PwC’s Chief Economist Amy Lomas says Australia’s exposure to the Iran shock has lifted the probability of a recession, but she still thinks the country avoids one. Here’s why.
Australia will likely avoid a recession in the near term, even as the country’s heavy diesel exposure leaves it uniquely vulnerable to the ongoing Iran shock and the persistent inflation it has fed into. That is the call from Amy Lomas, Chief Economist at PwC Australia, made on the new-look Switzer Investing TV last night.
Speaking to guest host Paul Rickard on the eve of the federal budget, Lomas made the point that the probability of an Australian recession has risen since the Middle East conflict began, but that her base case has not yet shifted. The reason it has risen comes down to how Australia’s industrial sector contributes to the economy.
“I don’t see a recession anytime soon. If you’d have asked me that question maybe before the Middle East war broke out, I would have said that I don’t see that there’s any likelihood of a recession in Australia anytime soon,” she said.
“With the war breaking out, and given Australia’s large freight industry, its manufacturing, its mining, its agricultural industry, we are particularly exposed to fuel costs. Far more exposed than what we were say to tariffs that were brought out last year by the Trump administration,” Lomas added.
She’s not wrong, either. Australia is one of the highest users of diesel in the world. As we continue to stare into the abyss of oil price rises (currently diesel is at almost $2.50 a litre in NSW, and that’s a good day). She adds that because we’re different from other economies, it’s particularly bad news when fuel prices in our market.
Diesel-dependent industries here have low demand elasticity, meaning higher fuel costs pass straight through to prices rather than reducing consumption.
“Australia’s economic composition does include a number of industries that are highly dependent on liquid fuels, particularly diesel. And those industries are often export-facing industries. So they have very low elasticity of demand,” she said. “If you are a miner, you need diesel and you’ll just pay the higher price in order to use the diesel. And ideally you would then pay or charge your customers more. So what it means is that Australian diesel consumption, which is right up there in the top of the world in terms of our diesel use, flows straight through into prices. It doesn’t necessarily lead to a reduction in demand.”
But still, despite the diesel-double whammy, Lomas maintains we’ll steer clear of a dip into recession.
“I would say the percentage likelihood of a recession happening has lifted relative to where I was before the war broke out. But do I see a recession? No, I don’t see one at all.”
The implication, in Lomas’s framing, is that the Reserve Bank’s interest rate hikes are doing the work of reducing demand because the supply-side shock cannot be neutralised through monetary policy. The RBA has to target inflation by squeezing the parts of the economy it can actually reach.
“So what that means for the RBA is that it has to firstly target inflation. And it needs to take demand out of other parts of the economy, which is what we saw them targeting with that rate increase last week. So it’s a pretty blunt weapon, the interest rate increases I guess many people pay.”
The oil price is the new unknown variable
For Lomas, the question of whether Australia tips into a downturn comes down to a single number: the oil price, and how long the Strait of Hormuz disruption persists.
Watch the full interview from Switzer TV:
“The bigger question is what will the oil price be if the strait remains closed, and that will flow straight into prices and inflation, if we see a much higher oil price,” she said.
On the rates path, her view aligns with the market, the big four banks and the RBA’s own statement on monetary policy: the cash rate peaks at 4.7 per cent. That implies one more hike across either the August or November RBA meetings.
“When you look at what the market is expecting, it’s putting the highest probability around rates sort of topping out at around four point seven percent. The big four banks have got something equivalent, maybe slightly higher. And then the Reserve Bank itself, when it brought out its statement on monetary policy last week, has a peak cash rate at four point seven percent. So really, the question is how do we get to the four point seven. I think it’s likely to be maybe one more rate rise before the end of the year.”
The bigger framing, though, is that the cycle is no longer about whether the next hike happens. It is about how long the elevated rate environment persists once it does.
“Inflation is well above the target of between two and three percent. And so I think the more important question is how long will inflation be elevated for. And we do need to work on the basis of a higher cash rate for longer. I think that’s the world that we’re in at the moment.”
What the budget needs to deliver.
How tonight’s Budget could hit the economy
The federal budget tonight is, in Lomas’s view, the second instrument that determines whether Australia steers around the recession the diesel exposure makes possible. The Treasurer’s spending decisions will either support the RBA’s inflation fight or work against it.
“What we need out of a budget in this environment, so out of the Commonwealth Government budget, is a combination of spending restraint, some targeted relief, and the Reserve Bank has talked about this as well. So unfortunately it is lower income Australians and more marginal businesses that are impacted by a higher inflation environment. So some targeted relief to those that most need it is I think an accepted practice. And we need supply-side investment and productivity initiatives to increase the capacity of our economy to meet demand when things in the Middle East settle down.”
Lomas welcomes the Treasurer’s flagged $64 billion in savings as the kind of spending restraint the moment calls for.
“I would like to see the budget deficit being smaller over time than what it has been historically. And that’s a really important part of the government contributing or sharing some of the burden of tempering demand in the economy to help tackle inflation.”
The piece of the budget she’ll be watching most closely tonight is the detail around the implementation of the tax reforms the government has signalled on capital gains and negative gearing. Her assessment is that the intent to address long-debated tax settings is the most significant signal of its kind from any recent government, but that the transition arrangements are what determine whether the changes actually achieve their objectives.
“There has been a lot of discussion about tax settings and its relationship to the housing sector that has been running for decades. And this is probably the first time we’ve seen a government willing to tackle some of those underlying tax settings. So the intent is there and the objective is to try and level the playing field a little bit between how we treat assets and how we treat income earned by salary earners, with a view to make it easier for younger people to enter the housing market.”
“What I’ll be looking for…is the detail around the implementation of that. It is not simply a case of switching the lever and making overnight adjustments. While everyone accepts that there are adjustments that need to be made, the process of implementing those adjustments is just as important in order to provide a certainty around the pathway to the changes being implemented.”
For investors and households watching tonight, Lomas’s framing is the one to keep in mind. The recession case rests on the oil price. The inflation case rests on what tonight’s budget delivers. Australia is not yet in trouble, but two variables outside the RBA’s control will decide whether it gets there.
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