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Is an Australian recession on the cards?
December 3, 2007
Dr Ron Woods, Econoclast

The economic slowdown has begun in the USA, according to a Federal Reserve report released last week.

The US economy continued to grow, but at a reduced pace, according to the report, known as the Beige Book, not for its language but for the colour of its cover. The report gives Fed officials information about conditions as they prepare for their next interest-rate setting meeting on December 11th.

Since the Fed is concerned we should also be worried about the economic outlook in Australia. That’s because it’s the Resources Boom that has kept our headline data seemingly robust. Yet without that Boom, not only would sectors outside those that directly benefit from Resources also be struggling, but the headline data that the policy makers rely upon would also be causing alarm.

How did this happen? In the early 2000s, the Fed kept US cash rates too low for too long and that fuelled the bubble in US housing. That caused a surge in demand for goods from China and elsewhere. The Chinese and others sourced some inputs for these exports from Australia, which was the basis of our Resources Boom.

Demand within China was stimulated by the US export boom and the multiplier effects were huge as the pall of pollution over the country testifies. Yet at the stem of most of this activity was the US housing bubble and as that continues to unwind our own economy will also be vulnerable.



The Resources Boom is the stimulus to spending that is driving the RBA into raising interest rates. But as that stimulus wanes that spur to spending will keep fading. Unfortunately if the RBA keeps raising rates or even keeps rates at the current too-high level then the risk of overkill on rates is setting the stage for a classic policy mistake.

That is what the free market yield curve, the green line in the chart (shown as 10-year minus the 3-year yields) is suggesting. In the US their free market yield curve has turned into positive territory on the expectation that the Fed will come to the “rescue” by more rate cuts.

However I doubt this expected “rescue” will turnaround the US economy quickly or adequately enough to reignite the Australian resources boom. This is where we may get into trouble. That is because Australian recessions usually require two preconditions: firstly some bad luck, say a US recession; and secondly, some home-grown policy mistakes, like too high official cash rates.

Now that its official, the US slowdown has arrived, the first precondition is more possibly in place now than at any other time since 2000. That was the last time when we almost joined the US in a full-blown domestic recession. Our yield curve also tells us the second precondition has been in place for some time and this is why I think investors should remain ever cautious about what appears to be a deteriorating Australian economic outlook.

Dr Ron Woods, regarded as one of Australia's leading market economists, has a knack for being far ahead of the curve in assessing the direction of the economy. With a PhD in Economics, Dr Ron Woods is a well-known commentator on economics and interest rates, and has worked for the Commonwealth Bank, Bankers Trust, NM Rothschild and Challenger. Dr Ron Woods produces the newsletter Econoclast, a fresh look at Australian economic events.



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