Has the Australian Economy Turned the Corner?

The balance of risks to Australia’s economy has barely shifted from last month, so that the consensus to keep the cash rate at its current level of 2.5% remains strong, according to Reserve Bank Shadow Board members.

The new coalition government has yet to announce any big policy surprises, the US government budget crisis has been deferred for a further four months (as widely expected), European economic growth remains subdued, and Asian economies are only slowing slightly.

Domestically, the signals are mixed. The Australian dollar remains relatively high while the real estate markets in the major cities appear to be responding to the low interest rates.

Inflation is well within the target range, the unemployment rate fairly stable around 5.6%, consumer and business confidence continue to improve, if only marginally. While a debt crisis in the US has been averted at the eleventh hour, the political problems leading to the stand-off remain.

Uncertainty about the US budget position is thus likely to resurface early next year. Germany’s economy is picking up slightly and there are green shoots in Spain and the UK. However, there is continued concern about the health of Europe’s banks. A stress test of 130 key European credit institutions, recently announced by the ECB, may reveal some unpleasant truths.

Asia is slowing slightly but not dramatically, as pointed out in the World Bank’s recent East Asia Pacific Economic Update, with China expected to hit the official growth target of 7.5% in 2013 and the rest of the region slowing to 5.2% before accelerating in 2014 and beyond.

The World Bank identifies an abrupt slowdown of investment in China as one of the immediate risks to the region’s economic prospects. The Shadow Board’s confidence in keeping the cash rate steady has strengthened a little, equalling 66% (up from 62% in October). The probability attached to a required rate cut now equals 5% while the probability of a required rate hike equals 29%.

At longer horizons the following picture emerges: the probability that the cash rate should remain at 2.5% is 34%. The need for an interest rate increase is estimated at 46% (47% in October), for an interest rate cut at 20% (23% in October). A year out, the Shadow Board members attach a 56% probability to the need for an increase in the cash rate (down from 58% in October) and a 23% probability to the need for a decrease in the cash rate (down from 25% in October).