Tightening up

01 February 2010

In stark contrast to 2009, the focus in Australia for the year ahead will not be centred on whether or not total output continues to grow. Rather, markets will likely focus on the way in which policymakers respond to the resurgence in both the domestic and global economies and the implications that these actions will have on different industry sectors.

While growth in consumer spending will be patchy, the sharp rise in building approvals suggests that both residential and non-residential construction will be stronger, improved trading partner growth will support exports notwithstanding a stronger AUD  and the level of business investment will be far larger than previously expected.

As a result, policymakers will look to gradually apply the brakes so as to keep the growth locomotive on course.

The looming risk however, is that the RBA moves to tighten policy more aggressively than currently expected, so as to limit the risk of overheating in 2011. In this regard, there will be considerable attention paid to labour market outcomes as economic capacity is tested.

It appears increasingly likely that the Australian unemployment rate has already peaked at 5.8%, which is very low by historical standards. This is a remarkable result given the steep rises in unemployment seen globally, but a pick-up in activity from this level of unemployment does pose some problems. The most significant of which is upward pressure on wages and inflation.

In the past four months, a net 136k new jobs have been created, more than half of which has been in full-time work. This highlights the consistency and strength of the recovery in labour market conditions towards the end of 2009.

And further gains in employment  and hours worked  are to be expected given the rapid improvement in leading indicators. A sharp rebound in business confidence has flowed through into far stronger demand for labour. This is evident in the recent improvements in job advertisements and hiring intentions.

We anticipate that unemployment will continue to bounce around current low levels, before falling to around 5.0% by the end of the year. Capacity utilisation is already back above long-run average levels and underlying inflation remains persistently above the Reserve Bank's target band.

Placing pressure on capacity is the impending rise in energy and mining projects, coupled with improving housing and non-residential building activity. Interestingly, this is a similar scenario to that faced during 2004 - 2008 and will likely exert similar pressures on demand for skilled labour.

Tight labour markets and inflationary pressure over that period was the major contributor pushing the Reserve Bank to lift interest rates up to 7.25% by March 2008 (from 5.25% at the start of 2005).

We currently anticipate that the RBA will raise rates to a more neutral level of 4.50% by the middle of this year. But, a rapid return to tighter labour market conditions and stronger wages growth could potentially force policymakers to shift the cash rate into a contractionary setting sooner than is currently expected.