STATEMENT ON MONETARY POLICY

August 2003

The material in this Statement on Monetary Policy was finalised on 7 August 2003.

The first chapter of this Statement is provided below. The complete Statement can be viewed as a 838K PDF file.

Introduction

The year to date has been marked by a contrast between a disappointing global environment and a resilient domestic economy. The recovery in the major economies has so far remained patchy, and information becoming available in the first half of the year tended to suggest that the likelihood of a more extended period of global weakness was increasing. During that period an additional source of external risk was presented by a strongly rising Australian dollar. Against this background, the Board took the view at its June meeting that the economy had entered a period where the monetary policy decision would be whether to hold interest rates unchanged or to reduce them. This assessment was made public shortly afterwards at the Governor’s Parliamentary appearance on 6 June. Within the context of this broad strategic assessment, the Board judged at the time of the June meeting that the case for an easing was not sufficiently strong and, in the event, subsequent developments tended to weaken that case further, so that the cash rate was again held unchanged at the July and August meetings.

In broad outline the domestic non-farm economy remains in a strong condition, as is evident from a round-up of the major economic aggregates. Growth of non-farm GDP over the latest four quarters for which we have data was just over 4 per cent; domestic demand, while slowing a little from its most recent peak, expanded by 5½ per cent over that period; employment growth over the past year has been around trend, though lower in recent months, and the unemployment rate has remained close to the lower end of the range in which it has fluctuated over the past two decades. Inflation, both as measured by the CPI and according to most underlying measures, is currently 2¾ per cent, slightly above the target mid-point.

While the Australian economy remains in a position to perform relatively well against a weak international background, the pace of growth of the non-farm economy is likely to ease during the remainder of 2003. The growth of domestic demand is now in the process of slowing from its recent rapid pace, and in the short term this is unlikely to be offset by stronger external conditions. As a result, a slowing in the overall growth of non-farm GDP is expected, bringing it below trend during the course of 2003, before growth returns to around trend the following year. With conditions in the farm sector improving, the growth in total GDP should pick up earlier than the non-farm component. In the short term, since the Australian economy is still growing more strongly than its trading partners, this scenario would probably see some further widening of Australia’s current account deficit. Underlying inflation is expected to decline to around 2 per cent next year as the effects of the exchange rate appreciation work through, though on a longer time scale, trends in domestic labour costs are seen as consistent with inflation returning to around the middle of the target. In summary then, the outlook is for a temporary period of below-trend growth with inflation below the target mid-point. This follows a period in which growth and inflation have both been above those norms.

On its own, this outlook does not present a strong case for interest rates to be lower than they currently are. Australia’s flexible inflation-targeting framework does not aim to fine-tune economic outcomes, but rather is designed to ensure that inflation remains on track over the medium term. This being the case, an inflation rate that is expected to move a modest distance away from the target mid-point would not of itself be a trigger for policy action, provided the medium-term outlook is consistent with the target. In the current context, the expectation of a temporary period of lower growth and inflation may well point to a case for monetary policy to be on the expansionary side of neutral, as it already is, but it is not of itself a case for moving to a more expansionary stance than is currently in place. That said, the current outlook would not stand in the way of a reduction in interest rates should a broader consideration of the balance of risks require it.

The key risks raising the possibility of an easing in monetary policy over recent months have been external. One is a possible failure of the world (particularly the US) economy to pick up. The central economic outlook described above is based on an assumed pick-up in global growth in the second half of 2003, along the lines that is widely incorporated in conventional forecasts. If the global economy were to fall short of those expectations it would further set back prospects for a recovery in Australia’s exports. A second source of risk would be a further sharp appreciation of the Australian dollar, which might be driven by additional interest rate reductions around the world to combat a weakening global economy. If this occurred, it would have an additional contractionary effect on the export sector, as well as further dampening inflation.

Both of these risks increased appreciably in the first half of the year, with the international economic data generally disappointing and the Australian dollar on a strong upward trend during that period, particularly during May. More recent developments, however, suggest that the risks from these two sources have lessened.

First, regarding the global outlook, there have been some slightly more encouraging signs recently. Economic data in the United States have been a little more positive, showing, among other things, stronger-than- expected GDP growth in the second quarter, improvements in business sentiment, a rise in capital goods orders and a small pick-up in industrial production in the past couple of months, though the performance of the labour market has so far remained disappointing. While the signs of improvement are still tentative at this stage, they have been accompanied by a noticeable lift in sentiment in international financial markets. Bond yields around the world have increased sharply over the past two months, reversing the declines that occurred earlier in the year. In the US, yields are now over 100 basis points above the troughs reached in early June. Equity prices have also increased over the past few months to be more than 20 per cent above their recent troughs in most major international markets. Thus financial markets are now taking a more optimistic reading of economic prospects than was the case a couple of months ago.

Second, the strong upward trend in the exchange rate seen during the first half of the year has not continued. The exchange rate against the US dollar peaked at US68.5 cents in early July, but it subsequently came down quite sharply, falling by almost 4 cents in the middle of the month, and has shown little net change since. On a trade-weighted basis, the exchange rate is now around 4 per cent below its recent peak. The significance of this is not so much the new level of the exchange rate as the apparent change in direction and market sentiment. The strong rise in the currency in the first six months of the year had been driven by investors chasing yields in the more stable economies, in what was a deteriorating climate for the world economy and share markets. More recently, however, investors have started to position themselves for a growth pick-up, and capital has flowed back into the US economy. This has taken the upward pressure off the Australian dollar. The same sort of sentiment can be seen within the share market, as investors have moved out of ‘defensive’ stocks (i.e. stocks thought likely to do well in an economic downturn) to ‘cyclical’ stocks which will respond best to a pick-up in economic activity.

For the present, then, the downside risks to the Australian economy from external sources appear less severe than they were a couple of months ago. Nonetheless, developments in these areas are subject to ongoing change and will continue to have a strong bearing on the policy assessment in the period ahead.

An additional complication for Australian monetary policy at present is posed by the rapid growth of credit and its flow-through into strongly rising housing prices. Currently, credit to the household sector is growing at an annual rate of about 20 per cent, well in excess of what could be considered sustainable in the medium to longer term (see the chapter on ‘Credit Growth’ for a detailed discussion). Much of this is flowing into the housing sector and is fuelling a rate of housing price increases of the order of 20–25 per cent around the country. Apart from inner Melbourne where apartment prices are falling, there are few signs yet of these pressures easing off. The latest indicators of housing prices continue to show strong growth in most areas, and new finance approvals for housing have been accelerating in the past few months.

The risk presented by these developments is that, the longer they go on, the larger will be the contractionary effect on the economy when they inevitably turn. Banks report that they are taking a prudent approach to lending for housing, with property loans well collateralised to withstand a fall in housing prices and significant safety margins built into households’ loan repayments. But increasingly there are signs of worrying practices elsewhere in the financial system. This is not untypical of a prolonged bull market, and could cause a good deal of distress to the economy when the housing price cycle turns.

Alongside the borrowing for the purchase of housing assets, there is the phenomenon of housing equity withdrawal, whereby households are borrowing against rising housing values to fund other forms of spending. This process is estimated to have been augmenting household cash flows in the past year by around 4 per cent. In the short term, absent an adverse shock, this is likely to continue, thereby supporting demand growth. But were Australia to enter at some stage a period of declining housing prices, it is likely that this equity withdrawal would be scaled back, or would possibly go into reverse, resulting in a cutback in spending, with a potentially destabilising effect on the broader economy. The risk of a large impact from such an event will be greater the longer these current trends in credit and housing markets persist.

The current situation, in summary, suggests an outlook that is consistent with the medium-term inflation target but subject to two broad sources of risk – the potential for further weakness arising from external factors, and the destabilising influence of a growing imbalance in the domestic credit market. These two factors have conflicting implications for monetary policy, since lower interest rates would help to offset the first of these risks but would amplify the second. In its policy deliberations the Board has had to take into account the balance of these risks and the way they have evolved over time.

The Board’s assessment at the time of its June meeting was that the balance of risks had shifted to a point where a case for reducing the cash rate needed to be brought under consideration. On balance, however, it was judged at that time that the case for an easing in policy was not sufficiently strong, so that the cash rate was held unchanged pending an assessment of further developments. While the situation is still subject to considerable uncertainty, the external risks to the economy seem subsequently to have receded, at least for the time being, with global prospects looking a little better and the exchange rate no longer rising quickly as it had in the first half of the year. At the same time, the risks posed by developments in credit and asset markets have not diminished. Given these considerations, and the current assessment of the economic outlook, the case for an easing was judged to have weakened since June, and thus the cash rate was again kept unchanged at both the July and August meetings.