Research Notes

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I'm currently preparing my quarterly updates, which includes revising my outlook for the U.S, the Euro Area, China, India, and Australia, focusing on both GDP and inflation. When discussing inflation here, I am referring to the headline measure of CPI inflation.

Looking at the outlook for growth, it’s quite benign, and the same goes for inflation.

GDP Growth:

In 2024, the U.S. economy grew by 2.8%, but we anticipate it will slow down to about 2.3% in 2025. The Federal Reserve tightened monetary policy for an extended period to slow the economy to a level that wouldn't be inflationary. So, for this year, U.S. growth is projected at 2.3%, with expectations for 2% growth next year.

The model we use for U.S. GDP, is based on the Chicago Fed National Activity Index This shows significant fluctuations in growth projections. The pandemic shutdown drove growth much lower than the model predicted. As the economy recovered, there were large swings above the model's projections, particularly in 2021 when actual growth was much higher than expected, followed by a downturn in 2022. In 2024, growth was then higher than anticipated but is now aligning more closely with our model, which projects US growth at around 1.9% to 2.0%.

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Turning to the Euro area, this has experienced a significant slump, with output in some countries even negative in prior years. However, growth picked up to 0.7% in 2024, and we're forecasting 1.1% for this year, with a slight increase to 1.4% next year. The key difference between Euro area growth and U.S. growth lies in population growth, which is about 1% faster in the U.S. than in the Euro Area. Much of the Euro Area’s growth is driven by productivity.

Officially China's growth was expected to be 5% last year. Amazingly , due to some unexpected lifts in output, it did ultimately reach 5%. Some believe that the actual growth rate was lower . This year, I expect growth to be around 4.5%, with a slight dip to 4.1% next year. For the second-largest economy in the world, a growth rate of 4.5% is still quite strong.

India continues to outpace other economies, with a growth rate of 6.3% last year. We forecast it will grow by 6.9% this year and next year as well.

Meanwhile, Australia has seen some interesting developments. Historically, Australia's economy follows the U.S. cycle, but this time, Australia is leading the U.S. cycle due to increased domestic demand driven by government spending. Growth in Australia was 1.1% last year, and we expect 2.4% this year, with growth stabilizing around 2.3% in the following years.

Inflation:

Now, focusing on inflation, we are primarily looking at Headline CPI inflation, which in the U.S. is projected to reach 2.5% over time. The Federal Reserve's target, however, is based on the Personal Consumption Expenditures (PCE) deflator, which is currently around 2.5% and should gradually decline to 2%. In the U.S., CPI inflation was 3% last year, projected to be 2.9% this year, and 3% again next year, before finally reaching the target of 2.5% by 2027.

In the Euro Area, inflation was 2.4% last year, with a slight decline to 2.1% this year. The Euro Area is targeting a CPI inflation rate of 2%, and we expect it to reach 1.9% by the end of 2025.

For China, inflation was much lower than expected last year, coming in at just 0.2%, compared to a target of 2%. It almost slipped into negative territory in the second half of the year. This year, Chinese inflation is expected to be between 0.6% and 1%, with a slight increase to 1.1% next year. The key issue in China is the lack of domestic consumption, which is necessary to drive economic growth.

India, which targets 4% inflation, saw 4.8% inflation last year. This year, inflation is expected to moderate to 4.3%, with a slight increase to 4.4% next year. India’s focus remains on growth rather than strict inflation control.

Australia’s inflation has been interesting due to government intervention. Last year, headline CPI came in at exactly 2.4%, but core inflation was much higher. This result was achieved through subsidies, particularly for electricity prices. If such subsidies continue into 2025, inflation will likely remain stable. However, without such support, inflation could rise to around 3.7% by 2025, potentially reaching 2.8% by 2026.

Overall, the outlook is one of moderate growth and moderate inflation across the major economies. Recession risks seem minimal, and the global economy is poised for steady, if unspectacular, progress in the coming years.

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What I'm looking at today is how the major campaign announcements we've seen in recent weeks, and those expected in future weeks, will affect the Australian budget deficit.

I think when the political history of this current period is written, significant emphasis will be placed on the long-term friendship between Prime Minister Anthony Albanese and the former Premier of Victoria, Daniel Andrews. This is a close friendship, which might even be referred to as a "bromance".

Andrews was a grand master politician. At the state level, he understood how his party worked and how to control it, knowing what to give different parts of it to ensure they stayed in line. He also understood how the budget cycle worked. Very significantly, he knew how to campaign, how to be a master of the campaign, and how to manage big project announcements, which in his case were always debt-financed. He was skilled at making announcements in such a way that they took the oxygen out of his opponent's campaign. Still, as I say, these projects were always deficit-financed. As a result, we saw Victorian debt levels rise relative to other Australian states.

Deficit spending was first analysed in the 1930s by Maynard Keynes. At that time, the major issue was deflation, meaning price levels were falling. As a result, real wages were rising, and people were being thrown out of employment. Maynard Keynes argued that running deficits would lift the price level, which would reduce real wages and push workers back into employment. This lead to a situation where employment rose, but living standards fell.

Just so, this current period of deficit spending, particularly in the US and to a lesser extent here in Australia, has driven down living standards and generated much of today's political sentiment.

The problem in Australia is that this debt will be paid down by younger generations who will pay a higher proportion of their income in taxes. As I mentioned earlier, further deficit spending will only worsen this problem of living standards; it will not make it better. The current government under Albanese is heading in this direction, with an increasing deficit and levels of debt.

A couple of months ago, Treasury released the Mid-Year Economic and Fiscal Outlook (MYEFO), which showed how future budget deficits and debt levels are moving compared to last year's budget.

According to the MYEFO, the deficit for the year ahead (2025-26) was expected to be $42.8 billion. However, that deficit rose by $4.1 billion to $46.9 billion. For the year after that (2026-27), the deficit was projected to be $26.7 billion but, according to MYEFO, increased by $11.7 billion to $38.4 billion. In 2027-28, the projected deficit of $24.3 billion from last year’s budget was project to rise to $31.7 billion. So, the deficit problem is worsening, and as expected, that means the debt problem is also getting worse.

In last year’s budget, the level of gross debt was expected to be $1.007 trillion for 2025-26. But in MYEFO, that expanded by $21 billion to $1.028 trillion. By 2026-27, the debt level is expected to expand by $36 billion, and the following year, by $49 billion. This shows that the situation is getting worse, not better.

Looking ahead to the election, given that Albanese has learned much from Daniel Andrews, we can expect to see the announcement of big projects. We've already seen the expansion of Medicare announced, and we're sure to get more before the budget is finalised.

The problem is that this situation of expanding deficits, which was a particular specialty of Daniel Andrews and is now a speciality of Anthony Albanese, will make the issue of living standards worse, not better. Let's see what further data we can get on this when the budget is released on 25 March.

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Yesterday, the Reserve Bank of Australia (RBA) board met and reduced the Australian cash rate by 25 basis points to 4.1%. At the same time, they released the Quarterly Statement of Monetary Policy, which provides a broad range of outlooks for various variables affecting the Australian economy. The release of this report, on a quarterly basis alongside the RBA meeting, serves a similar function to the Summary of Economic Projections released by the Federal Reserve.

The RBA’s initial message was that even with the reduction in monetary policy, the outlook remains restrictive. However, according to our own model, A Cash Rate of 4.1% is not restrictive, but modestly expansive. Our model is based on 35 years of data.

The Quarterly Statement indicated that the outlook for the Australian economy is for considerable expansion. After last year’s GDP growth of only 1.1%, which economists consider a soft landing, growth is projected to pick up, with a forecast of 2% for the year to June 2025. This is followed by 2.4% for the year to December 2025 Growth continues between 2.3% and 2.5% over the following years. Even in 2027, growth is expected to remain above 2%. This represents a promising future for the Australian economy. Interestingly, business investment is not expected to be the main driver of this growth. Business investment growth for the year to December was zero and is expected to remain at zero for the year to June, only growing by 1.4% by the end of 2025. It seems that growth will accelerate only after the economy picks up speed. Household consumption is also forecast to increase slightly from 0.7% last year to 2.6% this year.

The primary factor driving the anticipated growth is Public Demand, largely funded by "other people’s money". Public Demand (Government Spending) grew by 4.9% in the year to December 2024 and is expected to grow by 5.3% or more for the year to June 2025, with projections of 4.3% for December 2025 and 4% for 2026. This growth in public demand, largely financed through public borrowing, includes Federal and State Government spending, particularly on infrastructure projects. While this expansion will stimulate demand, it will be paid for later by taxpayers.

The unemployment rate, currently at 4%, is expected to rise slightly to 4.2% mid-year, where it is anticipated to remain. The RBA has indicated that this increase in unemployment will help reduce inflation, although not to the target of 2.5%. Inflation is projected to fall from a trimmed mean of 3.2% for the year to December 2024, to 2.7% by June 2025. However, inflation is expected to stabilise at this level, not reaching the 2.5% target.

This raises an interesting question: why does the RBA believe that inflation can fall to the lower end of the 2-3% range without unemployment reaching 4.6-4.7%, as suggested by historical data? We believe that the significant import boom in Australia, with imports rising by 6.2% for the year to December 2024, has played a role. Import growth is expected to slow in the coming years. We think that but year's surge in imported manufactured goods at low prices has created an illusion of sustainable low inflation at the same time as relatively low unemployment.

Our analysis suggests that such low inflation is unsustainable unless unemployment rises to 4.6% or higher. This issue may resurface in the coming quarters as the true challenges of reducing inflation are revealed. However, for now, we can say that the Australian economy appears to have bottomed out. We’ve had our soft landing with 1.1% growth in December 2024, and growth is now accelerating, even if it is being driven by public spending. By the end of 2025, growth is expected to reach 2.4%, and the economy is set to maintain above 2% growth for the next several years. This represents a strong recovery, and the Australian economy appears poised for a period of better performance in the coming years.

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