STATEMENT ON MONETARY POLICY

August 2004

The material in this Statement on Monetary Policy was finalised on 5 August 2004.

The first chapter of this Statement is provided below. The complete Statement can be viewed as a 773K PDF file.

Introduction

Economic developments over recent months point to continued good growth of the Australian economy. The global upswing has maintained its momentum since the early part of the year and should provide an improving environment for Australian exporters. Business and consumer confidence are at high levels. At the same time, adjustment is occurring in the Australian housing market, which is no longer in the overheated condition seen at the end of last year.

The renewed pick-up in global economic growth has been underway for more than a year now and has become increasingly broadly based. The US recovery is firmly established, with business investment contributing strongly to the expansion along with consumer demand. With healthy employment growth over recent months, initial concerns about a 'jobless recovery' have faded. Core inflation in the US remains relatively low but has picked up noticeably since the start of the year, so that earlier concerns about the risk of deflation have also moved off the agenda. Reflecting the strong growth prospects for the economy and the pick-up in price pressures, the Federal Reserve has begun the process of normalising official interest rates from their historical low point, lifting the fed funds rate by 25 basis points to 1.25 per cent at its end-June meeting.

Other parts of the global economy are also enjoying strong or improving conditions. The Japanese economy is now in a solid expansion, recording its best conditions since the bursting of the asset-price bubble more than a decade ago. In China, growth has been exceptionally strong, prompting the Chinese authorities to take action to rein in overheated sectors of the economy. These measures have had some success in restraining growth but, even so, the pace remains very fast by the standards of any other country. Other parts of Asia are also showing continued economic strength, supported in most countries by growth in domestic demand as well as a continued rapid expansion of trade with China. The euro area economy, though still lagging the rest of the world, has shown further signs of improvement over recent months.

Against the background of the firming US economy, financial markets had fully anticipated the Fed's decision to raise official interest rates at its late June meeting, and the announcement passed largely without market reaction. With US interest rates still well below historical norms, markets expect additional tightening, and a further increase in the funds rate of 100 basis points is currently priced in over the next six months. Several other central banks – the Bank of England, the Reserve Bank of New Zealand and the Swiss National Bank – have also raised their interest rates recently. In Australia, market interest rate expectations remained broadly steady through this period, with markets assessing that Australian rates were closer to normal than in most other countries. The market continues to expect that Australia's cash rate will remain unchanged in the next few months but that some further tightening will occur in due course.

The exchange rate of the Australian dollar has remained in a range well below the peak reached earlier in the year. The main reason for this change in sentiment towards the Australian dollar was the growing prospect of US monetary tightening, and the expectation that it would mean a narrowing of Australia's interest differential against the US. In late July/early August the Australian dollar was trading around US70 cents, 12 per cent below its February peak, and 9 per cent down in trade-weighted terms.

The Australian economy is continuing to expand at a good pace. Consumer confidence is at its highest level in a decade and consumer spending has started to receive a significant boost from the additional benefit payments and tax cuts announced in the federal Budget. Business surveys are reporting better-than-average conditions and, with strong profitability and an improving international environment, the situation appears favourable to further expansion in business investment. Consistent with the general strength of the economy, the unemployment rate has trended down over the past year to around the lowest level seen over the past two decades.

The growth of the economy has for some time been driven by very strong growth in domestic demand, which has been partly offset by the external sector. With the international economy picking up, it has been reasonable to expect a gradual rebalancing of growth to get underway, involving a stronger export performance and less reliance on growth in domestic demand. To date, while the economy has maintained a strong pace overall, this rebalancing has been slow to materialise. There are, however, some indications that the economy is now benefiting from the global upswing. One mechanism for this has been the lift in global commodity prices and the associated improvement in Australia's terms of trade. In the March quarter the terms of trade were 10 per cent higher than a year earlier, and they are likely to have risen further in the June quarter. The resultant increase in incomes is one of the factors that have supported domestic spending growth.

In addition, it now seems clear that, after an extended period of weakness, the level of exports has passed its trough. At this stage, the pick-up in exports has been quite narrowly based. Much of it has been driven by the improvement in rural conditions and the recovery in international tourism, while resource and manufactured exports have been relatively flat. Factors that may have contributed to the subdued performance in these sectors include the appreciation of the exchange rate during 2002 and 2003, which may have dampened growth in manufactured exports in particular, and capacity constraints in the resources sector. However, these effects are likely to wane, with the exchange rate having been well below its peak in recent months, while the resources sector will benefit from the significant new capacity starting to come on stream this year. Hence, given a supportive global environment, there are good prospects that export growth will become more broadly based over time.

Australia's inflation rate in underlying terms remains relatively low. The June quarter CPI showed a rise in the annual inflation rate to 2½ per cent, from a rate of 2 per cent in the March quarter, but this movement largely reflected the effects of petrol price fluctuations on the year-ended calculation. Looking through the volatility, the various underlying measures suggest an underlying inflation rate of just over 2 per cent, which is down by around a percentage point from its recent peak. It is unlikely, however, that this will decline much further, if at all. At present, inflation is still being held down by the ongoing effects of the 2002–2003 exchange rate appreciation, but it can be expected to move higher in due course as those effects wane. While this has been broadly the expectation for some time, it now appears likely that the trough in underlying inflation will turn out to be somewhat higher than envisaged in previous Statements. The Bank's current assessment is that underlying inflation will remain close to 2 per cent for a little while longer, probably through to around the end of this year, and then start rising to around 2½ per cent by the end of 2005. Beyond that period, it could be expected to rise further if the current strength of domestically sourced inflation persists.

Developments in the housing market, and the associated growth in credit, have had an important bearing on assessments of the economic situation in the recent period. The overheating in the housing market last year carried the potential to destabilise the broader economy, the more so the longer it continued. There are clear indications, however, that the situation has now changed. After the rapid increases in house prices up to the end of last year, the available indicators suggest that prices declined in the first half of 2004. Auction clearance rates fell sharply around the turn of the year and have since remained well below average, suggesting vendors' price expectations are not being met. There has also been an easing in the demand for housing finance, particularly from investors, though this will need to adjust further if the growth of housing credit is to return to a reasonably sustainable pace. Although, at this stage, the fall in house prices and slowing in finance have been relatively modest, these trends are indicative of an easing in demand pressures in the housing market after the overheated conditions that prevailed last year.

In its policy deliberations over the past three months, the Board has taken into consideration the improving international environment, the easing in pressures on the domestic housing market, and the broader outlook for growth and inflation in Australia. The international situation is one in which interest rates in the major countries are likely to be increasing from their current abnormally low levels. Australian interest rates were never reduced to the extreme position adopted in a number of other countries, and there is no automatic reason that they will need to be moved up in line with the increases that are likely to occur overseas. On the other hand, with the policy stance in Australia still mildly accommodative, and the global economic environment likely to remain favourable to growth, it would be surprising if Australian interest rates did not have to increase further at some stage in the current expansion.

At present the Australian economy is continuing to experience a good pace of growth with relatively low inflation. The part of the economy that had been most prone to overheating in the recent period was the housing market and, as noted above, this is now in a process of adjustment. At the same time, it has become apparent that the restraining influence of the exchange rate on inflation has now reached its point of maximum effect, so that the underlying inflation rate can soon be expected to start increasing. This will need to be closely watched. At this stage, however, while growth prospects remain firm, the pick-up in inflation from its current trough appears likely to be quite gradual.

In these circumstances the Board decided at each of its three most recent monthly meetings to hold the cash rate unchanged. The Board will continue to monitor these developments, and will make such adjustments to policy as may be required to ensure that the conditions for sustainable growth with low inflation remain in place.