A recession is a period where the economy shrinks—there’s less income (or output, they should be the same at the national level) than in the past. They measure economic output every three months and if there’s two consecutive periods where output goes backwards, two consecutive quarters of negative economic growth, that’s called a recession.
The most recent national accounts show that Australia’s economy shrank on a per person basis in the most recent three-month period, but because of extraordinary population growth, the economy as a whole keeps expanding.
We worry about recessions because they often come with rising unemployment that takes a long time to stabilise. Large, long recessions are bad for people’s wellbeing: businesses fail, people lose their jobs, people lose their homes, mental health suffers and families break apart. We had a small recession during the pandemic, and the economy recovered very quickly from that, thanks to abundant government spending. At that time though, inflation was low so the government spending wasn’t counter-productive. In our current circumstance it could be.
The main risk to the Australian economy is that falling consumer spending causes a recession. Remember that the RBA is trying to engineer falling consumer spending. This is why the RBA governor keeps describing the country as being on “a narrow path”. Using their blunt tool of interest rate rises, the central bank is trying to fine tune consumer spending so it falls enough to reduce inflation—but not too much.
As the next chart shows, spending remains elevated so far.
The economy is made up of spending by government, businesses and households. Household spending is the largest part. If it crashes, a recession becomes likely. The lack of spending then flows through to lower business income, and businesses stop hiring or even let people go. Unemployment rises, causing even more caution by households. It is quite a vicious cycle, and one that would traditionally be reversed by the RBA cutting rates rather than raising them. But if inflation is not yet under control, expecting rate cuts is unrealistic.
At the start of the current bout of inflation, price rises were mostly contained to imported goods. But the nature of inflation has changed in the last year: now Australian-made goods and services are the main drivers of inflation. That’s a concern, because inflation can get locked in. We have a problem if people demand higher wages to compensate for rising prices and then firms lift their prices to help pay for higher wages. That’s called a wage-price spiral. We also have a problem if firms start lifting prices simply because they think consumers will accept it.
Locked-in inflation causes inflation expectations to rise, and increases the chance we step off the “narrow path”, requiring a recession to end inflation.
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