A single event or trend never occurs in isolation. Reactions to it, as well as independent forces working in the opposite direction, mean the net overall effect can be uncertain and changeable.
This week we release our Market Outlook for March, updating our economic and financial forecasts. As well as the abrupt shift in market sentiment over the past few weeks, stemming from developments overseas, forecasting has been challenged by the prevalence of forces that are working in opposite directions on the same outcome. The net effect of these opposing forces can go either way, and it is often hard to know which direction will prevail.
The US tariffs are a case in point. They are likely to boost US inflation at the same time as being negative for growth. Which consideration will weigh more in the Federal Reserve’s monetary policy decision? You can rely on quantitative analysis to the extent possible, but often there is an element of judgement to these assessments. While it is hard to be sure, given the associated deterioration in market and consumer sentiment, we have – like market pricing – put more weight on the implications for growth and brought forward our expected timing of future Fed rate cuts.
More broadly, we cannot assess the net effect of tariffs and other US policies without also considering how the tariffed countries will react. This was one of the messages from our December/January Market Outlook, as expanded in a note with Westpac economist Illiana Jain. For Australia, the most salient reaction is how China will respond to the tariffs, particularly via domestic stimulus. More recently, countervailing tariffs – though not by Australia – and increased defence spending in Europe all come into the mix as responses to Trump administration policies.
The importance of how others react is also highlighted in the geopolitical sphere. Recent weeks have seen a clear break in how the US is perceived by its longstanding allies, and in the reliance those allies can place on US defence cooperation. We had already factored in the imperative for higher defence spending into our thinking to some degree, including in Europe. This was one of the shifts tilting the balance of global saving versus global investment relative to the pre-pandemic period that informed our house view that the global structure of interest rates is likely to average higher in future than it did in the period between the GFC and the pandemic. Developments in recent weeks reinforce the underpinnings of that view.
On the domestic front, we likewise see opposing forces with uncertain net effects. For consumption growth, we see a pick-up as tax cuts and declining inflation translate into stronger growth in real household incomes. Against those forces, though, population growth is slowing as the post-pandemic catch-up washes through. This could weigh on growth in total consumption even as per capita consumption and sentiment improve.
The unwind from the surge in population growth also complicates assessments of the outlook for the labour market. Recall that if population growth is high, employment growth needs to run very hard to keep pace with rising labour supply, else labour market slack will emerge. In the Australian context, a rising trend in the participation rate has added to this imperative. As the post-pandemic surge in population growth unwinds, that imperative will lessen.
At the same time, though, we know that the boost to employment from the ramp-up in the care economy will end, and employment growth in that sector will normalise. So we have a potential slowing in growth in labour demand at the same time as growth in labour supply (from population growth) is also slowing. The net of these two shifts is uncertain, and it could evolve over time and perhaps even change sign.
On top of the complexities of balancing two shifts in trend with uncertain net effects, any situation where trends are shifting presents measurement issues. A sharply changing growth rate is also one that is hard to measure accurately in real time. Interpreting the data to infer a trend becomes more complicated in this situation. For the labour market, one way to look through these changes in trend is to focus on ratio measures such as employment-to-population or the unemployment rate, rather than employment growth. It remains the case, though, that the dynamics of labour supply will reflect the net of the opposing forces of slowing population growth and a still-rising trend in participation.
There is a broader point here: when considering the effect of a shock, you cannot trace through its effect alone. It is important to factor in the reactions and whether there are other independent (ie not explicit reactions) forces that are offsetting. You also need to hold your assessment of the sign of the net effect lightly and recognise that small changes in relative strengths could flip that sign. This sounds like the general equilibrium thinking economists are trained to do. Most of the time, though, strategic behaviour by conscious actors is a better way to frame the situation.
Importantly, if the net effects of two or more opposing forces flips in sign (or could do so), you need to acknowledge that possibility, rather than getting caught in a narrative favouring one direction. Understanding those forces and how they might evolve can in any case be more useful for your own decision-making than a fixed view of their net effect.
