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There's a big problem with the RBA's economic growth target

Dean Alberga/ World Archery Federation via Getty Images

The Reserve Bank of Australia (RBA) thinks that Australian economic growth is going to accelerate sharply over the next couple of years, forecasting that it will lift to an above-trend pace of more than 3%, well above the 1.8% level seen in the year to June this year.

Some think that’s realistic, others think it’s overly optimistic.

To Adam Boyton, chief Australia economist at Deutsche Bank, growth is likely to fall somewhere somewhere in the middle of where the RBA and pessimists currently predict, acknowledging in a note released this week that while a move back to 3% is plausible, getting it significantly higher is, in his opinion, looking like a stretch.

Here’s why he thinks that getting growth back to 3% is plausible in the period ahead:

We can get to around 3% GDP growth. Namely, households at 1.25 percentage points (ppt) contribution to growth, investment at 0.75ppt, and public [spending] at 1ppt giving domestic demand growth of 3%. A little less than a percentage point of that is lost due to imports, while we assume around a 1ppt contribution from exports. That gives GDP growth of a shade over 3%, or 3.15% to be exact.

However, while growth with a 3-handle is not out of the question, Boyton says getting it any higher than that will be difficult:

We’d need the investment outlook to be really very positive, or public spending to sustain a contribution to growth that it hasn’t done in the past. The former seems somewhat unlikely — the non-mining investment expectations in the capex survey, while encouraging, aren’t that strong and we can’t see another mining boom on the horizon. On the public spending side sustaining a 1ppt contribution to growth is probably as much as can be expected given the general desire by the Federal and State Governments to preserve their credit ratings. Some form of export boom could, of course, give us faster GDP growth. Again, that is hard to see given the sand that appears to be in the gears of global trade or given the strength of the AUD.

With trade volumes a wildcard, and public spending and business investment unlikely to accelerate sharply, Boyton says a GDP growth figure well in excess of 3% would require Australia’s household sector to do much of the heavy lifting.

He’s not overly optimistic that can eventuate, pointing out that in order for households to come to the GDP growth party, they’ll need a boost from higher wage growth.

“It appears to us that the only way we can sustain GDP growth in Australia solidly above 3% is to get more of a contribution from the household sector,” he says.

“Given the contributions to growth that households have made in the past, getting more than a 1.25ppt contribution would seem quite possible. However, that would seem unlikely in the absence of a pick-up in household incomes growth, or in other words, wages.”

This chart from Deutsche Bank explains why Boyton is unconvinced, showing the relationship to annual household income growth to the contribution of household consumption expenditure to annual GDP.

Source: Deutsche Bank

Household incomes growth remains weak, with consumption only holding up at present because households are diverting more money away from savings to spending.

This is a stop-gap measure that is propping up consumption for the moment, but it cannot last indefinitely. In the absence of a pickup in wage pressures, households will have the choice of borrowing more or cutting spending should the current trend be maintained.

As Boyton points out, if households are not in a position to lift spending levels, this will create a problem for policymakers who are banking on strong economic growth to tighten labour market conditions, providing the conditions to boost wage pressures.

“[This] presents an interesting dilemma. Indeed a chicken and egg conundrum,” he says.

“Namely, if we take the apparent view of Australian policy makers that the way to faster wages growth is robust GDP growth, which in turn tightens the labour market, then it’s not clear to us that we can get GDP growth much above 3% in the first instance. That in turn makes any labour market tightening pretty modest, especially given population growth is running at 1.6%.

“In other words, waiting for the ‘traditional’ framework of faster GDP growth to tighten labour markets to lift wages growth means we could be waiting for quite some time. After all, this work suggests that we might need to get faster wages growth before we can really lift GDP growth.”

Essentially, in order to lift GDP, households will need a lift in incomes growth. But with incomes growth weak, it means that growth is unlikely to shoot the lights out, making it more difficult to tighten the labour market.

It is a conundrum, as Boyton suggests.

However, the one thing that remains crystal clear is that upcoming wage and labour market data will be crucial in determining where Australian economic growth, and interest rates, head next.

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