Batten down the hatches. The Australian economy will take a dive in 2009, but there won’t be a recession. The surge in unemployment will see a blow out in the Federal budget by a massive $30 billion “over the next couple of years”, and force residential house prices to fall by 5% to 10% over the next two years, according to two forecasts issued this morning.

And while interest rates will fall further and inflation will follow, the slide in house prices will see them stagnating for three to five years: up to 2013 or longer, according to one of those forecasts. In fact it was a gloomy morning for economic forecasting as we got more poor news from the frontline of Australian retailing from Harvey Norman..

The National Australia Bank reckons the Australian economy has slowed to 2001 levels (when we almost tipped into recession after the GST boost and the US slump), and sees the Reserve Bank cutting interest rates to 4.5% next year, but has forecast a $10 billion budget deficit for the 2010 financial year.

“While the Government’s Mid-Year Economic and Financial Outlook is due in a couple of weeks, fiscal expansion together with the negative impacts of slower economic growth may well see the Federal Budget turn to small deficit of say around $10bn during the next couple of years.”

It was around $21.7 billion in the year top June, 2008, so the turnaround would be of the order of $30 billion.

The NAB also forecast that unemployment rate to rise to 6% during 2009/10; compared with the current rate 4.3% and “core inflation will return to the RBA’s 2%-3% range’ despite another near term surprise”, and fall further in 2010.

The NAB’s forecasts, contained in its latest survey of monthly business conditions, comes as analysts at Merrill Lynch in Sydney have forecast a 10% fall in house prices over the next two years, followed by three to five years of flat or no growth.

The NAB supported the Merrill Lynch contention that residential property prices will fall, but not by quiet as much as 10%.

Our macro forecasts suggest that as the unemployment rate rises sharply through late 2009, the residential property market may deteriorate further into 2010 – notwithstanding improved affordability associated with significantly lower interest rates. Our forecasts are broadly based on unchanged housing prices in 2009 with a moderate further fall of around 5 per cent into 2010.

And leading retailer, Harvey Norman, revealed for a third week in a row that it is experiencing negative same store sales growth: in the seven days to Sunday October 26, same store sales across Harvey Norman’s Australian stores fell 3.6%, after falls of 5.7% and 4.8% in the preceding three weeks.

Harvey Norman’s experience was supported by an update from a smaller Melbourne-based competitor, Clive Peeters, which has told the market that same store sales were off 10% to 14% in the three months of the September quarter and things are not improving.

But it was the NAB forecasts for the economy and those from Merrill Lynch that provided the big news.

The NAB said it expects Australian economic growth to slow to 1.25% next year as the “full effects of falls in share & key commodity prices falls & slow global growth weigh on prospects, notwithstanding expectations of stimulatory policy responses from both Governments & RBA.”

It said its local forecasts remain “unchanged on the bearish side of “consensus” view. Downside risks remain – at home and abroad – with much dependent on success of global financial rescue underway.”

The NAB said it expects the RBA cash rate cut from 6% to 4.5% by mid 2009 as well as aggressive cuts by central banks elsewhere.

It said the:

Federal Budget likely to go from surplus to deficit of around $10 billion”, which would be a $31 billion turnaround.

Global GDP growth (on a broader definition) forecast lowered to only 2.5% in 2009 – including recessions in US, UK, Japan and Europe, together with slower growth in emerging economies.

Business conditions to weaken significantly to mid 2001 levels – consistent with subdued current activity & annual growth in non-farm GDP slowing to 2% in Q3 2008; Business confidence steadies for now – well above levels of 1990 recession.

In its forecast, Merrill Lynch said there were a number of positives for residential housing and prices:

Excess demand, affordability, buy versus rent

Firstly, we estimate underlying demand exceeds supply by 10-20% which, under normal conditions would lead to price pressure. However affordability constraints and slowing income growth should lead to lower household formations, distorting demand. Secondly, affordability has improved due to rate cuts, increases in the FHOG as well as moderate price declines.

If rates fall by a further 2.0% and prices by 3%, household debt service ratio’s would fall to their 25 year average which should stimulate activity within low end markets. Thirdly, the buy versus rent decision has become more compelling due to affordability improvements and rising rents. Using a total return model and a 10 year holding period, a typical first homeowner should receive a ~12% annual equity return purchasing a home.

But the negatives are stronger, according to Merrills:

After a decade of strong credit, income and asset price growth, imbalances now exist in household balance sheets. Household gearing increased from 12.1% to 18.5% between 1990 and 2007 and house prices currently exceed 6.5x pre-tax incomes. These in combination make the market particularly sensitive to employment and income growth, which will likely worsen in the coming years. Our economists are forecasting unemployment will rise from 4.2% to 5.75% by mid 2009 and income growth will slow from 6% to 4.5% pa. In this environment, households are likely to de-lever and the residential market is likely to worsen.

As a result Merrills said:

We forecast total price declines of 10% (including the ~3% declines to date) over the next two years followed by 3-5 years of relatively flat growth (~CPI) while unemployment stabilises. We forecast volume declines of 10% in 2009.