Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 2 November 2010
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), Ken Henry AC (Secretary to the Treasury), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, Graham Kraehe AO, Donald McGauchie AO, Warwick McKibbin
Guy Debelle (Assistant Governor, Financial Markets), Philip Lowe (Assistant Governor, Economic), Tony Richards (Head, Economic Analysis Department), Anthony Dickman (Secretary)
International Economic Conditions
The news on the global economy had been mostly positive, including a strengthening in commodity markets and lessening of concerns about a larger-than-expected slowing in growth of the Chinese economy. Overall, the central forecast for the global economy was still for around trend growth over the next couple of years.
Members noted that recent information about the Chinese economy suggested that growth had slowed to a more sustainable pace after the earlier rapid recovery. GDP was estimated to have grown by around 2 per cent in the September quarter and by 9½ per cent over the year, and the indices of activity in the manufacturing sector for October suggested continuing solid growth. While Chinese exports and imports had declined slightly over recent months, both consumption and investment looked to have grown solidly. There were also further signs that the property market was strengthening again after having cooled earlier in response to policy measures. Inflation had increased recently, largely reflecting higher food prices. In response to these developments, the People's Bank of China had lifted benchmark interest rates for the first time in the current phase and additional measures had been taken to dampen activity in the property market.
Growth in other parts of Asia had also eased from its earlier strong pace, but remained solid. While exports had softened recently, domestic demand was growing at a robust pace in most economies, with the exception of Japan. Consumption was growing solidly, consumer confidence was generally high and recent data pointed to continued strength in investment. In several of the higher-income economies in the region, as also in China, CPI inflation was rising again, largely reflecting increasing inflation in food prices.
In the United States, growth had slowed considerably over the June and September quarters, with GDP increasing by 0.5 per cent in the September quarter. While business investment was gradually picking up, weak consumer spending and high levels of excess capacity were acting as a drag on prospects for both capital spending and construction activity. Job vacancies had been growing since late 2009, although private-sector job creation remained very weak. Budget problems in state and local government were resulting in job losses in these sectors.
In Europe, confidence and activity indicators pointed to continued strength in Germany, and September quarter GDP in the United Kingdom had again surprised on the upside. Elsewhere in Europe, consumption growth and labour markets remained weak and the planned fiscal consolidation was weighing on the outlook.
Members discussed developments in inflation in the major advanced economies. Inflation had been trending down recently in most of these economies, reflecting the low level of resource utilisation, with year-ended core inflation around or below 1 per cent in the United States and the euro area, and prices were falling by around 1½ per cent over the past year in Japan. An exception was the United Kingdom, where core inflation had remained relatively high.
Most commodity prices had strengthened over the past couple of months. The spot price for iron ore was around 10 per cent above the estimated December quarter contract price. The combination of strong demand, low stocks and a range of supply disruptions had led to increases in the prices of a number of agricultural commodities. Members discussed the factors behind the increases in food prices, including the significant change in diet that was occurring as incomes rose in emerging economies. The terms of trade for Australia were estimated to have reached around a 60-year high in the September quarter.
Domestic Economic Conditions
Conditions in the domestic economy had continued to evolve broadly as expected. The main news over the past month related to CPI and employment data, and investment in the resources sector.
The labour market remained strong. The unemployment rate was unchanged at 5.1 per cent in September, with employment increasing by a further 50,000 in the month, and by around 3¼ per cent over the year. Members noted that other evidence suggested that the labour market might not be as tight as indicated by the unemployment rate.
Consumer sentiment remained at a high level, with consumer surveys reporting that it was a good time to buy major household items. While liaison and recent data on retail trade provided a picture of varied conditions across the different segments of the retail market, they mostly suggested that consumers were still cautious in their spending and that discounting was extensive.
In the housing market, conditions had softened relative to earlier in the year, with national housing prices broadly flat over recent months. Auction clearance rates remained around long-run average levels. Loan approvals had drifted down over the course of the year and growth in housing credit had been moderate over recent months. Other forms of household credit had been flat recently and liaison with retailers had noted a pick-up in cash payments relative to credit cards.
Business conditions remained generally favourable, although there were clear differences across sectors and regions. Indicators of investment intentions were mostly positive, particularly for the resources sector, where the pipeline of work to be done was large. Members discussed developments in the LNG sector, including the recent investment decision on the project in Queensland to convert coal-seam methane to LNG. There were also positive indications for some other LNG projects that were still in the planning stage. Developments in the LNG sector, including the likely significant imported component, appeared to be broadly in line with earlier assumptions.
The impact of the exchange rate appreciation was evident in a number of sectors. Visitor arrivals had increased only modestly over the past five years, while overseas departures by Australians had increased strongly, with a consequent decline in domestic tourism. The high exchange rate had also had a negative effect on the education sector, although changes in government policies were likely to have been a more important factor. Despite the strengthening of the exchange rate, surveys suggested that conditions in the manufacturing sector were around average. In part, this reflected the fact that many manufacturers benefited from cheaper imported capital equipment and components when the exchange rate appreciated, and that some focused mostly on the domestic market.
Conditions were mixed in other sectors, and there were few signs of recovery in non-residential construction, where access to funding remained tight. Members discussed recent developments in business finance. While credit outstanding had declined in recent months, it appeared that many large businesses had good access to funding from profits and the capital markets, and business surveys suggested that the availability of finance had improved relative to late 2008 and early 2009. It was noteworthy that business deposits had been rising over the past year while lending was falling.
The staff's revised central forecast for GDP growth was broadly similar to that at the time of the August Statement on Monetary Policy. GDP was expected to expand by 3½ per cent over 2010, with growth picking up to be in the 3¾–4 per cent range over 2011 and 2012. This positive outlook for the domestic economy was underpinned by the income surge flowing from the very high level of the terms of trade and the expected growth in investment in the resources sector. While the terms of trade were expected to decline over the next couple of years, export prices were forecast to remain at a higher level than at the time of the August Statement.
The CPI had increased by 0.7 per cent in the September quarter, to be 2.8 per cent higher over the year. This was a slightly smaller rise than had been expected three months earlier, partly reflecting a surprising fall in food prices and lower fuel prices. Utilities prices increased significantly in the quarter and rose by 12 per cent over the year, reflecting broad-based increases in electricity, gas and water & sewerage charges. Members discussed the significant increases in electricity prices in recent years, which in part reflected ongoing strong demand, especially at peak times, and an earlier period of under-investment in the distribution network.
In underlying terms, inflation was around ½ per cent in the quarter and 2½ per cent over the year. Members viewed the return of year-ended underlying inflation to the middle of the 2–3 per cent target as a positive development. However, the staff assessment was that underlying inflation was unlikely to moderate much further, given the pick-up in economic growth over the past year and the strengthening of the labour market.
The medium-term outlook for inflation was broadly unchanged, although the near-term forecast for year-ended inflation had been lowered slightly. In underlying terms, inflation was expected to remain around 2½ per cent until mid 2011, before gradually rising to 3 per cent by the end of 2012. Year-ended headline CPI inflation was expected to remain above underlying inflation in the near term.
The main driver of financial market developments over the past month had been the expectation that the Federal Reserve would engage in further quantitative easing. An announcement was expected following the FOMC policy meeting later in the week. The exact nature of the Fed's action was still uncertain but it was expected to involve significant further purchases of US Treasuries.
Government debt yields had remained low in most of the major economies, indicating that policy interest rates in those economies were expected to remain at their current levels for the foreseeable future. The Bank of Japan had announced additional easing, including a slight lowering in its target for the policy rate, a commitment to maintain this policy until price stability was in sight, and further asset purchases.
The balance sheet of the European Central Bank (ECB) had been contracting for several months as earlier liquidity operations matured. This was resulting in an upward drift in short-term market rates towards the ECB's policy rate. Data to the end of September showed a rise in borrowing from the ECB by Irish banks, but modest falls in borrowing by some of the other smaller countries. Spreads on Irish government bonds had widened recently.
A number of central banks had tightened policy. In China, the central bank had lifted deposit and lending rates for the first time since 2007. There had also been tightening of monetary policy in Chile, Singapore, Sweden and Taiwan.
The expectation of further easing by the Federal Reserve had provided a boost to global equity markets, which had risen back to their levels prior to the Greek turmoil earlier in the year. Emerging market equities had performed relatively better over this period.
One sector that had underperformed the global market was the US banking sector, whose share prices had been weighed down by recent earnings reports that showed a slowing in income growth, and by the concerns about the foreclosure process that had recently surfaced. Members noted that around 5 per cent of all US mortgages were in the process of foreclosure at the end of June.
Expectations of US monetary easing had affected currency markets, causing the US dollar to weaken. In trade-weighted terms, the US dollar was now only slightly above its record low in 2008. The Japanese yen was close to its record high (in nominal terms) against the US dollar. The Chinese renminbi had been broadly unchanged against the US dollar over the previous month, but had depreciated modestly in trade-weighted terms. The Australian dollar had reached parity against the US dollar briefly during the month, before falling back. This marked a post-float high against the US dollar, with the Australian dollar also close to its post-float high in trade-weighted terms.
The depreciation of the US dollar had prompted concerns among policy-makers in a number of countries about appreciation of their currencies and capital inflows, as well as the prospect of destabilising capital outflows in the future. The authorities in Brazil and Thailand had increased taxes on capital inflows, while the introduction of capital controls was being considered in Korea, Indonesia and South Africa. A number of countries had continued to intervene to limit the appreciation of their currencies, and data released over the past month had shown a significant build-up in reserves by a number of countries during the September quarter.
Domestically, the most recent data showed a continuation of the trends in bank funding that had been apparent for some time. The shares of relatively high cost funds, such as domestic deposits and long-term debt, had continued to rise, while the share of short-term debt had continued to fall. Members were briefed on developments in funding costs. Most banks had reported a small reduction in net interest margins in their most recent half-yearly accounts, though some had experienced an increase. Deposit competition appeared to have levelled off in recent months. In debt markets, spreads on short-term bank bills had narrowed to be not far above pre-crisis levels. Spreads on longer-term bank debt had stabilised at levels that were significantly higher than before the crisis. This was slowly adding to the banks' cost of funds as banks rolled over debt issued earlier at lower spreads. Members noted that there was a possibility that banks would increase interest rates on loans by more than any move in the cash rate.
Issuance of bank bonds and mortgage-backed securities had been fairly low over the previous month, partly reflecting the timing of bank profit announcements. The low level of global interest rates had allowed some companies to borrow in capital markets relatively cheaply at much longer maturities than had traditionally been available.
Considerations for Monetary Policy
Members noted that significant differences remained in the economic performance of various parts of the global economy. The expansion of the US economy remained weak and it was likely that the Federal Reserve would announce additional quantitative easing within a few days. Also, there were still fragilities in Europe relating to banking sectors and fiscal positions. In contrast, the past month had provided further confirmation that the Chinese economy was continuing to grow solidly and was not experiencing a greater-than-expected slowdown. The outlook for many other emerging economies also remained positive and there had been some increase in commodity prices. In relation to financial markets, members noted that the turmoil seen earlier in the year had continued to abate, though sentiment remained fragile.
Domestically, inflation had come in slightly lower than expected in the September quarter, partly reflecting movements in the prices of some volatile items, including food. In underlying terms, year-ended inflation was now at the centre of the target. The news on the real economy had been mostly positive, with an upgrade to forecasts for the terms of trade, further indications of a likely surge in resources investment, and continuing strength in the labour market. Developments in credit and asset markets, on the other hand, had remained subdued.
Overall, members considered that developments in terms of activity and inflation were broadly consistent with the central scenario the Bank had envisaged for some months. The outlook for growth in the resources sector was very strong and GDP growth was expected to rise gradually. While inflation had moderated, it was likely that the decline was now largely complete; inflation was expected to remain around the current level for several quarters, but was likely to move higher thereafter.
In previous meetings, members had discussed the likelihood that interest rates would need to rise, at some point, if the economy continued to evolve in line with the central scenario. Based on developments over the past month and the latest assessment of the outlook, members judged that the point at which some upward move in interest rates would be necessary had moved closer.
As in October, a case could be made for waiting a little longer: the expected pick-up in domestic growth would be only in its early stages; the latest CPI outcome had been relatively good; and credit growth and housing prices were subdued. In addition, the exchange rate had appreciated over the past month, and quite significantly over a longer period, which would dampen inflation pressures somewhat. There might also be a case for waiting to see if the Federal Reserve's upcoming announcement had a significant further effect on the exchange rate.
On the other hand, some of the uncertainties that had been a reason to keep interest rates steady over the past few months had lessened recently, even though they had not dissipated completely. Compared with several months ago, downside risks to the global economy had still not materialised in any significant way. Indeed, the uncertainty regarding the outlook for the Chinese economy had lessened, commodity markets had strengthened and the outlook for investment had firmed. With only a relatively modest amount of spare capacity in the economy, a gradual upward trend in inflation remained likely over the medium term. If monetary policy was to be conducted in a forward-looking way, these developments meant there was a case for increasing interest rates at the current meeting.
Members considered that the arguments were finely balanced. However, with the flow of information over the past month generally suggesting that the medium-term economic outlook remained one of strengthening economic activity and gradually rising inflation, the Board judged that the balance of risks had shifted to the point where a modest tightening of monetary policy was prudent. Members noted that lending rates might increase by more than the cash rate, but this tendency would not be lessened by delaying a change in the cash rate. Lending rates had been rising relative to the cash rate since the global financial crisis, and the Board had taken this into account in setting the cash rate. It would continue to take account of any changes in margins in its decisions in the period ahead.
The Board decided to raise the cash rate by 0.25 percentage points to 4.75 per cent, effective 3 November.