Tag: The Treasury

The Pre-election Economic and Fiscal Outlook 2016 is out.  The modelling is close to the budget numbers – though the deficit will be bigger sooner, then begin to reduce. The underlying cash balance is estimated to be a deficit of $37.1 billion (2.2 per cent of GDP) in 2016-17, improving to a deficit of $5.9 billion (0.3 per cent of GDP) in 2019-20. The current financial year deficit estimate has been changed since the budget, increasing by $100 million to $40 billion.  As with any “hockey stick” projections, you just know the timing of improvements will be uncertain.

The 2016 PEFO uses the same projection methodology that has been used in budgets and budget updates since the 2014-15 Budget.

Treasury’s medium-term economic projection methodology assumes that any estimated gap between forecast real GDP and potential GDP closes over the first five projection years (2018-19 to 2022-23) as spare capacity in the labour market is absorbed. Beyond that point, real GDP and other economic variables are assumed to grow in line with their estimated long-run trend rates.

The medium-term economic and fiscal projections are sensitive to the assumptions that underpin Treasury’s estimate of potential GDP — that is, assumptions about population, productivity and participation. They are also sensitive to the assumed pace of the economy’s return to potential — that is, the assumption that the adjustment period lasts five years.

Analysis reported in the 2016-17 Budget shows that a faster (two year) adjustment to potential requires comparatively faster growth in real GDP and employment as the output gap closes and spare labour is put to use. This leads to lower unemployment and faster growth in wages and domestic prices, increasing nominal GDP and improving the projected underlying cash balance over the medium term even as
Pre-election Economic and Fiscal Outlook 2016 long-run real GDP is unchanged from the Budget projections. A more gradual adjustment period (eight years) is estimated to have broadly opposite effects on the projections.

Analysis in the 2016-17 Budget also shows that lower trend productivity growth than assumed in the Budget projections would directly reduce potential growth — leading to permanently lower real GDP and wages with only a small impact on prices. In this scenario, lower nominal GDP leads to lower projected tax receipts which weakens the projected underlying cash balance over the medium term. By contrast, assuming faster trend productivity growth than assumed in the Budget projections results in higher nominal GDP and tax receipts, strengthening the underlying cash balance.

Net debt, net financial worth, net worth and net interest payments are essentially the same as published at the 2016-17 Budget. In 2016-17, net debt for the Australian Government general government sector is expected to be $326.1 billion (18.9 per cent of GDP). Net financial worth is estimated to be -$427.2 billion and net worth is estimated to be -$301.0 billion.

Net interest payments are estimated to be $12.6 billion in 2016-17 (0.7 per cent of GDP). Interest payments largely relate to the public debt interest on government securities, based on the interest rates on the existing stock of Commonwealth Government Securities (CGS) and the prevailing market interest rates across the yield curve for future issuance of CGS. This PEFO assumes a weighted average cost of borrowing of around 2.5 per cent for future issuance of Treasury Bonds in the forward estimates period, the same as the assumed market yields used in the 2016-17 Budget. Yields are volatile and could vary from those assumed in the Budget. Recent movements in interest rates, if maintained, would lower the government cost of borrowing, reducing interest payments and expenses over the forward estimates. It would also reduce interest receipts earned on assets.

The Secretary to the Treasury, John A. Fraser, has provided an opening statement to the 2016-17 Budget Estimates session of the Senate Economics Legislation Committee. In the statement he discusses weak inflation, prospective economic growth across the states, and the litany of global economic risks, including from a slowing China, financial markets, and low inflation. The fact is that global economic conditions continue to be challenging. Finally, he speaks to the 10 year costs of the budget plan to cut company tax over 10 years and lifting the small business threshold.

In essence, the Budget forecasts indicate that the Australian economy continues to transition from mining investment-led growth to broader-based growth. But real GDP growth is forecast to be below potential over the next two years at 2½ per cent in 2015-16 and 2016-17 and then strengthen to 3 per cent in 2017-18 as the detraction from falling mining investment eases. Over the following two years, real GDP is projected (not forecast) to increase by 3 per cent per annum.

The economy is already benefiting from rapidly rising mining export volumes and this is set to continue as more LNG export capacity comes on line. Mining export volumes are expected to increase by more than 20 per cent over the forecast period.

In the midst of this transition and as noted at our most recent Hearing, the labour market has been remarkably resilient. The labour market has performed better than expected at 2015‑16 MYEFO. Employment growth has been supported by moderate wage growth and the transition to more labour-intensive sectors of the economy.

Inflation outcomes so far appear to have been weaker than forecast in the 2015‑16 MYEFO. Consumer price inflation in the March 2016 quarter showed broad‑based weakness that was reflected in the very weak underlying inflation outcome. In that context, the Reserve Bank Board decided to reduce the cash rate by 25 basis points to 1.75 per cent, the lowest setting on record.

Reports from across Australia indicate that activity in New South Wales and Victoria remain strongest, while activity in Tasmania has also picked up. The Northern Territory and the Australian Capital Territory are performing reasonably well and Queensland is performing better than expected a year ago supported by a pick-up in construction activity around Brisbane. South Australia continues to remain soft, and there are clear signs that activity in Western Australia is weaker than expected.

Globally, growth is forecast to be weaker than 2015-16 MYEFO. The United States has had a slow start to the year but there are tentative signs of a pick-up in Europe. China’s growth continues to moderate, but remains relatively strong compared with most other major economies.

I want to focus my comments today on the risks to the global outlook.

Risks to the global growth outlook are present in both advanced and emerging market economies as global uncertainties increase. This message was made clear at the latest meeting of the G20 Finance Ministers and Central Bank Governors in April where the outlook for growth was assessed to remain modest and uneven.

As also noted previously, significantly for Australia are the uncertainties around the implications of the transition in the Chinese economy from investment-led to consumption and services-led growth given the exposure of Australia and its major trading partners to China. And while China’s economic transition is expected to contribute to more sustainable growth over the longer term, Chinese domestic consumption and a growing service sector is unlikely to fully offset the decline in investment and a slowing industrial sector in the near and medium term.

There will be opportunities for Australia in this transition. Our past trade has predominantly been focused on demand for our commodities. Trade with China as it transitions to a consumer-led economy will be more focused on demand for our services. We also expect a growing investment relationship with China, building off a strong base and further boosted by the China-Australia Free Trade Agreement.

A sharper than expected slowdown in Chinese growth, however, would have significant implications for our economy and the region. This is because China is Australia’s number one export market and import supplier. Globally, China is one of the main trading partners for more than 100 economies which account for about 80 per cent of world GDP; so a slowing China will have far reaching effects around the world.

There are risks of renewed volatility in financial markets, which we saw earlier this year. That volatility can reflect concerns in equity and credit markets as to whether the outlook for current global growth will be strong enough to drive corporate earnings and maintain low default rates in order to sustain current valuations. Such bouts of volatility have adversely impacted the financial conditions faced by businesses and households in key global economies.

Banks globally also continue to hold more capital than they did prior to the global financial crisis. However, a number of major economies continue to face financial challenges, particularly the euro area, Japan and a range of emerging market economies. Significant debt has been raised in recent years, particularly in emerging markets, which could also create challenges for both borrowers and lenders in a continued low global growth environment.

Inflation remains low globally reflecting, in part, the impact of low energy costs. I expect inflation in major advanced economies to remain below policy targets for at least in the near term and monetary policy in major advanced economies to remain accommodative for some time yet. Significantly, expectations for further US Federal Reserve rate rises have been pushed out a little.

There is also the risk that low inflation, coupled with low wages growth and low productivity growth experienced in many advanced economies, could become embedded in lower potential growth over time.

Estimates for long-run potential global growth are also being reconsidered by official forecasters. This partly reflects the ongoing legacy of the global financial crisis which has had long lived effects on investment in productive capital and on labour markets. In advanced economies, potential growth was slowing even before the global financial crisis.

Contributing to low productivity growth and declining potential growth is the significant transition underway in global demographic conditions. The global population is growing more slowly, and as fertility rates fall and people live for longer, populations are growing older. A number of countries — including Japan, China and Germany — are confronting declining working age populations.

There is also uncertainty about the effect of oil prices on global growth. This is because the response to lower oil and energy prices in 2015 has not been as strong as might be expected based on historical experience. Factors likely to have muted the positive net impact of lower oil prices on global growth include lower global energy investment and a smaller than expected increase in global private consumption, perhaps as consumers save part of the windfall from lower oil prices.

In summary, it is all uncertain. The Budget shows that the Australian economy continues to transition from mining investment-led growth to broader-based growth. As a still relatively small, open economy, global economic conditions are very important to Australia’s economic outlook. The fact is that global economic conditions continue to be challenging.

On another matter, Treasury standard practice is not to release costings beyond the forward estimates or for the medium term. On this occasion, the Treasurer has authorised me to provide to the Committee the medium-term estimate of the cost to the budget of lifting the small business entity threshold and reducing the company tax rate to 25 per cent by 2026-27. The cost of these measures to 2026-27 is $48.2 billion in cash terms. These estimates have been incorporated into the budget’s medium-term projections for tax receipts. I note that, as with all tax projections over 10 years, these costings have considerable uncertainty. I also note that the medium term economic projections in the Budget assume significant ongoing economic reforms. Finally, I note that Treasury has estimated that the Government’s tax package is estimated to increase the level of GDP by a little over 1 per cent in the long term.

Warren Tease, Principal Adviser, Macroeconomic Conditions Division spoke at CEDA’s Economic and Political Overview Conference about forecasting in Treasury.

Most forecasts for growth in most economies have been persistently too high over the past few years.

In that time, a key feature of the forecasts for the global economy and for Australia has been the persistent downgrading of forecasts. The pattern of downgrades is clear. In almost every year since the crisis, forecasters have been too optimistic about the outlook for growth. Treasury’s forecasts have exhibited the same behaviour. This persistent bias is perhaps the most unusual attribute of recent experience, at least in Treasury’s case, as past forecasting reviews have shown that Treasury’s real GDP forecasts have not exhibited persistent errors over time.

Digging a little deeper into this quantitative work I would also observe that Treasury’s forecasts did well in normal times but were challenged when conditions were unusual.

Thus, while there was no evidence of persistent errors over a very long time period, Treasury’s forecasts were punctuated by persistent and sometimes large errors over horizons relevant for policy makers and their advisers.

This can be seen in the following chart which compares Treasury’s forecasts of nominal GDP growth with actual outcomes since the early 1990s. I use nominal rather than real GDP as it is a key input into forecasting budget outcomes.

Chart 2 — Nominal GDP Forecasts and Outcomes

Source: Budget papers and ABS cat. no. 5206.0

It shows three distinct periods of forecast errors. Forecasts regularly overestimated nominal GDP growth in the early 1990s and after the financial crisis while understating outcomes for most of the 2000s prior to the crisis.

Each of these episodes coincided with Treasury persistently erring in its inflation (measured by the GDP deflator) forecasts. This observation has been made in each of the previous forecast reviews.

As previous reviews noted Treasury missed the decline in inflation in the early 1990s.

More recently, the forecasts did not incorporate fully the impact of the unprecedented rise then fall of commodity prices. In the upswing, Treasury’s forecasts did include projections that prices would eventually fall but these proved to be wrong as prices continued to increase. In the downswing, prices have fallen more rapidly than Treasury’s assumptions implied. Heightened volatility in Australia’s terms of trade has made it more difficult to forecast nominal GDP outcomes.

While difficulty in forecasting the GDP deflator has been a feature of Treasury’s (and others’) forecasts, past reviews have shown that its real GDP forecasts were more accurate and unbiased. Therefore, it is the persistent errors in Treasury’s real GDP forecasts of the past few years that have been unusual.

The chart shows that in the 1990s and 2000s there was no distinct under or overestimate in Treasury’s forecasts for the real economy. However, since the crisis Treasury, like the other forecasters presented earlier, has for the most part overestimated real GDP growth.

Chart 3 Real GDP Forecasts and Outcomes

Source: Budget papers and ABS cat. no. 5206.0

Now I do not wish to push this point too hard as the sample set is very small but it is consistent with what we are seeing across a range of forecasters and countries.

He has reviewed the forecasting approach, and concluded that in Australia a smaller number of input metrics have been used, compared with other countries. In addition Australia, as an open economy is wide open to international factors which impact locally.

“For a small open economy like Australia, persistent and short-term deviations from trend are likely to be driven by global economic shocks, large changes in commodity prices or from the financial sector. Other factors could also be important but these three factors encompass much of Australia’s experience with shocks.”

Finally, there is a bias towards trend performance, so any deviation is harder to cope with.

“It means that Treasury’s forecasting approach is likely to generate reliable forecasts at times when economic conditions are normal but will be challenged at other times.

There is a therefore a high probability that structural changes or persistent shocks will not be adequately incorporated into the forecasts”.

Good to see a discussion about the complexity of forecasting in a volatile environment. We should not be taking their projections as gospel truth. Forecasting ain’t easy!