The Australian economy should maintain a firm tone early in 2018 with support from buoyant global growth and low interest rates.
Conditions are, however, liable to deteriorate gradually during the year and there is a significant risk of a much more serious erosion of support over the second half of the year, especially if domestic and international interest rates are forced significantly higher by Federal Reserve tightening. In this context, there is the potential for a sharp slowdown in growth during the second half of 2018 and our forecasts suggest a potential dip into recession late in the year.
Low interest rates not likely to be sustainable
The Reserve Bank of Australia (RBA) cut interest rates to a record low of 1.50% in August 2016 and rates have been unchanged since then.
The low level of interest rates will continue to provide important support to the domestic economy in the short term with solid momentum, but with expectations that conditions will become gradually less favourable.
An extremely important market factor during 2018 will be whether low interest rates are sustainable. If the RBA can maintain a supportive policy, demand growth will remain firm in the short term. In contrast, there will be a high risk of recession if the Reserve Bank is forced to tighten monetary policy aggressively.
Inflation has remained low with the headline rate only recently returning to the 2-3% target range and inflation will not trigger a short-term increase in rates.
Jobs market in focus
The employment data has remained strong with the latest data recording an increase in employment of over 54,000 for August compared with consensus expectations of below 20,000.
This was the strongest monthly increase since October 2015, although the unemployment rate held at 5.6% as more workers entered the labour force.
Overall earnings growth has been tepid despite the strength in employment. If wages growth remains subdued, there will be reduced pressure for the Reserve Bank to tighten monetary policy.
Housing sector will also be crucial
Developments within the housing sector will continue to have a very important impact during the year ahead. The low level of interest rates has been crucial in boosting the housing sector with low borrowing costs encouraging increased credit demand.
Although there has been some tentative evidence of stabilisation, there is still an important risk of over-heating within the sector, especially with prices already close to record highs.
If there is strong evidence of overheating, there will be an important risk that the Reserve Bank will have to tighten monetary policy aggressively to curb financial stability risks.
Overall, interest rates are liable to edge higher during the first half of 2018 with the potential for more aggressive tightening later in the year.
US Federal Reserve likely to increase rates
Developments in Federal Reserve (Fed) policies will inevitably have an important impact on the Australian outlook.
The Fed has continued its policy of gradually increasing interest rates with an increase in the Fed Funds rate to a 1.00-1.25% range at the June meeting. The Fed remains committed to a policy of gradual policy normalisation following the extended period of extremely low interest rates following the 2008 financial crisis.
There have, however, been increased doubts whether there will be a further rate increase this year. A restrained Fed policy would be relatively benign for the Australian economy. There is, however, a significant risk that the Fed will have to tighten more aggressively, especially if the Trump Administration finally passes substantive tax cuts.
If the Fed tightens more aggressively, there would be an increased risk that the Australian Reserve Ban would have to increase interest rates.
A tighter Fed policy would also have an important impact in triggering less supportive financial conditions which would pose significant risks to the global economy.
China developments will also remain pivotal
Chinese economic developments will continue to have an important impact on the Australian economy, especially given the crucial factor of commodity exports to China.
Immediate concerns surrounding the Chinese outlook have eased with increased confidence that the People’s Bank of China (PBOC) can control the very high level of debt within the economy.
There are also reduced concerns surrounding the banking sector even though the burden of bad debts has increased steadily.
If the Chinese economy continues to expand at a firm pace, there will be strong demand for Australian exports which will provide important protection to the economy as a whole.
There is, however, an important threat of complacency over the Chinese outlook as countries historically, have found it extremely difficult to deflate a credit bubble on the scale seen in China without triggering a domestic recession and major downturn.
If there is a sharp downturn in China, there will inevitably be an important adverse impact on the Australian outlook and this is an important risk to the forecast growth outlook.
Geo-political risks important
The situation surrounding North Korea will continue to be an important focus during the year ahead.
Political tensions will inevitably continue surrounding the Pyongyang regime as the country continues to develop its nuclear programme which puts it on a collision course with both the US and China.
As long as military conflict is avoided, the overall impact should be limited. There will, however, be some risk of a serious miscalculation by either North Korea or the US which would risk some form of military conflict.
In these circumstances, there would be the risk of serious damage to the Asian economy which would inevitably have adverse consequences for the Australian economy.
Australian dollar liable to slip
Tighter global financial conditions are likely to undermine the Australian dollar during 2018, especially with a further increase in US interest rates. Slow depreciation would tend to be benign for the Australian outlook, especially as there would be a modest boost to exports. A sharp slide in the currency would, however, be damaging, especially as there would be upward pressure on inflation which would increase pressure for the RBA to increase interest rates at a faster pace.