STATEMENT ON MONETARY POLICY

November 2002

The material in this Statement on Monetary Policy was finalised on 7 November 2002.

The first chapter of this Statement is provided below. The complete Statement can be viewed as a 1.7M PDF file.

Introduction

Prospects for the global economy have evolved in two quite distinct phases during 2002, broadly corresponding with the two halves of the year. The first half of the year was a period of emerging optimism, with most observers expecting a gradual recovery in the global economy after last year’s downturn, and the momentum of growth expected to build steadily in all the major economic regions. These perceptions were encouraged by clear signs of stronger growth in a number of countries, particularly in the United States but also in parts of east Asia and, to a lesser extent, in the euro area. In the second half of the year, however, considerable uncertainty has emerged as to whether the momentum of growth will be sustained.

The changing mood about the global economic outlook has been most clearly reflected in financial markets. The major changes have been the fall in share prices in all major countries since early in the second quarter of 2002, the fall in long-term government bond yields to 50-year lows, and the widening in spreads on corporate debt.

Broader economic data in a number of the major countries have also taken on a softer tone in recent months, suggesting that the modest global recovery underway since the start of this year has weakened. In the US, which has been the strongest of the major economies this year, the expansion to date has been driven mainly by consumer spending, and there is little sign yet of a pick-up in business investment, which would be an essential element of a more durable recovery. Elsewhere, the picture has been very mixed. Growth in the euro area has turned out to be disappointing, after some reasonably promising signs earlier in the year. In Japan, there are some signs of a pick-up in activity, but the economy remains fragile and heavily dependent on export markets. Non-Japan Asia has been the best performing of the major regions, with the Chinese and Korean economies growing strongly, though some of the smaller economies in the region appear to have weakened recently. Overall, the global recovery has remained tentative and has fallen short of the relatively optimistic expectations that were held around the middle of the year.

Whether or not the global economy gains greater momentum will depend importantly on the resolution of imbalances still weighing on growth in the major countries. Of particular importance will be the ongoing effects of the cumulative falls in equity prices. These will affect the major economies in a number of ways, including not just through their impact on wealth and confidence but also through their effects on corporate and financial-sector balance sheets. Some of these effects are already being seen, with businesses in the US for example now finding it more difficult or more expensive to raise capital, reflecting perceptions of increased risk. This has been associated with disappointing corporate profits in the US, a result, in part, of an overhang of capacity in some capital-intensive industries. In some respects, financial stresses in the European economies may be more severe than those in the US, given that the falls in equity markets in Europe have generally been larger. Share prices in financial firms in Europe, particularly insurance companies, have shown pronounced falls in recent months. Japan, of course, has its own longstanding imbalances that continue to hamper growth.

The overall effect of these forces on the global economy is highly uncertain. In an optimistic scenario, cyclical growth spurred by consumer demand and expansionary policy may be sufficient to wind back the various balance-sheet stresses, but a more pessimistic scenario involving disappointing profits, heightened pressure on balance sheets and weak investment spending in the major economies is also a real possibility.

It is not surprising that in this environment there has been a marked reassessment about the outlook for official interest rates in all major countries. In the US, expectations of monetary tightening largely evaporated in the third quarter, and were replaced by expectations of easing, which the Fed delivered in November. Similarly, in Europe, expectations of tightening have been replaced by expectations of easing, though official rates have continued steady to date. The group of mid-sized economies that were raising interest rates in the first half of the year, which includes Australia, have all kept rates steady since at least July; markets do not expect any near-term moves and in some cases expectations of easing are emerging even among these countries.

Australian financial markets have not been immune from developments overseas. Share prices in Australia have fallen over the past six months and domestic interest rates, both long term and short term, have adjusted down. Overall, however, domestic financial markets continue to show a good deal more stability than markets overseas, reflecting the steadier path of the domestic economy.

In contrast to the tentative nature of the global expansion, the Australian economy has so far continued to grow at a good pace. This performance has been driven by strong growth in domestic demand which, to date, has broadly counterbalanced the dampening effects of the weak external sector. The growth of domestic demand over the past year has been spread across all main components, with consumer spending, housing construction and business investment all contributing strongly. These developments have been associated with above-trend growth in employment, and a declining unemployment rate. Prospects in the period ahead will of course depend importantly on global developments, but will also depend on a range of rather disparate domestic factors, most notably conditions in the business sector, the dynamics of the housing market, and the impact of the drought.

Business investment has been an important contributor to growth over the past year. In contrast to the major economies abroad, Australia’s business sector is in good shape, with a relatively high level of profits and generally sound balance sheets. In addition the direct effects of declining equity prices in Australia are likely to be more muted than those in other countries, given that Australia’s share market has remained relatively resilient. In these circumstances, prospects for further growth in investment are still good, particularly given that the level of investment is coming off a quite low base. A number of large resource and infrastructure projects have commenced recently, and data on building approvals and commencements indicate that further strong growth in non-residential building work is in prospect. Of course, recent financial market developments and weaker global economic prospects might yet affect business spending plans, but the most recent business surveys, in the main, suggest a generally positive outlook.

The large rise in housing construction has also made an important contribution to the strength of the economy over the past year. As well, the rise in house prices over much of the recent period has added to household wealth and boosted the capacity of households to borrow and spend. Investors have played a large part in the buoyancy of the housing market, accounting for virtually all of the growth in new finance approvals in the sector over the past year, presumably in expectation of strong growth in prices. It has been apparent, however, that this process would not be sustainable indefinitely, with emerging oversupply being bound at some point to limit the scope for further price increases.

While most measures of housing prices rose strongly in the September quarter, there are some signs that price appreciation in particular sectors of the market is starting to abate. Prices of apartments have lagged behind house prices recently, and there are indications that apartment prices in parts of Melbourne and Sydney showed little, if any, increase in the September quarter. Recent anecdotal reports point to a more general waning of buyer interest, and there has been a noticeable decline in auction clearance rates in the past month or so.

With regard to housing construction activity, the latest indicators have remained quite strong, with building approvals, and approvals for housing finance, generally moving higher in the September quarter. Hence, in the short term, housing construction activity is set to continue expanding. But given the emerging oversupply in the sector, housing activity now appears likely to begin declining in the first half of 2003.

The rural sector is continuing to experience a severe drought, which will sharply cut rural production and incomes. It is now estimated that the decline in farm production could directly reduce GDP growth by around 1 percentage point over the current financial year. Despite higher prices for some rural commodities, notably wheat and wool, net farm incomes this financial year are expected to be down by more than half from the high levels seen last year.

Drawing all these influences together, a modest slowing in domestic demand and output appears likely in the period ahead, principally reflecting the expected maturing of the housing cycle and the impact of the drought. While these factors have been evident for some time, they were initially expected to lead mainly to a rebalancing of growth, with the slowing in domestic demand being more or less offset by the impact of gradually improving external conditions. But with global economic prospects less assured, this expectation is unlikely to be met, and hence the economy overall can be expected to slow from its recent strong pace over the coming year.

Recent data on inflation have been consistent with the near-term outlook described in previous Statements. The CPI increased by 3.2 per cent over the past year, while measures of underlying inflation, designed to remove the effects of extreme price movements, are currently in a range between 2½ and 3¼ per cent in year-ended terms. The Bank’s assessment based on the range of available measures is that underlying inflation is currently around 2¾ per cent.

With evidence that wages and upstream price pressures are subdued, and no sign of global inflationary pressures, underlying inflation is likely to remain close to its recent level of around 2¾ per cent during 2003. This represents a slightly lower forecast than was presented in previous Statements, reflecting the noticeably weaker outlook for the global economy and, consequently, the less favourable environment for growth in Australia. CPI inflation could remain a bit higher than the underlying rate in the short term, reflecting the influence of the drought on food prices. But looking further ahead, the prospect is that CPI inflation will converge towards the underlying rate and hence will be within the target range. The risks around this forecast appear evenly balanced. If a reasonably favourable international growth outlook were to eventuate, the domestic economy could continue to expand at close to its recent pace, and in that scenario inflationary pressures may be expected to build gradually. On the other hand, an extended period of weaker growth in Australia and abroad might see inflation pressures easing further.

In its deliberations on monetary policy over recent months, the Board has taken into account the shifting prospects for the global economy as well as the range of important domestic influences on the economic outlook. These factors have been working in divergent directions, with the drought and the weak international environment subtracting from growth, while the stance of monetary policy and the dynamics of the housing market have been providing a stimulatory influence. The balance of these forces has shifted quite noticeably since mid-year. While initially it appeared that their net effect on the Australian economy in the medium term would most likely be in the direction of generating greater inflationary pressures, this became less clear as events unfolded during the second half of the year, as prospects for the global economy weakened. Some of this shift was already apparent at the time of the previous Statement in August, though subsequent events have suggested a further weakening in global prospects since that time. In view of these developments the Board at its recent meetings has judged that the most prudent course was to retain the current policy setting for the present time, while continuing to assess how the international and domestic economies evolve.