What will it mean for Australia if central bankers are wrong about inflation

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What would it mean for the Australia economy if the Reserve Bank of Australia (RBA) and other central banks are wrong about a gradual increase wage and inflationary pressures arriving over the next few years?

It’s a question many economists and investors have been grappling with recently, well aware that the RBA, among numerous other central banks, has been wrong on both fronts on countless occasions in recent years.

Just look at the RBA’s track record on forecasting for Australian wage growth, for example.

Source: RBA

It’s a similar story for inflation — which is partly linked to weak wage growth — with it continuing to undershoot the bank’s expectations, forcing it to push back the expected timing of when it will return to the 2 to 3% target.

In recent years, it’s been nearly as certain as night following day in terms that the RBA delivering forecast downgrades for both.

To be fair, it’s not the only central bank to do so.

This low wage growth, low inflation era has caught out many a policymaker in recent years, defying the economic textbooks that suggest tightening labour market conditions and strengthening economic growth should lead to higher price and wage pressures.

Currently, the debate is centred upon what a continuation of these themes would mean for interest rates both in Australia and abroad.

Most would agree that a continuation of weak wage and inflationary pressures would delay the timing for policy normalisation to begin, or, at the very least, ensure fewer rate increases than what would have otherwise been the case.

However, as has been seen in the United States, Canada and, more recently, South Korea, not all policymakers have required a strong pickup in inflationary pressures to begin lifting interest rates, seemingly expressing confidence in the economic textbooks that stronger growth and labour market conditions will eventually lead to higher inflation.

However, beyond what it would mean for interest rates, the other question that has played second fiddle recently is what would continued weak wage and inflationary pressures mean for the global economy?

To economists at BIS Oxford Economics, such an outcome would create an undoubted upside risk, not only for the global economy but Australia.

“Delayed policy tightening amid subdued inflationary pressures remains an upside for the global economy,” the group said in a note released today.

And while it suggests such an environment would benefit the US economy more than others, seeing longer-dated borrowing costs and the US dollar both decline, BIS Oxford Economics says Australia, as a small, open economy closely tied to Asia, would also stand to benefit.

“[If] the current trend of weak wages and price pressures in advanced economies persists for longer than expected, which has implications for monetary policy, financial markets and global growth… [it would result in a] more persistent pickup in global growth than in our baseline forecast, with both 2018 and 2019 seeing the fastest pace of expansion since 2011,” the group says.

“Australia and other advanced economies experience a boost from business and consumer confidence, investment picks up strongly and even consumer spending grows a little faster than in our baseline forecast as greater wealth, lower interest rates and rising employment counter the depressing impact of subdued pay growth.”

Given Australia’s close economic ties to Asia, BIS Oxford Economics says such a scenario would help Australia’s trade exposed sectors, too.

“Australia also benefits from positive spill overs from the rest of the world,” the group says.

“Key export markets such as China and Korea see an acceleration in demand for their exports, which translates into a pick-up in imports.”

And given the likelihood that would help to boost household incomes across the Asian region, the group says this should also provide an additional boost to Australian services exports.”

It sounds like a boom-time scenario, allowing Australia to join in the economic recovery seen in other parts of the world in recent years.

This chart from the group shows how a delayed central bank tightening scenario would alter its forecasts for Australian GDP growth over the next two years.

Source: BIS Oxford Economics

That would be an impressive rebound from the levels seen earlier this year, and much in line with those expected by the RBA.

However, before you start popping the champagne corks to toast to your future economic prosperity, the group says the likelihood of this scenario occurring is low, assigning just a 5% probability that weak wage and inflationary pressures will delay or limit policy normalisation around the world.

Instead, it says that Australia economic growth is likely to be slow and steady over the next couple of years.

“A recovery in public sector investment is set to fill the gap left by the downturn in residential construction and the end of the mining construction boom,” it says.

“We expect new public investment to increase over 2017/18 and 2018/19, driven by infrastructure construction funded by asset sales, record stamp duty revenue, increased mining royalties and growth in payroll taxes.

“Dollar exposed industries, such as education and tourism, and other services will be the industries underpinning Australia’s future growth. The contribution from net exports will also provide support, in line with additional LNG capacity and strengthening agriculture exports.

“However this will be offset by slowing consumer spending as a result of weak wage growth. Overall we expect Australia’s GDP growth to average around 2.5% over 2017/18 and 2018/19.”

Those forecasts are considerably lower than those from the RBA who currently expect GDP growth to accelerate to 3.25% per annum in the 2019 calendar year.

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