Underlying momentum in the economy remains strong: Australia Economic Outlook: Q1 2022

Despite a difficult start to 2022, with flooding and ongoing Omicron impacts, underlying momentum in the economy remains strong.

KPMG forecasts 3.8 percent growth in 2022 despite ongoing risks from inflation, the emergence of new COVID-19 variants and the uncertain geo-political outlook. But we do see that sliding to 2.2 percent next year after the easy wins from the re-opening of the economy from the shutdowns are exhausted.

Of these issues, inflation is likely to be the most impactful. Despite Australia’s relatively small exposure to Ukraine and Russia, hikes in commodity prices are expected to drive headline and underlying inflation higher. But compared to other countries Australia is well-placed, with the mining and agriculture sectors (and government revenues) already benefitting from higher revenues – this will help offset the drag on other parts of the economy.

With inflation rising, the RBA is now signalling that a first cash rate rise may happen this year, Governor Lowe calling it “plausible”. Financial markets continue to expect lift in early Q2 2022, but inflationary pressures are less pronounced here than overseas and so we expect the cash rate to remain on hold until August.

Although wages growth picked up to 0.7 percent on the quarter in late 2021, a headline inflation rate of 3.5 percent means that for now, the average worker is experiencing declines in real terms. So while household spending data is robust in the near term (helped by the $250bn of excess savings accumulated through the last two years), we expect growth momentum to cool through the end of 2022 and into 2023 as households are squeezed by higher living costs.

The labour market remains strong – although Omicron-related sick leave saw an 8.8 percent fall in hours worked in January, employment rebounded in February with an historically low unemployment rate of 4 percent. We see this being maintained, with the rate likely to dip below 4 percent next year.

Headwinds to growth will also emerge in government spending. The end of emergency pandemic supports and smaller incremental increases in investment expenditure will see government spending broadly hold steady over the next two years, after six years of healthy year-on-year gains.

The rolling off of the government’s HomeBuilder subsidy will also put a drag on activity in 2023, this time in residential construction, and, after a bumper year, the first estimate for business investment in FY2023 suggests a modest decline. While a potentially conservative assumption, we expect incremental capex spending will be limited.

In more positive news, the re-opening of borders looks set to provide welcome relief for the most acute skills shortages. Furthermore, inflows are likely to recover steadily over 2022 in a boost to tourism operators. Service exports were just 55.4 percent of their pre-COVID levels in Q4 2021, but we expect this to rebound strongly through 2022.

However, this will be mitigated somewhat by Australian households’ pent-up demand for overseas travel, with latest data suggesting outbound travel is outpacing inbound and leading to a deterioration of the services balance – mathematically this will put a drag on GDP.

In the long run, borders re-opening will provide a boost to economic capacity. We expect this to manifest primarily through workforce expansion and the technology and skills transfers made possible by reconnecting with the world.

Long-term, economic activity is constrained by supply side capacity – the three key factors here are: labour supply, physical capital stock and productivity. While these generally improve over time, growth is not guaranteed. The pace of GDP growth has slowed over the past twenty years, moderated by an ageing population (and low growth) and a slowdown in productivity gains. That said, Australia has continued to outperform most other developed economies.

It must not be forgotten that the covid pandemic, and the effective two-year pause in normal migration flows, have permanently reduced the size of the Australian workforce and left the overall population smaller and older than it would otherwise have been. The Treasury estimates a 1.5m gap in what would have been the total population by 2030/1.

But despite the turmoil of the past two years, and a raft of ongoing challenges, Australia’s economy remains in relatively good shape.

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