Dark clouds on the horizon

As a new Australian government attempts to navigate its way out of the economic doldrums, it will receive minimal help from a world equally beset by crisis and regime change, writes AICD chief economist Mark Thirlwell MAICD.

Australia’s new government faces a challenging set of economic circumstances, some old, some new. On the home front, it confronts a politically sensitive cost of living crisis, powered by the highest inflation rate since the start of the century and in the process of being exacerbated by rising electricity prices. In response, the Reserve Bank has initiated its first monetary policy tightening cycle in more than a decade, hiking interest rates against the backdrop of an historically tight labour market and record high household debt. Meanwhile, the economy is still suffering the after effects of the COVID-19 shock in terms of stressed supply chains, rising input costs and widespread labour and skills shortages. Granted, strong growth in consumption and a healthy investment pipeline has delivered some favourable short-term economic momentum, carrying the economy safely through a first quarter disrupted by both the Omicron variant and severe flooding in Queensland and New South Wales. But medium- term growth prospects continue to be clouded by a legacy of lacklustre productivity growth. Moreover, the scope for active fiscal action to deal with any of this is constrained by a long-term gap between revenues and expenditures, albeit one that, in the near term, is being masked by the boost to revenue delivered by high commodity prices.

That list of domestic challenges would be enough to keep Canberra busy on its own. But the international economic environment looks at least as daunting, with the world economy rocked by a series of overlapping, interlocking and reinforcing crises — a full-blown “polycrisis”.

COVID-19 aftershocks

The first element of that polycrisis comprises the ongoing aftershocks from a pandemic that at its outset helped produce the sharpest fall in global output since World War II. In 2021, there had been hopes that the world economy would put COVID-19 behind it this year with a rebound that would trigger the start of a new “Roaring Twenties”. Omicron put an abrupt end to that early optimism, and by January this year, the International Monetary Fund (IMF) had already trimmed half a percentage point from its forecast for world growth in 2022. Pandemic-instigated shocks to supply chains — and the consequent inflationary impulse — have been much longer-lasting than official forecasts earlier envisaged. And the interaction of new variants with Beijing’s strict zero-tolerance COVID-19 policy has compounded the problem. According to a CNBC estimate, in May, some 40 cities, 328 million people and about 30 per cent of national economic output were under partial or full lockdown in China. Those restrictions were in the process of being relaxed at the time of writing, but meanwhile the impact has been to further strain already stretched global logistics. Indeed, the scale of the recent disruption to supply chains has been unprecedented this century.

Geopolitical upheaval

The second crisis came in February this year, with the Russian invasion of Ukraine. As well as triggering humanitarian and geopolitical crises, the outbreak of a major land war in Europe has added to the pressures on the world economy, placing yet more strains on supply chains while disrupting commodity markets, particularly for food and energy, and increasing uncertainty. As a result, by April this year, the IMF was again downgrading its global growth forecast — this time by 0.8 percentage points — with cuts to its growth projections for 143 of the world’s economies.

The third element of the polycrisis — a worldwide stagflationary shock — is in large part a product of the previous two crises, including the extremely stimulatory macro-policy response to the initial pandemic-triggered growth collapse. By April this year, consumer price inflation across the OECD had reached an annual rate of 9.2 per cent, its highest since 1988, with nine OECD economies recording double-digit increases. Energy price inflation was running at more than 32 per cent year-on-year, while food prices were up 11.5 per cent. The Food and Agriculture Organization (FAO) world food index spiked to a record high in March, and although it has since fallen slightly, high food prices continue to threaten social, financial and political stability across the developing world.

Further complicating an already complex environment is the fact this polycrisis is unfolding alongside, while simultaneously contributing to, a series of regime shifts in the global economy. For example, the acute disruption to international supply chains is just the latest sign that the pre- global financial crisis (GFC) era of hyperglobalisation has departed. While at the same time, by boosting the case for resilience and self-sufficiency, it’s also contributing further to the fragmentation of the world economy. Similarly, just as the shift to an increasingly contested geopolitical environment clearly pre-dates war in Ukraine, it’s equally clear the war has accelerated that trend.

Money on the march

A third example of this process is the way that inflation rates at multi-decade highs have produced a profound shift in the global monetary regime, forcing central banks to unwind the ultra-easy policy settings that have a been a feature of the global economic landscape since the GFC. The US Federal Reserve has been at the centre of this process, earlier this year delivering both its first 50 basis point rate hike since 2000 and the first back-to- back rate increases since before the GFC (in 2006). But it is far from alone. The Financial Times recently noted more than 60 policy rate increases across the world’s leading central banks over the three months to June, the broadest increase seen since at least the start of the current century. That policy regime shift has contributed to a “risk off” mentality in financial markets that, over the second quarter of this year, shredded the value of risk assets from meme stocks, crypto and tech stocks, to emerging market bonds, sending the liquidity-fuelled “everything rally” into a painful reverse.

The overall impact of these developments is that three of the most important engines of the global economy are stuttering. China’s coronavirus lockdowns plus fallout from its faltering real estate sector have pushed down economic activity. Europe’s significant exposure to the war in Ukraine and heavy reliance on Russian energy supplies have likewise sapped that region’s economic momentum. And in the US, the risk is that a Federal Reserve that has fallen behind the curve on inflation may be forced to tighten so aggressively that it tips the American economy into a recession.

All of which means that Australia’s new government cannot look to a benign external economic environment while it negotiates its own domestic economic travails.