20 Jul 2022
The economic policy response to the pandemic is rightly being reassessed considering the inflation challenge we now face. But the power of policies to deliver macroeconomic outcomes, particularly when focussed on a general rather than specific goal, is stark.
Yet while the pre-pandemic decade was poor for the Australian economy, the policy response to the pandemic changed the baseline. The future is shaping up very differently.
“In other words, if inflation is sustained at higher levels, we should expect the real side of the economy to have improved: more demand, more employment and more investment.”
The Reserve Bank of Australia is part-way through what is likely to be its most substantial interest rate tightening cycle since the late 1980s. This is understandably raising concern. Inflation is too high and is particularly damaging to those on fixed or low incomes.
However the RBA would like some of the rate rise to be permanent. If monetary policy can deliver inflation of 2.5 per cent over time, rather than the 1.5 to 2 per cent that characterised the pre-pandemic period, it’s not just the rate of inflation that will be different. Much else will be as well.
This cycle is revealing strengths that emerged through the pandemic: unemployment is the lowest in five decades, the volume of consumer spending has risen 9 per cent above pre-pandemic levels and capacity utilisation in the business sector has been restored to pre-GFC highs.
As a result, capital expenditure plans for the year ahead are around the highest in nearly three decades.
In the pre-pandemic decade, Australia was deficient in these areas. Unemployment and the less visible but equally corrosive underemployment were too high. Household income growth was consequently low. So low in fact that real average earnings in 2020 hadn’t budged since 2012.
The resulting weakness in consumer demand meant that ‘need’ – the most crucial ingredient of business investment – was missing. Excess demand, and the resulting lack of productive capacity, is a pre-condition of investment. In this sense there wasn’t much of a pre-pandemic investment puzzle. There was no reason for business to invest.
Research from the Bank for International Settlements, the BIS, suggests the inflationary effect of fiscal deficits depends on how fiscal and monetary policies operate - but also on how they interact.
They have their largest impacts when fiscal policy dominates and when both are focussed in an unbridled manner on short-term objectives rather than issues of medium-term sustainability.
The role of wages in sustaining higher inflation is well known but wage growth doesn’t occur in a vacuum. To employ more people, give more hours to those working part time and raise wage growth, businesses need to see demand strong enough to pay for the labour. Some of the additional labour spend will be passed-on to higher selling prices. The need to invest in more labour is likely to go hand-in-hand with more capital investment.
In other words, if inflation is sustained at higher levels, we should expect the real side of the economy to have improved: more demand, more employment and more investment. This will result in a more balanced economy and stronger economic growth, at least for a period. Nominal GDP might average up to 1 percentage point higher than it did in the pre-pandemic period.
The household sector is also in the best shape for two decades. Aggregate household debt, net of liquid assets, is the lowest in 15 years. The RBA suggests around 70 per cent of the increase in household liquidity buffers was by households with mortgage debt.
Households in the highest 20 per cent of debtors accumulated the largest buffers. In addition, the share of mortgage debt held by the most liquidity constrained households has nearly halved from the early 2000s.
Implicit in the policy choices made by many economic policy makers pre-pandemic was the view excess unemployment is preferable to excess inflation. A rise in inflation might be expected to quickly enter expectations and become entrenched.
This doesn’t hold up. Unemployment also impacts the many and can easily become entrenched. Unemployment, underemployment and the inequality they contribute all affect macroeconomic outcomes.
Inequality is often entrenched for a range of socio-economic reasons. The United Nations suggests inequalities are “not only driven and measured by income, but are determined by other factors – gender, age, origin, ethnicity, disability, sexual orientation, class, and religion”.
Those on higher incomes tend to save more, reducing consumption, but those on lower incomes tend to borrow more. Inequality, in other words, tends to lower economic growth and exacerbate financial vulnerability.
The Federal Reserve Bank of San Francisco found rapid growth in the income share of the top 10 per cent of earners and prolonged low labour-productivity growth are robust predictors of financial crises.
Policy has to work through some challenges over the next 12 to 18 months. That is unavoidable but some structural shifts will stand Australia in good stead. Let’s keep an eye on the horizon – better times beckon.
Richard Yetsenga is Chief Economist at ANZ
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
20 Jul 2022
07 Jul 2022