Business Cycle Properties and Macro Forecasting of the Australian Economy - Example

Business Cycle Properties and Macro Forecasting Of the Australian Economy Word Count: 1885 Executive Summary The analysis of macroeconomic variablesis employed in determining the likely outcomes of a country’s economic, monetary and fiscal policies, in the light of changing local and global realities. Real GDP is the measure of a country’s economic health and performance, however there are a number of components that comprise the GDP: these are productivity, expenditure, investment and nominal variables. This study demonstrated that labour productivity and private consumption expenditure variables coincident with GDP are robustly procyclical, and are leading indicators to a more moderate extent. Unemployment is a countercyclical variable but may also perform as a leading indicator of GDP. The prospects for Australia are encouraging. The country’s economy has sustained one of the longest, most progressive runs in the world as cited by the IMF, and despite the recent slump in housing prices, a slight rise in exports and relative weakness in the Australian dollar, the prospects appear encouraging for the country as its macroeconomic variables show stability even through the global economic crisis. Although interest rates had risen somewhat in the past, the government intends to continue lowering interest rates to encourage consumption spending, which according to this study will likely spur continued economic expansion. Introduction The health of the economy of any country is dependent upon the insightful and timely application of the appropriate economic policies by the governing authority. However, deciding on which policy to adopt and the manner in which it should be implemented are not easily discernible by mere intuition. Reliance on the measurement of certain macroeconomic variables is crucial to forecasting the possible directions the economy may take, whether the implemented policies are helpful in propelling the economy towards the desired goal, or whether they are detrimental to the economic welfare of the nation. This report provides a cursory examination of Australia’s macroeconomic variables and their behaviour, with the aim of determining their usefulness in providing insight into the future directions of the Australian economy, as well as their effectiveness as tools in discerning the appropriate economic policy to be adopted to ensure progress. Ten variables are specified consisting of productivity, investment, expenditure, and nominal variables, so as to determine their relationship to GDP as the measure of economic health and viability. During the course of the correlational studies, the nominal variables including broad money supply, inflation, long-term and short-term interest rates, and currency exchange rates, were tested and found uncorrelated with GDP. As a modification of the original study by Fisher, Otto and Voss (1996), this study further sought to correlate the four aforementioned monetary variables with M3 in an attempt to determine whether or not they exerted any influence upon each other. It will be noted that interest rates and currency exchange rates were tools of monetary policy, while inflation rate is a vital price indicator, all of which are related in theory to money supply. The supporting graphs showing superimposed correlated variables are shown in the Appendices A to J, for both the quarter-to-quarter growth rates as well as the quarterly year-on-year (YOY) growth rates. Macroeconomic variables, their cyclicality and indicator properties Several macroeconomic and monetary variables exhibit cyclicalities as a result of their being correlated with the output. The following table shows the resulting correlational coefficients of each of the variables with their respective output. The first set of variables consists of monetary variables which are the subject of monetary policy employed by the government to control the money supply in the market, which in turn determines the inflation rate. Too much money chasing too few products usually results in accelerated inflation. On the other hand, excess liquidity may be controlled by the monetary authorities by setting the short-term and long-term benchmark interest rates of government securities, and intervening in the currencies market by releasing or buying up the US dollars in the market. By raising interest rates, the government increases the attractiveness of government securities and reduces the money supply. Raising interest rates excessively, however, may create a credit crunch which may raise credit costs, negatively affecting businesses and reduce productivity. From the foregoing table, however, it is evident that the long and short term interest rates, foreign currency exchange rate, and the inflation rate are not significantly correlated with money supply, since none of the correlation coefficients had an absolute value higher than 0.50. The lack of correlation is further seen in the graphs of the variables, both quarter-to-quarter and quarterly year-on-year (YOY), seen in Appendices A to D. The second set of variables were tested for correlation with real GDP growth rates, since they are determinative of the total goods and services produced in the economy within a period of time. The elements that contribute to the aggregate gross domestic product are the expenditure components (consumption and investment), and production inputs. The variables corresponding to the expenditure components are the private final consumption expenditure (consumption), the gross fixed capital formation (investment), and the inventory investment. Labour productivity is another variable bearing directly upon the GDP because it is a measure of the production inputs. Finally, broad money supply or M3 is added as the nominal variable (Fisher, Otto and Voss, 1996, pp. 304-315). There is a stronger correlation among these variables, particularly between the quarterly growth rates for consumption expenditures with GDP growth rates, which has a 95 per cent positive correlation, and labour productivity and GDP growth rates, at 96 per cent positive correlation; these two variables are therefore strongly pro-cyclical (both highlighted in yellow in the table above). The other variables show cross-correlated pro-cyclicality (positive coefficients) and countercyclicality (negative coefficients) but to a more moderate extent (highlighted in pink), except for inventory which is uncorrelated to GDP. These are also evident in the graphs in Appendices E to I. It is worthwhile to note that while consumption expenditure and labour productivity are strongly procyclical in the quarterly growth rates, consumption expenditure is only moderately so in the year-on-year growth rates, while labour productivity is uncorrelated. Unemployment, on the other hand, is negatively correlated and therefore counter-cyclical in the year-on-year growth, which is only to be expected because when unemployment rises, labour as well as overall productivity is expected to fall. Each of the variables have varying degrees of indicator properties, depending upon the correlation of the output with the leading or lagging value of the variable. Leading indicators for GDP are consumption expenditure, unemployment and labour productivity, particularly in the quarterly growth. Leading indicator in the YOY growth rates is unemployment, although only moderately so. Forecasts of specific variables Real GDP growth for 2012 Quarter IV and 2013 Quarter I The quarterly real GDP growth rate in Australia is seen to fluctuate with a predictable pattern during the four quarters of the year. The growth of GDP recovers from negative between the first and the second quarter readings, corrects slightly from the second to the third, then peaks at the fourth quarter before correcting deeply to negative growth rate on the way to the next year’s first quarter. This is evident in the graph below. The graph shows that after 2009, the pattern has modified somewhat so that in the last cycle, the strongest growth was experienced in the second quarter instead of the fourth, and the moderate correction between the two peaks was deeper, evidence of a slowing economy which Bloomberg attributed to weaker housing and rising imports (Heath, 2012), and Moody’s to falling commodity prices (Ell, 2012). With this caveat in mind and consistent with the historical behaviour of the GDP with its quarterly seasonality, the Quarter IV 2012 GDP rate may fall to negative six per cent, but may rise to positive four to five per cent in the first quarter of 2013. Inflation rate for 2012 Quarter IV and 2013 Quarter I The quarterly CPI plotted below shows a gradually increasing CPI which the Reserve Bank of Australia computes a year-end percentage change of approximately three per cent (RBA, 2012). The same source estimates a first quarter growth rate of approximately two per cent. This may be expected given the low interest rates to which the RBA is holding cash rate, encouraging the growth of liquidity and moving CPI closer to 185 in the preceding graph. Inasmuch as the percentage change in the consumer price index is the same as inflation rate, inflation rate of Australia’s final quarter 2012 will reach 0.2 per cent (CPI of between 183 and 184), and first quarter CPI may reach 184 due to a 0.1 per cent expected monthly growth rate, if the RBA does not otherwise intervene. Cash rate at Reserve Bank Board on November 6. 2012 According to the ANZ Bank, the overnight cash-rate target will be lowered by November, and then again by early 2013, due to the likelihood that the RBA will ease monetary policy further by the end of 2012. (Heath, 2012). This is consistent with the plan to lower interest rates in order to try to spur consumption which dropped in the first quarters of 2012. In the graph above, the falling cash rate corresponds to the continued intention of the RBA to bring down rates. Despite this, economists warn that there may be a need to rein in the economy by raising interest rates if the country’s GDP rises per prediction of the IMF, to attain 3 per cent level by year’s end. With these under consideration, it is likely that the monthly interbank cash rate, which the Australian Bureau of Statistics recorded the latest value of at 3.77 per cent in May and which the Reserve Bank of Australia reported at 3.5 per cent consistently from 6 June to 5 September 2012, may well remain at the same level in October and November, or may even descend further to the 3 per cent level where it historically rested. The average exchange rate AUS$ to US$ from Nov. 1, 2012 to June 30, 2013 The graph of the monthly average exchange rate shows that during the last twelve months, the exchange rate has moved sideways within a narrow band between 1.00 and 1.10 US$. The exchange rate usually tends to deteriorate in the face of falling interest rates, because investors would tend to sell AUS$ denominated securities and currency, and pick up on foreign-currency assets. This means there may be some pressure downwards for the AUS$ which may fall below the US$ 1.000: AUS$ level. However, a look at the US economy also shows some pressures towards further depreciation, because of the huge budget deficit and the fact that this is an election year, creating uncertainties for investors. Should these two factors offset each other, it is likely that the AUS$ shall maintain its current sideways movement of US$1.0 to 1.1 per AUS$, or eve appreciate to more than 1.1. Year-over-year percentage change in Australian House Price Indexes, in Q4 2012 The foregoing chart shows the graph of the YOY percentage changes of the Australian House Price Index weighted average of 8 capital cities. The growth rate showed volatility through the years. The growth rate has turned negative for the past five semesters to June 2012 (Australian Bureau of Statistics, 2012), although the drop has slowed and is gradually returning to positive percentage change. With the prospective drop in interest rates, private expenditure is likely to increase as well as interest in real property. Signs of recovery are imminent, so the housing price index may move sideways at 0 per cent change for the fourth quarter of 2012, hopefully to turn positive percentage change in the first quarter 2013. Conclusion The nominal variables which Fisher, et al. (1996) found to be correlated with GDP do not appear to show the same robust relationship, most likely because currency exchange rate is affected by the US dollar’s own weakness abroad, and the setting of interest rates is meant to spur the slowdown in economic activity. On the other hand, productivity and expenditure variables are highly pro-cyclical and may be relied on as drivers of GDP, although their correlations are largely coincident rather than leading, limiting their usefulness as indicators. Consumption, labour productivity, and unemployment are moderate leading indicators. The government hopes to take advantage of the optimistic GDP forecast by lowering interest rates, but economists generally disagree because of the possible inflationary pressure. The study showed, however, that inflation does not appear to be correlated with increased economic activity, probably because productivity increases in tandem with money supply. Government may still pursue more liberal monetary policies, but must proceed with caution. Bibliography Australian Bureau of Statistics, 2012. Economic indicators. Available at: http://www.abs.gov.au/AUSSTATS [Accessed 22 September 2012]. Ell, K., 2012. Falling Commodity Prices Hit Aussie Income Growth. Moody’s Analytics. 13 Sept 2012. Available at: https://www.economy.com/home/login/ds_proLogin_4.asp?script_name=/dismal/pro/blog.asp&cid=234027&tkr=1209251031[Accessed 22 September 2012]. Fisher, L.A., Otto, G. and Voss, G.M., 1996. Australian Business Cycle Facts. Australian Economic Papers, Dec 96, 35(67), p.300. Heath, M., 2012. Australia’s Economic Growth Slows as Rate-Cut Bets Rise: Economy. Bloomberg. 5 September. Available at: http://www.bloomberg.com/news/2012-09-05/australia-s-economic-growth-slows-more-than-forecast-on-housing.html [Accessed 22 September 2012]. Reserve Bank of Australia, 2012. Cash Rate Target. Available at: http://www.rba.gov.au/statistics/cash-rate/ [Accessed 22 September 2012]. Reserve Bank of Australia, 2012. Consumer Price Index. Available at: http://www.rba.gov.au/inflation/measures-cpi.html [Accessed 22 September 2012]. Taylor, D., 2012. Economists forecast rates rise as economy rebounds. ABC News. 15 August 2012. Available at: http://www.abc.net.au/news/2012-08-14/economists-foreshadow-interest-rate-rise/4198458 [Accessed 22 September 2012]. Appendices A. Correlation of CPI (green or red) and M3 (blue line) Quarter-to-quarter growth rate Year-on-year growth rate B. Correlation of Forex (green or red) and M3 (blue line) Quarter-to-quarter growth rate Year-on-year growth rate C. Correlation of Short-term Interest rate (green or red) and M3 (blue line) Quarter-to-quarter growth rate Year-on-year growth rate D. Correlation of Long-term Interest rate (green or red) and M3 (blue line) Quarter-to-quarter growth rate Year-on-year growth rate E. Correlation of Final Consumption Expenditure (green or red) and GDP (blue line) Quarter-to-quarter growth rate (Q1 2000 to Q2 2012) Year-on-year growth rate (Q1 2000 to Q2 2012) F. Correlation of Fixed Capital Formation (green or red) and GDP (blue line) Quarter-to-quarter growth rate (Q1 2000 to Q2 2012) Year-on-year growth rate (Q1 2000 to Q2 2012) G. Correlation of Inventory Investment (green or red) and GDP (blue line) Quarter-to-quarter growth rate (Q1 2000 to Q2 2012) Year-on-year growth rate (Q1 2000 to Q2 2012) H. Correlation of Unemployment (green or red) and GDP (blue line) Quarter-to-quarter growth rate (Q1 2000 to Q2 2012) Year-on-year growth rate (Q1 2000 to Q2 2012) I. Correlation of Unemployment (green or red) and GDP (blue line) Quarter-to-quarter growth rate (Q1 2000 to Q2 2012) Year-on-year growth rate (Q1 2000 to Q2 2012) J. Correlation of M3 (red) and GDP (blue line) Quarter-to-quarter growth rate (Q1 2000 to Q2 2012) Year-on-year growth rate (Q1 2000 to Q2 2012) Read More