The Australian economy – where the bloody hell are we?

The Australian economy has kicked off 2018 on a similar note to that evident in recent years. There are markedly diverging rates of activity between sectors and regions, there is neither a widely spread synchronised upswing in activity, nor are there broad-based areas of weakness that risk pushing the economy anywhere near a recession.

The ‘patchwork’ economy remains an apt description for the way the economy is performing and how it is likely to travel in 2018.

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One constant factor of the last few years has been the stubbornly low rate of inflation. This is driven, in large part, by the persistent and now record low wages growth which means that firms can maintain profits without significant increases in selling prices because their wages bill is been held down.

In turn, these trends mean that interest rates will remain very low for some time and there could even be an interest rate cut if inflation remains low and the unemployment rate edges higher.

The new economic event, which is set to dominate commentary and policy thinking in 2018, is the broadening of the decline in house prices. Perth and Darwin have registered large scale falls over the past few years and since September 2017, house prices in Sydney have dropped close to 3.5 per cent. In Melbourne, house prices have at least stopped rising and could be starting to edge lower.

If sustained, flat or falling house prices pose a risk to consumer finances, bank stability and the bottom line performance of the economy. House price weakness would also weigh on consumer sentiment and spending. And unless household spending can growth at 3 per cent or more this year, it will be difficult for bottom line GDP growth to pick up to the levels hoped for and forecast by Treasury and the Reserve Bank of Australia.

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There is, fortunately, some very good news in other parts of the economy, most notably in the performance of business investment and public sector spending.

After more than 5 years of a recession-like crash in business investment, 2017 saw a moderate but clear turning point. The level of business optimism revealed in the NAB and illion surveys suggests further considerable upside in investment right through 2018, especially in the non-mining sectors. This will be the foundation of the economy that will support growth and offset, at least to some extent, the likely softness in consumer spending.

Public sector spending has also been strong and is set to remain a meaningful contributor to economic growth. Transport infrastructure is a main source of these extra funds and with these projects taking several more years to complete, growth from this source seems assured.

A conundrum on the economy is the labour market. Employment growth over the past year has been tremendously strong, the pace that is usually seen when the economy is booming with annual real GDP growth consistently around 4 to 5 per cent.

Unfortunately, much of the jobs growth has merely absorbed the increase in population and has made only small inroads into the unemployment rate which remains comparatively high at 5.5 per cent – little changed from 18 months ago.

While there has been a lot of handwringing about this labour market conundrum, especially as it relates to wages, the remarkably straight-forward explanation is that economic growth has been too slow for too long.

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For 2018, the economy is set to be characterised by moderate growth, relatively high unemployment, low inflation and low wages growth. This is despite the good news on business investment and strength in government spending.

There is some hope that the stronger world economy will see exports make an unexpectedly large contribution to the economy, or perhaps housing will recover to provide support to household wealth and spending.

But for now the economy continues to muddle along, with every snippet of good news more or less offset by snippets of less favourable news. Which direction the balance of good news and bad news eventually falls will determine whether there will be any further improvement in the labour market, wages, inflation and indeed, which direction the next move in RBA interest rates will go.

Stephen Koukoulas is a Yahoo7 Finance expert with more than 25 years experience as an economist in government, as Global Head of economic and market research, as Chief Economist for two major banks, and as economic advisor to the Prime Minister of Australia.