Tuesday, January 18th, 2011 - BT Financial
A look forward

The Australian economy begins 2011 with a fair head of steam; employment has increased by 3.7% in the past twelve months, and the mining investment boom still has a long way to run. Given that we are starting from a low 5.2% unemployment rate, this boom can be accommodated only if growth elsewhere is restrained.

The best forecast is, therefore, that the economy will continue to do well, but with interest rates rising further again.

The RBA Governor, Glenn Stevens, has hinted strongly that the RBA still has a bias to raise rates further, but that it is in no hurry. It would be prudent to assume perhaps two more rate increases in 2011. Incidentally, the RBA is well aware that consumers and businesses do not borrow at the official cash rate. So when we get so-called “out-of-cycle” increases in the variable mortgage rate, as occurred in early-November, what this almost certainly means is that the RBA will need to increase the cash rate one fewer time than it otherwise would.

Of course, as always, there are risks. The international ones remain the same as in 2010: the possibility of a slowdown in China, the chance of a “double dip” recession in the United States, and some event emerging from the continuing debt problems in the eurozone. It is my view that all three of these risks have been overstated. While there is always a chance of a slowdown in China, the authorities there have proved remarkably adept at getting that economy going again should it falter. There was never much prospect of a double dip in the US, and the Fed’s new program of quantitative easing should help that economy. And the euro-debt issue is very unlikely to morph into GFC2. There are important differences from late-2008, when the full severity of the GFC struck. Back then, no-one knew who was holding what on their balance sheets, or what the “assets” were worth. Now at least, not only is the problem smaller but it is far more transparent. A default, full or partial, would hurt, but it would be a clearly survivable event.

The new domestic “risk” is, of course, the widespread flooding. As serious an event as this is, history suggests that economists tend to overestimate the economy-wide effects of disasters, whether natural or manmade. There is no question that the flooding will impede mining production and other economic activity, and it will clearly drive up the prices of many fruits and vegetables. But the water will eventually recede, and production will resume. Indeed, reconstruction will add to measured GDP. Importantly, the Reserve Bank will “look through” the extra inflation, which means that the floods have probably postponed the next rate rise.

And that leaves the exchange rate. Australia is caught up in a ‘currency skirmish’ going on around the world. Currency volatility will go on for some time yet. But we all know that the Australian dollar is currently overvalued and is likely to come down at some stage. By my reckoning, fair value is about 85 US cents, so that seems as good a forecast as any for end-2011. At the moment, however, the rest of the world is on sale for Australians, be they travelers, on-line shoppers or investors.

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Dr Chris Caton, BTs Chief Economist writes every month. To read the latest edition of Catons Corner, visit http://www.bt.com.au.
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