RBA SoMP gives Australian dollar another lift

Back to its old tricks with some SoMP scenarios:

Scenario 1: baseline – ‘gradual recovery’

This scenario assumes that most of the current domestic containment measures remain in place for most of the June quarter. Most of the restrictions are assumed to have been lifted by the end of the September quarter, aside from the limits on very large public events and gatherings, which are assumed to remain in place for longer. International border closures are assumed to be in place until the end of the year, consistent with recent statements from the Australian Government.

In this scenario, GDP growth is expected to start recovering in the second half of 2020, led by consumption, although the very large contraction in the March and June quarters would still result in a year-ended decline over 2020 (Table 6.1; Graph 6.3). Growth would then be stronger over 2021 as business and dwelling investment gradually recovered, although the level of GDP by mid 2022 would still be below the level expected at the time of the February Statement. Under these conditions, the unemployment rate is expected to decline substantially from its June 2020 peak of around 10 per cent but to remain above its pre-COVID-19 level in two years’ time (Graph 6.4). In underlying terms, inflation is expected to remain below 2 per cent over the next couple of years.

Scenario 2: faster recovery

A stronger economic recovery would be possible if further gains in controlling the virus were achieved in the near term and most containment measures were phased out over coming months. This, alongside the considerable policy support already in place, would help limit near-term damage to business and household balance sheets, and help drive a more rapid recovery in the economy. An important precondition for this scenario is that households and businesses expect a sustained economic recovery to build over coming months, underpinned by a high degree of confidence in the ongoing management of health outcomes.

In this scenario, much of the near-term decline in GDP could be reversed over 2020–21 as consumption and employment growth rebound. By the end of the forecast period, the level of GDP could still be a little below the level expected at the time of the February Statement. Some of this difference can be explained by lower business investment because it tends to lag other components of private demand during recoveries, in part due to lags in planning and construction. In addition, given the assumed ongoing low level of the oil price, work on the currently postponed large LNG projects is not expected to commence within the forecast period.

In this scenario, the labour market begins its recovery as soon as the containment measures are phased out. Because of the better health outcomes and policy stimulus in place, the rebound in consumer demand and reduced uncertainty about the outlook would allow businesses to rehire workers and resume investment plans quickly. The hours of existing workers would also increase in response to rising demand, and the unemployment rate would be expected to move from a peak of around 10 per cent to be around its pre-COVID-19 level by mid 2022. The stronger recovery would enable some catch-up in wages growth. Similarly, the stronger recovery would be consistent with a faster pick-up in inflation over the next few years, albeit from a low starting point.

Scenario 3: slower recovery

Alternatively, if the lifting of restrictions is delayed, the restrictions need to be reimposed or household and business confidence remains low, the outcomes would be even more challenging than those in the baseline scenario. For this scenario, we assume that many restrictions remain in place until closer to the end of 2020 and international travel restrictions are in place well into next year. In this scenario it is likely that household and business confidence would remain subdued for longer and income and spending would take longer to recover, notwithstanding the policy stimulus in place. Under this downside scenario, domestic activity would be expected to remain close to its June quarter trough for the rest of the year. A greater share of households would be likely to continue to engage in distancing activities beyond what is required because they remained concerned about the virus. Damage to consumer and business balance sheets and weak expectations for the outlook would mean consumption and investment would pick up slowly even after the restrictions are lifted. Employment growth would be much slower, and the unemployment rate would remain close to its peak well in to 2021.

There may also be some negative effects on the longer-term outlook for commercial property. A number of contacts in the Bank’s liaison program have indicated that valuations of commercial property assets are expected to decline over the period ahead because of lost rental income and lower expectations of future rental growth. In turn, lower valuations may affect the viability of future projects, in combination with many firms expecting to reduce their long-term floor space requirements. This is likely to be most pronounced in the office and retail sectors, given the large-scale shift to working from home and the acceleration in the shift towards online retailing.

A slower economic recovery would have ongoing adverse consequences for the labour market. The longer the economy remains weak, the more employment relationships are severed and the more households and firms will suffer severe financial stress. This would slow the recovery further and increase the chance that workers need to take jobs that are poor matches for their skills. Slow recovery and poor skill-matching are particularly likely if the economy’s industrial structure changes significantly to adapt to the post-outbreak realities. The longer someone is unemployed, the more difficult it is for them to find employment because of a loss (or a perceived loss) in skills or because they become discouraged and exit the labour force. Past experience also suggests that workers who first enter the labour market during a downturn are especially affected and can suffer long-term income and employment consequences. And with lower investment as well as poor skill-matching, the economy’s productive potential could also be damaged over a longer period. A slower recovery in economic activity would be consistent with inflation remaining low for longer. A more protracted period of low inflation outcomes could also lead businesses and consumers to adjust down their inflation expectations, which would make the subsequent pick-up in inflation more gradual.

Recent data suggest 2020 will start from a worse baseline than that for growth and unemployment.

David Llewellyn-Smith
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