Australia's economy grew 0.5% in the first quarter, which was the 5th straight quarter of growth, but the pace of growth fell off more than half compared to the upwardly revised 1.1% increase seen in the 4th quarter of 2009. On the year, growth was up 2.7%, when forecasts called for a 2.4% increase.

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Here's a look at the quarterly growth rate over the past 15 years. The Australian economy skirted a recession last year as it posted negative growth for only 1 quarter and rebounded as the central bank cut interest rates aggressively and used stimulus spending to help prop up demand.

In the 1st quarter of 2010 the situation is quite different as the RBA has hiked interest rates by six quarter-point increases since last October, bringing the benchmark interest rate from 3% to 4.5%. The RBA held steady on rates this week, its first pause in 4 months. The rate tightening campaign hit households which spend less this quarter, and private business investment also weakened. Strong government spending on infrastructure helped to offset the weaker private investment spending.

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Here is a breakdown of the main components of GDP, in quarterly and annual terms as well as the percentage each category contributed to the growth. Three things to take away here.

  1. Household spending rose 0.6% on the quarter, which was weaker than the 0.9% rise we saw in the previous 3 months. That could be contributed to the RBA rate tightening campaign.
  2. Private fixed capital formation was weak, with machinery and equipment leading the decline, shaving 0.4 percentage points off GDP growth. Government spending on capital meanwhile surged 11.6% on the quarter adding 0.7 percentage points to GDP. Therefore much of the investment spending was done by the public sector. The key going forward will be whether the economy can shift the composition of growth back towards the private sector as the year progresses.
  3. Exports were down 0.5% on the quarter, following a 2.0% increase in the 4th quarter. Imports were up 1.8% on the quarter, and total trade shaved off 0.5 percentage points from GDP.

That is the main story behind today's report, so let's examine the positives and negative for the Australian economy going forward.

Positives - Demand for Commodities Boosting Job Growth:

The RBA predicts that GDP growth will accelerate to 4% by the end of 2012. Growth will be boosted by surging demand from Asia for the country's commodities helping to continue spurring growth in the mining sector. Already that factor has helped Australia to push its unemployment rate to levels that are about half what we see in the US and Europe.

The jobs boom has stoked Australian wages, pushing up inflation which accelerated to 2.9% in the 1st quarter, the fastest pace in a year and at the top part of 2% to 3% target the RBA has for inflation.

Therefore the central bank may resume raising interest rates later this year, which would put monetary policy into a modestly contractionary phase, but would be beneficial to the value of the Australian Dollar.

Negatives - Domestic Economy Showing Some Weakness:

As we mentioned 1st quarter growth was concentrated in public spending. While government investment has surged, companies and households show some signs of weakness.

Bank lending rose in April at the weakest pace in five months, house-price growth slowed to a 16-month low, and building approvals fell for the third month this year, reports published this week showed. That means that the higher interest rates have filtered down into the housing market.

Manufacturing growth weakened last month from the fastest pace in almost eight years and growth in the mining sector may be affected as the Prime Minister Kevin Rudd announced plans last month to introduce a 40 percent tax on industry profits.

Euro-zone Debt Crisis Could Impact Global Growth:

The other major factor is what will happen with the Euro-zone and the high levels of sovereign debt that have garnered so much attention the past few months. The fear is that the world now enters a dangerous new phase of the deleveraging that began in 2007 that could spread to a double-dip global recession or deflationary pressures.

If there is a deflationary crisis this year or next, the Australian central bank is one of the few central banks that has flexibility in terms of monetary policy. In the interim the bank will hold steady until the picture surrounding the Euro-zone becomes more clear.

AUD/USD - Sharp Slides in May

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The strong growth in Australia - which outpaced other nations - boosted the Aussie by 27% in the 12 months through April 30th. The AUD/USD topped off near the 0.94 level, despite this being the time when the RBA was in the midst of its tightening campaign.

The pair then declined 9 percent in May as European Union policy makers moved to prevent a potential Greek debt default which hurt riskier currencies like the Australian Dollar which is tied to global growth prospects. Australia's benchmark S&P/ASX 200 index plunged 7.9 percent in May, the biggest monthly drop since October 2008, paced by banks and resources companies.

If the financial turmoil in the Euro-zone subsides, the Australian economy continues to add jobs, and the RBA stays on hold long enough so that the housing sector regains its momentum, the Aussie can bounce back from this correction. Barring a second financial crisis that threatens the market, the RBA will then proceed to raise rates to 5% by the end of the year supporting the country's currency.