In the lead-up to the 2013 Budget an issue that attracted much attention was the weakness of Australia’s nominal economy and the impact this would have on government revenue. For three consecutive quarters (June, September and December 2012), annual growth in nominal gross domestic product (GDP) was less than real GDP growth, the first time this had happened in at least the last 50 years. This short note uses the latest Australian Bureau of Statistics national accounts data to take another look at Australia’s nominal and real GDP growth story (figure 1).
Nominal GDP growth is a measure of economic activity before allowing for inflation. Usually you would expect nominal GDP growth to be higher than real GDP growth because of rising prices. Figure1 bears this out: over the last 40 years annual growth in nominal GDP has always exceeded real GDP growth except for two periods (the September and December quarters 2009; and the June, September and December quarters 2012).
Figure 1 also underscores an important transition in the Australian economy. Australia’s growth path has been much more stable in the twenty years following the recession in 1991 than in the preceding twenty years. And, with inflation more under control, the gap between nominal and real GDP growth has narrowed. In the twenty years to the June quarter 1993, on average, annual nominal GDP growth exceeded real GDP growth by around 8.8 per cent, compared to 2.9 per cent in the last twenty years.
Figure 1 Annual percentage change in nominal and real GDP (seasonally adjusted)
Source: Australia Bureau of Statistics, Australian National Accounts: National Income, Expenditure and Product, June 2013, Cat. No. 5206.0, 4 September 2013.
Real GDP growth measures the change in economic output after taking into account the effects of inflation. However, rather than using the consumer price index (CPI) as the measure of inflation, the implicit price deflator is used to calculate real GDP. The implicit price deflator is a measure of the change over time in the prices of all new, domestically produced, final goods and services in the economy. It therefore includes the prices of Australia’s exports but excludes the prices of imports. The CPI, on the other hand, is a measure of the change over time in the prices paid by households for a fixed basket of goods and services. It includes the prices of imports but excludes the prices of exports.
As the implicit price deflator reflects changes in the prices of Australia’s exports, the gap between nominal and real GDP is sensitive to changes in Australia’s terms of trade (a measure of the value of Australia’s exports relative to its imports) (figure 2).
When Australia’s terms of trade are rising rapidly nominal GDP should grow more strongly than real GDP. Conversely, when the terms of trade are falling rapidly then the gap between nominal and real GDP growth should narrow. And, as we have seen in recent times, if the fall in the terms of trade is large enough it is possible for nominal GDP growth to slip below real GDP growth.
Figure 2 Terms of trade (index) (seasonally adjusted)
The decline in Australia’s terms of trade since its peak in the September quarter 2011 has had a deflationary effect on the economy. While in real terms the economy continues to grow at a reasonable rate, albeit below trend, nominal growth is weak by historical standards. For the last six quarters annual nominal growth has been below 5 per cent, which as figure 1 shows is unusual given the experience of at least the last twenty years. It is one possible explanation for why over the last year or so people’s perceptions of the Australian economy have seemed at odds with the more positive headline indicators. At the end of the day, people’s perceptions are likely to be shaped by their experience of the nominal economy and how it has been changing.
Given the real economy continues to grow at a reasonable clip particularly when compared to many other developed economies it is reasonable to ask whether weaker nominal growth really matters. As noted at the time of the 2013 Budget, weak nominal growth tends to be correlated with lower growth in company profits, lower growth in wages and salaries, and hence lower growth in government revenues. In this sense weaker nominal growth has implications for our ability to fund further improvements in our living standards and deal with emerging challenges such as population ageing.
There is also a risk that nominal weakness can flow back into the real economy through sentiment and income channels. Households may defer spending and focus on balance sheet repair. It may also have a negative impact on business expectations of future demand, which may result in the business sector deferring investment and labour hiring plans.
Taken together figures 1 and 2 suggest that Australia is at an interesting juncture. Nominal growth is at historically low levels and it appears reasonable to assume that Australia’s terms of trade are unlikely to be the driver of higher incomes it has been in the recent past. Given this there is an imperative to lift Australia’s productivity performance if the community is to enjoy higher future living standards and have the wherewithal to address the challenges that lie ahead.