STATEMENT ON MONETARY POLICY

November 2005

The material in this Statement on Monetary Policy was finalised on 3 November 2005.

The first chapter of this Statement is provided below. The complete Statement can be viewed as a 600K PDF file.

Introduction

The global economic situation is continuing to provide a favourable environment for the Australian economy. Most regions of the world are experiencing good economic growth this year, with the United States and China in particular performing strongly. There has been a notable improvement in conditions in Japan, where spending by businesses and consumers has strengthened and there has been good progress in winding back the balance sheet excesses that had hampered growth in the past. Elsewhere, solid growth is being recorded in the east Asian region and in the emerging economies of Eastern Europe and Latin America, with the euro area the only significant weak spot at present. Overall the world economy is likely to record a further year of above-average growth in 2005, and most observers expect this to continue next year.

A lot of attention over the past couple of years has focused on the upward trend in oil prices and its effects on the global economy. While periodic disruptions to supply have at times contributed to this trend, the main cause has been the strength of world demand. In these circumstances, higher oil prices do not appear to have had a significant contractionary effect on the world economy, and observers have not generally been scaling back their expectations of future world growth during the period when oil prices have been rising. The main macroeconomic effects to date can be seen in higher headline inflation figures around the world, most notably in the United States. As yet, there has been little evidence of any significant second-round inflationary effects, and at this stage core inflation rates in most advanced countries remain contained.

The increase in world oil prices has occurred as part of a more general rise in global commodity prices over recent years. World prices of coal, iron ore and a range of other resources have risen sharply as a result of strong growth in global demand, with the rapidly expanding Chinese economy playing an important part. These trends are to Australia's advantage, providing a substantial boost to the country's terms of trade and hence having an expansionary influence on domestic incomes and spending. Indeed, over the past three years, the Australian economy has experienced its largest cumulative increase in the terms of trade since the early 1970s.

These favourable international conditions are helping to support growth of the economy at a time when domestic factors have been exerting a modest dampening effect on household spending. The net result is that growth of the economy overall has remained quite solid, while there has been a significant shift in the composition of demand and output. Australian households for a while now have been in a process of adjustment after a period of unsustainably rapid growth in their borrowing and spending, and the more cautious approach they are now showing has been reflected in a reduction in the growth of consumer spending and debt. Nevertheless, growth in household incomes and spending continues to be supported by strong growth in employment and real wages, and by recent tax cuts. Another factor that has been dampening household spending recently has been the downturn in the housing construction cycle, though this has been quite mild in comparison with previous cycles.

In contrast to the household sector, business investment spending has been expanding rapidly. One important factor contributing to this has been the high level of commodity prices, which has stimulated investment in the mining sector and in resource-related manufacturing and infrastructure projects. Nonetheless, the growth in investment has been quite broadly based, with forward indicators of investment intentions pointing to further solid growth. This is not surprising in an environment where businesses, with the exception of trade-exposed manufacturers, are generally experiencing good trading conditions, high levels of capacity utilisation and strong profitability, a situation which has also been reflected in a strong share market.

Favourable external conditions and high commodity prices have also contributed to a narrowing of Australia's trade and current account deficits this year. Although much of the improvement has been a direct result of higher export prices, there has also been some pick-up in export volumes, while the growth in import volumes has eased a little in response to the slower trend in domestic demand. The farm sector has seen some improvement in conditions in recent months, so that farm output this year now appears likely to be around its average of recent years, compared with the well-below-average outcomes that had seemed likely earlier in the year.

Drawing these trends together, the economy over the past year or so has been experiencing a welcome change in the composition of growth, after a period in which the expansion had been mainly driven by growth in household spending. Over the same period, growth in demand overall has shifted to a more sustainable pace after the rapid growth seen previously. Economic indicators over recent months have confirmed that these trends are continuing, while suggesting that the chance of a more pronounced slowing has lessened. Current indications are that the economy is still operating at a relatively high level of capacity utilisation and that labour market conditions remain tight, with many businesses continuing to report considerable difficulty in attracting suitable labour.

Consumer price inflation picked up in the September quarter, with the CPI increasing by 0.9 per cent in the quarter and by 3 per cent over the past year, the largest annual increase since March 2003. The CPI increase was heavily affected by rising petrol prices, and underlying measures of consumer price inflation constructed by the Bank remained around 2½ per cent over the year. These results were broadly in line with the outlook presented in the previous Statement.

The fact that the headline CPI figure has moved to the top of the range that the Bank seeks to achieve on average does not of itself call for a monetary policy response, but needs to be placed in the context of the medium-term monetary policy framework. While Australia's inflation target is specified in terms of the overall CPI rather than underlying measures, the policy framework allows flexibility to look through volatility caused by temporary shocks to particular prices. Hence the focus of monetary policy is on whether, looking beyond any such temporary influences, inflation appears likely to be contained to an acceptable level in the medium term. In making this assessment, underlying inflation measures can serve as a useful summary indicator of current trends.

At present the Bank's assessment is that underlying inflation is likely to increase gradually over the coming year, reflecting several forces. The effects of the earlier period of exchange rate appreciation in restraining import prices appear to have largely passed through, and prices of tradable goods in the CPI have begun to drift up. Tight labour market conditions are contributing to a gradual pick-up in wage growth, and business costs are also being pushed up by higher prices of fuel and other commodities. Producer prices data for the September quarter indicate that input costs have continued to grow quite quickly, though they are no longer accelerating as they were in the second half of last year. However, given the shift in the growth of demand to a more sustainable pace and the prospect of a mild easing in labour market conditions, the rise in inflation is expected to be relatively modest, with underlying inflation levelling out at around 3 per cent in the second half of 2006. Assuming no further increase in international oil prices, this would mean headline CPI inflation remaining close to 3 per cent over that period. Of course, if oil prices instead were to continue rising, CPI inflation would be higher and, should such a situation persist, it would increase the likelihood of significant second-round price effects and increases in inflation expectations.

Financial conditions at present do not appear to be inhibiting growth in demand and output. The cash rate has been unchanged since March at a level that is close to recent averages, and interest rates for business and household borrowers remain somewhat below average, reflecting the continued compression of interest rate margins for these borrowers over recent years. Credit growth has remained relatively stable at an annual rate of around 13 per cent, which should be ample to fund growth in private spending. However, the composition of credit growth has continued to shift. Growth in credit to the household sector has eased back from the exceptionally rapid pace seen a couple of years ago, reflecting the cooling in the Australian housing market and the more cautious approach to spending and balance-sheet expansion that households now seem to have adopted. At the same time, credit growth to businesses has been picking up after a number of years in which it had been unusually low.

In summary, the economic situation reviewed by the Board at its recent meetings has been one in which international conditions appeared likely to remain favourable to growth in Australia, while the domestic economy was continuing to operate at a relatively high level of capacity utilisation. Growth in demand and output remained solid, but had eased back from the peaks seen in recent years. The Board's assessment at the time of its September and October meetings was that these trends were likely to be consistent with demand growth over the period ahead being broadly in line with the growth of the economy's productive capacity. On that basis, while underlying inflation was forecast to rise modestly over the year ahead, inflationary trends overall were expected to remain consistent with the target over the medium term.

At its November meeting, the Board's judgment was that the September quarter inflation data did not significantly change that expectation. Nevertheless, the Board recognises that, with inflation likely to be close to 3 per cent for some time, policy will need to be responsive to any sign that demand and inflation pressures are stronger than currently expected. The Board will continue to monitor unfolding economic developments and make such adjustments to policy as may be required to promote sustainable growth of the economy with low inflation.