The road back to normal: Australia’s economic outlook

Intro:
Welcome to CPA Australia's With Interest podcast, bringing you this week's need to know information for businesses and accounting professionals.

Gavan Ord:
Hello, and welcome to CPA Australia's With Interest podcast. I'm Gavan Ord, senior manager, business and investment policy with CPA Australia. I'm joined by Warren Hogan, chief economic advisor to Judo Bank. Welcome Warren. Great to have you on the show.

Warren Hogan:
Thanks, Gavan. It's great that you've got me on.

Gavan Ord:
Today, we'll be getting Warren's perspective on some of the key economic issues Australia is currently facing, and there's quite a few. So getting right into it, Warren, what do you see as the key economic issues Australia is currently facing? What are the positives and what are the key pressures?

Warren Hogan:
Well, I think we're really well positioned as an economy, sitting here at the end of a pandemic or what we hope to be the end of a pandemic. So I don't think we should lose sight of that key positive. We have a platform of strong demand, low rates, available credit and low unemployment. And really, I think the economic outlook now is all about what I'd call normalisation. It's about getting back onto an even keel over the next few years and laying the platform for an extended expansion of our economy over the decade ahead, I would hope. And I think it's going to be based on a refitting of our capital stock and our labour skills for a post-pandemic, much more digitised economy. But we have to get there, and that's the real challenge. The challenge is going to be the next two years, and the main one is first of all, getting the inflation issues that have arisen, under control, and that's going to require one simple thing and that's interest rates back to a normal level.

So we've got to get through that process of rising interest rates and probably a two to 3% increase in interest rates over the next few years, which seems substantial, but that's what we're going to need to do. And there'll be other elements to it, which is things like, rebalancing the labour market, wages, getting the budget under control. So there's a whole range of different elements to this process of normalisation, but the end game is an economy that's able to expand, able to invest and employ in a productive manner. And I think that's also the key, is that we want to set ourselves up for growth based on productivity as much as anything else.

Gavan Ord:
Yeah. Thanks, Warren. And just on the inflation theme, and we know that's highly topical at the moment, in a recent webinar that you and Judo Bank did for CPA Australia, you mentioned that Australia's inflation rate is lagging that of the US and Europe. When do you think Australia's inflation rate will peak and do you have a forecast what it may peak at?

Warren Hogan:
Yeah, well, I do strongly feel that we are lagging developments in the Northern Hemisphere, and I think that's been confirmed with the latest inflation report, which unfortunately confirmed quite a lot of inflation coming through into the retail level, into the consumer price index in the start of this year. And I think that will continue and we'll probably see the peak in inflation in this country towards the end of the year, maybe Q3, but more likely Q4. Unfortunately in this country, we only get inflation every three months, unlike everywhere else in the world where they get an inflation report every month. But I imagine our inflation will peak around Q4, which is broadly in line with this six to nine month lag we seem to have on the rest of the world and consistent with, I think, what we're hopefully seeing overseas and that is their inflation peaking.

So we saw recently the US inflation report for April, annual inflation fall from 8.5 to 8.3, and I'd hope to see inflation continue to come down in the US and inflation pressures in the system start to ease back and that's going to have to start with commodity markets, transport and logistics costs, not so much falling or going back to where they were, but stopping the increases we've seen. And we're starting to get evidence of that. So I would say that we'll see global inflation pressures ease through the course of this year. Our inflation will peak at the end of the year, but we're not going to see inflation back to the RBA's target probably for another two or three years. And that's fine. It doesn't matter if they miss their target for a few years, as long as it comes back to target.

Gavan Ord:
And do you have a forecast of what the inflation rate may peak at in Australia?

Warren Hogan:
I think it'll peak at around six or seven. So hopefully a little bit below what we're seeing in the US and Europe. We do have a few slightly different characteristics to our inflation and our economy than they do. Most importantly, our domestic energy prices are unlikely to go up to the extent that we're seeing in Europe and the US. There will be some pressure there, but I think yeah, six or seven on the headline core inflation, probably around five, which is high. And I think it'll take a little bit of time to come down. So by the middle of next year, it'll still be probably around five. Then, as I said before, it'll probably take at least two years, if not three, to get down under three again.

Gavan Ord:
You mentioned some of the drivers of spike in inflation, if that's a correct description, what do you see as the main drivers of this current increasing inflation rate?

Warren Hogan:
Yeah. And I think that's the problem that we initially thought it was a spike, this argument or debate that was had around transitory. I think it's actually more of a genuine inflation pressure, which is more of a bulge than a spike. And what that means is that yes, there are a couple of key drivers like in Australia right now, the three main drivers that matter to the broader community are housing costs, which includes rents as well as the cost of building a house as they put it in the CPI. It's energy, obviously, which hopefully will start to come off, especially with the cut to the fuel excise. And it's food and grocery. But the reality is, and what I think worried the Reserve Bank and forced them into that early rate hike in May, is it's broad-based. It's actually seeing price increases happen across the board.

That's what we're seeing in the Northern Hemisphere, particularly in the United States. And that's why it's not so much a spike as is this inflation bulge. And it's serious. We do need to get interest rates back to at least a neutral setting to ensure that the inflation bulge remains a bulge and comes back down to target rather than persisting, like we saw in the 1970s when there was real inflation problems. It's important to remember that low interest rates and accommodative monetary policy prior to the pandemic, were not producing inflation for very specific reasons. Most importantly, globalisation, manufactured good price falling, particularly out of China, but also we had higher unemployment. But the world has changed a lot in the last three years and easy monetary policy or accommodative monetary policy I believe is now inflationary.

So the absolute priority is to get those interest rates up and to get them up there pretty quickly, because the longer you leave it, the more the inflation can get entrenched. And the greater the risk that actually monetary policy has to get to a point of being tight in order to eradicate these inflation pressures, which is code for putting the economy into recession. And I don't think anyone wants to see that. So it's much better that central banks get on with the job and reduce the risk of having to do that at some stage down the track.

Gavan Ord:
And you talk about to a neutral rate. And obviously the question for people is what is that neutral interest rate? And I think it's very hard to define, but as you said, like New Zealand is now increasing by 50 basis points. The US is also increasing interest rates. Where do you see Australian interest rates may end up in the next year to two years?

Warren Hogan:
Yeah, neutral is a difficult concept. It's in my mind, theoretically, quite straightforward. And that is, a neutral interest rate is an interest rate that broadly matches up with the growth in your economy, whether measured in real or nominal terms. And we've got an economy, which I think should generate growth of two or 3% in real terms, if the RBA can hit their inflation target, then that's another two to 3% of inflation. So we're talking about nominal growth of 5%, which is very much the Australian historical experience. Now the RBA cash rate doesn't need to get all the way to five. Well, given margins in the banking and financial system and so forth, mortgage rates are a lot higher than for example, the cash rate. Maybe it doesn't have to get all the way up there, but I think at least 3% is going to be a neutral rate.

So how do they get there? Well, I think they've got to show some urgency about getting that cash rate up to about one and a half percent, because that's still going to be an accommodative level of interest rates. It'll still be a mortgage rate of well below five for most people. But it'll also have an effect. I mean, the problem is our starting point. They had interest rates so low and so far away from neutral because of the pandemic that you did see things like the property market respond to that. And you're seeing volatility in financial markets on the back of this globally, i.e., the normalisation of interest rates.

So I think the RBA needs to get on with it. They need to get the cash rate up to one and a half percent by the end of the year. And I think that should involve a 40 basis point increase in June, in a few weeks. That gets the cash rate to 0.75 and back on that 25 point cycle. And then it's just simply another three 25 point hikes over the back half of the year, which basically means every second meeting. So it's not that onerous. And then I think they can pause. There will be side effects and we may touch on this through the conversation, but everything from falling house prices to pick up in insolvencies in the business community, financial market volatility, which will be more of a global event, but this is a global event, the normalisation of policy. So I think they should pause then.

And then, the next wave of tightening that gets you up towards two and a half, three can commence maybe mid '23 or late '23, and take us through into 2024. So, they need to be concerted early, but then cautious, but then concerted again. And that's all on the premise, that is really my view, that the economy will withstand this first one and a half percentage points of rate hikes pretty well. Might be a few wobbles here and there, as I said, but the underlying economy, employment, business investment will continue to rise through that first wave of rate hikes. So it is going to take a few years, but I think they should get on with the job.

Gavan Ord:
You just mentioned, the economy will withstand these interest rate increases. What potential impacts could these interest rates increases have on the economy? For example, you mentioned housing, could it flow through to credit standards as well? So just maybe a few words on what do you think would be the major impacts of these increase in interest rates. And do you think the media is over-hyping the negatives?

Warren Hogan:
Well, they certainly are, and they will. It's going to get a lot louder in the next six months. And a lot of economists will as well. It's not going to be an easy process. So the main impact on the Australian economy will be the housing market. I suspect that actually that first percentage point or so of rate increases, is going to have a reasonably modest effect. So, some parts of the housing market may fall in price, and we're starting to see evidence of that. Very small falls, of course, but against that backdrop of rising rates, we're probably going to start to see wages go up, or I believe we are seeing wages go up. So household income growth is likely to offset some of the effect of higher funding costs. But the housing market, I think, is the canary in the coal mine.

The other area is going to be an increase in business insolvencies. They've been extraordinarily low through the pandemic for both policy reasons, but also broader economic reasons. And I think there's a natural process where that rate of insolvencies picks up. And that of course is going to hit the news and cause a bit of fright. But I think all of that is part of this process in the underlying economy, i.e., employment or unemployment is not going to substantially shift because of this.

I think the other area that will be needed to be watched closely is the financial markets. So you talked about credit standards and I think in the core regulated banking system, credit standards have been maintained at a very good level through this period and will continue to be. The real issue is going to be outside of the core regulated financial system. I think that's where you see the slip in credit standards when you have easy money. And that's, I think what we're going to discover in the course of the next year or so, is how much unsustainable lending activity has been going on outside of the banking system. And that's not just here, that's all around the world. And a proxy for that is often what's happening in financial markets. So right now you're already seeing big hits in the crypto space, in the tech space, which is essentially speculative money, chasing assets that have potentially high returns, but not a lot of strong income fundamentals now.

And I think that all fits into the same bucket of the great Warren Buffett saying, "When the tide goes out, you find out who's been swimming naked." Well, the tide of liquidity is going out and those skinny dippers are usually found outside of the core economy, core banking system. And there will be damage done. Now again, how much of this produces any sort of contagion into the real economy, into the core banking system remains to be seen. But if it's limited, and it wasn't limited in the GFC, as we know, in fact it was amplified. But the regulatory environment's shifted a lot since then, and I think if it is limited, then you'll still find that credit worthy borrowers will get access to credit. They may obviously have to pay more for it as rates are going up, but again, I would emphasise, it shouldn't derail the underlying economy. But this is what we're going to find out over the course of the next six to 12 months.

Gavan Ord:
Yeah. Changing tack a bit to some of the election discussions. So last week there was quite a bit of debate on the impact of raising the minimum wage. What's your view on raising the minimum wage?

Warren Hogan:
Yeah, I think it's potentially seen as quite controversial because I'm actually agreeing with, on the election campaign trail, policy gaff from Anthony Albanese. I think we probably should see the minimum wage go up by 5%. I'd imagine my thinking on this is a little more advanced and nuanced than his because I think his answer of, absolutely wages should keep up with inflation, was the only answer he could give, given the leadership of the ALP at this stage of the game. But from my point of view, it's part of this adjustment process. So at first glance you would think, well, Warren, you've been talking about inflation risks and the need to really address those, so why are you supporting outsized increases in wages? The answer is quite simply based on a number of factors.

First of all, the real minimum wage has fallen by about 5% in the last two years or by the time we get to the 30th of June, that will be the case, because the Fair Work Commission decisions on the minimum wage refer to the year ahead. So for example, this current year, a year ago, the Fair Work Commission increased the minimum wage by two and a half percent. And as we now know, inflation's going to have increased by somewhere between five and 6%. So that's a big cut and it actually happened the previous year in 2020-21, where the Fair Work Commission gave a very modest increase of 1.8% in the middle of a pandemic. Quite right, I think on their part to be cautious. But in the end, inflation turned out to increase by 3.8%. So that was a 2% cut in the real wage.

Now that first year, you can understand it's transitory, it's a temporary thing potentially, but as it's turned out, it wasn't. So 5% decline in the real minimum wage so far. And we're staring at another year, the year ahead, which is what the current Fair Work Commission decision will relate to where inflation, according to the RBA will be 4.3%. My view is it'll be closer to five as we've already discussed. So if you don't increase the minimum wage by an unusually large number, you're looking at a period of three years where you're going to take a big, big fall in real wages.

And apart from any issues of fairness that may come out of that, and I think they're legitimate and real, there's an economic issue. And that is that the only way to get rid of inflation is to get interest rates up. That is my very strong view and I'll debate any economist who wants to take that view. As I said, we're in an inflationary environment previously, we weren't. And we're going to need a few things.

One we're going to need to get rates up and we're going to need the economy to withstand it, as discussed. And I think if you're seeing a lot of workers' wages going backwards in real terms, then you really do risk some retrenchment of spending. You can already see consumer sentiment soft. It's yet to result in a retrenchment of spending, but it could happen. So to give the lower end of the income spectrum, a bit of a boost with wages, I think will solidify demand and allow us to put those rates up over the course of the next few years.

The other thing is that beyond this current year, we're going to need wage restraint over the next three to five years in order to bring down the inflation of two to 3%. And we're going to need to ask workers for some wage restraint. Now to ask workers for wage restraint in 2023 and 2024, after we've already seen their real wages fall by let's call it 7% if we do little this year, is going to be a tough ask, and you're going to see social and industrial disruption, and we're already starting to see that.

So I think a reset now of 5%, not only shores up demand in the economy for higher rates, gives the RBA confidence to do it, it also gives us a platform for asking for wage restraint in the medium term, which is critical, I think, to the inflation story. So I think it's a very simplistic view to say a 5% increase in the minimum wage and other wages for that matter right now is highly inflationary. It's obviously a highly politicised issue right now. It's a lot more nuanced than that. Economic models aren't going to give you a very good read on the current economic environment in Australia and what I think the strategy should be for getting our economy back to normal, and I think this minimum wage decision is a critical part of it.

Gavan Ord:
And just going on to the election and for listeners, Treasury prepare an incoming government brief, whoever that may be. I think it's called a blue and a red book, depending on who wins. If you were asked to prepare an incoming government brief on the state of the economy at the moment, Warren, what would your brief say?

Warren Hogan:
Well, for a starter it would be the same for either government. The problem with being an economic analyst in an election campaign is one week, one side likes you, in the next week the other side likes you, but eventually you upset everyone. So I would prepare the same brief for both sides. That's being a little unfair on Treasury, I suppose. But anyway, what I would say is that there are five elements of modern Australia's prosperity, the modern Australian economic model, that are under pressure, and they all need to be addressed and assessed as part of the government's policy strategy.

So number one, low and stable inflation. I actually see that as not a debate. We've got to get back there. So what have we got to do to get inflation back to two to 3% and everything back on an even keel on the price front or on the nominal side of the economy?

Two, government financial responsibility. Foundational to modern Australia is the fact that our governments run a sensible fiscal policy. That is, they use deficits when needed, but then they try and get back to balance. And of course, right now we don't have that. The charter of budget honesty has been thrown out the door and we have deficits for as far as the eye can see. It's fine. We may decide that's the way to go, but just be clear of the consequences of that. We have the highest household debt in the world. And I believe a big part of that is because our governments have been running reasonably low debt levels. So if you change the government debt strategy, then you're going to have to expect repercussions in the household balance sheet, i.e., house prices down.

Three, immigration, foundational to modern Australia, foundational to modern Australia going back 200 years. The good news is that the government is getting immigration back gradually. But I think this country needs to be a lot more transparent in its debate around immigration. And of course, by just going back to normal, we're still going to end up being about seven or 800,000 workers short. The last time we took a big hit to immigration in World War I and World War II, we played catch up after both of them. There's no plans for that and I'm not arguing the case for it, but we just need to be clear about what we're doing on that front.

Four, globalisation is clearly in retreat. It has been for a decade. What does that mean for Australia at the moment? Not a lot. We're still selling our commodities at a high price, but it could change. And onshoring manufacturing, supply chain resilience, there's a whole range of different elements to this. The governments are going in now to support domestic manufacturing, but what does that actually mean, and what do we expect to get out of it? I think we need a clearer strategy on that.

And then five, shared prosperity, balance growth. The big difference between Australia and the US in the last 40 years of deregulation and the opening up of these economies is that we've made sure we brought the bottom end along, that they shared the prosperity. And as we've just discussed with the minimum wage, that's something that's under threat. If the minimum wage only goes up by 3% this year, as many business groups are looking for, then I would suggest a seven or 8% decline in real minimum wages over a three year period is significant and pushes us more towards the American model.

So we just need to face up to those five key threats to the modern Australian economic model and the government needs to be clear on what they want to do. And that needs to be put into the context of what I just said before, around the normalisation of the economy in the next two years. I believe we've got a great opportunity to get back to normal if we can make some difficult decisions around interest rates and potentially the budget, and then lay the foundation for a refitting of our economy, both in terms of the capital stock, as well as the labour skills for a post-pandemic, digitised, de-globalised world, whatever we see the world playing out. And we're in a great position in this country, we always have been. We're our own worst enemy in many respects, but if we can get it clear, we can prosper and really succeed over the 10 to 15 years ahead. But we've got to have those big picture settings right. We've got to go back to your Hawke and Keating era, of understanding what the big levers are and what we're going to do with them.

Gavan Ord:
Well, thanks Warren. That's all we've got time for today. I'd like to thank our special guest, Warren Hogan from Judo Bank, for the fantastic insights you have shared.

Gavan Ord:
If you've enjoyed this episode, we'd love to have you as a regular listener. With Interest is a weekly podcast, bringing you current developments affecting business in the accounting profession. You can download episodes of With Interest on all major podcast apps. If you've got a question about CPA Australia's policy work, or there are topics you'd like to see discussed on the show, please email us at [email protected]. From all of us here at CPA Australia, thanks for listening.

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