May 26, 2016

Australia’s Changing Growth Potential – 26 May 2016

The release of Australia’s National Accounts next week is likely to reveal a solid rate of economic growth in Q1 2015.

Key points:

  • The release of Australia’s National Accounts next week is likely to reveal a solid rate of economic growth in Q1 2015. However, strong increases in commodity production/exports will be a major driver of this outcome, while domestic demand most likely remained soft. While further increases in mining production will help support growth over 2016/17, the effect is expected to be temporary, while underlying drivers of growth in the economy are at risk of remaining weak. This note attempts to lay out the challenge that now faces the Australian economy by providing estimates of Australia’s potential growth rate post the GFC. This serves to remind us how important it is for Australia to embrace innovation and find new sources of growth.
  • Potential growth in Australia is now estimated at approximately 2½% (previously thought to be around3¼%), below recent estimates from the Treasury and the RBA (≈ 2¾%), but closer to IMF estimates.
  • Productivity growth has slowed noticeably in Australia since the 1990s. However, the negative impact on potential growth and national income has been postponed by the (temporary) offsetting effects of the mining boom. With those offsets now unwinding, if nothing else fills the gap, Australia may experience its worst decade of national income growth (and potentially a deterioration in living standards) in nearly half a century.
  • Expected trends in population growth and investment suggest a resurgence in productivity growth will be the only answer. Mining productivity gains will only provide temporary support, raising potential growth above2½% in the near term, but declining thereafter as structural productivity declines resume. This may partly reflect the shift towards services-based drivers of growth, which have lower (measured) labour productivity.
  • To return to previous average rates of growth, productivity growth would need to pick up to 1½% from ¾% currently. Unfortunately, productivity has slowed globally (pointing to complex structural factors) and without an unexpected technological advancement or significant progress on the reform front, raising productivity growth will be challenging.
  • Previous reforms have addressed the ‘low hanging fruit’ for productivity gains (competition policies etc), meaning further progress may prove more difficult. However, firms continue to highlight pain points such as industrial relations and taxation where more progress can be made. In addition, product market reforms would also assist allocative efficiency – IMF analysis shows there are still some industries in Australia that could benefit significantly from efficiency gains.
  • We also note that NAB’s research on innovation provides encouraging signs that business – particularly small business is working hard to lift productivity and efficiency. The production function approach used to estimate potential growth in this note does not and cannot consider the impact of this or current innovation policy, which suggests some upside risk to these estimates.
  • The implications of lower potential for monetary policy are mixed. It implies that the output gap is smaller than previously thought, suggesting a need for tighter monetary policy at this point in the cycle should inflation pressures develop more quickly (not a concern at present given the global disinflationary backdrop). However, lower potential growth also has a negative impact on the ‘neutral rate’ of interest – potentially lowering it (all else equal) more than ½ a ppt below historical levels, to around 3½%. If so, the lower neutral rate more than offsets the smaller output gap in a simple monetary policy framework (Taylor’s rule), justifying the current modest easing bias.
  • Lower growth potential can also have an impact on fiscal policy. Previous modelling work undertaken by Federal Treasury suggested that a 25bp fall in potential growth would subtract around $9 billion from the underlying cash balance over four years.

For further details, please see the attached document: