Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney - 7 October 2008
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, Graham Kraehe AO, Donald McGauchie AO, W arwick McKibbin
David Gruen attended in place of Ken Henry AC (Secretary to the Treasury) in terms of section 22 of the Reserve Bank Act 1959.
Guy Debelle (Assistant Governor, Financial Markets), Malcolm Edey (Assistant Governor, Economic)
David Emanuel (Secretary), Anthony Dickman (Deputy Secretary)
The Board received a comprehensive briefing on financial market developments during the past month, which had been one of the most turbulent periods in recent decades.
Financial markets had been characterised by a high degree of pessimism, with the effective failure of several large financial institutions and the nationalisation or take-over of other financial institutions in the United States and Europe. These developments had seen the demise of the US investment banking model and changes to the financial landscape in several countries. There had been a virtual complete closure of wholesale capital markets in the United States and Europe, beyond only the very short term. In Australia, such markets had performed better than their overseas peers, but they were nevertheless severely strained.
Public policy responses had culminated in the US Government’s plan for the US Treasury to purchase distressed assets from financial institutions in order to facilitate the process of balance sheet repair. There had also been deposit and debt guarantees instituted in some countries.
The unfolding crisis had been reflected in high levels of volatility in all financial markets over the past month. Government bond yields had declined as investors sought the safety of sovereign fixed interest securities. Equity markets, in particular, had fallen significantly, with the US S&P 500 down by 25 per cent over the course of the month. Equity markets in emerging economies were also sharply lower. Further declines in commodity prices had led to falls in non-financial shares, whereas, until recently, falls in equity markets had been driven mainly by falls in financial shares. Declining prices of shares in other sectors of the market suggested that investors were starting to price in a significant downturn in the global economy. Share prices in the major markets had fallen back to 2004 levels.
The Australian equity market had fallen broadly in line with overseas markets, with the most noticeable falls in the past month in resources shares, reflecting the falls in commodity prices from their recent peaks. Daily volatility of share prices had been very high; 2008 thus far had recorded more days with large price movements than 1987.
Members noted that the failure of Lehman Brothers was the catalyst for the current bout of market turmoil and had markedly undermined trust among counterparties. Perceived risk among financial institutions in North America and Europe had risen sharply, as indicated by credit default swap indices. Financial institutions in those markets were willing to deal with one another at only very short horizons.
US money market mutual funds had suffered losses as a result of the Lehman default, and subsequent redemptions by investors had made it impossible for the funds to maintain their traditional strong demand for short-term bank paper. This greatly added to banks’ funding difficulties. The run on these funds also led to Treasury bill yields falling to zero as investors switched to government debt, and, subsequently, to the provision of a capital value guarantee on money market fund assets by the US Treasury.
Global money markets had been dysfunctional. The three-month US dollar LIBOR to swap spread had increased very sharply, though it was not a meaningful indicator given the lack of activity in that market at present.
Another market that had suffered dislocation was the foreign exchange swap market. Increased counterparty risk meant that a structural shortage of US dollars was denying investors the capacity to hedge US dollar assets, with the cost of borrowing US dollars outside the United States increasing very sharply. In response to this problem, the Federal Reserve had set up large swap lines with central banks across various time zones in order to distribute US dollars to other markets. Swap lines had been in place with the European Central Bank and the Swiss National Bank and were subsequently extended to several other central banks, including the RBA. The process involved swapping local currencies for US dollars, which were then auctioned to counterparties in each location against domestic collateral. This had been particularly important around the end of the September quarter, when liquidity had been very tightly held. The RBA would shortly be conducting another auction of US dollars, with a term of 95 days in order to span the end of the year.
In their efforts to ease these market strains, central banks were acting as intermediaries of last resort, by expanding their domestic liquidity operations and balance sheets accordingly. The Federal Reserve’s balance sheet had increased substantially in the past two weeks, part of which included higher gross foreign exchange reserves resulting from the US dollar swap program.
Bond spreads had risen over the past month. In the euro area, a sharp rise in other sovereign spreads to German bunds implied that investors had begun to regard even sovereign issues outside the three largest bond markets as risky. Among rising market bond spreads to US government bonds, the most notable was the rise in spreads of low-rated US bonds.
Turning to foreign exchange markets, members observed that exchange rates had moved in wide ranges over the past month. In net trade-weighted terms, the US dollar was higher, though it had fallen against the yen as traders unwound positions that had involved selling yen. The US dollar had increased against most currencies over the past year and was about 5 per cent higher in trade-weighted terms.
The Australian dollar had been extremely volatile over the past month, trading in a US10 cent range. The exchange rate was 16 per cent lower over the month, measured on a trade-weighted basis, having fallen against the currencies of all of Australia’s trading partners, and was now about 20 per cent lower compared with its level a year ago.
In reviewing market expectations for policy rates, members noted that official rates in most countries were now expected to fall by the end of the year. The US Fed was expected to cut the federal funds rate by 50 basis points at the next FOMC meeting in late October, with markets attributing some chance of an easing before then. The European Central Bank and other central banks were now also expected to cut policy rates at their next meetings.
Members noted that US 30-year mortgage rates had fallen somewhat following the announcement of the conservatorship of Fannie Mae and Freddie Mac early in September. However, one-year adjustable rate mortgage rates had remained relatively high.
In Australia, a marked shift down in the expected cash rate had led to falls in bank bill rates, but not to the same extent. Bill rates had spiked up around quarter-end, despite there being reasonable turnover in the bill market, and the RBA had injected a large amount of liquidity in its market operations, raising exchange settlement balances to around $11 billion. The RBA had introduced a term deposit facility, partially to absorb the higher exchange settlement balances. The yield on this facility is determined by auction.
Members discussed the implications for banks’ lending rates of market expectations of official rate cuts this month and later in the year, noting that market expectations were for the cash rate to reach 5½ per cent by mid 2009. They were informed that staff estimates suggested that banks ’ funding costs had risen by about 20–25 basis points above relevant benchmarks. Banks were still keenly bidding for deposits across the yield curve.
One of the consequences of the conditions facing banks was that there was a likelihood of tighter quantitative credit conditions in the period ahead.
International Economic Conditions
The Board’s discussion of international economic conditions commenced with a review of the latest data for the United States, which were for August and September and thus predated the latest bout of financial market turmoil.
Business conditions in the US manufacturing sector fell sharply in September, in a continuation of the downward trend over the past year. Conditions in non-manufacturing businesses were little changed in September but the trend was down also. Members noted that there was as yet no sign of an end to the housing downturn. The latest data indicated continued falls in housing starts, and house prices had also fallen further over the past few months. While the stock of unsold new houses was falling, it remained well above the average of the past two decades. Consumer spending, which accounts for the bulk of spending in the economy, had slowed noticeably since mid year as the effects of the boost to incomes from the package of tax rebates in the June quarter faded.
Conditions in the US labour market deteriorated further in September, with a large fall in employment, which had fallen each month this year. The unemployment rate had risen by 1¾ percentage points since its trough early in 2007.
Turning to conditions in China, members observed that the growth of industrial production had slowed to around 13 per cent per annum, which was the lowest rate in five years. The slowdown in production of steel, concrete and energy had been much more pronounced. Growth in export volumes from China to the major economies had fallen markedly over the past year. As a result of these developments, the Chinese authorities had eased monetary policy somewhat.
There had been a similar pattern of slowing growth in other parts of the world.
Revised estimates showed the Japanese economy had contracted by ¾ per cent in the June quarter, and the Tankan survey measure of business conditions had fallen over the past eighteen months to its lowest level in five years.
In the rest of east Asia, estimates of growth in aggregate industrial production had fallen from around 10 per cent per annum at the beginning of the year to about 2 per cent at present.
The New Zealand economy had experienced a contraction in the first half of the year.
In the euro area, GDP fell in the June quarter. Other more recent indicators, such as measures of business and consumer sentiment, were also declining. The United Kingdom was undergoing a significant economic slowdown. GDP had stopped growing, house prices had fallen since the start of the year and housing credit had slowed sharply.
Members discussed the implications of the current financial market turmoil for global economic prospects, particularly through the channel of credit provision to businesses and households. Credit was no longer expanding in the United States and had slowed sharply in the euro area and United Kingdom, which were also at the centre of the financial crisis. The slowing in credit had been less pronounced in Canada, which had been affected to a smaller extent by the financial crisis.
Members observed that the falls in commodity prices in the past month or so, notably but not only for oil, meant that headline CPI inflation rates in most countries had probably peaked.
Domestic Economic Conditions
Before turning to the most recent data on the domestic economy, members reviewed the national accounts for the June quarter, which were released the day after the previous meeting. GDP increased by 0.3 per cent in the quarter, with the slowing broadly in line with the staff’s expectation. Members noted that real gross domestic income, which incorporated the effect of the rise in the terms of trade, had increased significantly more than GDP. However, with the terms of trade now appearing to have peaked, this gap was likely to narrow over the period ahead.
The staff forecasts for growth, which incorporated the effect of the September rate cut, were little changed from those published in the August Statement on Monetary Policy. More recently released indicators suggested that there had not been any further significant slowing in the economy in the September quarter, though this information predated the onset of the latest bout of financial market turmoil.
Members then considered in more detail the information provided by the run of regular monthly data releases, covering household consumption, the housing sector, the business sector, the labour market, commodity prices and wages.
There had been some improvement in indicators of consumption in the past few months, but the overall trend had been weak since the end of 2007. Retail sales had increased in July and August, though members noted that the reduction in the sample size for this survey meant that the estimates were now less reliable than they had been previously. The increase in retail sales in August, in particular, was unlikely to have been as large as the seasonally adjusted figure suggested, as the large stores, which were fully enumerated in the survey, had not recorded any increase in sales. Although retail sales in the early part of the September quarter had been stronger than in the June quarter, assisted by lower petrol prices and income tax cuts, liaison conducted by the staff suggested that conditions had deteriorated in September. Members noted that, as with some other economic indicators, NSW was experiencing slower growth in retail sales than other parts of Australia, though the data were volatile and generally less reliable at the state level of disaggregation.
Another monthly indicator of consumption was motor vehicle sales, which had fallen and were now more than 10 per cent lower than at the end of 2007. Consumer sentiment had increased modestly in August and September, most likely reflecting the positive effect of lower petrol prices, the tax cuts and the September rate cut, but predating the most recent financial market turmoil.
Overall, members thought the slowing in consumer spending that had been recorded over the past year was consistent with the significant slowing in growth of real household disposable income, which, after interest payments, had slowed from about 6 per cent over the year to mid 2007 to 2½ per cent over the year to mid 2008.
In the housing sector, housing loan approvals had fallen a little further in July and, according to estimates, in August. The broader measure of household credit was now expanding at a six-month annualised rate of 6 per cent, which had not been seen since the early 1990s. Estimates for house prices in the September quarter suggested that average nationwide prices had fallen a little further, following a fall in the June quarter. On the other hand, auction clearance rates had increased in both Sydney and Melbourne following the rate cut in September.
Members observed that there had been a compositional shift in spending in the economy in the first half of the year, characterised by a slowing in consumption while business investment and government spending remained strong. Business investment had increased by 10 per cent over the year to the June quarter, but the outlook was now more uncertain. Despite the positive intentions reported in the capital expenditure survey, private-sector business surveys suggested that investment plans were being scaled back.
Business debt funding, which included intermediated and non-intermediated financing, had slowed over the past year, but appeared to have stabilised at growth of around 8 per cent in recent months.
Turning to the labour market, members observed that the gradual slowing in trend employment growth had continued over the past month. Statistics suggested that the slowing was most pronounced in NSW compared with elsewhere in Australia, though the employment data by state were quite volatile. Job advertisements had been falling over the past six months, with newspaper job advertisements sharply lower. This suggested further slowing in employment was in prospect.
Members discussed the recent falls in spot commodity prices. Oil prices had fallen sharply, with Tapis crude falling over the past month from US$120 per barrel to US$90 per barrel. Movements in the oil price had not been as marked in Australian dollar terms, as the exchange rate had generally appreciated when commodity prices were rising and depreciated when they fell, thereby dampening the effect of the US dollar price movements. Coal prices had also fallen. The premium between the spot thermal coal price and the most recent contract price, which had been close to 40 per cent around mid year, had been eroded; spot prices were now trading at a slight discount to the contract price. There had been similar price movements in the iron ore market.
The only data on wages that had become available over the past month had been those from the national accounts, namely average earnings. This series, which was volatile, was growing at about 4 per cent per annum, broadly in line with other wage indicators.
Considerations for Monetary Policy
The paper prepared for the Board recommended a large reduction in the cash rate, of at least 50 basis points, with the amount to be subject to review in light of any events occurring between the preparation of the paper and the time of the meeting. In the event, the recommendation put to the Board at the meeting was for a reduction of 100 basis points, to 6.0 per cent.
The key factors for members’ consideration were the sharply worsening conditions in international financial markets during September and the consequential deterioration in the global economic outlook. Prices in global asset markets had fallen sharply and growth in credit in the major economies had slowed to unusually low rates. These developments meant that households and businesses in many countries would have difficulty accessing funding and that global economic activity, which had already slowed significantly, would probably slow further. Members noted that forecasts of growth in GDP in both developed and developing economies were, therefore, in the process of being revised down, particularly for 2009. Members also noted that Australian financial markets were being affected to a lesser extent than in many other countries, given the relative strength of the domestic banking system. Nonetheless, the deterioration in the outlook for global economic activity posed downside risks to the domestic economy.
Members observed that, domestically, the path of economic activity had to date evolved in line with the Board’s previous expectations, with the needed moderation in demand occurring. However, the latest economic data predated the onset of the current bout of financial market turmoil. The June quarter national accounts had presented a picture of weak consumption and strong investment, with the aggregate growth of demand slowing. While investment spending had been strong over the year to the June quarter, and stated expectations by firms in July and August had been for further strength in the year ahead, it was becoming more likely that these intentions would be scaled back. Members noted that the expansionary effects of the recent surge in Australia’s terms of trade were still being felt. With the world economy clearly slowing, however, and many commodity prices now having fallen significantly from their peaks, the external stimulus to Australian incomes and demand was expected to fade over the year ahead.
Although the September quarter CPI, to be released before the next meeting, was likely to show an increase of around 5 per cent over the year, members noted that the current staff forecast was for inflation to start to decline in 2009. Moreover, the recent deterioration in global growth prospects, together with the more difficult market conditions even for creditworthy borrowers, increased the risk that demand and output could be significantly weaker than earlier expected. In that scenario, inflation would most likely fall faster than expected previously.
In view of the latest economic and financial market developments, members judged that the material change to the balance of risks surrounding the outlook for growth and inflation in Australia meant that a significantly less restrictive stance of monetary policy was now appropriate. It was acknowledged that the current level of interest rates meant that monetary policy had significant capacity to provide stimulus.
In assessing the recommendation, members observed that an easing of 100 basis points would bring forward some of the easing markets had already priced in for following months. The increased downside risks to growth and the improved prospects for lower inflation meant that there was a strong economic case to do so. As staff estimates suggested that banks’ funding costs had risen by about 20–25 basis points relative to relevant benchmarks, any reduction in interest rates that banks announced on loans to customers would most likely be less than the change in the cash rate by a similar margin.
The Board considered the possibility that a larger-than-expected easing of 100 basis points could have a negative effect on market sentiment. The exchange rate in particular had fallen sharply over the preceding 24 hours. Members concluded that, despite the possibility of a short-term adverse reaction, stronger action would help sentiment over time.
Taking careful note of all those considerations, the Board decided that, on this occasion, a reduction in the cash rate of 100 basis points was appropriate. Members did not regard this unusually large adjustment as establishing a pattern for future monetary policy decisions.
The Board decided to lower the cash rate by 100 basis points to 6.0 per cent, effective 8 October.