STATEMENT ON MONETARY POLICY

August 2005

The material in this Statement on Monetary Policy was finalised on 4 August 2005.

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

Introduction

The global expansion is continuing to provide a favourable backdrop for the Australian economy. In the United States growth remains well entrenched, with another solid outcome being posted in the June quarter. In China the rapid expansion seen over recent years is showing no sign of slackening. The Japanese economy, although not generally a significant contributor to world growth in recent years, now seems to be performing better after some disappointing results in 2004. Growth in the rest of east Asia appears reasonably solid this year, while the main weak spot for the world economy remains the euro area. Overall, most official and private-sector forecasts are that world growth will be above average in 2005 and 2006, though below last year's pace. Higher oil prices in recent months have not generally been viewed as endangering the global expansion, but are seen mainly as a sign of continuing demand pressures.

The main news in world financial markets recently was the announcement of new exchange rate arrangements for China, involving an immediate appreciation of 2 per cent against the US dollar and the move to a managed peg. While the initial appreciation was small, the new arrangements provide for greater flexibility of the exchange rate over time. This should be of benefit to China in the medium term, as it will help the authorities to gain greater control over their domestic monetary conditions, and hence to contain inflationary pressures in goods and asset markets more effectively. Most other Asian currencies rose in parallel with the Chinese currency. The Australian dollar was little affected, and remains in the same broad range it has been in since late 2004. Aside from the Chinese announcement, there were few major developments in global markets in recent months. Market expectations of monetary policy tightening in the US have increased a little, with the fed funds rate now expected to reach 4 per cent by the end of the year. Global equity markets have remained strong, underpinned by strong company profit results in all the major countries.

In Australia, recent economic data continue to suggest that domestic demand is growing more slowly this year than it was in 2004. Households now seem to have entered a phase in which they are consolidating their balance sheets, borrowing less and increasing their spending less quickly than they were a year or two ago. Combined with the mild downturn now underway in the housing construction cycle, the adjustment in consumer spending is helping to put overall growth in domestic demand onto a more sustainable trend, after the period of rapid growth in demand that was experienced particularly in 2002 and 2003.

This adjustment in household balance sheets comes at a time when other factors are continuing to support spending and activity. Employment has been expanding strongly, which is contributing to growth in household incomes, as are the tax cuts that came into effect on 1 July. The boost to national income from rising export prices is continuing to support growth of the economy overall, and the outlook for the farm sector has improved over the past couple of months following widespread rains in the eastern states. It now appears likely that crop production this year will be around average, compared with the well-below-average outcomes that seemed likely three months ago.

Recent indicators suggest that conditions in the Australian business sector have remained favourable. The broadest surveys of non-farm businesses are reporting above-average conditions, though they are not as strong as in 2004; capacity utilisation in the June quarter is reported to have remained close to its highest level in more than a decade. Given high levels of capacity utilisation and profits, and the sound balance sheets of the business sector, businesses seem to be in a good position to continue expanding their investment spending. Forward indicators are generally pointing to further growth in aggregate investment, with the prospects for engineering construction activity looking particularly strong. The good condition of the business sector has been reflected in the Australian share market, which has risen strongly this year.

There are also signs that the economy is benefiting from an improving international trade performance. Preliminary estimates suggest that growth in import volumes has eased in the first half of this year, while export growth has picked up a little. With export prices up strongly, this has meant a narrowing of the trade deficit, which should also be reflected in lower current account deficits in coming quarters.

Overall, while the growth of domestic demand in Australia has eased this year, the economy continues to be characterised by a solid pace of growth in non-farm output and by strong labour market conditions. There are, as always, some regional disparities in economic performance. Relative to the national economy, the larger states (particularly New South Wales) have experienced a more pronounced slowing in demand and activity over the past year, with the other states, particularly resource-rich Western Australia and Queensland, performing more strongly than the national average.

Consumer price inflation remained stable at around 2½ per cent over the year to the June quarter, in both headline and underlying terms. Data on producer prices in the quarter suggest that upstream prices are no longer accelerating as they were during the second half of 2004. The recent increases in international oil prices have not yet been fully reflected in the quarterly prices data, and will add to consumer and producer prices in the September quarter. As a result, the annual CPI inflation rate is likely to move somewhat higher than underlying measures in the short term.

The outcome for underlying inflation in the June quarter was consistent with the inflation outlook described in the May Statement. The Bank's assessment is that underlying inflation is likely to increase gradually from its current level, partly as a result of the fading of exchange rate effects which have been holding the inflation rate down during the past couple of years. Nonetheless, the slowing in domestic demand that has now occurred should help to contain pressures in the medium term. Underlying inflation is forecast to rise to a peak of around 3 per cent by the second half of next year. A possible source of upside risk to this forecast is the tightness of the labour market, which might generate faster growth in labour costs than is currently assumed. On the other hand, the easing in domestic demand could have a larger-than-expected dampening influence, and the current below-trend pace of GDP growth should contribute to some easing in labour market pressures over time. Currently the risks to the forecasts are judged to be evenly balanced, whereas earlier in the year they had appeared to be weighted to the upside.

Financial conditions do not appear to be inhibiting the growth of the economy at present. The current level of the cash rate is close to its historical average, and lending rates are still somewhat below average as a result of the increased availability of discounted loans. While overall credit growth has eased from the pace of a year ago, it has only fallen to an annual rate of around 12 per cent. There has, however, been quite a pronounced change in the composition of credit growth. The amount of credit flowing into housing has slowed substantially over the past eighteen months, and this has been associated with a cooling in the housing market. In contrast, business credit has been strengthening during this period. Unlike households, businesses had previously been quite restrained in their use of credit, and they appear to have considerable scope to borrow more to finance further growth in investment.

In summary, the economic situation under consideration by the Board at its recent meetings has been characterised by a number of favourable developments. Domestic demand has slowed from its previous rapid pace and is now on a more sustainable trend. Households appear to have entered a period of balance-sheet consolidation. This adjustment is coming at a time when national income is being boosted by the increase in Australia's terms of trade, while the substantial downside risks to the farm sector have eased following recent rains. Overall, the Australian economy is operating at a high level of capacity utilisation, and recent economic data have appeared consistent with an economy growing at a reasonable though not excessive pace. Against this background the Board took the view at its June and July meetings that the medium-term inflation risks were not as strong as they had been earlier in the year. As a result, it decided to hold the cash rate unchanged pending any further information on prices that might prompt a reassessment of the inflation outlook.

In the event, June quarter inflation data available for the August meeting indicated that consumer price inflation had remained stable in both headline and underlying terms, while upstream price pressures appeared to have eased. While the Board's judgment remains that underlying inflation is likely to increase over the next year or so, the extent of the increase should be quite limited, unless there is a significant re-acceleration in domestic demand. The latter seems unlikely, although of course it cannot be ruled out entirely. Given this combination of circumstances, the Board decided in August to hold the cash rate unchanged. The Board will continue to monitor developments and make such adjustments as may be required to promote sustainable growth of the economy with low inflation.