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Economic and Financial Market Update: Powering ahead - but what are the risks

19 April 2022

Summary:

The economic outlook is good for the next 12-18 months;
The combination of a strong economy and higher inflation will require higher interest rates, starting with a 15bp increase in June;
There are risks surrounding the outlook;
The biggest is whether rising interest rates leads to a too drastic slowing of economic growth.

The combination of Russia and Ukraine are important exporters of a number of commodity products. Even in an optimistic scenario it will take some time before full Russian and (particularly) Ukrainian supply is restored. The significant jump that has already taken place in commodity prices unless unwound quickly can be expected to make a notable dent in global economic growth this year.

The big concern before the war was that the Russians would stop all energy exports to Europe. That has not yet happened although the threat has again recently made the headlines. Economic modelling by the OECD indicates that when combined with the hit to growth from the rise in commodity prices the stop in energy imports would substantially slow European economic growth this year. The impact on the wider global economy (including Australia) of a stop in gas exports would be less. But given its size a substantial weakening of the European economy would take a notable chunk out of global economic growth.

After dominating the headlines for the past couple of years, COVID has dropped down the rank of domestic news importance. This is a sign that society is getting more comfortable about living with the virus. It is possible that a steep rise in hospitalisation rates could lead to another tightening of government restrictions. But unless a new substantially more dangerous variant appears lockdowns are likely to be a thing of the past.

Most of the world has moved on from the zero COVID strategy. But some countries have not, most importantly China. From a global standpoint, the ongoing COVID struggles in China has a couple of implications. First, as one of the world’s largest economies it has the potential to notably slow global economic growth. Commodity exporters (such as Australia) would be particularly hit. Ironically there is a silver lining in that lower Chinese demand might help reduce commodity prices and therefore inflation. Second, as a key participant in many global supply chains ongoing COVID-issues in China will continue to crimp supply. The end result of sustained Chinese struggles with COVID is that the global economy will be weaker, although the impact upon inflation might be more ambiguous.

Combined with strong demand, global supply problems have led to a jump in inflation. To date the economic impact of higher inflation has been minimal. Consumers are still spending and firms are still investing and employing. But higher inflation acts as a tax on incomes. A rising proportion of firms (particularly smaller companies) are starting to find it difficult to meet their financial commitments.

Current financial market pricing indicates that inflation is going to remain above the RBA’s 2-3% inflation target for the next year before declining towards the top end of the inflation band. Partly that moderation of inflation would reflect the view that the supply-chain problems will ease over the next year. But a significant factor is the pricing of a substantial increase in the cash rate in Australia (as well as the US, Canada and New Zealand) by financial markets over the next couple of years. The increase in the cash rate expected by financial markets is aggressive. The clear risk is that interest rate increase move too high, too fast.