STATEMENT ON MONETARY POLICY

August 2002

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

The first chapter of this Statement is provided below. The complete Statement can be viewed as a 1.1M PDF file.

Introduction

There has been a marked deterioration in sentiment in global financial markets over the past couple of months, with a considerable increase in uncertainty about the short-term course of the global economy. During the first half of the year, despite a generally downward trend in share prices, there was a mood of cautious optimism about prospects for the US economy, where recovery had commenced after an apparently very mild and brief recession during the second half of 2001. Signs of a turning point in Europe and Japan had also emerged, and most forecasters expected global growth to gradually strengthen through the remainder of the year. The US dollar had begun to decline, and the Australian dollar to rise both against the US dollar and other currencies.

In the second half of June, however, market sentiment turned decidedly more bearish. At that stage, US share prices were still high relative to longer-run norms and there was a recognition that businesses would struggle to achieve the profit growth required to validate them. In addition, renewed doubts emerged about the strength of the economic recovery itself, as economic data for the middle of the year proved to be softer than expected. Revisions to earlier national accounts data, moreover, showed a noticeably lower level of economic activity through the past couple of years, and a somewhat deeper recession in the US than had earlier been thought, even if still a relatively mild one by historical standards. While all this was taking place, there was growing concern over the quality of corporate governance and accounting in the US. Earlier confidence that these problems were confined to a few isolated cases gave way to perceptions that there were systemic deficiencies.

In these circumstances, US share prices fell very sharply, particularly in the first three weeks of July. Even after a brief recovery late in the month, by early August the broad US share price indexes had declined by around 45 per cent from their peaks in March 2000. Similar declines since the peak have been recorded in a number of European markets. The Australian share market has been more resilient, but has fallen nevertheless. Bond yields around the world have declined, and risk spreads have widened noticeably, over the past couple of months. Market expectations of monetary tightening in a number of countries, including Australia, have been scaled back. The exchange rate of the Australian dollar was particularly affected. It seems that once market participants started to feel that US share market developments could potentially have a dampening effect on US and world economic growth, they unwound long positions in the Australian dollar that they had built up in earlier months in anticipation of global economic recovery. Other currencies, such as the Canadian and New Zealand dollars, were similarly affected. In trade-weighted terms, the Australian dollar unwound all the rise that had taken place earlier in the year.

At the current juncture, then, confidence about US economic prospects is a good deal weaker than it was a few months ago, mainly because of financial developments, but not exclusively so; recent ‘real economy’ data have also been on the disappointing side. To this it must be added that the pick-up in growth in the Euro area has not, as yet, built much momentum, and while Japan is experiencing better growth, much of that is externally sourced. In contrast, in much of the east Asian region, increases in domestic demand have bolstered the impetus to growth from the export sector. Production has recovered to be around its peaks in late 2000, and the associated improvement in the labour market in a number of countries has helped support household spending.

In assessing global economic prospects the key issue is the extent to which the general weakness in equity markets will exert a dampening effect on activity in the major economies. The size of such an effect will depend, among other things, on the extent to which business and consumer confidence in the major economies are affected, on the way businesses respond to a higher cost of equity capital, and also on whether markets stabilise near their recent levels or decline further. All of these things are inherently difficult to predict. One important factor in assessing the overall impact is that economic behaviour may not have fully adjusted to the run-up in share prices in the late 1990s and so, to that extent, the impact of the subsequent decline could be somewhat limited. It should also be noted that the equity market declines have occurred against a background of expansionary policy settings that will help to offset at least some of their impact, and that the asset price declines have not apparently seriously undermined the asset quality of the global banking system. At this stage, while acknowledging the uncertainties, the most likely outcome in the major economies still appears to be one of moderate growth, though at a slower pace than earlier thought.

The Australian economy is continuing to grow more strongly than the major economies. Quarterly growth has been close to 1 per cent for some time and appears to have maintained a good pace in the June quarter. While the slowdown in the global economy in 2001 has been reflected in lower Australian exports, this has been compensated by the strength of domestic demand. Household spending has been an important driver of domestic demand, and conditions are generally supportive of further good growth. Household incomes are being supported by rising employment and real wages, and consumer confidence remains at a high level. While the pace of employment growth has slowed in recent months from the rapid growth experienced earlier in the year, forward indicators of the labour market suggest reasonably firm labour demand in coming months.

Housing construction has contributed to growth over the past year and, on the latest indications, is likely to remain at a high level in the second half of this year. Demand for investment housing remains strong, and lending to investors for housing has continued to rise at a fast pace in recent months. This looks to be in part a result of expectations by investors that the strong increases in housing prices over recent years will continue into the future. However, the attractiveness of this form of investment now appears to be waning, with the potential for further capital gains in the housing market likely to be countered by increased supply of rental properties, rising vacancy rates and falling rents in some areas.

The Australian business environment should contribute to a pick-up in investment spending, as already signalled in the business surveys. Business confidence is generally at levels consistent with good economic growth and corporate profits have risen at a healthy pace over the past year. The cost of external financing remains low (although the recent turbulence may have reduced the attractiveness of equity finance) and this has been reflected in a marked pick-up in intermediated business borrowing. Notwithstanding this, the overall level of corporate debt remains low. While it is not yet clear whether the general equity market weakness over recent months will have any significant impact on business confidence and investment intentions, it is noteworthy that the corporate sector is in much sounder condition than it was on the previous occasion of sharp equity market declines, in the late 1980s.

The notable exception to the overall positive outlook for the Australian economy is the farm sector. A number of areas of the country — particularly New South Wales, southern Queensland and parts of the wheat belt in Western Australia — have experienced acute rainfall shortages, which are likely to have a detrimental effect on farm production and incomes. Conditions in South Australia, Tasmania and parts of Victoria, however, have been closer to normal.

The CPI outcome in the June quarter was consistent with the inflation forecasts presented in previous Statements. In year-ended terms, the statistical measures of underlying inflation have declined from a little over 3 per cent in the December quarter 2001 to around 2½ per cent. The CPI measure of inflation is running at a slightly faster pace on a year-ended basis, and this may persist for another quarter or two yet. The divergence has predominantly reflected the large increases in the cost of overseas travel, insurance and meat in recent quarters.

The effect on inflation of the exchange rate depreciation of recent years appears to have broadly run its course, and the exchange rate appreciation in the earlier part of this year contributed to the low outcomes for producer price inflation in the June quarter. Combined with the moderate growth in wages, this means that there are few sources of pressure on business margins, with the continuing exception of rising insurance and utility costs. Consequently, as set out in previous Statements, the Bank’s assessment is that underlying inflation is likely to remain around the middle of the target band in the second half of 2002. However, a continuation of the current pace of growth in the domestic economy would most likely see increased pressures on wages and prices over the course of 2003. This outlook is predicated on a modest global recovery, albeit at a slower pace than seemed likely a few months ago. As discussed earlier, this appears the most plausible scenario for the world economy at present, although the downside risks have clearly increased in light of financial market developments over recent months.

In the environment of the stronger world economy in the first half of the year, the Board took the view at its May and June meetings that the expansionary stance of monetary policy which had been in place during late 2001 and early this year was no longer warranted, and that a process of returning rates to levels more consistent with the economy’s more favourable circumstances should commence. At both meetings, it increased the cash rate by 25 basis points. Even after these adjustments, however, the cash rate remained on the expansionary side of neutral. With the weight of domestic economic indicators pointing to continued strong growth, and inflation remaining in line with earlier forecasts, there was a general case to be considered at both the July and August meetings for further rises.

The Board also had to take account, however, of the sharp decline, and the considerably increased volatility, of global equity markets, and the possible impact of those changes on the economic outlook. As discussed above, those impacts are difficult to predict, not least because it is not yet known at what level markets will stabilise. If the effects on growth of the global economy, and consequently on Australia, turn out to be quite small, the case for further rises in interest rates would remain intact. While this appears the most plausible scenario, the possibility of a significant dampening impact of the financial turmoil on the global economy must be taken into account. Given these uncertainties, the Board judged at both its July and August meetings that it was prudent to leave the cash rate unchanged.