Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 3 August 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 (Acting Secretary)
International Economic Conditions
The economic data becoming available for the June quarter indicated that the global economy had continued its expansion, though conditions differed across regions. Growth in Australia's trading partners had been very strong, at around 6 per cent in export-weighted terms over the year to June. Broader measures of global growth, which placed a higher weight on the North Atlantic economies, had been lower but above trend over the past year. Recently, economic activity appeared to have strengthened in Europe after a half year of little growth, but there had been moderation in some other parts of the world.
Members noted that, in Asia, this moderation was occurring from a very rapid pace, and was likely to put these economies on a more sustainable path. In China, estimates of GDP had shown an increase of around 2½ per cent in the June quarter, which was another strong result but a little below the quarterly outcomes recorded over much of 2009. The monthly indicators suggested that investment had slowed in June, while growth in retail spending had remained firm. Members discussed developments in the Chinese property market, where the earlier policy measures were contributing to a cooling, with turnover lower and housing prices declining in a number of markets. There had also been a slowing in the construction sector and the production of inputs, such as cement and steel, after very strong growth in 2009. Overall, while the extent of slowing in the Chinese economy remained uncertain, the recent indicators did not suggest a more marked slowing than the staff had been expecting.
Growth in other parts of Asia remained solid but, as expected, it appeared to be moderating from the rapid pace seen over the previous year. There were indications of some slowing in the monthly data for industrial production and exports in Asian economies, as well as in the June quarter GDP data for Korea. The Indian economy had been expanding rapidly and was expected to remain strong, but inflation pressures remained elevated. In Japan, the expansion appeared to be continuing, though growth in exports and production had slowed over the past couple of months. In the household sector, measures of consumer sentiment had continued to rise to above-average levels, though the unemployment rate had recently edged up.
In Europe, the recent economic data had been better than expected, and measures of business and consumer sentiment in the larger countries did not appear to have been much affected by the recent concerns over fiscal policy. GDP growth in the June quarter was surprisingly strong in the United Kingdom, and a solid increase in euro area GDP was expected after little growth over the previous half year. Conditions in Germany were better than in most other countries, with consumer sentiment now well above its long-run average and the unemployment rate below its level prior to the recent recession. Members noted that Germany had been benefiting from earlier structural reforms, including of labour market policies, and had experienced a significant rise in its employment-to-population ratio over the past five years. Germany had also benefited from the depreciation of the euro over the past year or so. Notwithstanding recent positive developments, the outlook for Europe in 2011 would probably remain subdued, with fiscal consolidation and ongoing banking system repair likely to weigh on growth prospects.
The US economy had continued to expand, with GDP estimated to have grown by 0.6 per cent in the June quarter. This was somewhat slower than in the previous two quarters, and most forecasters were expecting only moderate growth over the second half of the year. Equipment investment had picked up further, business conditions remained generally positive and corporate profitability was strong for this stage of the cycle. However, the recent national accounts had contained a downward revision to the level of household consumption and an upward revision to the saving rate. Growth in household spending appeared to be slowing and consumer sentiment had fallen over recent months. The solid growth in output over the past year was yet to translate to a significant recovery in the labour market.
After weakening over May and June, commodity prices had tended to strengthen over the past month as concerns about the situation in Europe had eased and sentiment in financial markets had improved.
Domestic Economic Conditions
Domestically, the labour market has continued to firm. Employment increased by a further 46,000 in June, with growth of 3¼ per cent over the year. The unemployment rate was 5.1 per cent, around ¾ percentage point below its level in mid 2009. While this suggested that labour market conditions had tightened over the past year, other indicators, such as business surveys, suggested that businesses in most sectors were not encountering significant difficulty in finding suitable labour. In addition, average hours worked had picked up only modestly after falling significantly during late 2008 and early 2009. Members noted that a significant decline in the unemployment rate typically suggested that the economy had been growing at a rate above potential, though this stood in contrast to the GDP data, which suggested that growth had been below potential.
While growth had been boosted by fiscal stimulus over the past year and a half, this would be reversed in the period ahead as public investment declined following the completion of stimulus-related projects. At the same time, a strengthening in business investment was in prospect. Capital goods imports had increased over recent months and most survey-based measures of firms' investment intentions had increased.
Business conditions, as measured by surveys, remained at or above average levels. One area of weakness continued to be commercial construction, where financing conditions remained tight, though both liaison and approvals data provided some early indications of a strengthening in office construction. This was consistent with office vacancy rates having peaked in Sydney and Melbourne. Business credit was unchanged in June, though commercial loan approvals had been trending modestly higher over recent months.
Measures of consumer sentiment had risen in July to be at quite high levels again. The Bank's liaison with retailers suggested that households generally remained cautious in their spending, though a number of firms had reported that conditions had improved a little from earlier in the year. The retail trade data showed a further modest increase in spending in the month of June and a 0.8 per cent increase in the volume of spending in the June quarter. These data also provided evidence of significant discounting, with retail prices only 0.1 per cent higher in the quarter.
Members discussed broader trends in household behaviour. They noted that the household saving rate was at a higher level than a few years earlier, and credit growth was much lower than over the past decade. Household surveys suggested some change in attitudes to saving and a greater degree of caution about household finances. Looking ahead, members observed that the challenges of dealing with a terms of trade boom and strong growth in investment would be lessened if these trends in household behaviour continued.
There had been further signs of a cooling in the established housing market after a year of strong price increases. Housing prices had shown little growth over the past few months, with prices falling in June, including in Melbourne where price growth had earlier been strongest. Auction clearance rates in Sydney and Melbourne had declined significantly, to around average levels. Housing loan approvals were estimated to have declined further in June and housing credit growth had moderated. These developments suggested that the earlier increases in lending rates were having an effect on household behaviour.
The CPI data for the June quarter had showed a further decline in underlying inflation, consistent with the Bank's earlier forecasts. In underlying terms, inflation was around 0.5 per cent in the quarter and 2¾ per cent over the year. This was the first time that underlying inflation had been below 3 per cent in nearly three years, though headline CPI inflation was a little higher, at 3.1 per cent, with a significant contribution from the effects of the increased tobacco excise.
Members noted that the moderation in inflation reflected a combination of factors, including the relatively subdued demand conditions over much of 2008 and 2009, the slowing in private-sector wage growth in 2009 and the appreciation of the exchange rate. Discounting at retail stores had continued to depress the prices of many goods. There had also been a large decline in the price of domestic holiday travel and accommodation, partly reflecting subdued demand in parts of that industry. Food price inflation had been relatively low, reflecting softness in the prices of some global food commodities, the appreciation of the exchange rate and discounting. Unlike in previous quarters, there was little change in utilities prices, though substantial rises were expected over the next year.
Members discussed the updated staff forecasts, which were little changed from the forecasts prepared at the time of the May meeting. The central forecast was for GDP growth to increase gradually to the 3¾–4 per cent range in 2011 and 2012. The outlook was underpinned by the positive prospects for the resources sector, which in turn rested on the bright medium-term outlook for the economies in Asia. Reflecting developments in commodity markets over the past three months, the forecast for the terms of trade had been revised down slightly since May, but the terms of trade would still be at an historically high level and were expected to continue supporting domestic incomes and business investment.
The central forecast for inflation was essentially unchanged. Underlying inflation was expected to be around 2¾ per cent over the next year or so, though year-ended headline inflation was likely to be above 3 per cent over the next year, largely reflecting the rise in tobacco excise and large increases in the prices of utilities. Underlying inflation was then expected to increase gradually to around 3 per cent in 2012. This reflected the expectation that strong economic growth associated with the expansion of the resources sector would again put pressure on the economy's supply capacity. Members noted that there remained both upside and downside risks around these central forecasts.
The main influence on financial markets over the past month had been the publication of the results of the stress test of the European banking system, conducted on 91 institutions representing two-thirds of banking system assets. Members discussed the nature and results of the stress test. They noted that financial markets had generally responded favourably to the results, in part because of the information provided about banks' exposures, including their sovereign debt holdings.
Sovereign yields in the major economies rose somewhat after the stress test results were published and the release of stronger euro area economic data, but they remained at low levels. Yields on government debt in Australia over the past month had moved in a similar fashion to those in the major economies.
Spreads on the sovereign debt of the smaller European countries had fallen over the past month, and debt issuance by a number of these countries over the past month had been oversubscribed. Spreads on emerging market debt in Asia and Latin America had also declined over the past month. Spreads on corporate debt in the United States and euro area had also fallen, with issuance by European financial institutions increasing following the publication of the stress test results, as well as favourable banks' earnings reports. Members noted that, in the United States, issuance of mortgage-backed securities continued to be dominated by the mortgage agencies.
Turning to monetary policy settings around the world, members noted that policy rates had not changed in the major economies, where expectations of any change had been pushed out until well into 2011 at the earliest. This had resulted in two-year bond yields in the major countries declining further, including to a 70-year low in the United States. Monetary policy operations by the European Central Bank (ECB) had provided less liquidity over the past month and debt purchases had slowed considerably, which led to a decline in the ECB's balance sheet. Euro area interbank lending rates had risen back towards the 1 per cent policy rate, following a period in which these rates had been around ½ percentage point below it. Central banks in several other countries had begun to raise policy rates. The Bank of Canada and Reserve Bank of New Zealand increased their policy rates by 25 basis points for the second consecutive month. In emerging market economies, the central banks of Brazil, Chile, India, Israel and Malaysia raised rates over the past month.
Global equity market price indices rose in July, supported by the stress test results, stronger data from Europe and better-than-expected corporate earnings. Equity prices had largely retraced their sharp falls of a month earlier, but remained below their peaks in mid April.
In foreign exchange markets, the US dollar depreciated against most currencies over the past month, as US economic data were generally below expectations, in contrast to data for other regions. Following its initial appreciation after the change in the exchange rate regime in June, the renminbi had been little changed against the US dollar, which implied that it had depreciated on a trade-weighted basis because of the US dollar's broad-based depreciation. The Australian dollar had appreciated by around 5 per cent on a trade-weighted basis over the past month, with a larger rise against the US dollar, reflecting relatively strong domestic economic data early in the month and a general increase in risk appetite among market participants.
Members discussed developments in Australian banks' funding. Reflecting improved market conditions, bond issuance had increased in July, particularly offshore. Activity in the local securitisation market had increased, albeit with continued support from the Australian Office of Financial Management. Members noted that the composition of banks' funding had changed over the past few years, with the share of deposits and long-term debt having increased and funding from short-term debt and securitisation having declined. There had been little change in the cost of deposits in recent months as competition in that sector had stabilised. Short-term wholesale costs had fallen back towards recent average levels but longer-term spreads had increased somewhat, as had cross-currency basis swap spreads. Overall, funding costs were estimated to have risen modestly recently. However, members noted that business lending rates had also continued to rise gradually. The staff assessment was that these developments had resulted in banks' net interest margins declining slightly from their peak a year ago, though they remained above pre-crisis levels.
Considerations for Monetary Policy
Members noted that sentiment in financial markets had improved over the past month, particularly following the publication of the results of the stress test of the European banking system. Volatility in financial prices nonetheless was still higher than normal. The economic data suggested that the global economy was continuing to expand, though the pace of growth had probably eased since earlier in the year and it was still uneven among regions. Growth remained generally subdued in the North Atlantic countries that had been most affected by the financial crisis, though recent indicators for Europe had been more positive. Growth in the United States had moderated since the start of the year. The Asian region had experienced very strong growth, though it looked now to be slowing to a more sustainable rate. The moderation in growth in the Chinese economy had contributed to some easing in commodity markets, but the prices of Australia's major export commodities were still at very high levels.
The major news in the domestic economy had been that underlying inflation had continued to fall, in line with the Bank's expectations, and was now below 3 per cent. Were it not for the effect of the rise in tobacco excise earlier in the year, CPI inflation would have remained below 3 per cent. Employment had continued to grow solidly but consumer spending remained subdued, even though confidence was high. Credit growth remained soft and the housing market had stabilised after the surge in prices late last year and earlier this year. Indicators of business investment remained strong. The staff forecast continued to suggest that GDP growth would strengthen in 2011 and 2012 to above-average rates. Accordingly, even though underlying inflation was expected to remain around 2¾ per cent over the next year, it was forecast to pick up a little thereafter.
Over late 2009 and early 2010, the Board had removed the unusual degree of monetary accommodation that had been put in place during the global financial crisis. By May, interest rates on loans to households and businesses had returned to around average levels. In the subsequent two months, with economic growth close to trend and inflation expected to decline to the target range later in the year, the Board had felt comfortable with the existing level of interest rates, particularly in an environment where there was a significant degree of market volatility.
Developments over the latest month had not materially changed the Board's assessment. The inflation data released during the month were in line with the Board's expectations for a decline, and the outlook for economic growth had not changed. Markets had settled somewhat, but there was still more uncertainty over the global outlook than there had been earlier in the year. The Board therefore judged the existing level of the cash rate as still appropriate, and decided to leave it unchanged for the time being, pending further information.
The Board decided to leave the cash rate unchanged at 4.5 per cent.