Christopher Kent: After the boom
Speech by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of
Australia, at the Bloomberg Breakfast, Sydney, 13 September 2016.
* * *
Introduction
Today I want to talk about some important developments shaping the Australian economy,
focusing on the sharp fall in commodity prices over the past few years.
In 2012, just after taking on my current role, some colleagues and I were looking at how the
1
Australian economy had been adjusting to the unprecedented boom in commodity prices. By
the time I presented that work, prices of Australia's key commodities had begun to turn down and
2
mining investment had just peaked at a record level.
Since then, commodity prices have fallen much further and so Australia's terms of trade (the
price of our exports relative to imports) have fallen significantly. The fall was more than we, and
most others, had expected. More recently, though, commodity prices have risen. And more than
three-quarters of the anticipated decline in mining investment is now behind us.
The adjustment of the economy to the decline in the terms of trade and the large fall in mining
investment has been a drawn out process, adversely affecting a range of industries and regions.
But growth in the economy overall has been close to trend, and while the unemployment rate
3
rose, it reached only a little above 6 per cent in 2015. More recently, inflation has declined.
Before talking about the period after the boom, I want to set the scene. First, I'll briefly review the
boom years. Second, I'll describe what we anticipated four years ago would be likely to happen
after the boom.
The Boom Years
The rapid industrialisation and urbanisation of the Chinese economy underpinned the strong rise
in commodity prices from around the mid 2000s. As global demand for commodities began to
outstrip supply, the prices of Australia's key commodity exports rose dramatically.
Australia's terms of trade rose by 85 per cent from the average of the early 2000s to the peak in
late 2011 (Graph 1). That implied a significant boost to the real purchasing power of domestic
production. Some of those gains were retained by foreign owners of mining assets, but a share
of the gains stayed at home in the form of higher wages, tax revenues and profits for Australian
owners of mines and of firms supporting mining activity.
The rise in Australia's terms of trade was associated with a large appreciation of the nominal
exchange rate (see Table 1 in the Appendix). While this lowered the returns to Australian
commodity exporters (and Australian exporters more broadly), it allowed real income gains to
flow to the rest of the economy via the associated decline in the prices of imports.
The resource sector here and abroad responded to the commodity price boom by expanding
productive capacity. This occurred gradually, reflecting both the unforeseen magnitude of the
boom, its unexpected persistence, and the time required to plan for, approve and then complete
large resource projects. In mid 2012, investment in the Australian resource sector had peaked at
just under 8 per cent of GDP, compared with its average of around 2 per cent prior to the boom.
In the lead-up to that investment peak, growth in output, employment and wages in the resource
sector (broadly defined to include those industries servicing it) was relatively strong. The boom in
those industries led to strong economic conditions in the resource-rich states of Western
Australia and Queensland.
The significant appreciation of the exchange rate provided a signal for labour and capital to be
redistributed from the 'other tradable' sector towards the resource sector. As a result, the growth
in investment, output, employment and wages was weak in the 'other tradable' sector.
The large nominal exchange rate appreciation also helped to contain inflationary pressures in an
environment of strong growth in domestic demand and a decline in the unemployment rate to
relatively low levels. Notwithstanding that assistance, overall inflation picked up to be a little above
its inflation-targeting average. Non-tradable inflation was elevated during the boom years and
growth in nominal unit labour costs was relatively strong for most of this period. In response to
these inflationary pressures, the Reserve Bank raised the cash rate to be above its
(inflationtargeting) average.
After the Boom - What We Had Thought Might Happen
In our previous analysis, we noted that during the commodity price boom the economy had
behaved, in many respects, as theory suggested. We also discussed how the economy might
adjust as the terms of trade declined.
It was clear that mining investment would fall, but at the same time, resource exports would
increase as additional productive capacity came on line. However, overall demand for labour in
the mining sector (and in mining-related activity) would decline because the investment phase in
5
that sector is relatively more labour intensive than the production phase.
With the global supply of commodities catching up to global demand, we thought that commodity
prices and, therefore, Australia's terms of trade would decline (but remain higher than their
preboom levels). That would normally be associated with a depreciation of the Australian dollar.
We anticipated that demand in the non-mining sectors would pick up and that labour and capital
would be drawn back to that part of the economy. Any depreciation of the nominal exchange rate
would facilitate that transition by improving the competitiveness of the 'other tradable' sector. The
movement of labour would also be facilitated by some decline in wage growth, as the labour
shed by companies that had undertaken the mining investment looked to move back into the
nonmining sectors. In other words, we thought that the requisite real exchange rate depreciation
would occur largely via the nominal exchange rate, but might also be assisted by a decline in
domestic cost pressures.
These developments were expected, at least in part, to reverse some of the effects on consumer
price inflation seen during the investment phase of the boom. In particular, a gradual depreciation
of the exchange rate would put upward pressure on tradable inflation for a time, while a reduction
in wage growth and domestic costs more generally would put downward pressure on
nontradable inflation. These opposing effects could potentially result in little net change to overall
inflation, but given that inflation had been above average during the boom, it would not be
surprising to see inflation below average after the boom.
But having made some predictions about the direction of some key variables, we also noted the
considerable degree of uncertainty, including that related to the global economic outlook.
After the Boom - What Actually Happened?
Many of our predictions have been borne out. Mining investment declined significantly and
resource exports grew strongly. Mining investment has further to fall, although the largest drag on
GDP growth from that source is likely to have come and gone over the financial year just passed.
The decline in mining investment from 2012 led to lower growth in overall mining activity (mining
investment plus resource exports; Graph 2). More recently, growth of mining activity has picked
up. Mining activity is set to continue to grow for a time as the drag from mining investment wanes
and production of liquefied natural gas continues to ramp up.
As had been anticipated, mining-related employment has contracted and wage growth in those
6
industries has declined to be noticeably below that of other sectors.
In the non-mining sector, growth in activity and employment (more recently) have picked up. The
reduction in interest rates over the past few years has been assisting in rebalancing activity
towards the non-mining economy, which is currently growing at around its long-run average rate
(Graph 3). The depreciation of the nominal exchange rate since early 2013 has also supported
activity in the 'other tradable' sector. Net service exports have made a noticeable contribution to
GDP growth over the past few years, with tourism, education and business service exports all
expanding.
Overall, inflation has declined, driven by lower inflation of non-tradable items and consistent with
a significant decline in the growth of labour costs. At the same time, inflation of tradable items
has increased following the exchange rate depreciation.
In short, the patterns of behaviour of these key macroeconomic variables have been quite
consistent with what we had initially thought might happen. However, the magnitudes and speed
of some of the adjustments have surprised us. In part, this reflects external developments, most
notably:
the larger-than-expected decline in commodity prices and the terms of trade; and
the extent and persistence of low growth and low inflation in much of the world and the
associated easy monetary policies of the major central banks.
Despite these challenges, the Australian economy has displayed a degree of flexibility that has
helped the process of adjustment.
Commodity Prices and the Terms of Trade
Australia's terms of trade declined by more than had been expected a few years ago (Graph 4).
Around the time of our previous analysis, we were forecasting a further decline in the terms of
trade over the coming years. But then from 2012 to 2015, we repeatedly revised down our
forecasts.
The larger-than-expected decline in Australia's terms of trade reflected both demand- and
supply-side factors. Growth in the demand for commodities from Asia, and China in particular,
declined noticeably. In large part, this was in response to excess capacity in manufacturing as
well as a decline in real estate investment in China. Among other things, this has seen the
growth in global steel production stall, and hence lower growth in the demand for iron ore and
coking coal.
On the supply side, commodity producers have been able to reduce their costs by more than
initially thought possible, and some higher-cost suppliers sustained their production levels for
7
longer than anticipated.
The larger-than-expected decline in the terms of trade has weighed on growth in economic
activity, employment, profits, wages and fiscal revenues, as well as on inflation. The effect has
been largest in the mining sector and the key mining states, but it has been evident across the
economy more broadly.
The Exchange Rate
The depreciation of the Australian dollar over recent years has improved Australia's
competiveness and thereby supported production in the tradable sector. However, the
depreciation didn't start in earnest until 18 months after the terms of trade had peaked. And while
it is hard to be precise, our modelling suggests that the exchange rate (the real trade weighted
index, or real TWI) has not depreciated by quite as much as might have been expected in
response to the actual decline in the terms of trade (and the reductions in domestic interest
rates) (Graph 5). At least in part, this reflects lower-than-expected global growth and inflation,
which has led to a prolonged period of very low interest rates and unconventional monetary
8
policies in the major economies.
Real GDP
Australia's real GDP did not increase by quite as much as we had expected back in late 2012.
The GDP forecast in the August 2012 Statement on Monetary Policy was a bit over 1 percentage
point stronger than what came to pass over the year to March 2013 (Graph 6). We subsequently
revised down our forecasts. In the intervening years growth was sometimes a little above our
forecasts, sometimes below. GDP growth more recently has been a bit stronger than we'd
expected a year ago.
Much of the early forecast miss for GDP growth owed to mining investment. In late 2012, we had
forecast that mining investment would be likely to rise a little further and stay elevated for a time
(Graph 7). It soon became apparent, however, that mining companies had revised their earlier
plans in response to lower-than-expected commodity prices. We revised down our forecasts
accordingly. Since 2013, our liaison efforts have been instrumental in generating quite accurate
forecasts for mining investment. The forecasts for resource exports have also been reasonably
accurate over recent years.
Since 2012, growth in real non-mining activity has picked up gradually and has generally been a
little stronger than was expected, supported by lower interest rates and the depreciation of the
9
exchange rate.
Nominal GDP
The weaker than earlier expected outcome for real GDP growth was not particularly large in
comparison with the usual range of forecast uncertainty, and as I noted, real GDP growth over
the past year has actually been a bit stronger than earlier anticipated. In contrast, the
larger-thanexpected decline in the terms of trade over the past few years has meant that nominal outcomes
have been significantly weaker than earlier forecast. From 2013 to 2015, nominal GDP increased
by around 8 per cent, which was half the initial forecast of 17 per cent. That has had important
implications for growth in wages, costs and prices.
Labour and Labour Costs
Given that real GDP growth was initially a bit weaker than expected, it's not surprising that
employment growth was less than forecast and the unemployment rate higher than expected
(Graph 8). More recently, however, the unemployment rate has declined by a bit more than had
10
been anticipated.
Shortly after the fall in the terms of trade, wage growth declined significantly across every
industry and all states. It is currently lowest in Western Australia and Queensland, and in
industries exposed to the end of the mining investment boom (Graph 9). Some decline in wage
growth in response to the decline in mining investment and the terms of trade was to be
expected, but the decline in wage growth has been greater than implied by historical relationships
11
with the unemployment rate. That could reflect several factors:
Workers who had been engaged in mining-related activities moved to lower paid jobs
outside the resource sector. This compositional effect contributed to lower growth in
12
average earnings per hour than in the wage price index (at least until very recently).
Compared with earlier periods of high unemployment rates (e.g. in the 1980s and 1990s),
increased labour market flexibility may have provided firms with greater scope to adjust
wages in response to declines in the growth of their nominal revenues (which, in turn,
followed from the fall in the terms of trade).
Workers may be less certain of their employment prospects, possibly because of rising
competitive pressures in a more globalised world, leading them to be more willing to accept
lower wage outcomes in exchange for more job security.
The decline in inflation and inflation expectations over recent years may also have influenced
wage negotiations.
It is important to note that low growth in labour costs has, in many respects, helped the economy
adjust to the lower terms of trade. In addition to the nominal exchange rate depreciation, low
growth in labour costs is helping to improve Australia's international competitiveness and has
encouraged more employment growth than would otherwise have occurred. More recently, wage
growth has shown signs of stabilisation, with growth in the private sector wage price index
unchanged for the past six quarters, while a broader measure of wage pressures, the growth in
average earnings per hour, has picked up of late.
Other Costs and Margins
Spare capacity in a range of product markets also led to downward pressure on other costs and
margins along the supply chain. This sort of pressure is particularly evident in low inflation of final
retail prices for items sold in supermarkets and for many consumer durable goods.13
Inflation
Lower growth in labour and other costs, as well as lower margins, have contributed to
lowerthan-expected outcomes for inflation of both non-tradable and tradable items. Compared with
earlier forecasts for 2013-2015, inflation in underlying terms has only been a little below
expectations (7.1 per cent versus 7.8 per cent cumulated over that period). However, inflation
has also been lower than expected more recently; our forecasts for 2016 have been revised
down from a bit above 2 per cent to about 11⁄2 per cent between February and August of this
year.
Interest Rates
The initial misses on GDP and unemployment, and more recently on wage growth and inflation,
owed significantly to the effects of the larger-than-expected decline in the terms of trade on the
mining sector and the economy more broadly.
In response to the evolving outlook, the Reserve Bank Board has reduced the cash rate to low
levels to improve the prospects for sustainable growth in the economy, with inflation rising to be
consistent with the medium-term target.
The low level of interest rates and the depreciation of the exchange rate have underpinned a rise
in the growth of non-mining activity, which is currently running around its long-run average.
Western Australia and Queensland have been most directly affected by the fall in commodity
prices and mining investment, and so economic conditions there are still relatively weak
(Graph 10). However, New South Wales and Victoria have been less affected by those
pressures and so low interest rates and the lower exchange rate have led to an improvement in
economic conditions in those states.
Conclusion
The pattern of adjustment of the Australian economy to the decline in the terms of trade and
mining investment is generally consistent with what we had anticipated. However, the decline in
the terms of trade was larger than expected. In response, there has been significant adjustment
in a range of market 'prices' - including wages and the nominal exchange rate, although the
exchange rate has depreciated a little less than otherwise given global developments. Monetary
policy has also responded, with interest rates reduced to low levels. So while mining investment
and nominal GDP growth have both been weaker than the forecasts of a few years ago and,
more recently, inflation has been a bit weaker than expected, growth in the non-mining economy
has picked up and been a bit better than earlier anticipated. Indeed, of late, real GDP growth has
been a bit stronger and the unemployment rate a little lower than earlier forecast.
In many respects, the adjustment to the decline in mining investment and the terms of trade has
proceeded relatively smoothly. The Australian economy has performed well compared to other
advanced economies (Graph 11). Moreover, the drag on growth from declining mining
investment is now waning and the terms of trade are forecast to remain around their current
levels.
Of course our forecasts are subject to the usual range of uncertainty. But, given that commodity
prices have increased substantially over the course of this year, some stability in the terms of
trade from here on seems more plausible than it has for some time. Developments in China are
likely to continue to have an important influence on commodity prices, given China's role as both
a major producer and consumer of many commodities. For this reason the outlook for the
Chinese economy is a key source of uncertainty for the Australian economy.
If commodity prices were to stabilise around current levels, that would be a marked change from
recent years. Also, the end of the fall in mining investment is coming into view. The abatement of
those two substantial headwinds suggests that there is a reasonable prospect of sustaining
growth in economic activity, which would support a further gradual decline in the unemployment
rate. There is also a good prospect that the growth in wages and the rate of inflation will gradually
lift over the period ahead. That's what's implied by our central forecasts.
Thank you. I'd be happy to take a few questions.
Appendix
This was published in early 2013. See Plumb M, C Kent and J Bishop (2013), 'Implications for the Australian
Economy of Strong Growth in Asia', RBA Research Discussion Paper No 2013-03.
2
Speech delivered to the joint IMF/Treasury/RBA conference on 'Structural Change and the Rise of Asia',
Canberra, 2012. For other work done on this topic by RBA staff, see: Jääskelä J and P Smith (2013), 'Terms of
Trade Shocks: What Are They and What Do They Do?', Economic Record 89, pp 145-159; Downes P, K
Hanslow and P Tulip (2014), 'The Effect of the Mining Boom on the Australian Economy', RBA Research
Discussion Paper No 2014-08; Kulish M and D Rees (2015), 'Unprecedented Changes in the Terms of Trade',
RBA Research Discussion Paper No 2015-11; and Manalo, J, D Perera and D Rees (2015), 'Exchange Rate
Movements and the Australian Economy', Economic Modelling (47), pp 53-62.
3
The economic adjustment this time around stands in contrast to previous terms of trade booms in Australia,
which - despite being smaller than the recent boom - tended to end in sharp contractions in economic activity
and large increases in unemployment. See: Battellino R (2010), 'Mining Booms and the Australian Economy',
RBA Bulletin, March, pp 63-69; and Atkin T, M Caputo, T Robinson and H Wang (2014), 'Macroeconomic
Consequences of Terms of Trade Episodes, Past and Present', RBA Research Discussion Paper No 2014-01.
4
Inflation peaked at 5 per cent in late 2008, but declined as economic conditions moderated during the global
financial crisis. Growth in nominal unit labour costs also eased during the financial crisis, but rebounded to a
peak of around 7 per cent in year-ended terms in early 2011.
5
Even so, labour demand in the resource sector would still remain somewhat higher than it was prior to the
terms of trade boom, given the operational needs associated with producing more output.
6
Nevertheless, as anticipated, employment in the resource sector remains higher than pre-boom levels as
production of resource commodities has increased.
7
For a discussion of the costs of producing iron ore, see:
<www.rba.gov.au/publications/smp/boxes/2015/feb/a.pdf>. The decline in Australian producers' costs would
have supported their profitability, but the decline in the costs of offshore producers would have allowed them to
keep producing more than otherwise, and this extra supply would have weighed on commodity prices and,
hence, the profits of Australian resource producers.
8
See Hambur J, L Cockerell, C Potter, P Smith and M Wright (2015), 'Modelling the Australian Dollar', RBA
Research Discussion Paper 2015-12.
9
The improved growth in non-mining activity has occurred despite non-mining business investment remaining
subdued. Weakness in non-mining business investment has been most evident in Western Australia and, to a
lesser extent, Queensland, where the decline in mining investment and commodity prices have contributed to
weak conditions in those states more broadly. More recently, non-mining investment appears to have increased
in New South Wales and Victoria, where economic conditions have been improving.
10
There has also been some decline in population growth, most notably in Western Australia.
11
See Jacobs D and A Rush (2015), 'Why Is Wage Growth So Low?', RBA Bulletin, June, pp 9-18.
12
For a discussion of the differences between these measures, see:
<www.rba.gov.au/publications/smp/2016/aug/price-and-wage-developments.html>.
13
See Ballantyne A and S Langcake (2016), 'Why Has Retail Inflation Been So Low?', RBA Bulletin, June, pp 9-17.