Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Melbourne – 4 May 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
Data that became available over the past month indicated that the global economy was continuing to recover. In its April update, the IMF had again raised its forecasts for global growth. In 2010, this was now expected to be around 4¼ per cent, which was a little above trend, with a modest strengthening in the subsequent two years.
While the overall outlook had improved, there remained significant differences across regions. Growth in Asia remained strong and the focus in those economies was now on withdrawing policy stimulus to prevent inflationary pressures building. Conditions were now clearly improving in North America, though Europe remained weak.
The Chinese economy continued to expand strongly, with growth estimated at nearly 3 per cent in the March quarter and around 12 per cent over the year. While there had been a slowing in investment spending late in 2009, there had been a fresh acceleration early in 2010. Housing prices had been growing rapidly, with particularly strong growth early in 2010. The authorities were taking a range of steps to cool the market, including increases in the interest rate and in minimum deposits required for repeat home buyers and investors.
Recent data for other economies in Asia had been strong. GDP data for Korea had shown growth of nearly 2 per cent in the March quarter and 8 per cent over the year, and GDP data for Singapore had also been strong. The ongoing recovery in east Asia was feeding through into broad-based falls in unemployment in the higher-income economies. Inflation had increased in these economies, but only modestly so far.
The US economy was continuing to recover, growing by 0.8 per cent in the March quarter and 2½ per cent over the year. Domestic demand was becoming a more important driver of growth, with the contribution from the inventory cycle declining. Equipment investment had risen for a second quarter, although construction investment – particularly commercial property construction – had continued to decline. Household consumption spending was growing solidly.
While the information becoming available on the Japanese economy had been reasonably positive, data for European economies continued to be fairly soft. The UK economy had grown modestly in the March quarter, but activity in the euro area appeared fairly flat. Growth in exports was providing the main support to domestic production. The most recent data showed that retail sales were still trending downwards, and uncertainty surrounding Greece's fiscal problems was likely to prolong this weakness (see discussion below under ‘Financial Markets’).
Domestic Economic Conditions
The major news on the domestic economy had been the further strengthening in commodity markets and the slightly higher-than-expected inflation data for the March quarter.
Most indicators of the domestic economy continued to suggest that it was expanding at a reasonable pace. Although conditions varied somewhat across sectors, business surveys suggested that business conditions were at relatively strong levels. Employment was estimated to have grown at a solid pace in March, though growth appeared to have slowed a little from the rapid pace seen in late 2009. Forward-looking indicators of the labour market suggested solid growth in the period ahead. The earlier decline in business credit appeared to have ended and liaison was providing more indications that banks were looking to boost their lending to that sector.
Consumer surveys continued to indicate that households were confident about the future, but that their perceptions about current conditions in the economy were closer to average levels. Consumption spending had been quite subdued, consistent with some caution on the part of households, perhaps reflecting some impact from rising interest rates.
The housing market had remained strong, especially in Melbourne and Sydney. Nationwide, average prices had grown by around 1 per cent per month in the first three months of 2010 and auction clearance rates had remained strong in April. This was despite the fact that housing loan approvals for owner-occupiers had continued to decline. Members noted the weakness in approvals for home-building in the high-rise apartment sector, especially outside the capital cities.
The ongoing strength in global, and especially Chinese, steel production was feeding through into strong demand for steel-related commodities. Contract prices for iron ore were estimated to have risen by close to 100 per cent in the June quarter, with spot prices strengthening further since those contracts had been negotiated. Coking coal prices had recently also risen significantly.
Given these increases in commodity prices, the staff forecast for the terms of trade had been revised upwards. The terms of trade were now expected to rise by close to 20 per cent over 2010, boosting nominal incomes by around 4 per cent. In the medium term, the terms of trade were forecast to decline somewhat, as additional global supply in commodity markets came on stream. Members discussed the expansionary effects of boosts to the terms of trade and the experience in some previous episodes.
The staff forecast for growth had been revised up somewhat, partly reflecting the stronger outlook for the terms of trade. While GDP growth was still expected to be around 3¼ per cent over 2010, it was expected to pick up in 2011 and 2012 to be in the 3¾–4 per cent range. Growth in private demand was expected to strengthen through this year. A very large increase in engineering investment was forecast, and business investment (excluding livestock) was expected to rise to its highest share of GDP seen in the five decades of quarterly national accounts. As a result, the capital stock was expected to continue to grow at a high rate. Growth in household consumption was expected to be somewhat below the rate seen in earlier periods of strong income growth, with a gradual rise in the saving rate.
Members discussed the March quarter inflation data, which showed that underlying inflation had continued to fall in year-ended terms. However, the quarterly increase in prices was slightly higher than expected at the time of the February Statement on Monetary Policy. Underlying inflation was around 0.8 per cent in the quarter and 3 per cent over the year. CPI inflation was also close to 3 per cent. The prices of tradable items (excluding fuel and food) had fallen in the quarter, reflecting discounting by retailers, the sharp exchange rate appreciation during 2009 and tariff cuts that had taken effect in January. In contrast, non-tradables inflation (excluding deposit & loan facilities) had picked up to a year-ended rate of 4.4 per cent, with significant increases in the prices of housing-related items, most notably utilities.
Reflecting recent developments in inflation and the stronger outlook for the economy, the staff forecast for inflation had been revised up a little. Underlying inflation was now expected to fall to around 2¾ per cent over 2010, compared with the forecast of 2½ per cent in February. It was then expected to trend gradually higher to around 3 per cent over 2012. CPI inflation was expected to be somewhat above underlying inflation in 2010, in part because of the large tax-driven increase in the price of tobacco.
Members spent considerable time discussing the financial problems facing the Greek Government, the resulting turmoil in financial markets and the implications for the global economy. The key facts were: Greece's sovereign credit rating had been downgraded by all three rating agencies; details of a financial assistance package from euro area governments and the IMF had now been finalised; and the European Central Bank had decided to suspend its collateral standards to ensure that Greek debt remained eligible in its repurchase operations. The announcements had not calmed markets; spreads on Greek government debt had widened further and the market in Greek debt had become dysfunctional.
Members discussed the serious challenges the Greek authorities faced in order to overcome the current financial difficulties. The large fiscal consolidation required over the next several years was likely to lead to a serious economic contraction. Members considered the risk of contagion to other countries in Europe and noted that the sovereign debt of Spain and Portugal had also been downgraded. However, to date, the problems in debt markets had been predominantly confined to Europe, though global equity markets and exchange rates had been affected.
Yields on 10-year government debt had fallen in the major countries, including those in the larger countries of the euro area following a flight to quality. Australian government bond yields had also fallen slightly. Emerging market sovereign debt spreads had been largely unaffected by the crisis in Greek public finances, apart from rises in spreads on debt of emerging European economies. There had been virtually no effect on corporate bond markets, where market conditions were still improving and the default rate on speculative grade debt had declined from its peak reached in 2009.
World equity markets had reached a 19-month high during April, bolstered by better-than-expected first-quarter earnings results, particularly in the United States, before being affected by the deterioration in the situation in Greece towards the end of the month. Greek share prices had fallen sharply over the past month, with banking shares particularly hard hit. Uncertainty over the effect of policy tightening by the Chinese authorities had led to a significant fall in Chinese share prices.
Turning to foreign exchange markets, members observed that the euro had depreciated further over the past month, but currency markets overall had been fairly calm. The US dollar had appreciated in trade-weighted terms, reflecting its rise against European currencies, but had depreciated against a range of Asian currencies. It was slightly lower over the year in trade-weighted terms. Over the past month, the Australian dollar was little changed against the US dollar, had reached new highs against the euro and had appreciated moderately on a trade-weighted basis. It was almost 20 per cent higher over the past year.
Australian banks had issued a relatively small amount of bonds in April following the large amount of issuance in recent quarters, which had put their funding on a good footing. There had been continued strong Kangaroo bond issuance over the past month.
Competition among the banks for deposits had levelled off somewhat over recent months, with rates on term deposit specials flat since the end of 2009, albeit at high levels relative to other interest rates. The increase in the cash rate in April had been passed through to intermediaries' lending rates in full. Housing and business lending rates were now a little below the average of the past decade and a half.
Monetary policy had been tightened in several emerging market economies over the past month: in India, the repo rate and reserve requirements had been raised; in China, the reserve ratio on banks was lifted further and a range of other measures tightened to curb property price inflation; and there had also been policy tightening in Brazil. The Monetary Authority of Singapore announced that it would allow the exchange rate to appreciate as a means to tighten policy. Expectations were for tightening in Canada and New Zealand around mid year, but any tightening in other major countries was not expected before the end of the year.
In Australia, expectations of a further rise in the cash rate at this meeting had strengthened following the release of the CPI for the March quarter.
Considerations for Monetary Policy
In considering the stance of monetary policy, members noted that, even though the global recovery continued to be uneven, the overall pace of global growth this year was likely to be at least average. Importantly for Australia, Asia was expanding strongly. There had been further sharp increases in commodity prices and it was likely that Australia's terms of trade this year would recover to the high levels reached in 2008. This would provide a large boost to nominal income.
At present, the domestic economy appeared to be growing at an around average pace, although conditions varied across sectors of the economy. Retail spending was relatively subdued but investment was strong. New housing loan approvals had slowed but the overall pace of housing credit growth remained solid. Credit conditions for parts of the business sector were starting to improve. The latest forecasts suggested that domestic output growth was likely to strengthen further over the next couple of years, with the expansionary effects of the rise in the terms of trade more than offsetting the scaling back of fiscal and monetary stimulus. Labour market conditions were expected to continue to tighten gradually.
Members noted that the latest inflation numbers were a little above the expectation. Even though inflationary pressures in the traded sector had been held in check, partly owing to tariff cuts and the appreciation of the exchange rate, there had been strong rises in the prices of many services, which suggested that these sectors of the economy were operating with limited spare capacity. The forecast for inflation had been revised up, and over the next couple of years it was likely that inflation would not be much below the top of the target range.
Members spent considerable time discussing the disturbances in financial markets arising from concerns about sovereign debt in parts of Europe, with their focus particularly, but not only, on Greece. The measures of financial support for Greece so far announced had not managed to calm markets. There was a risk that the situation could worsen further, damaging the global economic recovery. However, while there had been some decline in global equity prices and some impact on exchange rates, so far at least there had not been significant contagion to debt markets outside Europe; the direct impact of Greece on Australia was considered to be small. The timeframe over which developments might play out was not clear, and it could be some time before the uncertainties were resolved.
Members noted that the increases in interest rates to date had been timely. There were some early signs that they were beginning to affect behaviour, with retail sales subdued and housing loan approvals falling noticeably. Nonetheless, the stimulatory effects of the resources boom would be building over the year ahead. Members were conscious of the need for this not to result in a material worsening in the medium-term outlook for inflation. This was weighed against the case that could be made for a pause in the process of normalising interest rates owing to the uncertainty in the euro area. On balance, members judged it to be prudent to undertake some further monetary tightening at this meeting. They noted that, if lenders responded as expected to another rise in the cash rate, interest rates faced by most borrowers would then be at around their average levels over the past decade. Members felt that this would leave monetary policy well placed for the present. The Board therefore supported another rise in the cash rate.
The Board decided to raise the cash rate by 0.25 percentage points to 4.5 per cent, effective 5 May.