STATEMENT ON MONETARY POLICY

November 2003

The material in this Statement on Monetary Policy was finalised on 6 November 2003.

The first chapter of this Statement is provided below. The complete Statement can be viewed as a 965K PDF file.

Introduction

The economic situation has evolved rapidly over recent months, both in Australia and abroad. For the global economy, prospects for growth have improved considerably after a period of deterioration in the first half of the year. The early stages of this improvement were already apparent at the time of the August Statement on Monetary Policy, and subsequent information from most parts of the global economy indicates that conditions have strengthened further.

In the United States, the pick-up in growth that had been expected for the second half of the year is now underway. The national accounts recorded strong growth in the September quarter, and the prevailing conditions in the US seem favourable to continued recovery in a number of respects. Monetary and fiscal policy settings are highly expansionary; profits have picked up over the past six months; business inventories are at low levels, suggesting that production will need to accelerate to keep pace with demand; and surveys suggest that business confidence is rising. The labour market has been disappointing to date, but there have been some tentative signs of improvement recently, with a gradual decline in new jobless claims and an increase in non-farm employment in September. Taking all these things together, the prospects for the US economy, while not entirely free of risk, look better than for some time.

Recent data from other parts of the world have also been stronger over recent months, though less so in the euro area. In east Asia, the data available for the September quarter show a strong bounce-back in growth in a number of the smaller economies in the region, while China continues to grow at a rapid pace. In addition, the Japanese economy continues in a cyclical upswing, with an easing in the rate of price deflation and improvements in business confidence.

The generally positive run of economic data around the world has been reflected in a clear change in sentiment in financial markets since mid-year, as concerns that the global recovery would falter gave way to increasing confidence about the outlook. This is evident in several areas. First, bond yields and share prices have risen around the world. Second, commodity prices have firmed, and resource stocks have outperformed in global equity markets, despite the substantial rise in the exchange rates of the countries of domicile of these resource companies.

Third, market expectations of official interest rates have also been affected. In most countries, the short end of the yield curve implies a view that official interest rates are at their trough for the current cycle, and attention is now focused mainly on the question of when interest rates will begin to rise. In Australia, as well as reflecting the favourable overseas developments, financial markets have been influenced by the run of strong local economic data, with the result that markets had begun to anticipate some tightening of monetary policy ahead of the Board’s November decision, though a rise in cash rates had only been fully priced for the December meeting.

Finally, currencies which traditionally have been favoured by investors in the upswing in the international business cycle have risen in value, the Australian dollar among them. This has brought the trade-weighted index to a level slightly higher than its mid-year peak – but in circumstances quite different to those which prevailed then. At that time, the rise was largely driven by expectations that other countries would cut interest rates further due to weak growth. More recently, the rise in the exchange rate has occurred against a background of strengthening economic conditions, both in Australia and abroad. In this environment a rising exchange rate is the normal pattern.

The improving international situation has been accompanied by a marked strengthening of the domestic economy since mid-year. Consumer spending in Australia has picked up over recent months, with strong growth being recorded in retail sales and in motor vehicle sales. Consumer confidence, after increasing earlier in the year, has in the past few months been close to historical highs. The buoyancy of consumer spending is being supported by rising household wealth, driven in large part by continuing increases in house prices.

In addition to the strength of consumer spending, the prospects are for continued strength in business investment. Businesses are reporting substantial improvements in business conditions and in confidence about the future. According to a range of surveys, business confidence has now risen to levels consistent with well-above-average growth of the economy, with profits, sales and employment all reported to have increased strongly in the past few months. The unemployment rate has declined in recent months, to levels last seen in the late 1980s.

The one area of the Australian economy not to share in this general strength to date has been the export sector, where performance has been held back by a number of factors including the weak global environment of the past couple of years, the drought, the downturn in international tourism earlier this year, and the recent appreciation of the exchange rate. However, there are signs that the trough in exports has now passed. Rural exports will start to recover from the end of 2003, while international tourist numbers have already bounced back after their sharp drop in the June quarter. The improving global situation should mean, during 2004, a more favourable climate for most types of exports.

Inflation in Australia over the year to the September quarter was 2.6 per cent. This was little changed from the June figure, but noticeably below the results earlier in the year. The main reason for the recent decline in inflation is the dampening effect from the exchange rate appreciation over the past two years. This has resulted in a sharp fall in import prices and a broader deceleration of the prices of traded goods in the CPI. In contrast, inflation in the domestically oriented sectors of the economy has continued at a higher rate, with the non-traded component of the CPI increasing by around 4 per cent over the latest year, reflecting ongoing growth in costs and strong domestic demand pressures.

In the short term, continued pass-through of lower import prices will reduce the overall inflation rate. Over the longer term, inflation can be expected to be driven more by domestic pressures. The Bank’s current assessment is that inflation could fall a little further than earlier expected over the next year, but pick up a little more after that, so that it will be about 2½ per cent by the second half of 2005. The balance of risks around this medium-term central forecast, however, seems now to be shifting to the upside. Businesses are already reporting greater-than-average difficulty in obtaining suitable labour. While overall wage costs remain contained at present, despite pressures in particular sectors, ongoing strength in demand would pose an increasing risk of acceleration of costs over time.

As has been clear in previous Statements, the Bank has judged the stance of monetary policy over the past several years to be expansionary when compared with relevant historical benchmarks. Both the cash rate and indicator rates of financial intermediaries have been at lower-than-average levels. It is clear, moreover, that borrowers in the private sector, and particularly households, have found it attractive to borrow at these rates of interest. The rate of growth of credit increased further in September, to be at an annual rate of 15 per cent over the latest six months; for credit to households, the corresponding figure is 22 per cent.

With the risks to the Australian economy from abroad abating further over recent months, and with signs that domestic growth was running faster than expected, the Board's deliberations turned to the question of how much longer such an expansionary stance of policy should be maintained. As discussed above, the outlook for inflation over the next year remains quite benign, due to the assumed effects of the higher exchange rate. But a rising exchange rate cannot be relied on to control inflation over the medium term; that requires domestic pressures to be properly contained. While at present those pressures appear manageable, over the medium term they are more likely to grow than to diminish in an economy growing faster than trend. In the mature stage of a long expansion, with less spare capacity than would have been the case some years ago, monetary policy needs to keep a close eye on future growth in demand.

A separate, but no less important issue, flagged repeatedly in previous Statements, is the rapid run-up in household debt. While this has been associated with a boost to domestic spending which was welcome in a weak international environment, such trends carry increasing risk if they persist over long periods. Those risks, discussed at length on other occasions and so not repeated here, appear to be growing. Monetary policy should, as far as possible, avoid adding to them.

Given all the above considerations, the Board judged at its November meeting that a firming in the stance of policy was appropriate, with the timing of such a change the main question. The Board took the view that the general macroeconomic case to move was quite clear, and that there was little to be gained by delaying action. Hence the cash rate was increased by 25 basis points in early November. Over the period ahead, the Board will continue to assess the changing balance of risks to the economic outlook and adjust the stance of policy as needed to foster sustained and balanced growth, consistent with achieving the inflation target over the medium term.