Economic momentum in Australia has been slowing for 18 months. In the June quarter 2008 GDP increased at a trend annualised rate of just under 2%, about one third of the pace in the March quarter 2007. This slowing has not been an accidental response to slowing global growth or the shakeout in the global financial system. Rather, it has been a cooling deliberately engineered by the Reserve Bank of Australia, through progressive increases in interest rates, in order to dampen uncomfortably high price pressures.

The slowdown has not been even across all sectors of the economy. The primary burden of higher interest rates has been borne by the household sector. In conjunction with higher fuel prices and a moderation in household asset values, this has led to a significant slowing in household consumption. Industries which are closely linked into household spending, such as retail and wholesale, have felt the pain.

A spillover effect of subdued household spending power and high interest rates has been continued softness in dwelling construction. Residential construction approvals have fallen steadily through 2008.

In contrast, non-dwelling business investment has remained very strong, largely but not only in mining, and business profitability has remained high, despite the recent quarter century high in the A$.

The relative performance of the states can be viewed in the light of the differential performance of the household and business sectors. Those states with a greater reliance on domestically generated demand and the activity of the household sector have performed less well while states and territories with a greater reliance on business spending and investment have continued to do relatively better.

The state which has been most negatively impacted by these developments has been New South Wales. New South Wales was the only state to experience negative growth in state final demand in the June quarter. No other state came remotely close; the next slowest growth in the quarter was a perfectly respectable positive 1% by South Australia. New South Wales has suffered the perfect storm. Its households are the most highly indebted, and so most sensitive to higher interest rates. Population growth is the second slowest in the country. Sydney is (arguably) the financial capital of Australia, and is bearing the brunt of financial market uncertainty. The residential construction industry is in recession, partly due to lack of demand, but also due to the highest government developer fees and charges. And the business investment boom has largely bypassed the state. As a result, New South Wales is one of only two states in which employment is now falling (the other is the Australian Capital Territory).

Looking forward, the squeeze on the household sector will loosen now that the financial pressures are beginning to ease. The September cut in the official cash rate is likely to be followed by another 25bp reduction by years end. Petrol prices have fallen in response to the sharp fall in global oil prices. These developments have already had a positive impact on household finances, with retail sales rising by a strong 1.4% in July and with consumer confidence lifting in August and September. And for the business sector the nearly USc20 fall in the A$ will boost exporters incomes, and also improve international competitiveness, important for hard hit export service industries such as tourism.

For rural Australia water remains the key issue. Recent widespread rains have led to cautious optimism for the winter crop, with estimates pointing to closer-to-average production of around 24 million tonnes. However, irrigators in the Murray Darling Basin are facing the grimmest conditions in living memory, with the irrigation season opening with 0% allocations in many instances.

While some of the financial headwinds for businesses are now easing, the dominant influence on economic activity over the next year or so will be the Reserve Bank’s desire to hold Australian GDP growth a little below trend – say at no more than 3% - to allow room for inflationary pressures to subside. But that in itself is good news, as it will continue the long run of prosperity that Australia has enjoyed over the past 17 years.

Tony Pearson
Deputy Chief Economist, ANZ
12 September 2008