Forecast Sensitivities

Construction forecasts are always subject to substantial uncertainty, being sensitive to a wide range of underlying assumptions. For example, construction forecasts are sensitive to the underlying assumptions made about economic growth and interest rates.

A tightening in monetary policy has seen the cash rate increase by 150 basis points from a neutral rate of 5.75 per cent in July 2006 to a high rate of 7.25 per cent in March 2008. The 90-day bank bill rate increased by an additional 40 basis points because of increased risk premiums.

Australia has entered an economic slowdown, but not a recession. High interest rates and tight credit availability mean that economic growth will be weak during 2008. This weakness will be seen in a virtual halt to growth in business and housing investment and low growth in consumption. However, by 2009 this will be offset by an improving trade performance driven by mining and agriculture, lifting economic growth towards to a normal rate. On a financial year basis, this means that growth in GDP is forecast to slow from a normal rate of 3.2 per cent for 2007/08, to a low rate of 2.3 for 2008/09, before returning to 3.3 per cent for 2009/10. This slowdown in economic growth is forecast to lead to unemployment climbing from a low point of 4.0 per cent in February 2008 to over 5 per cent by mid-2009.

Any interest rates moves in 2008/09 would be in response to inflation returning to the RBA's target band of 2-3 per cent. Given the RBA's higher inflation outlook, we expect that the 90-day bill rate will fall by 50 basis points by mid-2009. The upside risk to interest rates are the rising terms of trade and personal income tax cuts announced in the May 2008 Federal Budget. These two factors could potentially sustain the strong growth in domestic demand, and hence lead the RBA to delay any cuts in the cash rate. Thus, an alternative scenario has modelled the effect of leaving the cash rate unchanged in 2009. This would mean that the cash rate would still be 7.25 per cent at the end of 2009.

If the current high level of interest rates are sustained, weaker growth in domestic demand will push GDP growth down slightly. Specifically, under the alternative scenario, GDP growth is forecast to be 3.2 per cent in 2009/10 and 3.5 per cent in 2010/11. This is slightly lower than under the baseline scenario where GDP growth is forecast to be 3.3 per cent in 2009/10 and 3.6 per cent in 2010-11.

In the sensitivity analysis, we show how our construction forecasts would change under the alternative assumption about interest rates compared with our baseline scenario forecasts. A continuation of high interest rates would reduce the level of profitability in trade-exposed industries, causing a fall in those industries' activity levels. In terms of the impact on construction activity, this will particularly effect the level of investment by the trade-exposed industries of mining and manufacturing. This can be seen in the detailed sensitivity analysis results for Industrial building (in which the manufacturing industry invests heavily) and Heavy Industry construction (in which the mining industry invests). Residential building activity is particularly sensitive to interest rate changes. Therefore, a continuation of high interest rates would dampen residential building activity because the cost of borrowing would remain high. This would lead to lower levels of residential building activity. The change in construction activity (relative to the baseline) in 2010-11 is shown Table 1.

Table 1
Change in Construction Activity, 2010-11 (Real terms)

	Increase in interest rates
Residential building	-0.9%
Non-residential building	0.0%
Engineering construction	-0.4%

Note: alternative scenarios are shown as deviations from the baseline scenario.

Overall, these effects are not very significant - the construction forecasts are not overly sensitive to whether the baseline or alternative macroeconomic scenario turns out to be correct.

For further details of the results of an increase in interest rates, see the sensitivity section of the forecasts.