Transcript of Speech and Q&A Session Remarks and panel participation at the Australian Business Economists (ABE) Forecasting Conference

Alex Heath

Well, thank you all for coming. I'm actually pretty impressed at the turnout I have to say. By necessity what I'm going to present is a fairly small snapshot of what's in the Statement on Monetary Policy. I think we'd be here for several hours if I went through everything in the Statement. So, if you want any more details on any of the topics that I do cover or you think there's something really obvious that hasn't been covered, it's probably in there and I would encourage you to go to the website to have a look.

This is traditionally a forecasting conference so what I will focus on is the outlook for the global and the domestic economies, highlighting things that have changed and some of the areas where we think the uncertainties are particularly important. That's partly because I think a discussion about the forecasts from the panel is going to be a discussion about differences of opinion, so it's probably best to focus on things where reasonable people could disagree.

When we think about the outlook for the Australian economy we always start with the international economy. Clearly we're a small open economy - what happens in the rest of the world matters a lot. One of the things that I think really has changed over the past three months since we last published our forecasts is that the outlook for the global economy is feeling quite a bit more positive both in terms of growth and in terms of the inflation outlook. For the United States, the data have been a bit more positive and the turnaround that we've been looking for is feeling a little bit more likely. Financial market pricing suggests there's also quite a bit of positive sentiment about the prospects for US growth based on some of the policies of the new US administration that are more likely to be implemented. I'm not going to say a lot more about that because that's going to be covered by Justin.

The other part of the world that really matters a lot for Australia and has been performing relatively well is China. For a long time in the Statement on Monetary Policy we were flagging that policy uncertainty in China was a big deal. There was a real trade-off that the Chinese authorities had to make a decision about: were they going to put in place policies to support near-term growth, potentially at the risk of increasing some of the risks to the medium term? Some of the growth that we've seen, particularly in real estate markets, has been associated with reasonably strong credit growth that's significantly faster than income growth. What that means is the debt-to-income ratio is increasing in China.

For households the debt-to-income ratio is relatively low by international standards but it is increasing quite quickly. From a financial stability perspective, very rapid credit growth is a flag that you want to pay a lot of attention to. Fiscal policy is also being used actively to boost growth, and there has been a noticeable deterioration in the fiscal balance as a result. So, it seems pretty clear that the Chinese authorities are going to support near-term growth, but there is a risk to sustainable growth in medium term building up.

I mentioned global inflation. One of the consequences of the sustained growth in China has come from the real estate market, and there's been much more demand for steel than had been expected if you go some six months or nine months back. So strong demand from China and other parts of the world has been one of the factors that's led to stronger-than-expected a pick-up in global inflation, in particular for commodity prices.

We can see in this graph that headline inflation really has turned around. A large part of this story is around the oil prices, but the longer that persists, the more likely it is that it will going to show up in second round effects and the core measures of inflation that central banks tend to focus on. So I think one of the things that's happened in this three month period is that there's been a bit of a reassessment about where growth and inflation are going and a bit of a reassessment about the likely path for monetary policy particularly in the major advanced economies.

Higher commodity prices have also led to a very significant pick-up in Australia's terms of trade. Again, if we go back six months this is this is a much bigger pick-up than what we had expected. We'll probably pick up on this in the panel, but our assessment at this point in time is that there are supply side reasons to expect that the prices won't be sustained at these very high levels. Particularly if you look at iron ore and coking coal prices, the chances of them staying at these very elevated levels are not high. But there is a lot of uncertainty about how long they will stay high and where they might fall to. Our current expectation is that the terms of trade will come down from where they are, but that they'll still be higher than the recent trough that we had in 2016.

The higher terms of trade means that Australia's income is significantly higher for a period of time. So one of the questions we have to ask ourselves is how is that going to flow through to the domestic economy? I think we feel reasonably confident in saying it's unlikely to lead to a particularly significant pick-up in things like mining investment, but we're not really very sure exactly how it's going to feed through and we would probably say that offers some upside risk to the forecasts for the domestic economy.

The September quarter GDP came out in December and in quarterly terms it fell. Without going into too much detail, our assessment is that most of the factors that led to that fall are temporary, and we are expecting growth to resume. One of the areas that we pay particular attention to in the national accounts is consumption. For two quarters in a row, the June quarter and the September quarter, consumption growth had been relatively weak. So the question for us was: is this temporary? Is there some reason why it's temporary and we should expect it to pick back up again or is there a signal that maybe things are going to be weaker for a longer period?

Subsequent to the September quarter national accounts, we've received the December quarter retail sales. Aand what you can see from this graph, is that they've picked up and the December quarter is looking a lot healthier. But ultimately the forecasts for consumption are going to depend on forecasts for income. We know that income growth has been relatively subdued and the data suggest that households have recently been a little bit less willing to support their consumption growth by running down on their savings.

So a really important factor behind our forecast for GDP growth is consumption growth and a really important factor lying underneath that is how we see the labour market. We've flagged these risks in the Statement on Monetary Policy for a while; we're not very certain about the momentum in the labour market. There's quite a lot of conflicting evidence. It depends on which measures you look at, it depends on how you think about the spare capacity in the labour market. But one thing we can definitely say is that wage growth has been very low and it has been low for some time.

The wage price index has been very low, and other measures of wages that take into account changes in the composition in the economy have also been very low. We expect that some of the downward pressure on wages has come from the fact that wages appear to have been an important part of the adjustment process to the end of the mining boom. So to the extent that we're getting close to having worked our way through that, we would expect wage growth to pick up. We also spend quite a bit of time in our liaison program also talking to firms about how they're viewing their wage bargaining processes. Our assessment is that while wage growth is going to stay low, it's probably going to be stable around these levels and probably won't fall further.

But there's a lot of uncertainty around exactly how quickly or how far wage growth is going to pick up and, as I said before, that's going to be a really important factor in how fast income growth proceeds. So I mentioned that assessing the momentum in the labour market has been a little bit tricky. Towards the end of last year, the unemployment rate had come down, which is obviously a good thing. But employment growth in the first three quarters of 2016 was all in part-time jobs, which doesn't feel quite so positive. In the December quarter it turns out most of the employment growth was in full-time jobs, which was more positive, but in the month of December the unemployment rate ticked up.

How ongoing growth plays out in terms of employment and unemployment is going to depend on the participation rate and there are a lot of factors that affect people's decisions about whether or not to participate. Some of them are cyclical, some of them are structural, like the ageing of the population. We spend a a lot of time trying to understand which of these factors are most important to help determine what the momentum in the labour market might be.

Another area of the economy that we flag in the Statement is the housing market. Developments in the housing market have a lot of implications for various parts of the economy. The one I'm going to focus on here is inflation. Developments in housing markets have been quite diverse across the country. In places like Sydney and Melbourne, housing activity has been relatively robust and housing prices have been growing relatively strongly, but when you go to places like Perth the story is quite different. Perth has experienced a significant decline in population growth and housing prices are falling. You can see from this graph that rents in Perth are also falling. Despite the relatively robust growth in the population in the eastern states, there's also been a very big increase in the supply of housing. One consequence of this that rent inflation has been falling and is actually quite low by historical standards.

This is important because rent is a reasonably sizeable part of the CPI. So when we talk about the domestic cost pressures in the CPI, this is one of the factors that we have to think about. Wage pressures are another important factor. You can see from this graph of non-tradeables inflation that these domestic cost pressures are actually low but they look like they've probably stabilised. We are expecting inflation to pick up gradually as economic growth picks up. However, it is worth noting at a forecasting conference, that forecasting is not a precise science. We put the confidence intervals on the graphs of our forecasts to make the point that historical forecasting errors are reasonably sizeable. So any conversation you get from a panel of economists, asked to discuss where things may go, is likely to come up with a range of opinions because reasonable people can disagree on a number of elements that go into the forecast and arrive at quite different answers that are all quite reasonable.

Question & Answer Session

Moderator

Now, Alex told me she loves talking about the labour market and she really wanted a question from the labour market, so I thought I'd be kind and give her a question on the labour market. You did talk about the momentum in the labour market in your speech giving quite mixed messages. We know that full-time job growth last year was pretty weak, in terms of the net change it was the weakest since 2013 and the unemployment rate, even though it's still relatively low, is at a 6 month high. So I was just wondering whether you could maybe talk us through some of those mixed messages in a bit more detail and also about the spare capacity that you see in the labour market and where that's heading over the next two years?

Alex Heath

Sure. So, I think I've already talked a little bit about the recent history and why that's sending mixed messages. I alluded to the fact that the participation rate is a particularly key variable. So, the participation rate has fallen over the last little while and there's two explanations for that. One is that cyclically things haven't been very strong in the labour market and there's been a lot of adjustment as we've got to the end of the mining boom. The types of jobs that are being created are quite different to the types of jobs that were being created and people are leaving. So, we know that the industries that are producing the most jobs at the moment are things like health and education jobs, and they're quite different to the mining-types of jobs that a lot of people are in the process of adjusting away from.

So you know, the participation rate could be falling just because people are leaving the labour force as a part of this process of adjustment, as things sort of move along that will pick up again. Another possibility is that as we get the ageing population, the participation rate is just going to fall in a structural sense. Australia is a little bit behind in that process relative to other countries like the US and Japan. And so it really matters which of those two things is playing out in the participation rate as to how we see the unemployment rate and employment growth. At this point in time we basically assume the participation rate is going to go sideways, but if the participation rate was going to pick up considerably, for a given amount of employment we're could have an increase in the unemployment rate and the converse of that is also true.

So I think that's one of the things that we really spend a lot of time trying to think about and understand. And then I think it's also been quite clear that the dynamics in the labour market and how that plays out in wages has been quite different. So obviously as an inflation targeting central bank it's really important to understand what those underlying drivers of inflation are. And wage growth has been a lot lower than perhaps you would expect based on historical relationships between the unemployment rate and wage variables. So, we can't look at history to get a good guide as to what's happening now and that just makes the process of forecasting those relationships just a little bit more difficult as well.

So, I think we've written quite a lot about the potential explanations. One of them as I say is, it's a part of the adjustment process. So, international competitiveness can be regained in a number of ways, one is depreciation of the exchange rate, another one is that labour costs in Australia fall relative to the rest of the world, and that requires relatively low wage growth for quite some time. So, they're the sorts of things that we think about and the reasons they're important for the forecasts.

Moderator

Thank you. Rather than me keep asking questions I think I might actually throw it out to the floor and let the floor ask questions. Please avoid RBA questions to Alex because I think that'd be quite unfair. So I can see that Rory Robertson has got his hand in the air nice and high. So, nice loud voice.

Question

I actually will ask Alex a question. I've sort of noticed that I like charts and Alex likes charts and I spend a lot of time staring at charts at the University of Sydney about charts that I've been putting up and they make the conclusion which says the trend is down, the great Australian paradox here. But so I'm not alleging anything like that. But I wonder if you could just explain what I think is a little bit of an inconsistency between the chart showing the Reserve Bank's forecast of trim mean inflation, so core inflation, which sort of trends gradually up. And what the Bank says in its box of forecast. The box of forecasts say that the next two years ended December 2017, December 2018, you've got 1.5% and 2.5%. And then in the mid-year of 2019 it's sort of 2-3%.

And that's sort of fair enough, I'm not disputing the forecast, but in the picture of your forecast there's a great lump of trend and at the sort of end point in mid-2019 it looks like it's about 2.05% and suddenly the rounding of that takes us to 2-3%. So 1.5%, 2.5% and then we kick up by half, it's a healthy lift up. So I'm just wondering if there's not a little bit of inconsistency between the picture of your forecast which get you to 2.1%, which is sort of 1.5% to 2.5% to 2-3%. So it just seems to be a threshold or rounding issue and I'm wondering if you could explain the methodology behind the rounding of, I think this is inconsistent between the chart and the box of forecasts.

Alex Heath

Yep, so I think you've described the two pieces of information reasonably accurately. My personal preference is – oh we've lost the graph, that doesn't matter. Oh here we go. So the graph shows band charts that – so that is our central forecast, the black line is the central forecast. The bands around that are, for want of a better word, scientifically based on forecasting historical forecasting errors. So, I personally prefer to think in terms of this graph when talking about where we see inflation going and what sort of uncertainty is around that. I think the table of forecasts, as you refer to, so it's not scientific in this sense. So we use a kind of fixed range.

A gradually rising profile is going to have a point at which you jump from one range to the next range. And I think the main point to take away from the table is that there is an expectation conditional on the profile for interest rates that we have that inflation will continue to pick up. So I think in terms of a communication device that's the message I would take away from the table, but I would personally focus much more on the graph.

Moderator

I'm conscious that we're running close to time, so any more questions?

Question

I wonder whether the panel can talk a little bit about domestic investment. Josh, you made the point that long term growth supply side … Just interested, you know, I mean you look at the – not surprisingly – investment, the GDP is still coming down really driven by engineering. But you look at the plant and equipment figures, they're horribly weak relative to the last 20 or 30 years. So, I'm interested in any comments on that?

Josh Williamson

Look, I think we're getting close to the end of the mining correction in terms of the drag that you're going to get from growth from mining. So, the outlook for investment I think is critically driven by the amount we might get out of some of the other sectors. So, I tend to agree with Alex that it doesn't look like the pick up in commodities is going to drive another sort of 03/04 style mining capex uplift which is highly labour intensive and we're probably not going to see that again. But we are seeing a lot of cash or income coming into the economy. We are seeing some of the sectors that have been involved in the rebalancing like education, tourism, finance, retail, all suggesting they're going to do a little bit of investment over the next couple of years. So, that would suggest that as the drag from mining goes from big figures down to zero, we get a little bit of incremental investment coming out of all these cyclical parts of the economy.

We should see investment actually add a little bit to growth and on your point around plant and equipment, I'm not completely sure about the mix of that that's mining, but one of the things we do hear from our mining analysts is in the debate about how low mining should go in its correction is that a lot of these miners with iron ore prices around $30-35, they've really done no opex on these mines over the last 3-4 years. No, tyres and roads and all that sort of repair. So, with iron ore today at $92, that sort of cash flow, we're starting to see or hear about a lot more of this opex coming through. So that should really support some of that plant/equipment type investment and just the maintenance capital associated with the LNG projects should give us a baseline estimate of a bit of growth coming through. Maybe not in ‘16/17 obviously, but in ‘17/18 and beyond.

Alex Heath

Yeah I was just, well going to agree, but I think the other element of this story that is positive is that if you look at non-mining business investment by state, you can see a very clear distinction between what's happening in states like New South Wales and Victoria that really haven't been dealing with the adjustment process from the mining investment boom versus states like Western Australia, where it turns out a large part of what we call non-mining business is in fact related to the mining sector. So, if we move into a world where some of this opex is occurring and, you know, they're much more likely to do the repairs to get the maintenance done, that sort of thing is likely to flow through to what we classify as non-mining business sectors in states like Western Australia. So, I guess one of the things we learnt through the mining boom is that there is quite a strong connection and there are significance with a lot of this, so that's should reinforce the positive.

Moderator

We've only got time for one more, so is there one more question out there? This lady here in the front row?

Question

Alex, I'm just particularly interested if you think much about the potential downgrade to the AAA credit rating. If so, how do you think about it as it flows through to monetary policy?

Alex Heath

So, the credit rating question probably relates more to questions about cost of funding at the banks, that's obviously going to be a reasonably important thing. I tend to think about these questions in terms of the experience of the global financial crisis. I think one of the things that was quite clear from that experience was that investors and people who are likely to be in the business of lending money to banks, for example, are actually quite sophisticated and they're quite capable of looking at fundamentals of an economy on their own merits. We saw quite a lot of differentiation in how pricing worked that, you know, I guess wasn't as closely correlated with the credit rating as it had been historically. So, in answer to the question I think what's really important is, you know, what are the fundamentals of the Australian economy? Do we have really a good macroeconomic policy framework? Do we have important things like floating exchange rate operating in our favour? And I think, ‘yes’, so I guess the answer to your question I think the important things are the fundamentals of the economy and I think people can do that assessment on their own.

Moderator

Thank you. That concludes the panel. I'm going to hand it back to [unclear 12:45.1] now, so thank you Scott, Alex and Joshua.

[Applause]