Mission Concluding Statement 

Australia: Staff Concluding Statement of the 2023 Article IV Mission

October 31, 2023

Sydney:

• Australia’s economy has been resilient, even though growth is forecast to slow to 1¼ percent in 2024, in response to tighter macroeconomic policies and financial conditions. Unemployment remains low, output above potential, and housing prices have picked up after a correction in 2022. Risks to the outlook stem from high and persistent inflation, a more uncertain global environment, and climate-related shocks.
• While headline inflation has peaked, its decline is slow and core inflation remains sticky. The authorities have implemented several policy measures which have significantly contributed to stabilizing the economy and reducing inflation, but staff assess that more is needed to bring inflation back to target and keep inflation expectations anchored. Continued coordination between fiscal and monetary policy is key to achieving a soft landing, while alleviating the impact of policy tightening on vulnerable households.
• Structural policies should be centered around promoting productivity growth and supporting the green transition. Continued investment in digital infrastructure, fostering competition and innovation, sustained efforts to address climate change, as well as labor market and tax reforms are among the key recommendations. The authorities have made significant efforts to improve the framework for detecting foreign bribery, but further enforcement is needed.

After a strong post-pandemic recovery, Australia’s economy is slowing but remains resilient. GDP growth slowed to 2.1 percent (y/y) in 2023Q2, from 3.7 percent (y/y) in 2022, as consumer demand slowed in real terms, due to a decline in real household disposable income driven by higher inflation and higher mortgage interest rates. Elevated net migration, resilient private investment, and strong public investment in transport, health, education, and national defense were the main drivers of growth. Net exports also contributed to growth on the back of robust sales of iron ore and coal, and a strong rebound in tourism and education. Output is estimated at around 1 percent above potential, with unemployment remaining at a low rate of 3.6 percent in September, albeit with some emerging signs of weakening in hours worked.

Like in other advanced economies, inflation is declining but remains too high. Headline inflation declined to 5.4 percent in 2023Q3 (from a peak 7.8 percent in 2022Q4), well above the Reserve Bank of Australia’s (RBA) 2-3 percent target range, and services inflation remains sticky. Easing of global supply chain pressures and a slowdown in domestic demand – owing to tighter monetary policy – helped reduce goods inflation. However, despite a recent moderation, services inflation remains high and broad-based, driven by strong demand, input cost pressures from both labor costs (reflecting historically tight labor markets and weak productivity outcomes) and non- labor costs (such as rent and electricity), and supply constraints. Tight conditions in the rental housing market have led to a significant acceleration in rent inflation, while higher insurance premia, including from increasing weather-related claims, are adding to pressures. The authorities have introduced targeted policies to address the cost of living.

Economic activity is projected to further decelerate in the near term, alongside a slow decline in inflation. Given the lags in the transmission of monetary policy to growth, the bulk of the impact of rate hikes to date is likely to materialize in the coming quarters. Moreover, external demand – including from China – is expected to soften. Accordingly, growth is expected to slow to around 1.8 percent y/y in 2023 and 1.2 percent y/y in 2024, and the output gap is expected to close in 2024. Staff projects inflation to remain outside the RBA’s target band for an extended period, with average inflation of 5.8 percent in 2023 and 4.0 percent in 2024. Australia’s external position and exchange rate appear broadly in line with medium-term fundamentals and desirable policies.

Risks to growth are broadly balanced, but inflation may continue to exceed expectations. Near-term growth risks stem from the external environment, for example in case of a more protracted downturn in China, deepening geo-economic fragmentation, or escalating conflicts. Upside risks to growth include higher migration, faster execution of public investment, and an acceleration of housing price increases that can boost consumer sentiment and household consumption through wealth effects. However, this would add to inflation pressures and exacerbate policy challenges. Higher for longer inflation could de-anchor inflation expectations, which could generate further wage pressures. Spikes in energy (particularly for petrol) and food prices could add to inflationary pressures. Additional uncertainty relates to household consumption behavior which depends on the use of pandemic-related savings. Other downside risks include climate-related natural disasters and cybersecurity risks.

The authorities have substantially tightened monetary policy, alongside fiscal consolidation, but further policy actions are recommended to bring down inflation faster. Monetary policy has tightened significantly so far, with cumulative rate hikes of 400 basis points since early 2022. The fiscal deficit has contracted at a faster pace than in other advanced economies. Commonwealth’s fiscal strategy has returned the majority of improvements to revenue towards improving the fiscal position. Cyclical windfalls from higher commodity prices and a stronger labor market have been re-directed towards improving the fiscal position, which is helping to ensure fiscal policy is working with monetary policy to avoid inflationary pressures. Although inflation is gradually declining, it remains significantly above the RBA’s target and output remains above potential. Staff therefore recommend further monetary policy tightening to ensure that inflation comes back to the target range by 2025 and minimize the risk of de-anchoring inflation expectations. In that context, continued coordination between monetary and fiscal policy is key to securing more equitable burden sharing. The Commonwealth Government and state and territory governments should implement public investment projects at a more measured and coordinated pace, given supply constraints, to alleviate inflationary pressures and support the RBA’s disinflation efforts. Otherwise, interest rates would have to be even higher, putting the burden of adjustment disproportionately on mortgage holders.

Over the medium term, the governments need to reduce structural deficits and promote economic efficiency. All levels of government need to improve expenditure outcomes and contain structural spending growth in health, aged care, and the NDIS. The new national wellbeing framework, designed to improve the quality of lives, can turn the focus on achieving better outcomes by fostering cooperation across different levels of governments. Greater expenditure decentralization would enable the governments to implement comprehensive tax reforms, including rebalancing from high direct taxes to underutilized indirect taxes. Support to vulnerable households may be needed to address the regressive impacts of such reforms. At the state and territory level, implementing recurring property taxes in lieu of stamp duties on housing transactions would promote housing affordability, more efficient use of the housing stock, labor mobility, and more stable tax bases over the medium term. Transitional revenue losses, if substantial, could be bridged, for example with higher GST. Re-calibrating the GST equalization formula can address the differential impacts of the pandemic on fiscal sustainability at the subnational level.

Financial stability risks appear contained, despite heightened global uncertainty. Lending conditions have tightened in many advanced economies, including Australia. While business insolvencies have increased and are now at their pre-pandemic level, banks’ non-performing business loans remain very low. Risks from mortgage lending are also limited, though pockets of vulnerability exist, particularly among the relatively small segment of lower income households with high debt and low equity. Conditions in office and retail commercial real estate are difficult, but banks’ direct exposures are small, and developments are being closely monitored by the regulatory agencies. A sharper-than-expected slowing in growth and increase in unemployment would add to risks. However, Australian banks are well placed to manage near- and medium-term risks to their loan portfolios, given Australian banks are profitable and capital levels are at a historic high following the commencement of the enhanced capital framework in January 2023. Even so, given that housing prices have resumed their upward trend, additional borrower-based tools, such as loan-to-value and debt-to-income limits, that have been applied successfully elsewhere, should be considered to boost the overall macroprudential toolkit and contain build-up of risks.

A greater housing stock is needed. Notwithstanding the housing price correction in 2022, the affordability challenge has not abated, as prices have started increasing again and mortgage payments as a share of disposable income have doubled due to higher interest rates. Rents have also increased at a very fast pace, with strong growth in immigration following the post-COVID re-opening adding to pressures, given housing shortages. The authorities have planned a suite of housing policies which, if implemented, would boost supply. Supportive planning and land-use policies are critical.

Efforts to jump-start productivity growth should be a priority. Like in many advanced economies, Australia has experienced a sustained decline in productivity growth in recent decades. This has contributed to higher unit labor costs, reducing Australia’s competitiveness. Policies to promote innovation should include continued investment in digital infrastructure, while a more open FDI regime and better labor market integration of skilled immigrants could speed up technology adoption from abroad. The authorities’ Competition Policy Review, review of skilled migration settings, and development of a Migration Strategy will help develop policies to boost dynamism in the economy. The authorities’ participation in a voluntary review of policies to curb transnational corruption is welcome. Recent improvements in the framework for detecting and investigating foreign bribery should be supported by stronger enforcement. 

Education and a dynamic labor market are essential for addressing skills shortages and harnessing the full potential of Australia’s workforce. Australia has relatively high rates of labor force participation but also relatively high rates of part-time work, especially among women. To facilitate full-time work, particularly for women, the authorities recently increased the childcare subsidy rates. Immigrants have, on average, higher education levels than the Australian-born population but often face placement challenges, despite skills shortages. The authorities’ efforts to boost spending on vocational training will help reduce skills shortages and could lift productivity. Efforts to address declining education outcomes, as indicated by test scores, are also needed. We welcome the Employment White Paper’s focus on these issues.

Building on recent reforms, the authorities should continue their efforts to address climate change. An economy-wide carbon price would be the most effective way to achieve net zero. As a second-best, strong sectoral policies, with price signals where possible, can help deliver the needed abatement. In this regard, Australia’s new law to reform the Safeguard Mechanism is an important milestone. The authorities should consider gradually expanding the coverage of the mechanism to a greater share of the economy. Moreover, efforts to ensure the integrity of carbon offsets will be key for the functioning of the system. Staff also welcomes the authorities’ objective of increasing the share of renewable energy to 82 percent by 2030 and their announcement to impose fuel efficiency standards. By contrast, tax incentives for EV purchases are potentially regressive and seem less effective, given supply bottlenecks. Additional policies are needed to achieve the mitigation goals, including through additional investment. Price signals, such as feebates in the energy and transport sectors, could elicit broad behavioral responses without impacting average prices.

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.