Overall, the outlook for the domestic economy remains strong with higher than average growth despite global growth in 2008 likely to moderate. Since peaking in November 2007, the Australian share market has fallen more than 20 per cent. This year so far the market is down 15.2 per cent wiping away most of the gains achieved during 2007.The primary cause of the market’s weakness and its volatility is the health of the US economy. There are concerns that the US will slip into recession during 2008.

Denting US economic growth has been its sub-prime mortgage problem. Loans were made to people who simply couldn’t afford it. Eventually the borrowers defaulted and some US banks and other financial institutions reported very large losses. At the same time, the US home building sector has been shrinking and acting as a drag on the economy. Even though the US Federal Reserve has reduced its official cash rate, borrowing costs for businesses in the US have risen. This is also hurting the economy and business profits. Lenders are simply charging higher interest rates to customers with lower credit ratings. When large US banks reported actual losses and when economic indicators pointed to a slowing economy, US investors decided it was time to sell and Australians followed suit. Despite the fact that the Australian economy is strong and growing, investors became nervous. There were too many uncertainties for investors to cope with and January saw 12 consecutive days in which the Australian share market fell. Australia is not alone in experiencing market weakness. Since the start of the year, the US Dow Jones Industrial share price index has fallen 7.5 per cent. In the United Kingdom the FTSE 100 index is down 13.1% while in Japan the Nikkei is down 16.2 per cent.

Outlook: However the Australian economy and the outlook for the Australian economy is positive. In fact, at present the Australian economy is growing rapidly. The weakness of the share market, in light of the strength of the Australian economy, can be frustrating. But markets are affected by sentiment in the short-term and so far in 2008, sentiment has been negative. The economy as it stands still enjoys low unemployment (close to multi-decade lows), reasonable consumer confidence and strong domestic growth – despite recent reports to the contrary.

Australia’s 33-year low unemployment rate could add to inflationary pressures in the economy. Australia’s unemployment hit a low of 4.1 per cent in January, while official data showed inflation rose at its strongest pace in 16 years at 3.6 per cent in the last quarter. Australia’s central bank this month cited the tight labour market as one reason for raising interest rates to an 11-year high of 7.00 percent in February, with economists expecting a further rate hike in March to curb inflationary pressures.

Wages data showed annual increases running at 4.2 percent in the fourth-quarter, still below the 4.5 per cent pace analysts have typically seen as a threat to inflation. However, the central bank, in its quarterly policy outlook this week, highlighted that the average earnings measure of wages from the national accounts was growing at a much greater 5.9 per cent annual rate, the fastest pace since 1996. The government has announced plans to deliver a budget surplus of at least 1.5 per cent of gross domestic product in May as part of a package designed to help cool price pressures.

But the government has also promised to go ahead with A$31 billion ($28.44 billion) in tax cuts over the coming three years, saying they would be an incentive to encourage greater workforce participation and would therefore not fuel inflation. The planned surplus would be “a material tightening of fiscal policy” compared to the surplus projections released last October, and would help cool demand in the economy. That would make some contribution to reducing aggregate demand.

According to the Reserve Bank of Australia (RBA), Australia continues to face inflationary pressures as domestic demand and activity have remained strong and capacity usage is high after a long period of economic expansion. The risk of inflation remains uncomfortably high even in the absence of a further shift in economic risks to the downside. Therefore, monetary policy is likely to need to be tighter in the period ahead. Inflation is forecast to decline gradually from late this year, but will still be around three per cent in two years’ time, even taking into account recent interest rate rises. The RBA is aiming to keep annual inflation within a 2-3 per cent range.

The central bank said there have been persistent signs that productive capacity is stretched with demand still growing strongly after a long period of expansion. The RBA said the high levels of business investment now underway will undoubtedly assist in alleviating bottlenecks over time and add to the growth of the economy’s productive potential. Financial conditions facing household and business borrowers in Australia have become more restrictive since the middle of last year, reflecting the combination of higher interest rates, reduced access to capital markets and, for some borrowers, tighter credit standards.

Funding cost: In addition, lenders have raised the interest rates on their loan products in response to higher wholesale funding costs. But it remains to be seen how far funding difficulties in wholesale markets will curtail the ability of lenders to provide credit to households and businesses. Tighter financial conditions since the middle of last year seem to have had a modest restraining influence on household borrowing, though the effect on businesses has been less clear. Lending to businesses has remained strong, expanding by 24 per cent in 2007, the fastest pace since the late 1980s. Even allowing for the sharply reduced borrowing by businesses on capital markets in recent months, the growth of total business debt has remained very rapid, rising 19 percent in 2007, faster than before.