The Long Run: Low probability, high impact scenarios for the Australian economy and financial markets, by actuary Hugh Miller and independent economist Michael Blythe, first identifies a baseline scenario.

This is the outlook for the Australian economy if key indicators such as inflation, unemployment, and GDP growth are in-line with expectations.

All three of these latest economic figures point to a strong and robust economy, so in the baseline scenario a recession is avoided.

However, the paper then identifies two situations that would cause a notable shift, where a significant recession becomes likely.

Stagflation

The scenario

Stagflation means that both inflation and unemployment are well above target levels.

It occurs when the cost of goods persistently rises over a period of time, until people anticipate prices to continue rising for the foreseeable future.

This causes workers to become more likely to ask for wage increases to keep up with inflated prices, and consumers to not delay purchases (as they expect the price to become more expensive in the future), both of which increase demand.

Businesses would likely respond by rising prices to meet increased demand, which drives up inflation even more.

The RBA would then need to make aggressive cash rate hikes to combat this.

From there, an extended period of high interest rates could see consumers and businesses cut spending, which slows economic growth, but may not be enough to bring down inflation.

With wages already driven up, a major way for businesses to cut spending would be to cut employment.

This occurred in the 1970s, as RBA Governor Dr Phillip Lowe highlighted earlier this year in a speech confirming combatting inflation was the main priority of the Reserve Bank.

Is it likely?

According to the paper, the main reason a stagflation situation is viable is the "interest rate sensitivity of the Australian economy".

"The ability to lift interest rates to levels sufficient to kill inflation is limited by the expansion of household debt," Miller and Blythe wrote.

"Household debt stands at a record high of 188% of household disposable income.

"Too aggressive of a lift in interest rates would push households into financial stress."

According to the report, this scenario requires the supply chain shocks of the last few years to have a more persistent effect than forecast.

It also would need inflation to reach a higher level than the annualised 8% mark currently expected by the RBA.

A 30% drop in house prices

The scenario

The back end of 2022 saw house prices begin to fall from their high point earlier in the year.

Overly aggressive tightening from the RBA could see house prices fall 30%, which is beyond most expectations of 18-20%.

The higher rates would see a reduction in household spending as their debt servicing costs would increase.

The housing market crash would also see a large reduction in demand for construction, in which spending and construction account for up to 55% of GDP according to the paper's authors.

Is it likely?

Shane Oliver, Chief Economist at AMP, has predicted prices to fall to around 15-20% of the high point during 2023

Mr Oliver said that a 30% incline was possible if the RBA were to bring the cash rate up to above 4%.

The cash rate currently sits at 3.1% after a 25 basis point increase in December.


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The adoption of Modern Monetary Theory

The scenario

Modern Monetary Theory (MMT) means that government spending is funded by creating new money through further borrowing and bond purchase programs rather than repaying debt.

Government spending can therefore be increased significantly with the goal of achieving full employment.

Miller and Blythe suggest that MMT could backfire, causing rampant inflation.

Inflation would come from both the boost to spending and the lack of spare resources in the economy.

Is it likely?

MMT is a controversial theory that is unlikely to be adopted in-full in Australia.

However, the paper called the pandemic stimulus packages and near zero interest rates "MMT type policies", that saw "apparent success".

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