CBA: Commodity bust to drive MOAR RBA cuts

From the excellent Gareth Aird at CBA:

Overview

Output growth in Australia has been soft over the past year.  The latest national accounts put real GDP growth at just 1.8% over the year to Q1 2019.  But over that same period, total national income growth has been decent.  Indeed nominal GDP, the broadest measure of national income, has been pretty healthy over the past few years (chart 1).  And it is set to push higher when the Q2 2019 national accounts are released in early September.

A lift in commodity prices, which has driven the terms‑of‑trade higher, is behind the decent growth in nominal GDP.  For most households, however, it doesn’t feel like national income growth has been so healthy.  Market driven wages growth remains soft.  And real household disposable income per capita has fallen through the year.  It’s quite an unusual situation for nominal GDP growth to have been so robust at the same time as wages growth remaining dormant (chart 2).

In this note we take an in‑depth look at nominal GDP in the context of wages.  We begin with a discussion on the importance of nominal GDP and why national income growth can decouple from output.  We then look at why the lift in national income hasn’t flowed through to the household sector.  And we outline the reasons why nominal GDP growth is set to ease from here.  This feeds into our view that Australia is set to remain in a constrained wages and inflation environment for the next few years which means we expect the RBA to take the cash rate down to 0.5%.  It also underpins our belief that we need more income tax relief for households.

National income matters

Most commentary around GDP focuses on real GDP – the change in the total quantity of output in the economy.  This makes sense because it paints the actual picture of economic activity.  But nominal GDP is also very important.  As distinct from real GDP, nominal GDP is the income generated by production.  In other words, it takes account of the price changes of the goods and services produced as well as the quantity.  In Australia, commodity prices play a big role in nominal GDP moves.  As a result, nominal GDP growth is more volatile than real GDP.

Nominal GDP is important for earnings and revenue.  Wages, profits and taxes are all measured in nominal terms.  And importantly, debt is denominated in nominal dollars.  As a result, nominal income growth is necessary to reduce the debt burden faced by households, businesses and government.

Weak nominal GDP growth can have bad consequences for an economy.  Wages, for example, are sticky downwards with a zero lower bound (workers are generally not asked to take pay cuts).  As a result, if nominal GDP growth is persistently weak firms may seek to cut costs through a reduction in headcount or hours worked.  Weak nominal GDP growth also discourages investment because it makes it harder for firms to repay debt.  Central banks take note of nominal GDP growth.  Indeed, some high profile economists have called on central banks to consider targeting nominal GDP rather than inflation.  But we digress.

For the Government, nominal GDP is effectively the tax base.  Tax revenues are strongly correlated with nominal GDP growth (chart 3).  And the national debt burden is often expressed as a ratio to nominal GDP because it reflects the capacity of the Government to meet its debt obligation.

As a general rule, the household income experience should be more linked with nominal GDP than real GDP.  But over recent times, there has been a distinct breakdown in the relationship between nominal GDP and household income growth.  We discuss below.

What has happened?

Nominal GDP growth in Australia is heavily influenced by commodity prices and therefore the terms‑of‑trade (chart 4).  Commodities make up around 65% of Australia’s exports with bulk commodities worth a little over 50% at present.  The prices of commodities can be highly volatile.  As a result, Australia can experience big swings in the spread between real and nominal GDP when there are sizeable movements in commodity prices, particularly the prices of iron ore, coal and more recently LNG.

Commodity prices and the terms‑of‑trade have moved fortuitously for Australia over the past few years.  In particular, a big lift in the price of iron ore has pushed up national income significantly.  Australia has been posting record size trade surpluses (chart 5).  And we expect to see a first current account surplus since 1975 in Q2 2019.    But for all intents and purposes, the income experience of most households has not been commensurate with the solid growth in nominal GDP.

Why?  First, the lift in nominal GDP has not been distributed evenly between the household and corporate sectors of the economy.  Wages growth, particularly in the private sector, remains weak.  And the wages share of nominal GDP sits near a multi‑decade low (chart 6).  In stark contrast, the big rise in national income has been captured through a lift in company profits which have pushed higher as a share of national income.  Of course some of the increase in nominal GDP growth from higher commodity prices has flowed through to the household sector via the share market.  In particular, households that own shares in resources companies (including via superannuation) have benefited.  But a lot of households don’t own stocks directly.  In any event, household income growth, which includes dividend payments, has been weak.

Second, the Commonwealth fiscal position has improved, in part through a higher tax take and higher‑than‑expected mining royalties (chart 7).  The Government is pursuing a balanced budget.  This means that it is holding on to some of the revenue windfall courtesy of our external sector rather than circulating it back through the economy through tax cuts.  Shrinking the deficit in this manner effectively sucks money out of the economy.  On the other hand, putting the money back into the pockets of households via tax cuts would share the gains of decent national income growth.

Why haven’t wages responded to stronger nominal GDP growth?

Wages growth remains weak despite the lift in nominal GDP growth.  There are a few reasons for this, but in our view the single biggest factor that has weighed on wages growth is elevated labour market slack.  There is very little incentive for firms to pay higher wages when labour market supply exceeds demand, even if profit growth is decent.

The latest data pertaining to the labour market doesn’t bode well for a lift in wages growth.  Despite strong employment growth, the trend unemployment rate has drifted higher from 5.0% in February to 5.3% in July because there has been a surge in labour force participation.  Underemployment also remains stubbornly high.  As a result, there has been no decline in overall labour market slack over the past year (chart 8).  This makes it harder to generate the desired lift in wages growth despite decent nominal GDP growth because of the relationship between underutilisation and wages (chart 9).

The other reason for the disparity between nominal GDP growth and wages is that the recent increase in commodity prices, which has driven the lift in nominal GDP, has not and will not generate a lift in investment like in previous cycles.  There is set to be a modest rise in resources investment which will benefit the WA economy.  But in the main, the lift in export revenue because of firmer commodity prices won’t materially contribute to labour market tightening like in prior commodity price booms.

The outlook

Commodity prices and therefore the terms‑of‑trade rose solidly in Q2 2019.  Our model puts the terms‑of‑trade up by 1.9% over the June quarter.  This will boost nominal income growth and the impact will be evident when the national accounts print on 4 September.  On our forecasts, nominal GDP will rise by 2.0% in Q2 which will see annual growth lift to 6.0%.

But this is likely to be the peak in nominal GDP growth for the next few years.  Our views on real GDP, inflation within the broader economy, the terms‑of‑trade and the exchange rate influence our nominal GDP forecast.  We expect the terms‑of‑trade to trend lower from here, but to remain above its trough in early 2016.  As a result, our forecast profile has annual nominal GDP growth easing to a low of 3.8% in Q3 2020 despite our forecast profile for a lift in real GDP growth.

In summary, the lift in nominal GDP growth looks fleeting and with little spill‑over to the household sector.  Australia looks set to remain in a constrained wages and inflation environment for the next few years.  This means that we expect the RBA to continue to take the policy rate lower.   We have them cutting the cash rate by 25bp to 0.75% in November and expect a further rate cut in Q1 2020 taking the policy rate to just 0.5%.

The tax rebates announced in the April 2019 Budget will help provide a modest income boost to the household sector.  But more should be done including reform to shift the tax mix more broadly.  Relative to the OECD average, Australian tax collections are significantly “overweight” personal income tax and “underweight” consumption taxes (chart 10).   This means that workers in Australia are shouldering a disproportionate tax burden relative to most other comparable nations.  And that burden is being magnified each year through bracket creep.

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