Introduction
The past few weeks have seen lots of talk again about a recession - particularly in Australia. This has been a recurring theme over the last year or so but has intensified lately. But what's driving it? How serious is the risk of recession? And what would it mean for Australians and investors?
But first what is a recession?
A recession is generally defined as a contraction in the level of economic activity. In some countries it’s technically defined as two or more quarters in a row of falling economic activity as measured by GDP but this measure can have its failings, e.g. if GDP falls 1% in one quarter, rises 0.1% the next next and then falls 1% it wouldn’t meet the technical definition of a recession but most would agree that it is. So, some like the US adopt a wider definition based around a period of contraction as measured by GDP and a range of other economic indicators including industrial production, income and employment.
Because Australia has strong population growth there been a focus on “per capita recession” which is where the economy still grows but at a lower rate than the population so GDP per person goes backwards. This is arguably more relevant for individual living standards. GDP per capita has already contracted in the March quarter and most, including the RBA and the Government, are forecasting at least a per capita recession.
Why the concern now?
The concern about recession has been rising with central bank interest rate hikes. The rise in interest rates is aimed at slowing inflation by slowing demand and hence economic activity. It does this by:
increasing debt servicing costs for households (particularly those with mortgages) and businesses with debt, which reduces spending power;
raising the cost of future borrowing which slows down home building and business investment;
lowering asset values – for say shares and property – which results in less spending as people feel poorer via the “wealth effect”; and
by pushing the currency higher than otherwise making it cheaper to bring in imports and reducing demand for exports.
Because central banks never know when they have raised interest rates enough to control inflation they often go too far – pushing the economy into recession. This was the case prior to recessions in Australia in the early 1980s and 1990s and in the US in the early 2000s and 2008.
We have been off the view that easing global inflationary pressures – as evident in improving supply and falling price pressures in various business surveys, etc – would have enabled central banks to have stopped raising interest rates by now. But central banks have gone further than we thought and remain hawkish. This includes the RBA which following signs of increasing upside risks to wages growth – particularly the higher than expected increase in minimum and award wages at a time of low productivity growth – appears to have become more hawkish and be giving less weight to keeping the economy on an “even keel”.
Why all the fuss about faster wages growth?
Everyone wants to see their wages grow faster than inflation. But when wages are simply chasing inflation higher as we saw in the 1970s it can lead to a wage price spiral which perpetuates high inflation as companies raise prices to maintain profits in response to stronger wages. As a result the second round response to the initial spike in inflation of catch up wage growth risks entrenching high inflation. Hence the more aggressive approach by central banks to guard against this. The Bank of England has gone down this path & the RBA appears to be doing the same.