Economy moves into uncharted territory as markets surge, fires hit

2020 is a huge year for the Australian economy. Our record run of growth is on the line, unprecedented monetary policy is a possibility, and the nation must rebuild from devastating bushfires.

To think about how it all fits together, it’s helpful to consider the predicament of the Reserve Bank of Australia (RBA).

The RBA is charged with generating growth and inflation, and promoting employment and financial stability. Recently this has proved, frankly, too hard. Growth has been weak, unemployment and underemployment are still too high, inflation is below the bottom of the RBA’s target range, and house prices have oscillated wildly.

In 2020, the RBA must try to pull everything back together, while the real world keeps throwing up new and terrifying risks — first trouble in Hong Kong, then unprecedented bushfires, then the spectre of a horrible war in Iran.

A cut? And then?

The RBA’s decision-making in 2020 starts with the February board meeting two weeks next Tuesday. It has never faced a board meeting like this one, with just two more cuts up its sleeve.

The RBA may well use up one cut in February — according to the RBA Rate Indicator, there’s a 56% chance there’ll be a cut in official rates from 0.75% to 0.5%. That will reduce its remaining ammunition to one. The bank has said that once rates hit 0.25%, there will be no more. Then, RBA Governor Lowe has indicated, it will move to unconventional monetary policy.

That means buying bonds. Once the official cash rate sinks to 0.25%, the RBA has said it will intervene in long-term government bond markets to try to reduce long-term interest rates. There is a real chance of this in 2020.

Intervening in bond markets is a risky and untried manoeuvre that could come with great costs. The greatest of which might be that it doesn’t work. The EU, US and Japan have all been engaging in unconventional monetary policy in recent years and none of them have a growth record that is especially impressive.

The whole conceptual basis of monetary policy — that lower interest rates generate inflation and growth — is up for debate in 2020. This is because, at the moment, lower interest rates seem primarily to jack up asset prices. US stock indexes and Australian house prices alike attest to how effectively they do so. Recent new record level in Australian stocks — indexes have risen over 7000 — is as much about monetary policy as earnings growth performance.

Expect a lot of headlines about the RBA this year. Its work has never been more risky.

The fires

Bushfires will obviously affect the Australian economy in 2020. But how, and how much? The roaring flames have destroyed a vast amount: lives, homes, livestock. But we measure the economy not by the stock of things that exist but the flow of activity: spending and income.

The bushfires will have two effects on economic activity: suppressing it now and boosting it in the recovery phase. The suppressing effect may well be the greater. Holidays have been cancelled, farms and businesses are forced to shut down, and people are trapped at home by appalling smoke in Sydney, Melbourne and Canberra.

But later in the year, as insurance payouts flow, government fiscal responses begin to hit, and rebuilding starts, economic activity will rise. However, this will be focused on a narrower group: those who live in the path of the flames.

Incidentally, it is during disaster recovery that you really come to realise the inadequacies of GDP as a way of measuring the economy. All the money spent rebuilding lost homes counts as economic activity. Working overtime to rebuild what was lost shows up in the economic measures looking like progress.

Risks we no longer face

But while there are significant new problems, it’s worth remembering other risks have faded. US-China relations look to be on the mend, with a phase one trade deal inked and progress to phase two.  Brexit is working its way to a resolution. Even the US-Iranian dispute appears, for now, to be amazingly short-lived. These issues were set to blow up our economy, so putting them behind us can’t hurt.

Indeed, you can make a case that we may already be in the beginnings of a recovery — globally and domestically.

Australia’s economy increasingly depends on the vicissitudes of the global economy, and hopes are high for both the US and China. Meanwhile, Australian retail spending was strong enough in November to be a shock to all market watchers. It rose 0.9% in one month alone, compensating for several bleak months prior. December will tell a different story, but it could also be that a turning point has been reached. After all, unemployment fell sharply in November too.

The RBA could even discover during 2020 that its vigorous rate-cutting in 2019 is finally taking some effect, removing the need for further cuts. Economies are inherently unpredictable, and even in the most terrifying moments we should remember that the presence of risks does not automatically mean the absence of growth.