A Soft Landing is Now Off the Table in 2023
A soft landing is now off the table for the Australian economy. The recent national accounts showed that GDP increased by only .2% in the first quarter of this calendar year. This falls within the scope of rounding error which could be revised to a negative number by the time the next set of national accounts are published in three months from now.
The Picture Has Not Improved
The economic news in the first two months of the second quarter of the calendar year hardly inspires enthusiasm as to any improvement. This means that in three months from now we will be listening to news telling us about the ‘technical recession’ we have entered.
This will put an end to the hoped for soft landing scenario and Governor Philip Lowe will have ended his tenure at the Reserve Bank of Australia, or be starting a new term, in the grip of a recession.
Lack of Productivity is the Problem
The problem that we face is the dearth of productivity that has been absent from the Australian Economy for a long time. Without productivity, it is very difficult for average wages to rise above the level of inflation without entrenching inflation.
This means that in order to counter the pressure for further inflationary price rises the demand for goods and services within households and businesses has to be curtailed. Money has to be taken off consumers.
Monetary policy and the further implementation of rising interest rates are the only economic lever available to implement this. Fiscal policy is too partisan to deliver any help in defeating inflation even though in theory it can play a large role.
The interesting part of the debate in the fight against inflation is how it is driven by the rising costs of services and not goods.
Increasing Productivity and Lowering Inflation A Service-Based Economy
The argument goes that services are a difficult area to increase productivity compared to the goods sector. The input of labour is difficult to reduce in the production of a service compared to the production of a good and since our economy is predominantly made up of the provision of services we are stuck in a low productivity path.
This is why our hope for a soft landing is in such jeopardy. The pathway to that utopia is just too narrow.
I have written more about this in my budget 2023 report titled “The Budget 2023 Based on Luck“.
The question now is how effective will increasing interest rates be in curtailing inflation in a service-based economy where we are forever reminded about how tough working families, or what used to be called the middle class, are now doing it.
If the aim is to reduce the demand for services among working families so that we can achieve a soft landing it will be difficult to get traction. If they are already going without, what else is there to take away from them?
Time to Shift the Target
The target may have to be elsewhere.
There is a large cohort of home-owning savers who will feel little pain from the increase in interest rates and may actually gain a benefit from increasing deposit rates on their savings. It is this group that will have to be bought back into line to help the inflation fight if means are not found to increase productivity and achieve a soft landing.
It’s not clear how this will occur but one possible pathway is through what is called the wealth effect related to asset price inflation. When consumers feel less wealthy because the value of their assets is falling they tend to slow down in their demand for goods and services.
Asset Price Inflation may be the Culprit
The asset that is of interest here is residential property. For most of this year, those values have been back on the rise after an initial period where they had fallen a modest amount. https://propertyupdate.com.au/australian-property-market/
There is a strand of thought that is not often openly discussed that asset price inflation is a driver of overall price inflation because of the way that wealth effects work in increasing demand for goods and services of those who are benefiting from the increase in asset prices.
When people feel wealthier they spend more. This increases demand for goods and services in the economy and does little to help us achieve a soft landing. More pressure is placed on monetary policy.
A Very Blunt Instrument
Increasing interest rates can have an impact on increasing wealth by curtailing the market in those assets. The problem is that it is not very easy to manage.
An analogy would be the quantitative easing that was put in place to support economic activity during the global financial crises. While that approach may have diverted the world economy from going into a depression of a 1930s style, it created a lot of distortion in financial markets.
Strangely, this inflationary burst is helping monetary authorities remove the greatest of these distortions which involved getting interest rates to near zero levels. That is one of the distortions that helped cause the asset price inflation that has so cruelled the aspirations of the young seeking to enter the property market.
The Current Interest Rate Cycle Has More To Run
If interest rate policy is to have the effect of stopping or even reversing some of the asset price inflation that is driving general price inflation it is unlikely that the current interest rate cycle has run its course. This will make it even more difficult to achieve a soft landing.
Three of the four big banks expect another interest rate rise this year as stated by many sources, including Rate City.
If the Reserve Bank sticks to its job of managing price levels as a priority over economic activity, it is likely that these expectations will fall short of reality. Further interest rate rises will be needed which will take away the chance of a soft landing.
It is also likely that just as quantitative easing was a blunt policy that caused a lot of side effects in its efforts to stimulate the world economy, using the wealth effect will be just as blunt but more directly brutal.
Getting Back To Normality is Not Straightforward
We are still recovering from the policies that were put in place to avert catastrophe during the global financial crises well over a decade ago. The path to the normalisation of the financial markets has now well and truly commenced and a large part of it is to get interest rates back to a positive number.
Unfortunately, this means that further adjustments will occur throughout the world economy and particularly in asset markets as this adjustment back to normality filters through household, business and government budgets.
