Brian Fallow: Prepare for the hangover

Gather up the glasses. Sweep up the streamers. The party is over.

Last Friday's gross domestic product figures confirm that the peak in this economic cycle is behind us.

For the third quarter in a row, growth was below trend. The economy expanded 2.5 per cent in the year ended March, the weakest annual growth rate for four years and well below the average of 3.4 per cent over the past 10 years.

Growth over the past three quarters has averaged 0.5 per cent a quarter, only half what the Reserve Bank forecast.

Deutsche Bank chief economist Ulf Schoefisch said it could be argued that the weakness in GDP growth was largely driven by an underperforming export sector while the domestic sector remained uncomfortably buoyant.

But he said a further rise in interest rates would be the wrong response to that problem. Its main effect would be on the dollar, increasing the pressure on exporters, rather than on mortgage rates and domestic spending.

Nonetheless, there continues to be a troublesome gap between the rate at which demand within the economy is growing and the rate at which the output of goods and services, the supply side, is growing. We are better at consuming than producing.

Domestic demand (the combination of household and government spending, plus investment in buildings, plant and machinery) grew 1.3 per cent in the March quarter and by 5.2 per cent over the year ended March.

Production GDP, by contrast, was up only 0.6 per cent in the quarter and 2.5 per cent for the year.

Both have been heading down. Annual growth in GDP peaked at 5.8 per cent in June last year, while internal demand growth hit 9.3 per cent three months earlier.

When demand growth outstrips supply like this, it pushes up inflation and sucks in imports, which rose 13 per cent in volume terms over the year.

Meanwhile exporters - at least in those sectors which have not enjoyed the benefits of near-record world commodity prices - are struggling.

The Reserve Bank's seven interest-rate rises over the past 18 months may have had, so far, only a moderate effect in cooling the domestic economy.

But they have pushed the official cash rate to 1.25 percentage points above Australia's, 3.75 percentage points above the comparable US rate and 4.75 per cent above the euro zone's.

Those interest rate differentials have pushed the dollar to levels historically painful for exporters and the anaesthetic of currency hedges is wearing off.

Exports of services fell in the March quarter, reflecting a 10.7 per cent drop in spending by tourists. Arrivals numbers are holding up, but tourists aren't staying as long and are spending less a day.

Most manufacturing sectors' activity shrank as well, with a notable 6.5 per cent decline in the forest products sector.

By contrast, service sectors such as retailing, transport and communications, exposed to the free-spending household and government sectors, have been flourishing, growing two to four times faster than the economy as a whole.

The construction sector grew 4.5 per cent in the March quarter but that just reversed declines over the two previous quarter.

Westpac economists see faltering demand, rather than capacity constraints, behind this flattening off in construction activity.

The net migration cycle peaked more than two years ago and the number of building permits issued peaked early last year.

The Westpac economists also cite the Institute of Economic Research's latest quarterly survey of business opinion that recorded an easing of capacity constraints in the construction sector. Less overtime was worked and builders saw fewer new orders.

Since the construction sector has been an inflationary hot spot in recent years, this should come as a relief to the Reserve Bank.

Meanwhile, household borrowing has been outstripping incomes by a wide margin. The combination of employment growth and higher wages has boosted households' incomes in aggregate by 7 per cent over the past year. But their debt has climbed 15 per cent.

That increase in debt, combined with higher interest rates, has pushed debt servicing costs up 23 per cent over the past year, Schoefisch says.

Looking forward, he sees the household sectors squeezed between that increase in outgoings on the one hand and weaker growth in incomes on the other as the job market cools.

"Furthermore, farm incomes will come under pressure as the full effect of the past dollar appreciation is felt and export commodity prices undergo a modest correction."

Schoefisch expects economic growth to remain subdued this year and next year at around 2 per cent per annum, reflecting the lagged effects of weak net immigration, rising interest rates at a time of high household debt levels and the large appreciation of the dollar.

The risk is that it could be weaker than that, given worsening business confidence and renewed concerns about global prospects, he warns.

Our trading partners chalked up 4 per cent growth last year but the consensus view of economic forecasters in those countries is for growth to slow to 3 per cent this year before recovering somewhat to 3.3 per cent and 3.4 per cent next year and the year after.

Expectations for Australian growth, in particular, have been cut back, with the consensus now an anaemic 2.3 per cent this year and 3.2 per cent next year.

That is still a rosier outlook than ours. The consensus view among 11 economic forecasters gathered by the institute last week has growth at 2.4 per cent over the year to March 2006 and 2.3 per cent the year after.

But although the economy is slowing, the labour market is expected to remain tight.

Even though growth in the number of jobs is expected to slow from a strong 3.4 per cent in the year to March 2005 to 1 per cent in the March 2007 year, the supply of labour will grow more slowly too, because of weaker net inflows of migrants.

As a result, the unemployment rate is forecast to increase only moderately, the institute says, remaining fairly stable at 4.1 per cent in the year ahead before edging up to 4.4 per cent the following year.

Such a tight labour market will maintain the upward pressure on wages.

But Schoefisch says the anecdotal evidence is that a slowing economy and a competitive trading environment are largely preventing firms from passing on the extra cost.