Mission Concluding Statement 

Australia: Staff Concluding Statement of the 2022 Article IV Mission

November 15, 2022

Sydney:

· While the economic recovery in Australia since the depth of the pandemic has been among the strongest in the advanced economies, growth is expected to slow to about 1.7 percent in 2023 amid a difficult global economic outlook. There are significant downside risks to this assessment, including a more pronounced global growth slowdown, more persistent inflationary pressures, and an acceleration of the ongoing housing price decline.

· Continued monetary and fiscal policy tightening is needed to rebalance domestic demand and keep inflation expectations well anchored. The RBA should continue to raise interest rates, and fiscal policy should support it in moderating domestic demand growth through judicious budget execution and saving of any revenue overperformance. Fiscal support to address cost-of-living pressures should be temporary and well-targeted to help those in need, so that broader demand stimulus is avoided.

· Risks to financial stability have increased but appear contained despite falling housing prices and elevated household debt, given significant household and bank capital buffers.

· The government should seize opportunities in structural and climate policies. Australia’s strengthened climate mitigation targets are highly welcome. Achieving abatement goals will require strong policy actions, including greater use of market mechanisms and strong sectoral policies. Housing market policies should help address affordability concerns. Structural reforms can help reverse the labor productivity slowdown and achieve greater inclusion.

Australia’s economic recovery has been strong. Australia has recovered faster than most other advanced economies and has returned to its pre-pandemic output trend. Growth in the first half of 2022 was 3.4 percent y/y, despite headwinds from the Omicron variant, floods in eastern Australia, and external factors such as China’s ongoing slowdown and global growth uncertainty resulting from Russia’s war in Ukraine. Labor markets also reflect the strength of the recovery, with employment and labor force participation near record highs while increasing capacity constraints are reflected in the unemployment rate, which is near a 50-year low. Despite recent depreciation against the U.S. dollar, the Australian dollar and the country’s external position appear broadly in line with medium-term fundamentals and desirable policies.

Rising inflation has led to monetary policy tightening. Inflation rose to 7.3 percent y/y in Q3 2022—well above the target range—as a result of high commodity prices, supply chain pressures, and strong domestic demand. That said, the pick-up in wage growth has remained modest despite acute labor market tightness and stayed below that of most other advanced economies. In response to high inflation, the RBA has hiked the policy rate by cumulatively 275 bps since May to 2.85 percent, reaching roughly neutral territory.

Between the slowing global growth and some still-resilient domestic buffers, Australia is on a narrow path for a soft landing. Growth is projected to slow from an expected 3.7 percent in 2022 to about 1.7 percent in 2023-24 given higher interest rates, persistent inflation, weakening export demand, and declining housing prices. However, there is high uncertainty regarding the transmission of tighter monetary policy to domestic demand amid still elevated household savings. Under baseline expectations, underlying (trimmed mean) inflation is likely to remain elevated on the back of high energy and transport costs and rising nominal wages, before declining to around 3 percent toward the end of 2024. Acute pressures on the labor market are likely to continue in the near term, with some upward pressure on wages.

Risks to the outlook are pointing firmly to the downside amid significant uncertainty. In staff’s baseline scenario, Australia is expected to steer clear of a recession, but with significant downside risks. On the external front, a more pronounced growth slowdown in main trading partners, including China, would affect Australia’s exports. Domestically, more persistent and higher inflation and wage pressures would require steeper and more prolonged monetary tightening, affecting growth. The decline in housing prices has the potential to accelerate, which can reduce household consumption, with some impact on banks’ balance sheets.

The ongoing policy tightening is appropriate and should continue. High inflation, the positive output gap, and the very tight labor market necessitate monetary and fiscal policy tightening. Policy needs to be nimble given uncertainties surrounding the global environment and monetary policy transmission.

Monetary policy tightening should continue. Monetary policy needs to be focused first and foremost on keeping inflation expectations well anchored, which clearly points to more tightening in the short term. However, there remains uncertainty with respect to the intensity of monetary policy transmission. High household debt and the large share of mortgages that is either on a floating rate or resetting within short periods point to relatively strong transmission. In contrast, accumulated savings during the pandemic and the still elevated household savings rate point to significant buffers that could dampen and delay the transmission, depending on households’ behavioral responses. Careful communication of the assessment of the balance of risks and of policy intentions will thus continue to be key in guiding market expectations.

Near-term fiscal restraint should support monetary policy in addressing demand pressures. The October budget introduced measures to provide cost-of-living relief, alleviate labor and skills shortages, promote productivity growth, and facilitate the climate transition. The budget’s streamlining of spending in other areas should help avoid adding to aggregate demand pressures. In addition, saving of expected revenue overperformance and judicious implementation of the budget’s spending programs, including infrastructure investment, would help in containing demand and inflation. In this context, activity through newly created investment vehicles (National Reconstruction Fund, Rewiring the Nation, and Housing Australia Future Fund) should also be phased judiciously, and, more broadly, a proliferation of such vehicles should be avoided. Any additional cost-of-living support to soften the impact of high inflation should be temporary and well targeted to the vulnerable.

Medium-term fiscal plans should remain on a continued consolidation path in the face of significant spending pressures. Public debt remains sustainable, with substantial fiscal space. Nonetheless, growth in spending on the National Disability Insurance Scheme (NDIS), healthcare, and aged care is a risk to fiscal consolidation and reduces capacity for other priority spending. Reviewing these programs, as already underway in some cases, and designing reform options to strengthen their efficiency and contain cost growth would help provide space for other priority spending and faster fiscal consolidation to rebuild buffers for future shocks.

Tax reform could strengthen economic efficiency and public revenue. This should include a transition from currently high direct taxes to underutilized indirect taxes, with the regressive impacts mitigated by targeted cash transfers to vulnerable households. The stage 3 personal income tax cuts will reduce the personal income tax burden, and bracket creep should be addressed by raising the tax brackets periodically, including to limit distributional implications for low-income households and women. Longstanding recommendations include broadening the goods and services tax (GST) base to limit exemptions for healthcare spending, and restricting the capital gains tax exemption for the sale of main residences. The planned publication of additional information on the distributional features of the tax system will be helpful in identifying areas where the tax system can be further strengthened. At the state and territory level, implementing recurring property taxes in lieu of stamp duties would promote housing affordability, labor mobility, and more stable tax bases over the medium term.

While the financial system appears resilient, close monitoring amid tightening financial conditions will be important. The financial system is robust, with adequate buffers and an overall good liquidity position. That said, higher global and domestic interest rates, together with falling housing and stock prices, warrant close monitoring for any pockets of vulnerability. Declining housing prices and higher interest rates are not expected to pose material stability risks, though some increase in non-performing loans appears likely, especially among lower-income, highly indebted households with recent mortgages. An expected increase in bank wholesale funding at a time of higher rates and slowing growth may pose some vulnerabilities, although liquidity coverage ratios are well above regulatory minimum requirements and the share of deposits in the funding mix has improved. The increase in banks’ required capital buffers in the 2023 capital framework is welcome. To facilitate assessment of climate and transition risks and foster better allocation of capital, the Council of Financial Regulators, including ASIC, can further improve standardized climate-risk disclosures for large, listed companies. Potential cyberthreats on financial infrastructure require continued investment, close monitoring and contingency planning. Close scrutiny of non-bank financial institutions is important given their rapid growth, albeit from a low base. The Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) regulation should be expanded to cover designated non-financial businesses and professionals, and progress should continue on enhancing beneficial ownership transparency.

The ongoing RBA review is welcome. The review presents an opportunity to reaffirm the inflation targeting regime within a clearly focused mandate and revisit the RBA’s governance arrangements and decision-making processes. This could also be an occasion to institute periodic reviews in line with the practice of some other central banks.

Housing market policies should help alleviate affordability constraints. Amid rising interest rates, high inflation, and increasing housing supply, the earlier surge in housing prices has reversed, and housing prices are expected to continue declining significantly. Yet, affordability concerns are increasing given strongly rising rents and lower borrowing capacity amid much higher mortgage rates. A strong focus on boosting housing supply remains essential, supported by well-targeted support for lower-income households.

Australia’s crypto and payments regulatory agenda is evolving and should aim to provide broad protection while allowing for innovation to continue. Crypto assets are currently largely unregulated for conduct and prudential purposes in Australia, with various agencies providing supervision under frameworks not originally designed to regulate crypto assets. While greater efforts are underway with respect to classifying the crypto ecosystem via “token mapping” and identifying needed regulation, there is also an opportunity to achieve greater clarity in the regulatory architecture to ensure timely risk monitoring, provide clarity with respect to the roles and coordination of existing regulatory agencies, and strengthen consumer protection. Reforms to the payments regulatory framework are also needed to address new products and technologies in the payments system.

The upgraded climate change mitigation targets are welcome and should be supported by strong policy actions. The revised 2030 greenhouse gas emissions target (reduction by 43 percent from 2005 levels) is broadly in line with the long-term goal of reaching net zero by 2050 and puts Australia within the range of targets of other advanced G20 economies. The new Climate Change Act creates a framework for accountability and future action, including by legislating the mitigation targets. While politically challenging, an economy-wide carbon price is the most effective way to achieve emission reductions. In the absence of a broad-based carbon price, strong sectoral policies, with price signals where possible, can help deliver the needed abatement. In this context, transforming the Safeguard Mechanism into a binding baseline-and-credit scheme, as planned, is welcome and can drive down industrial emissions in an efficient manner. Stepping up energy sector investment under the Rewiring the Nation program can play a key role in speeding up the deployment of renewables. Higher renewables penetration combined with adequate dispatchable capacity and an upgraded grid can improve the resilience of the electricity sector, reducing risks of disruptions and price spikes.

Greater structural reform efforts are needed to address the labor productivity slowdown and achieve greater inclusion. Sustained infrastructure spending will be needed to deliver on key policy goals, including the climate transition. However, given the strong cyclical position and the binding constraints in the construction sector, the government should continue to reprioritize and streamline the ambitious infrastructure pipeline, while working proactively with the construction industry to alleviate capacity constraints. Supporting greater innovation, building digital infrastructure and skills, and reducing the regulatory burden on business can help boost potential output. The recent Jobs and Skills Summit highlighted several policy priorities to boost inclusion, encourage female labor force participation, and tackle skill shortages. In this context, recent policy initiatives including free vocational training, expansion of university capacity, a temporary increase in migration, larger child-care subsidies, and expanded parental leave are welcome.

The mission would like to thank the authorities and counterparts in the private sector, think tanks, universities, and other organizations for frank and engaging discussions.