STATEMENT ON MONETARY POLICY

May 2002

The material in this Statement on Monetary Policy was finalised on 8 May 2002.

The first chapter of this Statement is provided below. The complete Statement can be viewed as a 930K PDF file.

Introduction

Since the beginning of this year there has been a clear shift in sentiment regarding prospects for the world economy. Forecasts for global growth have been revised upwards, and the large downside risks that were prevalent earlier in the year have generally dissipated. It now appears that most economies passed their weakest point late last year or early this year, although the recovery in 2002 embodied in current forecasts is generally relatively modest.

The turnaround has been most marked in the United States, where the economy grew strongly in the March quarter following modest growth in the December quarter, confirming that the slowdown in 2001 was quite mild and short-lived. This does not, of course, mean that the imbalances affecting the US economy have been fully resolved. The corporate sector in particular is still facing difficulties, and there are also doubts as to whether household spending growth can continue at its recent pace. Hence there remain risks to growth, and a somewhat slower pace can be expected in the remainder of the year. Even so, the recovery to date has exceeded earlier expectations. Monetary and fiscal policy settings are assisting growth and confidence has improved.

Conditions are also looking more promising in other parts of the world. The recovery in the US and improved conditions in the technology sector have contributed to a rebound in most east Asian economies in the early part of this year. In addition, domestic demand in these countries has been bolstered by the policy stimulus put in place last year. Cyclical conditions in Europe appear to be lagging those in the US, but there are signs that growth has resumed in recent months. There have also been signs of stabilisation in Japan. Although considerable downside risks remain, there has been an encouraging pick-up in the export-oriented sector of the Japanese economy, with manufacturing production increasing in the March quarter for the first time in over a year.

In contrast to most other economies, the Australian economy continued to grow strongly, despite the contractionary effect of the global slowdown. GDP grew by slightly more than 4 per cent over 2001, and appears to have sustained a similar pace of growth to date in 2002. In part, this relative strength has reflected the absence of a number of imbalances that have been retarding growth in other countries, particularly the US (for a comparison of the US and Australian economies, see Box A).

The latest indications are that household spending is still expanding at a robust pace, and conditions appear supportive of a continuation of this trend. Consumer confidence is high, and the strong growth in employment over the first part of this year should help sustain further growth in household spending in the period ahead, although this may to some extent be offset by rising petrol prices. While some of the recent strength in the labour market may have reflected postponement of hiring by businesses late last year when growth prospects were less promising, there does seem to have been a marked turnaround in labour market conditions since the beginning of the year. Forward indicators of labour demand remain favourable, with surveys of business hiring intentions at high levels and measures of job vacancies stronger in recent months.

Household spending has also been supported by increases in wealth, primarily resulting from rising house prices. House price rises of around 15 to 20 per cent have been recorded in a number of cities over the past year and, while increases of this magnitude are not exceptional for a single year, strong price rises have been ongoing for several years. Hence the cumulative increases over the past five years have been substantial, and are similar in real terms to those that occurred over the second half of the 1980s. Associated with the general rise in house prices in recent years has been a rapid expansion in household borrowing, which grew by 16½ per cent over the past year. A continuation of this trend clearly carries the risk of households, at some point, becoming overstretched.

The strength of house prices at present appears to be decoupled from trends in house-building activity. There are signs of over-supply in some areas of the market, and forward indicators of the housing sector have for some time been indicating that activity will slow in the second half of the year. At the same time, other parts of the economy are likely to strengthen, so that the composition of growth can be expected to change during the course of the year. Exports are likely to strengthen in line with an improving international outlook, and a rebound in business investment is also in prospect.

Businesses have become significantly more optimistic since the beginning of the year and balance sheets are in a healthy position, given the solid growth in profits that has occurred over the past year. Combined with the low cost of financing, these factors have contributed to a significant upgrade in investment intentions. In addition, there are a number of large infrastructure projects already underway or soon to commence which should also contribute to robust growth in output in the period ahead.

With global economic prospects improving in recent months, financial markets in many countries have begun to price in monetary tightening in the year ahead, in expectation that central banks will look to restore interest rates to more normal levels after the substantial easings that took place last year. A number of central banks have already begun to raise official interest rates.

This swing in interest rate expectations was also evident in Australia. In fact, with the Australian economy surprising most observers with its resilience, and maintaining a growth rate substantially faster than that of other developed economies, expectations of monetary tightening built quite quickly. As late as February, markets were pricing in the likelihood of a prolonged period of steady interest rates, but by early May they were expecting increases in official rates of about one percentage point over the course of this year. The Bank’s decision to raise official rates by ¼ percentage point, to 4.5 per cent, in its May Board meeting had therefore been largely anticipated by markets.

The relative strength of the Australian economy has also been reflected in other ways in financial markets. Share prices in Australia, despite recent falls, remain more robust than in other countries, as company profits here have held up better than elsewhere. Also, there has been a significant increase in demand for Australian dollars, resulting in a rise in the exchange rate of about 5 per cent against the US dollar and a little less in trade-weighted terms.

The inflation outcome in the March quarter was broadly in line with the outlook presented in previous Statements, and showed that inflation remained close to the top of the target range. The increase in the CPI in the quarter was boosted by a number of seasonal influences, including the price of pharmaceuticals and education, as well as a further large rise in the cost of overseas travel, while petrol prices again fell slightly in the quarter and, over the past year, have reduced the rise in the CPI. Over the year these influences have roughly offset one another, so that underlying inflation is probably about the same as CPI inflation.

The recent rise in international oil prices, if sustained, should boost the CPI over the next few quarters both through the direct impact on households and possibly indirectly through increased pressure on business margins. At the same time, upstream cost data suggest that other sources of pressure on business margins may have eased for the time being (except for rising insurance premiums and utility prices).

In the past few years the broader trend in inflation has been upward, with the inflation rate (excluding tax effects) gradually rising from under 2 per cent in 1998 to around 3 per cent in the most recent couple of quarters. This trend has in part reflected the substantial depreciation of the Australian dollar that took place over the 1997–2000 period. These exchange-rate effects have been expected to fade gradually, and, with domestic cost pressures well contained, recent Statements have presented a relatively benign inflation outlook, stating that inflation would decline to around the middle of the target band over the course of 2002. The Bank’s assessment is that this outcome is still likely over the coming year, particularly given the recent tendency of the Australian dollar to appreciate, which should help further dampen inflation pressures in the tradable sector. However, the significant strengthening in the domestic economy that has become evident in recent months suggests that the longer-term risks to the inflation outlook have increased, with upward pressures on inflation likely to predominate beyond the end of this year. Over the course of 2003, inflation is expected to rise back toward the top of the target band, as a continuation of rapid growth in demand and activity would see capacity constraints start to put upward pressure on wages and prices.

During 2001 the Bank reduced interest rates to historically low levels, reflecting principally a deteriorating international outlook and the potential risks that this posed to the Australian economy, while at the same time Australia was judged to have a relatively benign inflation outlook. In recent months the economic climate has clearly changed, with the Australian economy proving very resilient to these forces and global prospects improving. Against this background the Board concluded at its May meeting that the previous setting of monetary policy was no longer appropriate. Maintaining the cash rate at such a low level risked amplifying inflationary risks and fuelling other imbalances that could jeopardise a continuation of the current economic expansion. The decision to raise the cash rate by 25 basis points was aimed at reducing these risks, and thereby enhancing the prospects for sustained growth with low inflation.