The masquerade

April 8, 2024

By: Sophie Photios, Graham McDevitt

Executive summary

Australia’s economy can be likened to a “masquerade” where the economy is dancing along from song to song, but at the end of the night when the mask comes off, what lies beneath it? Australia’s economic growth is slowing, inflation remains elevated, and there is tight monetary and fiscal policy, but where the surge in immigration has turned up the music and kept the drinks flowing, it has masked the divergence between aggregate and per capita growth – and hidden the long-term macroeconomic implications. 

Population is at the centre of the Australian story as it is working on growth in a “positive” way and on inflation in a “negative” way – and has offset the impact of combined policy tightening. Australia’s migration pulse is expected to taper off in 2024, and when this happens, it does not appear that households, business, or trade will be able to fill the growth void.  

We expect gross domestic product (GDP) to slow into stagnation, which we define as between -0.5% and +1%, with prolonged combined policy tightening increasing the risk of recession to 50-50 in the second half of 2024. Inflation is expected to gradually slow through 2024 but remain above the Reserve Bank of Australia (RBA) target by year end. This combination of slowing growth and a gradual slowing of inflation warrants an extended RBA pause, during which we expect rate cuts to be delayed until the second half of 2024, with the timing of the first rate cut dependent on the domestic outlook at the time.

Introduction

Australia’s economy is slowing while inflation remains elevated, creating a stagflationary environment amid combined monetary and fiscal policy tightening. It is a “masquerade," as the surge in Australia’s population growth through immigration is holding up aggregate growth and inflation but masking the impact of monetary and fiscal policy tightening on growth per capita. Australia is in a "per capita recession,” and this compels us to ask: Will this turn into an outright recession in 2024?  

Our outlook, expressed through the 2023 series of Australian Strategic Forums, has largely played out as expected. Growth has slowed, but inflation is falling more slowly than in other developed economies, a combination that we suggested created a dilemma for the RBA. The RBA must decide whether to base its decision making on either the stickiness of inflation or the prospect of a "per capita recession” falling into outright recession. We expect that weak growth points to lower inflation in the long term and therefore easier monetary policy, which would support bond yields grinding lower.

The population trap

Australia’s economic environment is being driven by population as immigration has skyrocketed. This is not just the recovery from the COVID-19 border closures; it is also a direct result of a federal government policy change. Australia’s net overseas migration pre-COVID-19 averaged 110,000 per year and stepped up to 600,000 in 2023 (Figure 1). This population explosion has created a gap between aggregate and per capita growth (Figure 2). Despite the policy headwinds, the huge surge in population has pushed up aggregate growth for the entire economy, yet individually, it doesn’t "feel" like strong growth because everyone is getting a smaller piece of that growing pie. As a result, Australia has sunk into a “per capita recession” – typically a leading indicator of an outright recession – and this is deepening with the 4Q23 GDP report revealing a fourth consecutive quarter of negative quarter-on-quarter growth (Figure 3).

Source: Australian Bureau of Statistics, March 2024.

This, in turn, creates a "population trap.” If an economy’s growth is being driven by immigration, as Australia’s is today, more and more immigration is needed to hold up aggregate growth in the future. Without it, the gap between aggregate and per capita growth could close. The Australian government’s budget has set out that immigration is to progress at triple the pre-COVID-19 average over the next five years; therefore, the levels of immigration will remain high, but the rate of change would taper. If population growth slows, then aggregate growth slows, and if there is no other driver of growth, the economy is at risk of recession.  

Figure 3: Australia's per capita recessions 

Source: Australian Bureau of Statistics, March 2024.

This migration boom also has important long-term macroeconomic implications for productivity, which can structurally impact inflation and complicate RBA policy decision making. In today’s migration boom, around 1.4 million working visas were granted in 2023, but only 5% of these were skilled visas. In contrast, during the 2005-2007 migration boom, 20% of the visas granted were skilled visas (Figure 4).  The higher skilled immigration during 2005-2007 resulted in much higher labour productivity, which contrasts with today's low level of skilled migration and the resultant significant drop off in labour productivity  , which can be structurally difficult to reverse (Figure 5). 

Sources: Australian Department of Home Affairs, December 2023 (Figure 4). Australian Bureau of Statistics, November 2023 (Figure 5).

What, if anything, can fill the void if migration tapers?

Households

Today, Australia’s economy resembles in many ways that of the 1992 “recession we had to have." Australia’s consumption and confidence today as shown in retail sales are as negative, if not more negative, than in the 1992 recession (Figure 6), and consumer confidence has not been this low for such a sustained length of time   (Figure 7) since then. Australia’s household income and consumption are falling, and people are resorting to more use of credit cards as incomes are insufficient. Australia’s real household disposable income growth has   taken a dive and is, in fact, lower than the 1992 recession, with both discretionary and non-discretionary spending sliding since mid-2023. Australia’s income growth has not kept pace with the growth of essential spending, creating a "cost-of-living crisis,” with elevated household stress.

Sources: Australian Bureau of Statistics, November 2023 (Figure 6). Melbourne Institute of Applied Economic and Social Research, February 2024 (Figure 7).

Businesses

Australia’s business income is mixed but pointing lower as inventories rise. Australia’s company profits, as segregated by mining and non-mining, are seeing a significant divergence. Mining profits have – after a decade – weakened, but non-mining profits have strengthened. Mining profits tend to follow commodity prices, and as bulk commodity prices have fallen, so have mining profits. Inventories are rising, but this coincides with a rising ratioof inventories relative to sales – which tends to be interpreted as a sign of weak demand. Australia’s total company profits have dropped (combining mining and non-mining),  and this tends to signal that business capital expenditures (capex) will turn with income. Australian new orders, a leading indicator for capex, have weakened, and despite the tax incentives leading up to June 30 boosting capex in 2Q23, they made a quick reversal and have since fallen.

Trade

Australia’s trade outlook, an important contributor to growth for the country, is recovering but is not back to its pre-COVID-19 trend. The Australian dollar weakening has supported exports but has made imports more expensive, and the terms of trade have fallen. Resources exports have come off their highs as commodity prices have declined from their COVID-19 highs, reflected by the RBA Index of Commodity Prices. China’s ability to “rescue" Australia is not assured as the Chinese economy is suffering its own weakened outlook post-COVID-19, and demand from other main trading partners remains low. Australia’s exports with its other trading partners – the US, Japan, and South Korea – have weakened amid the global downturn  .

“Balancing act” of monetary and fiscal policy

This Australian picture sits against a backdrop of both tight monetary and fiscal policy, working together to tackle inflation and slow growth. This combination of policy is important, as it contrasts with the US policy mix in which loose fiscal policy is counteracting tight monetary policy. In Australia, both monetary and fiscal policy are tight (Figures 8 and 9), and as a result, the Australian economy is much slower than that of the US.

Sources: Reserve Bank of Australia, US Federal Reserve, March 2024 (Figure 8). Australia Department of Treasury, US Office of Management and Budget, December 2023 (Figure 9).

Monetary policy

Australia’s monetary tightening has been the fastest and most significant rate hiking cycle in the nation’s history. The RBA’s aggressive rate hiking has taken average variable mortgage repayments to double their pre-COVID-19 level, and the share of household income used to service principal and interest debt repayments has soared to the highest level in history. The RBA has now "paused,” and markets are asking, When will the RBA cut rates? History shows that the RBA cuts rates as inflation moderates but not necessarily when it’s back at target, nor does it require a recession (Figure 10). Historical comparison of the RBA’s past rate cut cycles reveals that there has been no consistent pause length, and compared with the US Federal Reserve’s interest rate move, the lag has varied from 12 months to just one month, suggesting that domestic fundamentals hold the key to the RBA timing (Figure 11).  

Sources: Reserve Bank of Australia, Australian Bureau of Statistics, February 2024 (Figure 10). Reserve Bank of Australia, US Federal Reserve, March 2024 (Figure 11). CPI: Consumer Price Index.

Fiscal policy

Australia’s fiscal policy is tight in absolute terms, but there is notable divergence between the federal government, which has been tightened back to a surplus, and the state governments, which have gradually loosened their budgets. The Australian federal government’s budget position tightened significantly post-COVID-19 and even returned to surplus in fiscal year 2023. The Australian government budget projects that both the underlying budget balance and government payments will tighten even more than the projections from the prior government budget update,  and we expect this to continue in fiscal year 2024 as the government prioritises “balancing the budget."

The state governments, on the other hand, are gradually loosening their budgets with further widening expected in fiscal year 2024, having upped their new spending policy decisions. Our Australian Strategic Forum series has previously articulated that the exploding population theme has created a conflict for fiscal policy in which Australia’s federal government is incentivised to increase immigration as it results in increased personal tax revenues, while the state governments bear the brunt of the cost of immigration via the infrastructure and services required for growing populations. State government net debt is expected to balloon along with state populations, but the states have more funding constraints than the federal government, which raises questions over the sustainability of state spending plans.

Is recession therefore inevitable?

Australian households, businesses, and foreign trade do not all seem in a position to fill the void when population growth falters. So, is a recession therefore inevitable? In our view, it is not, as long as employment stays strong. Employment is what stands between a recession and a “low-income, low-spending growth trajectory."   

Australia currently has close to full employment, as mirrored in many other economies, where employment is growing but shifting from full-time to part-time employment, and there is a decline in hours worked. This combination is reflective of “labour market stress,” similar to the experiences in 2001 and 2008-2009 shown in Figure 12, when neither resulted in technical recessions but created low-income, low-spending growth environments. Thus, employment is a key data point to watch in the coming months and is expected to be crucial to whether the economy avoids or falls into a 1992-like recession.  

Figure 12: Employment is key to minimising recession risk

Source: Australian Bureau of Statistics, January 2024.

Australia’s housing market at centre of the inflation story

Australia’s housing market is at the centre of the inflation story, as it is keeping inflation elevated and creating a dilemma for the RBA. Australia’s inflation is slowing as supply recovers and demand slows, and we expect this to continue but not at the same rate as its global counterparts as housing across four key expenditure categories is putting upward pressure on CPI .  

1. The cost of building a home has risen sharply due to the demand-supply imbalance and the cost of materials.
2. Rents have risen sharply due to the same demand-supply imbalance and the population boom.
3. Insurance has risen sharply due to a large increase in premiums for house insurance given the big lift in the cost of building a home over the past two years as well as natural disaster costs.
4. Electricity prices have risen sharply despite Australia being a net energy exporter, as poor policy and regulation around energy have worked to slow the process of energy prices being passed on to consumers.

Australia’s demand-supply imbalance in housing has created a dilemma for the RBA. Demand for housing has surged due to the sixfold increase in immigration, but there is a structural supply shortage of housing, and the residential construction industry can’t keep up. Australia’s total population increased by 680,000 in 2023, but there were only 174,000 dwellings constructed, some of which were “‘knock down and rebuild," so they did not ultimately add to the nation’s housing stock (Figure 13). Australia’s housing vacancy rate has hit a low of 1.1% (Figure 14), and this is uniquely leading to rising house prices and rents despite an interest rate hiking cycle, which has added to inflationary pressures.

Sources: Australian Bureau of Statistics, April 2023 (Figure 13). SQM Research, December 2023 (Figure 14).

This creates a self-defeating loop for the RBA: a shortage in housing ￫ boosts inflationary pressures ￫ which encourages the RBA to hike interest rates ￫ which disincentivises residential investment ￫ which leads to an ever-deeper housing shortage (Figure 15). This is a supply-side problem, but the RBA only has a demand tool, and a pause at current levels for an extended period could   constrain construction activity further, leading to an even bigger gap between supply and demand.

Figure 15 : Housing shortage keeping inflation elevated

Source: Macquarie, March 2024.

Conclusion

At our most recent Australia Strategic Forum, we concluded that Australia’s economy is slowing while inflation remains elevated, creating a stagflationary environment amid combined monetary and fiscal policy tightening. It is a "masquerade" as the surge in Australia’s population growth through immigration is holding up aggregate growth and inflation but masking the impact of monetary and fiscal policy tightening on growth per capita. Australian households, businesses, and foreign trade all do not seem in a position to fill the growth void when population growth falters, but recession is not inevitable as long as employment stays strong. Australia has both tight monetary and fiscal policy, even with the neutralisation from the state governments, and this is working to slow the economy more than in the US.

We expect GDP to slow into stagnation, which we define as GDP between -0.5% and +1%, with prolonged combined policy tightening increasing the risk of recession to 50-50 in the second half of 2024. We expect inflation to gradually slow through 2024 but remain above the RBA target by year end. This combination of slowing growth and a gradual slowing of inflation warrants an extended RBA pause, during which we expect rate cuts to be delayed until the second half of 2024 with the timing of the first rate cut dependent on the domestic outlook at the time.

Authors

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