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Outlook for the domestic economy

Date



The forecasts for the domestic economy are underpinned by several technical assumptions. The exchange rate is assumed to remain around levels observed at the time of writing (a trade-weighted index of around 54 and a $US exchange rate of around 66c). Interest rates are assumed to decline broadly in line with market expectations which suggest a cash rate of 3.25 per cent by March 2009. World oil prices (Tapis) are assumed to remain at around $US 50 per barrel. The farm sector forecasts are based on an assumed return to average seasonal conditions over the forecasting period, but take into account the effects of sustained drought conditions in the preceding period.

Household consumption

The outlook for household consumption remains very weak following flat outcomes in the June and September quarters. Real household consumption is forecast to grow by 1¼ per cent in 2008-09 (Chart 1), down from 2 per cent at MYEFO. Significant falls in household wealth and general uncertainty around the global outlook have sapped consumer confidence and are expected to further curb consumption over the forecast horizon. The share market has continued to fall since its peak in late 2007, with the S&P ASX 200 plunging a further 25 per cent since the 15 September collapse of Lehman Brothers. House prices also declined by around 2 per cent over the June and September quarters.

On the positive side, the implementation of the Government's Economic Security Strategy will increase household income by $8.7 billion and is expected to boost consumption particularly over the next two quarters. Households have also experienced significant falls in petrol prices (down around 35 per cent since the July 2008 peak) combined with a 300 basis point cut in official interest rates since August 2008 and an additional 100 basis points of cuts has been priced in by markets.

Chart 1: Household consumption and gross disposable income (real, year average)

Source: ABS Catalogue Number 5206.0 and Treasury.

Household consumption is expected to grow by just ¾ per cent over 2009-10, as the boost from the Economic Security Strategy unwinds and rising unemployment weighs on consumption.

Tighter credit conditions may also limit households' spending. There are already signs that households are paying down their debt. Moreover, as asset prices have fallen sharply, household wealth has declined. As a result, the household saving ratio (as measured in the household income account) is expected to continue its recovery over the forecast period as households rebuild their balance sheets (Chart 2).

Chart 2: Household saving ratio

Source: ABS Catalogue Number 5206.0 and Treasury.

Dwelling investment

The outlook for the residential construction sector has improved since the MYEFO. The recent cuts in interest rates provide strong support for dwelling investment, particularly in 2009-10 (Chart 3).

Chart 3: Dwelling investment (real)

Source: ABS Cat. No. 5206.0 and Treasury.

The outlook for new dwelling investment and alterations and additions has improved and both components are expected to grow by ½ of a per cent in 2008-09. The weak outlook for 2008-09 is confirmed by recent partial data on housing finance and building approvals which indicate continuing weakness in the short-term.

Despite the weak outlook for dwelling investment in 2008-09, fundamental forces in the housing market will support activity in the longer term. Strong population growth and underlying demand for housing combined with expansionary monetary policy and the stimulus from the First Home Owners Boost are expected to support dwelling investment.

Reflecting this strong underlying demand, the new dwellings component of investment is expected to drive a rebound in total dwelling investment, with growth of 11½ per cent in 2009-10, Investment in alterations and additions is also expected to pick up in 2009-10, growing by 3½ per cent.

The risks facing the forecasts include sustained weakness in investor sentiment, the possibility of further declines in house prices and tighter credit conditions. While credit appears to be readily available for owner-occupiers, investors may have greater difficulty finding finance.

Business investment

New business investment is expected to increase by 3½ per cent in 2008-09 and fall by 9½ per cent in 2009-10, significantly weaker than MYEFO. Expected sharp declines in non-rural commodity prices and the softer domestic outlook, are expected to substantially slow investment over the forecast horizon. Business investment as a share of GDP is expected to ease following recent record highs although it is expected to remain slightly above the long run average (Chart 4).

New engineering construction investment is expected to increase by 6 per cent in 2008-09 reflecting the existing pipeline of work. Sharply weaker global demand for non-rural commodities combined with extremely tight credit conditions have significantly increased the risks that projects will be delayed or cancelled. In addition, there are very few new projects entering the project pipeline. As a result, new engineering construction is expected to fall by 16½ per cent in 2009-10.

Chart 4: Business investment to GDP ratio (nominal)

Source: ABS Cat. No. 5206.0 and Treasury.

There are also substantial risks around the non-residential building investment outlook. Non-residential building is expected to be weaker than at MYEFO and is forecast to fall by 7½ per cent in 2008-09 and 10½ per cent in 2009-10. Tighter credit conditions, softer employment growth and increased supply from near-term building completions are expected to significantly weaken activity in the office market while a softer consumption outlook is expected to weaken activity in the retail sector.

Investment in new machinery and equipment is expected to grow by 6 per cent in 2008-09 before falling by 10 per cent in 2009-10. The fourth estimate of CAPEX investment intentions for 2008-09 implies strong investment growth, particularly in the mining sector. However, these investment intentions have been discounted, to some extent, with low levels of business confidence, tight credit conditions and weaker demand expected to weigh on investment.

Public final demand

In real terms, new public final demand is forecast to grow by 4¾ per cent in 2008-09 - up from 3½ per cent at MYEFO - reflecting additional spending contained in the COAG and the Nation Building packages.

Growth is expected to ease to 3 per cent in 2009-10, ¼ of a percentage point higher than MYEFO.

Table 3: Real new public expenditure

Source: Treasury.

The outlook for total government consumption in 2008-09 (3¼ per cent growth) is slightly higher than at MYEFO, reflecting s
tronger consumption at both Commonwealth and State and Local levels. In 2009-10, government consumption is expected to moderate to 2½ per cent.

Growth in new public investment is also expected to increase compared to MYEFO. Total new public investment is expected to grow by 10¾ per cent in 2008-09 and 4¾ per cent in 2009-10, following strong growth of 9½ per cent in 2007-08. Stronger Commonwealth, State and Local investment is expected to flow from the COAG and Nation Building packages.

New public demand has grown broadly in line with nominal GDP in recent times but is expected to increase as a proportion of the nominal economy over the forecast horizon (Chart 5).

Chart 5: Nominal public expenditure

Source: ABS Cat. No. 5206.0 and Treasury.

Exports, imports and the current account deficit

Since MYEFO the global outlook has continued to deteriorate, which has resulted in significant downward revisions to the forecasts of the external sector. The collapse in the global economy over the past few months has been dramatic, with G7 economies now expected to slip into recession and demand in China showing clear signs of slowing sharply. A trade deficit is now expected in 2008-09, largely reflecting weaker export volumes and lower prices for commodity exports.

Net exports are expected to subtract ¾ of a percentage point from GDP growth in 2008-09, and contribute ¾ of a percentage point in 2009-10. Compared with MYEFO, the expected subtraction for 2008-09 is ¼ of a percentage point larger, reflecting decreased expectations for export growth due to weakness in major trading partner demand.

Total export volumes are expected to grow by 2 per cent in 2008-09 and by 1½ per cent in 2009-10. Compared with MYEFO, the current forecasts are 4½ percentage points lower in 2008-09 and 4 percentage points lower in 2009-10.

Non-rural commodity export volumes are expected to contract over the remainder of 2008 and into early-2009, weighed down by a slump in raw materials demand. Slowing industrial activity, a deterioration in the automotive sector and a weakening investment climate have combined to bring about significant reductions in global steel production. As a result, in recent weeks major mining companies have announced significant reductions in export volumes of iron ore and coal. These cutbacks are expected to continue through until mid-2009, when a recovery in the Chinese steel sector and rebuilding of inventories is expected to begin.

In addition, the demand collapse in the second half of 2008 is also making it extremely difficult for producers to justify expanding capacity. There have already been several examples of producers delaying planned expansions in reaction to the slump in prices and tightening credit availability, and we expect to see many more project delays and even cancellations in the coming months.

Non-rural commodity volume growth is now expected to moderate to 2½ per cent in both 2008-09 and 2009-10, from 7 per cent in 2007-08 (Chart 6).

Chart 6: Non-rural commodity exports (year average)

Source: ABS Cat. No. 5302.0 and Treasury.

Farm production is expected to rebound by 11 per cent in 2008-09, slightly lower than forecast at MYEFO due to weaker-than-expected rainfall during Spring. Contingent on average seasonal conditions, farm production is forecast to increase by a further 5 per cent in 2009-10.

The recovery in farm production is expected to boost rural exports, which are forecast to grow by 9 per cent in 2008-09 and a further 9 per cent in 2009-10.

Sharply lower world growth is expected to more than offset the boost from a weaker exchange rate for elaborately transformed manufactures (ETM) and service exports. ETM exports are now expected to contract by 1½ per cent in 2008-09 and by a further 3 per cent in 2009-10. The decline in ETM exports is expected to be driven by car exports, where the outlook has deteriorated rapidly following the sudden collapse in demand in key export markets, particularly the United States. Growth in services exports is also expected to ease to 5½ per cent in 2008-09 before contracting by 2 per cent in 2009-10.

Imports of goods and services are expected to grow by 5 per cent in 2008-09, before contracting by 1½ per cent in 2009-10, as domestic demand continues to moderate. Compared with MYEFO, the current forecasts are 2 percentage points lower for 2008-09 and 5 percentage points lower in 2009-10, largely reflecting a significantly weaker outlook for domestic business investment which has a large imported component and the impact of the depreciation of the exchange rate on volumes.

The terms of trade are forecast to increase by 7½ per cent in 2008-09, before decreasing by 10¾ per cent in 2009-10. This further downward revision from MYEFO is due to the continued deterioration in commodity demand and sharp falls in spot prices for all major non-rural commodity exports. Contract prices for Australia's bulk commodity exports are all expected to fall significantly - iron ore (down by 50 per cent), metallurgical coal (down by 50 per cent), and thermal coal (down by 40 per cent). In addition, base metal prices have also come under significant pressure in recent months and are likely to remain at much lower levels. There is still considerable uncertainty regarding the future path of commodity prices over the next few months.

Chart 7: Terms of trade

Source: ABS Cat. No. 5302.0 and Treasury.

The trade balance is expected to record a deficit of 1 per cent of GDP in 2008-09 and 2¾ per cent of GDP in 2009-10. The change to a deficit in 2008-09 and the further deterioration of the deficit in 2009-10 relative to MYEFO reflects lower export volumes and prices outweighing lower import values.

The net income deficit (NID) as a per cent of GDP is expected to narrow to 3¼ per cent in 2008-09 and 3 per cent in 2009-10. The narrowing largely reflects weaker growth in mining profits over the forecast horizon commensurate with lower prices for coal and iron ore exports, along with lower net interest payments on the stock of net foreign debt due to lower global interest rates.

The current account deficit (CAD) is expected to narrow to 4¼ per cent of GDP in 2008-09 before widening to 5¾ per cent of GDP in 2009-10. These movements of the CAD are similar to that forecast at MYEFO, with a forecast narrowing of the NID being offset by the expected widening of the trade deficit (Chart 8). From a savings and investment perspective, gross investment is forecast to decline as a share of GDP over the forecast horizon. Gross savings is forecast to rise in 2008-09 as households seek to rebuild their balance sheets, before declining in 2009-10 as corporate savings fall in line with reduced profitability.

Chart 8: Current account balance

Source: ABS Cat. No. 5302.0, 5206.0 and Treasury.

Employment, wages and inflation

Labour market

Labour market conditions are expected to decline compared to MYEFO, in line with the weaker outlook for economic growth. Employment is expected to contract through the remainder of 2008-09 into 2009-10.

Chart 9: Labour market

Source: ABS Cat. No. 6202.0 and Treasury.

The participation rate is expected to remain high at 65 per cent by the June quarter 2009, before easing to 64½ per cent by the June quarter 2010. This reflects an expected easing in net overseas migration levels, and weaker employment prospects as the labour market begins to slow.

With employment anticipated to contract, the unemployment rate is now expected to rise to 5½ per cent by the June quarter 2009, and to 6½ per cent by the June quarter 2010.

Prices and Wages

Wages

The outlook for wages is for more moderate growth than was expected at MYEFO, in line with the weaker outlook for the economy and the labour market.  Lower business and consumer confidence and recent falls in inflation expectations are expected to reduce upward pressure on wage growth in the near term, while the forecast increase in the unemployment rate will start to influence wage growth towards the end of the forecast period.

The WPI is expected to grow by 3¾ per cent through the year to the June quarter 2009 and by 3½ per cent through the year to the June quarter 2010.

Prices

Headline inflation forecasts have declined since MYEFO, driven by lower oil prices and weaker domestic demand. Headline consumer prices are forecast to grow by 2½ per cent through the year to the June quarter 2009 and 2¾ per cent to June 2010.

Forecasts of underlying inflation are broadly unchanged from MYEFO except towards the end of the forecasting period. Underlying inflation is expected to grow by 3¾ per cent through the year to June 2009 and 2¾ per cent through the year to June 2010.

Inflation is expected to fall in line with weaker GDP growth and easing wages pressures. Australian dollar oil prices are assumed to be lower over the forecast period compared to MYEFO, which is expected to have a significant near-term impact on headline inflation.

Chart 10: Headline Consumer Price Index

Source: ABS Cat. No. 6401.0 and Treasury.


1 This spending was included as expenditure by States and local authorities in the UEFO forecasts but has been subsequently reclassified as renovation spending by households.