Falling Commodity Prices: Riding the Rollercoaster
In recent years, the Australian economy has been the beneficiary of strong global demand for commodities and the correspondingly high terms of trade (TOT). Since then, sluggish global demand conditions alongside the transition within the mining sector from the investment to production phase has mismatched supply and demand and translated into falling commodity prices. To the extent that this weak demand and over-supply is protracted, we can expect to see a rebalancing of the economy as the non-mining sectors grow in importance over time. This rebalancing process will be facilitated by robust and proactive monetary and fiscal policy response.
Cause for concern?
Importantly, commodity prices are likely to continue to fall in the future. Weak global demand conditions alongside the transition into the production phase of the mining boom have misaligned the forces of supply and demand. This is evidenced in Figure 1.
What are the consequences?
TOT and Macroeconomic stability
Declining commodity prices correspond strongly to a reduction in the TOT. [2] Historically, downswings in the TOT have been accompanied by below average per capita GDP growth and at times sharp increases in unemployment. [3] In particular, the protracted duration and magnitude of the current TOT boom implies that a sharp contraction in economic activity in line with the falling TOT is possible. [4] Increased labour redundancies corresponding to decreased profitability and reduced labour demand in the mining sector could exacerbate frictional and even structural unemployment outcomes.
Fortunately, so far, the current downward trend in the TOT has not caused any major macroeconomic disruptions. Inflation is slightly below the target level (1.5%, July 2015), unemployment is moderately above most NAIRU estimates (6%, July 2015) and output is growing at close to—though slightly under—trend rates. [5] Moreover, Minifie finds that TOT booms followed by slower or negative economic growth occurred in countries with high levels of inflation during the boom period, leading to post-boom stagflation. [6] Conversely, in Australia, there has been overall macroeconomic stability and anchored inflationary expectations during the growth phase of the TOT—implying a subsequent contraction in economic activity in the non-mining sectors is less likely.
Mining sector
Falling commodity prices will impact negatively on the mining sector by reducing the marginal value of extracting additional deposits. Lower marginal returns are counterbalanced to some extent by increased iron ore and coal exports as the mining sector evolves into the production phase. [7] Given output is a function of both price and quantity, the net effect on sector-output is theoretically unclear. Empirically however, GDP from mining has steadily been increasing over time and peaked at A$35,173m in the first quarter of 2015 (see Figure 3). Figure 3 Source: Trading Economics
Other Sectors
Fortunately, any evidence of the so-called ‘Dutch disease’ is tenuous. Minifie [8] and Banks [9] independently conclude that the mining boom has not caused permanent damage to the manufacturing sector, although it may have accentuated the persistent downward trend in trade-exposed manufacturing. On the contrary, we can expect manufacturing exports to rebound alongside the depreciating exchange rate. Similarly, education and tourism sectors should benefit from the lower Australian dollar. Moreover, manufacturing subsectors that are dependent on commodities for intermediate inputs—petroleum, coal, chemical and rubber—should experience lower cost-inflationary pressures—crystallising productivity gains. [10]
What now?
It is possible that the economy may undergo a period of subdued confidence during the transition away from the mining sector. A swift and appropriate policy response is necessary.
Low confidence constitutes a negative demand shock to the economy, manifesting in lower growth and deflation given time. Critically, inflation has halved in the space of 12 months (3% in July 2014 to 1.5% in July 2015). Low interest rates can be used to ensure confidence does not continue to fall. This is consistent with the RBA’s recent reduction of interest rates to historically low levels of 2%. Low interest rates can be supported by a sustained commitment to a nominal anchor in order to preserve inflation within the target range of 2–3%.
Overall, there is a tension between lower marginal returns derived from falling commodity prices and higher corresponding volumes of resources supplied as a result of enlarged production capacity. Consistent with the evidence, the growth in GDP contributions from the mining sector suggests that the volume effect—at least for now—has outweighed the price effect; ensuring that the mining sector will continue to contribute materially to overall GDP growth. However, diminishing profitability within the sector should eventually lead firms to cut back on production, manifesting in a lower GDP contribution from the resource sector over time.
Monetary policy is necessary, not sufficient. Fiscal stimulus must also be used to further ease the transition away from the resource sector. Low trade barriers, decentralised wage determinations and strong pro-competition regulation will assist in driving productivity gains throughout the economy and moderating the effects of a declining TOT. [11] This should smoothen the rebalancing of the economy and minimise the likelihood of a corresponding recession/protracted decline in economic activity.
Future directions
Unfortunately, as history has often shown, commodity prices tend to move in cycles. The present commodity prices boom seems to have come to an end. Fortunately, the key macroeconomic indicators (unemployment, inflation, GDP growth) do not seem to foreshadow a post-boom downturn. Moreover, a robust and proactive policy response should ensure that the transition away from the mining-sector occurs without any major disruptions to the Australian economy.
Hugh is a fourth year commerce (economics) and law student. His passion for economics stems from the field’s ability to explain real life phenomena.
[1] The Economist. (2014, Oct 4). ‘Oil and Trouble.’ The Economist. Viewed 7th July 2015.
[2] Stevens, G. (2011, Feb 23). ‘The Resources Boom.’ Remarks at the Victoria University Public Conference on The Resources Boom: Understanding National and Regional Implications, Melbourne.
[3] Atkin, T., Caputo, M., Robinson, T. and Wang, H. (2014). Macroeconomic Consequences of Terms of Trade Episodes, Past and Present. RBA Research Discussion Papers January.
[4] Minifie, J. (2013). ‘The Mining Boom Impacts and Prospects.’ Grattan Institute Report No. 2013-9.
[5] Trading Economics. ‘Australia: Economic Indicators.’ Retrieved July 4th 2015, from http://www.tradingeconomics.com/australia/indicators
[6] Minifie, J. (2013). ‘The Mining Boom Impacts and Prospects.’ Grattan Institute Report No. 2013-9.
[7] Bureau of Resources and Energy Economics. (2013). Resource and Energy Quarterly, September 2013. Australian Government; Department of Industry and Science.
[8] Minifie, J. (2013). ‘The Mining Boom Impacts and Prospects.’ Grattan Institute Report No. 2013-9.
[9] Banks, G. (2011, June 30). Australia’s Mining Boom: What’s the Problem? Melbourne Institute and The Australian Economic and Social Outlook Conference
[10] Knop, J. and Vespignani, J. (2014). ‘The Sectorial Impact of Commodity Price Shocks in Australia.’ CAMA Working Paper.
[11] Minifie, J. (2013). ‘The Mining Boom Impacts and Prospects.’ Grattan Institute Report No. 2013-9.