In its first report of 2009, National Australia Bank has downgraded Australia’s economic outlook, forecasting a shallow recession, a sharper rise in unemployment, official interest rates cut to 2.5% in the September quarter and a budget deficit hitting $40 billion next year.

The recession is expected to see the economy contract by a quarter of one percent on average, and there won’t be any growth rebound in 2010 when the economy is expected to shuffle back into positive territory.

The bank, whose business confidence and conditions survey picked up a small upturn in both areas last month — thanks, it seems, to the Government’s spending package — said that “despite avoiding the worst of global carnage in late 2008, Australian GDP forecasts have been cut significantly in light of global developments, notwithstanding aggressive policy responses.”

The December reading on confidence conditions was a lot better than the nasty November outcome when the index fell to levels lower than those associated with the 2000 domestic slowdown. Conditions in November were the weakest since the 1992 recession, but the NAB commented today that “the level of -20 is little better than the bottom of the 1990 recession.”

“For 2009, we expect GDP to shrink by 0.25%- with a number of negative quarters during the year. As such the forecasts imply (moderate) recession in 2009. With no recovery till late 2009, the 2010 GDP forecasts have been lowered to 1% (0.25% for 2009/10).”

The NAB had previously forecast 2009 growth at 0.50% and 2010 growth at 1.75%.

“For non farm GDP that equates to a small fall of -0.25% in 2009 and a rise of around 1% in 2010. In financial year terms we expect GDP growth of 0.8% in 2008/09 but only 0.25% in 2009/10.”

The bank said that when an economy shrinks over a 12-month period “that clearly represents a recession.”

That said, “the forecasts imply a relatively mild Australian recession — especially compared to falls in growth of around 2% in the major industrialised economies.”

The Japanese economy is expected to contract by 2% this calendar year, Singapore by up to 5%, the UK by nearly 3% and Germany over 2%. The US will contract by 3% or more according to most surveys but we will get a better idea on Friday when the first estimate of 4th quarter GDP is released.

The NAB emphasised that it sees “no fast recovery in Australian activity”:

That is, the path of growth is more U than V shaped — with recovery not really getting underway till 2010. This shows up most in the financial year forecasts and especially that for 2009/2010 (growth of 0.25%).

The NAB said its forecasts include cash rates falling to 3% from 4.25% at the moment (The RBA board meets next Tuesday):

But the deterioration in the labour market will see further rate cuts (2 x 0.25% in the third quarter).

We also expect further aggressive fiscal policy stimulus in 2009.

That implies worse fiscal outcomes (a deficit of around $40 billion in 2009/10) and a sharply deteriorating labour market (unemployment reaching 7%).

With inflation likely to be negative in Q4 2008 (figures out tomorrow) and wage pressures stalling, we see core inflation back in the RBA target range by the second half of 2009.

The Producer Price Index for the December quarter and 2008 was also released this morning: a rise of 1.3% in the final stage of production, down from 2% in the September quarter, but still well above most forecasts, with the market consensus for a rise of 0.3%.

The Australian Bureau of Statistics commented that the sharp fall in the value of the Australian dollar had a big impact with “imported commodities […] impacted by exchange rate driven price increases” which offset a 29% fall in the cost of oil and oil products.

With those dramatic downgrades, the slight upturn in December registered in the NAB’s survey looks interesting, but irrelevant.