The Victorian and national economies have grown quite strongly in recent times. This growth has been supported by very strong population growth, the need to expand the economy’s capital stock, and historically high terms of trade and associated income gains. These fundamental drivers of growth are expected to persist over the coming years. At the same time, this strong growth – after 16 consecutive years of expansion – has led to rising inflationary pressures. Both monetary policy and federal fiscal policy are currently aimed at slowing the growth of domestic demand to reduce inflationary pressures. The global economy and financial markets are also exerting a moderating influence on the domestic economy. These two broad forces underpin and influence the Victorian economic outlook.

The Victorian economy is expected to grow by 3.25 per cent in 2007-08. The main contributors to domestic demand growth are expected to be household consumption and non-residential construction. Export growth is expected to be moderate, with solid services exports growth offsetting weaker merchandise export growth. The rural sector has partly recovered from the drought conditions experienced in 2006-07, so agricultural production will make a moderate contribution to economic growth.

Economic growth is forecast to ease to around 3 per cent in 2008-09 and remain around that rate throughout the forward estimates period. This represents slower near-term growth than envisaged in the 2007-08 Budget Update. In response to heightened inflationary pressures, the Reserve Bank of Australia (RBA) has lifted the official cash rate four times since mid-2007 to 7.25 per cent in March 2008. The impact of these higher interest rates, combined with a higher exchange rate, is likely to be felt more strongly in Victoria than in some other states due to its large manufacturing base and limited mining resources.

Growth in Victorian gross state product (GSP) in 2008-09 will be supported by solid, albeit slower, growth in household consumption, dwelling investment and business investment as well as continued recovery in the farm sector (assuming a return to average seasonal conditions). Although employment growth is likely to slow from its recent strong pace, the labour market is expected to perform solidly and will be supported by population growth and high rates of labour force participation. Near-term growth in wages and consumer prices has been revised up, but is forecast to gradually ease towards trend rates by the end of the forecast period.

The Victorian economic projections are sensitive to a number of risks, including wage and inflation pressures (and their effects on interest rates), the uncertainty regarding the global economy and financial markets, exchange rate movements and the prospects for the rural sector. These risks are of greater magnitude than usual, and hence the outlook is less certain than has been the case in recent years.

International economic conditions and outlook

After a sustained period of above-trend growth, the world economy is expected to slow markedly in 2008, weighed down by a weak United States economy and continuing financial market turmoil. Most advanced economies outside the United States are also expected to record slower growth, but growth in emerging economies should continue to be relatively strong, albeit slower than in 2007. The International Monetary Fund’s (IMF) April World Economic Outlook forecasts world growth to slow from 4.9 per cent in 2007 to 3.7 per cent in 2008 and 3.8 per cent in 2009. Consensus Economics have also become more pessimistic, progressively revising down growth forecasts as the weakness in the United States economy became more apparent (see Chart 2.1).

Global financial markets have deteriorated and become more volatile over recent months, due to developments stemming from the sub-prime mortgage crisis in the United States. There has been a general widening of credit spreads, reflecting a re-pricing of risk, and difficulty for private borrowers in accessing capital markets. A lack of liquidity has persisted in the financial system to date, despite efforts by major central banks to inject liquidity into money markets. Equity markets of the major advanced economies have been volatile and equity prices fell significantly in early 2008. This reflects significant write-downs reported by a number of major financial institutions, growing concerns about the global economic outlook and uncertainty about further losses from sub-prime related investment products. The main area of weakness in the United States is the housing market. House prices have fallen, mortgage foreclosures are rising and housing construction is down sharply. Further, it appears that this weakness is spilling over into other sectors of the economy, with recent data showing weaker consumer spending, industrial output and employment. On a more positive note, the depreciating US dollar is contributing to strong export growth. In response to the weakening economy, the US Federal Reserve has cut official interest rates sharply and the United States government has delivered a major fiscal stimulus package designed to provide a boost to household and business spending. Yet despite these interventions, the outlook for the United States economy is relatively poor. The IMF forecasts the United States to grow by only 0.5 per cent in 2008 and 0.6 per cent in 2009, although the Consensus Economics panel of forecasters is somewhat more optimistic