Australian economic outlook in FY26

As inflation subsides and rate cuts begin, Australia has entered the new financial year with cautious optimism – but household spending remains the key swing factor.

With the post-COVID surge in inflation almost completely unwound and the Reserve Bank gradually taking its foot off the interest rate brake, the outlook for the Australian economy heading into the new financial year is one of cautious optimism.

Of course, there are risks – particularly with a feisty new US President seeking to reshape global trading and security arrangements to his liking.

The key to the domestic economic outlook, however, is the behaviour of households.

Consumer spending initially burst back strongly as COVID-related restrictions eased. But in more recent years, household spending has slowed to a crawl, not helped by a significant decline in real income from 2021 to 2023 due to higher inflation, higher interest rates and the long-term effects of income tax bracket creep.

Even more surprising, household spending has remained weak even as household income began to recover from late 2023, with a large chunk of the extra income saved rather than spent. Even a strong rebound in immigration has not lifted overall consumer spending, with more people around to spend being largely offset by a decline in per-capita spending.

All up, in the March quarter consumer spending grew by only 0.4.%, to be up a measly 0.7% over the year. High interest rates – courtesy of the Reserve Bank – and lingering fears of a recession have kept household purses shut.

Consumers cautious, care sector growing

All that said, with inflation falling and the Reserve Bank shifting to an easing policy bias, there’s light at the end of the tunnel for downtrodden consumers.

Annual underlying inflation – as estimated by the trimmed mean measure – has eased from a high of 6.8% in the December quarter of 2022 to 2.9% by the March quarter of this year. The Reserve Bank expects underlying inflation to ease to 2.6% by mid-year and hold there over the next year or so. That’s close enough to the mid-point of the RBA’s 2-3% inflation target band to justify a lowering in official interest rates back to less restrictive levels.

Having lifted rates from 0.1% to 4.35% over 2022 and 2023, the RBA cut rates by 0.25% in both February and May this year. At 3.85%, the RBA cash rate can still be considered restrictive – but less than it was – and markets expect a gradual easing to just under 3% by early 2026. That would leave rates broadly neutral; neither overly restrictive nor expansionary.

The weakness in economic activity, however, especially in consumer spending, has not stopped continued strong gains in the labour market. Helped by strong growth in the care sector, covering everything from health care, childcare and disability to aged care, employment growth has remained firm and unemployment low at around 4%.

In an ideal world, the Reserve Bank would welcome a lift in GDP growth, driven by higher consumer spending, although with some moderation in employment growth so that the level of unemployment drifts up closer to 4.5% – a level the RBA feels is more consistent with low and stable wage growth and price inflation over time. That might come about if Australia’s current abysmal rate of productivity growth, or growth in economic output per worker, improves back towards more normal long-run average levels.

But with the growth in the care sector seemingly unstoppable, where productivity growth tends to be low, I won’t hold my breath for a productivity rebound any time soon. The lack of any productivity-enhancing incentives or competition policy reforms from state and federal governments is also not encouraging.

Therefore, if consumer spending does recover, it seems even more likely that employment growth will remain firm and unemployment low. Thankfully, however, and contrary to RBA fears, today’s low level of unemployment has not stopped an easing in price and wage inflation in recent years, suggesting the sustainable level of unemployment may be nearer to current levels than the 4.5% long desired by the RBA.

Housing recovery, green energy and exports poised for growth

Beyond consumer spending, there are good grounds to expect a stronger recovery in housing construction.

Despite housing shortages, a drain on skilled tradespeople combined with a boom in infrastructure projects has constrained the supply of new housing in recent years, while high interest rates, poor affordability and weak household income have constrained demand. With many infrastructure projects now winding down, and affordability improved by lower interest rates, housing construction is well placed to recover.

Both public demand and private business investment are expected to remain firm, although moderate somewhat as drivers of economic growth. Given the needs of the green energy transition and growth in online shopping and data storage, ongoing private investment in renewable energy projects, warehouses and data centres will be required. Ongoing growth in health, education and social services will also continue to underpin public demand, despite some efforts to reign in government budget deficits.

That leaves exports, where growth is expected to remain positive but subdued as the influx of foreign students and tourists continues to level out following their strong post-COVID rebound. Weakness in China’s once red-hot property sector, and occasional weather-related local supply disruptions, are also constraining growth in coal and iron-ore exports.

Risks to the outlook: Upsides and downsides

While there are both upside and downside risks to the economic outlook, they appear mainly skewed to the downside. The main upside risks are a strong home price and consumer spending rebound as the RBA continues to lower rates. But lingering consumer caution – particularly given the global outlook – and already poor housing affordability should constrain these risks.

Meanwhile, the major downside risk is a deterioration in the global economic environment should higher US tariffs lead to a tit-for-tat trade war.

At this stage, markets are placing great hope on the ‘TACO’ trade, or the belief that ‘Trump Always Chickens Out’. While talking tough, the hope is the US President will ultimately pull back from draconian tariff increases – an inflationary tax on imports – if that risks pushing the US economy into recession, as this could in turn cost the Republican party in next year’s mid-term Congressional elections.

(Source: BetaShares Insight)

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