, we saw a significant decline in the value of the Australian dollar. A weaker Australian dollar (especially if it weakens further) could lead to higher prices on imported items, and contribute to inflation. Imports account for almost a quarter of the Australian economy (in current price terms). In this context, any further deterioration in the Australian dollar might make it difficult for the RBA to reduce interest rates. 

Conclusion

Inflation should continue to moderate in 2025, allowing the Reserve Bank the opportunity to lower interest rates. However, I would expect only two or three interest rate cuts in 2025, and I would remain alert to the risk of further inflationary pressures.

Usual caveats

This think piece is not financial advice. 

The housing affordability that will matter

When people talk about housing affordability, they are not always talking about the same thing. There are three distinct housing affordabilities:

• purchase affordability - how much it costs to buy a new or existing house at the time of the purchase,
• repayment affordability- how much it costs to service a mortgage on a house, and
• rental affordability- how much it costs to rent a house.
  

In this post I want to talk about the one that will be important over the next 18 months: repayment affordability. 

As interest rates were lowered following the COVID pandemic, these were capitalised into higher housing prices. This is a long run trend, since the peak home loan rates in 1990. As lower and lower interest rates have allowed borrowers to borrow more money, this has contributed to higher and higher house purchase prices. [Note, this is not the only contributor to growing house prices; for example, long-run growth in two income households has also been important].

But this is all about to change. It has been more than 30 years since Australia has operated in world of high inflation. Most of our nation’s policy thinking is now rooted in the low interest world of recent decades. Yet the latest headline inflation figure of 5.1 per cent suggests we might be about to re-experience high inflation (above the agreed target of keeping inflation within a 2 to 3 per cent per year range).

Higher inflation means the Reserve Bank of Australia (RBA) will lift interest rates to bring downward pressure on inflation. The ASX RBA rate tracker indicates there is a one-third probability that interest rates will increase on Tuesday this week. Rates will almost certainly rise by the first Tuesday in June. Over the next 18 months, the markets think that the RBA cash target rate will rise from the current target of 0.1 per cent to just over 3.3 per cent. That is a substantial increase.

What does this mean for variable rate home loans? The short answer is that they are likely to increase by a similar amount. By December they may be around 2.5 per cent higher, and by June next year they may be 3.2 per cent higher. 

According to the ABS, the average new home loan for an owner occupier was \$595,873 in February 2022, down from \$620,315 in January 2022. According to the RBA, owner-occupier variable home loan rates are typically around 2.5 per cent, per year. 

A 30 year, \$600,000  loan, with an interest rate of 2.5% has monthly repayments of \$2371. At a notional 5 per cent home loan borrowing rates in December 2022, the repayment increases to \$3221 per month. And at 5.7 per cent in September 2023, the repayment would be \$3482 per month. 

Even for people whose loan is half that amount, they will experience a dramatic increase in household costs. A 25 year, \$300,000 loan, at a 2.5% interest rate has a monthly repayment of \$1346 per month. At 5% interest rate, the repayment becomes \$1754. At 5.7% the monthly repayment is \$1878. 

If inflation breaks out as the market expects, and the RBA reacts as the market expects, repayment affordability will become the big concern of middle Australia over the next 18 months. 

Ironically, when interest rates on home loans appreciate, house prices are likely to depreciate. This means that purchase affordability should improve over the next 18 months (albeit, not as much as some would hope as house prices are often what economists call sticky-downwards). Reduced house prices will leave some recent home-buyers with a difficult decision. Do they stay with an increased mortgage they are finding difficult to afford, or do they sell their new house and take a loss because house prices have fallen (what is good for the buyer is bad for the seller).

Christmas 2021 - a complete set of Covid charts for Australia

At Christmas 2019 I was newly retired and completely unaware of the global pandemic that was already nascent in Wuhan China. The past two years have been a rough, roller-coaster ride. The shock of the initial cases and deaths. Victoria's second wave. The serendipity that flattening the curve managed to achieve the elimination of local transmission. A slower start to mass vaccination in Australia compared with other high income nations. The arrival of the more infectious Delta variant, which proved challenging in NSW and Victoria, and the resulting interstate travel restrictions. And in the past four weeks, the arrival of the even more infectious Omicron variant. Largely as a result of Omicron, 14 per cent of all Australian cases occurred in the past week.

So far, the case burden of COVID-19 has been felt the most in Victoria, followed by NSW.

 

Recent case growth with Omicron can be mapped in a few ways. Let's focus on NSW, as it has a longer Omicron growth trajectory. We are seeing daily new case numbers double every 4 days or so in NSW. The effective reproduction number is around 2 in NSW (every infected person infects two others on average).

There have been 2182 deaths in Australia from COVID-19. More than half of these deaths were in Victoria. While the total is a relatively small number by international comparison, it is not insignificant.

 

Where there has been some good news is in the death rates. Last year during Victoria's second wave we saw 4.3 deaths for every 100 diagnosed cases.

Currently, we are seeing 0.51 deaths per 100 cases in Victoria and 0.38 in NSW, a tenfold improvement on the Victorian second wave on 2020. This can be attributed to a number of factors including mass vaccination and better treatment regimes.

A key policy concern with COVID is the capacity of the hospital system to cope with the peak demand. So far, all hospital systems have managed, albeit with some pressure during the Delta wave in the second half of 2021.

The present concern for hospital systems is the rapidly increasing case numbers associated with the Omicron variant. While the international evidence is that Omicron cases are less severe there are a couple of points of concern. The first is that the unvaccinated in Australia are unlikely to have any natural immunity. The second is that while Omicron might result in less severe disease, the volume of cases may still overwhelm the hospital system. The NSW data suggests that we are not seeing the same rate of hospitalisation (but there are a few caveats here). The picture should be much clearer by new year's day.

Another pressure from the emergent Omicron outbreak is on testing systems. We are seeing increased testing and positivity rates (noting that positivity rates may be impacted by the recent availability of rapid antigen tests).

Finally, let's look at vaccination rates. After a slow start, Australia is among the most vaccinated nations in the world.

As usual, the code for these charts is available on my GitHub site. I use covidlive.com.au as the data source for these charts.