The State of the Australian Economy

I am seeing posts on X (formerly Twitter) and Bluesky that argue all is well with the Australian economy. The stylised facts go something like this:

• Unemployment is at 4.0 per cent
• Headline inflation is at 2.3 per cent / year
• Wages growth is at 3.5 per cent / year (well above inflation)
• The stock market is at record highs
• Household Wealth is at a record high

And in the main these statistics are correct, although arguably some are in part misleading. More fundamentally, these statistics are cherry picked: Good statistics are highlighted and the more challenging ones are glossed over. I would contend the state of the Australian economy is much more of a mixed bag. There are definite strengths. But there are also challenges. And, importantly, there are pain points arising from the economic trajectory since the COVID pandemic notwithstanding the current good news. Let's begin with the strengths.

The Strengths

Unquestionably, the currently low unemployment rate (compared with the period since the mid 1970s) is good news. While the unemployment rate has been lower, it has not consistently been so for 50 years.

Focusing on the latest monthly data, the rate is currently at 4.0 per cent, and the trend appears to be downwards.

The only caveat is whether the unemployment rate can be sustained at this level without putting upwards pressure on inflation. This Phillips curve suggests there may still be some tension here.

As we will see in the next two charts, while the monthly CPI indicator suggests headline inflation is at 2.3 per cent (largely due to government subsidies and measurement issues), underlying inflation remains above the target band. The next quarterly inflation print will be on Wednesday this week.

Nonetheless, across all measures, inflation has been slowly returning to target since peaking around December 2022. Unquestionably good news.

Wages growth for the September quarter was at 3.5 per cent, the same as Trimmed Mean in flation, but below headline inflation. 

This is good for workers. However, since the pandemic, the consumer price index (inflation) has grown faster than wages. In real terms, workers are out of pocket, and have some way to go to get back to the pre-pandemic situation. This is one of the pain points in the economic trajectory of the nation after the pandemic. 

The stock market is near record highs. Technically it peaked in early December 2024, with the All Ords Index at 8754.7. The index is currently at 8660.4, up almost 11 per cent on where it was a year ago. It is a similar story with the ASX S&P/200 Index, up a touch over 11 per cent on where it was a year ago.

In aggregate, the net worth of households as shown in the ABS Household Balance Sheet (HBS) is also at a record high.

However, when adjusted for population growth and inflation, we see that real average household net worth has not changed substantially since mid 2022. In this context, record household net worth is not such a compelling story. 

The Challenges

While Australia has avoided a technical recession (two quarters of negative GDP growth), it has seen a substantial and persistent slowdown in GDP growth: in short, stagnation. A multi-year stagnation has more impact on the economy than a short, sharp recession.

The current stagnation appears to be part of a longer-run trend. When we look at the decadal compound average annual growth rate for GDP, we can see it is in slow decline.

The second challenge is labour productivity growth. In the next two charts we can see that the decadal compound annual average growth rate has slumped.

Productivity growth facilitates rising living standards. It allows wages to grow faster than inflation, without putting upwards pressure on inflation. Low productivity growth over the medium term makes it harder to fight inflation. It also makes it harder to grow the economy. 

A third area of concern is global uncertainty, and the risks to global trade. Australia's well being increasingly depends on trade.

China is Australia's largest export market, primarily in natural resources: iron ore and natural gas being the most important. Most analysts predict that the Chinese economy will continue to slow in 2025. This will put downwards pressure on Australia's GDP growth. A second major source of global uncertainty is the new Trump administration in the US. There is some risk that it will impose sizeable tariffs on imports, particularly from China, which will have a flow-on effect with Australian exports.

Pain Points in the Australian Economy

While there are strengths in the Australian economic data, most Australian's experience of the economy is in terms of whether they feel better off now than they did (say) 3 or 5 years ago. Here, the evidence is challenging. 

Unquestionable, interest rates are higher than before the pandemic. That benefits retirees with savings, but disadvantages workers with mortgages. 

Credit card lending rates have recently increased and are the highest than they have been for many years. This rate is often experienced by borrowers on lower incomes. 

When we combine the impact of wages growing slower than inflation (see above), we have a situation where real incomes have dropped on average in the past 3 years.

When combined with increased interest rates (and increased taxes in income), household disposable income is also lower.

Conclusion

The current state of the Australian economy is a mixed bag. There are strengths. There are challenges. And there are pain points.

On the positive side of the ledger we have a low unemployment rate and inflation appears to be coming back to target (albeit more slowly than our international peers). The stock market is up 11 per cent on a year ago. While households in aggregate are wealthier than they have ever been, when we adjust for inflation and population growth, this statistic is less impressive.

Of concern, Australia's GDP growth has stagnated to around 0.8 per cent per year. Australia's labour productivity growth is in the doldrums. And Australia faces a more uncertain world. 

For individuals, their primary concern is whether they are better off than they were (say) two or three years ago. Here the story is not compelling. Years of inflation outpacing wage growth have reduced real ages. Rising interest rates have hit the disposable income of many households. Typically, households are worse off than they were two or three years ago. 

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.