Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Adelaide – 7 September 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), Malcolm Edey (Assistant Governor, Financial System), Philip Lowe (Assistant Governor, Economic), Tony Richards (Head, Economic Analysis Department), Anthony Dickman (Acting Secretary)
International Economic Conditions
Members noted that the world economy had grown solidly in the June quarter, though there had been some moderation in the pace of growth in recent months.
Various pieces of data had pointed to some loss of momentum in the US economy. GDP growth in the June quarter was revised down to a below-trend rate. Household incomes and confidence had been subdued, in part owing to the continued weakness in the labour market, where data for payrolls and jobless claims had been disappointing. Sales of new and existing homes had dropped sharply following the expiration of the homebuyers' tax credit at the end of April. With the number of vacant housing units still rising, construction of new homes was likely to remain weak. More positively, profit growth in the business sector had been reasonably firm and investment spending was rising again from the very low levels of last year. Industrial production had continued to grow and the ISM index for the manufacturing sector was at an above-average level. Overall, with households expected to continue deleveraging and the boost from the inventory cycle declining, members thought it was likely that growth in the US economy would be quite subdued over the next few quarters.
Momentum had also slowed in Asia, though this broadly appeared to have brought growth back to a more sustainable pace after the earlier surge. Across much of the region, industrial production and exports had moved sideways over recent months, following the very strong growth earlier in the year. Other indicators of economic activity, however, suggested a somewhat stronger picture, with domestic demand growing solidly. Japan was the main exception, with the economy continuing to operate with considerable excess capacity. Members also discussed the recent increases in trade surpluses in a number of east Asian economies.
In China, retail sales had increased strongly over recent months, and credit growth had remained firm, albeit below the extraordinary rates seen in 2009. Of particular relevance to Australia, Chinese steel production had fallen over the past few months. However, steel and iron ore prices had held up, suggesting there was still solid underlying demand for steel. There had also been a noticeable slowing in growth in fixed asset investment, partly reflecting the withdrawal of the earlier fiscal stimulus, but private investment had continued to expand.
In Europe, after a period of quite gloomy news earlier in the year, recent data had tended to surprise on the upside, particularly in the United Kingdom and Germany. The latter had benefited from strong demand for its exports of capital goods. Elsewhere in the euro area, growth continued to be modest. However, euro area consumer and business sentiment had been surprisingly resilient in recent months, while new capital goods orders had risen strongly, pointing to growth in business investment in the near term. Notwithstanding the more positive tone to the recent data, the medium-term economic outlook for Europe still looked quite weak given the public debt problems in a number of countries.
Spot commodity prices had generally risen a little over the past month, after falling during May and June. In the June quarter, the terms of trade rose by 12½ per cent – reflecting the large increase in bulk commodity contract prices – to be slightly above the very high level reached in 2008. A further increase in the terms of trade was expected in the September quarter, followed by a modest decline.
Domestic Economic Conditions
The recent data on the domestic economy had been positive and had provided further evidence that the economy was growing at around trend pace.
The national accounts for the June quarter had shown an increase in real GDP of 1.2 per cent in the quarter and an upward revision to the estimate for the March quarter. GDP was up by 3.3 per cent over the year, which was around the average growth rate for the past two decades. In nominal terms, GDP rose by 10 per cent over the year, reflecting the large increase in the value of exports. The rise in commodity prices, together with the growth in resource export volumes, had seen the trade balance record its largest surplus (as a share of GDP) since 1973.
Public demand continued to contribute to GDP growth in the June quarter, though by significantly less than in earlier quarters, and it was expected to subtract from growth over the next few quarters as stimulus projects were gradually completed. Private demand was recorded as having grown strongly in the quarter, with both consumption and dwelling construction showing solid increases.
While business investment fell slightly in the quarter, the capital expenditure survey for the June quarter showed a significant upgrading of investment intentions from what was already a positive outlook. Members discussed the factors underpinning this increase, including high commodity prices, strong corporate profitability and above-average levels of capacity utilisation. Members expected that the boost to investment in the resources sector would stimulate activity elsewhere in the economy, even though there was a significant imported component in the planned LNG projects. Business surveys reported that conditions remained at, or above, average levels, though confidence had softened a little. The main area of weakness continued to be commercial construction, where funding constraints remained an issue. Business credit had remained broadly flat over recent months, though lending to small business had increased.
Members discussed trends in the household sector, where there was some evidence to suggest that the cautious approach to spending seen over recent times could be starting to wane. While retailers continued to report that conditions were challenging, retail spending had picked up in recent months and the national accounts measure of consumption was surprisingly strong in the June quarter. This strength was, however, partly a reflection of a boost to spending on motor vehicles following damage from hailstorms in Victoria and Western Australia. Consumer confidence was at high levels and labour income growth had been solid. In contrast, the household sector's reduced appetite for debt was continuing, with housing credit growth easing over recent months and repayments of credit card debt picking up.
Conditions had cooled in the established housing market, partly reflecting the return of mortgage rates to more normal levels. At the national level, prices had been broadly unchanged since April, with the top end of the market tending to be softer than the rest of the market. Auction clearance rates in Sydney and Melbourne had been around average levels recently, after having been considerably above average earlier in the year. Housing loan approvals were estimated to have been broadly flat in July and were well below their peak in late 2009.
In the labour market, hiring remained strong. Employment rose by 23,000 in July, to be 2¾ per cent higher over the year. Business surveys and data on job advertisements suggested further solid gains in employment over coming months. The unemployment rate had risen a little to 5.3 per cent in July and had been broadly unchanged since the start of the year, which was consistent with the economy growing at around trend pace.
The main news on prices and wages had been the release of the June quarter wage price index, which showed that wage growth in the private sector had remained relatively modest, though it had picked up a little over the first half of 2010. In contrast, growth in public-sector wages had continued at a firm pace. Business surveys and liaison suggested that a gradual pick-up in wage growth was expected over the next year.
Several measures of inflation expectations had eased a little over recent months to be around average levels. Similarly, business surveys reported that the share of businesses planning to increase their prices over coming months was around average.
Financial markets had been fairly pessimistic for much of August, though sentiment had improved somewhat late in the month. This pessimism had been reflected in a marked decline in government bond yields, which had fallen to low levels in the major advanced economies. This was particularly so at the shorter end of the yield curve, reflecting the expectation that policy rates in the major economies would remain low for an extended period. Locally, long-term yields had also fallen noticeably, though less so than in other countries, reflecting the stronger domestic economy.
Yields on securities issued by higher-rated corporates also fell to low levels in the United States. This had generated a solid amount of corporate issuance, which had offset the decline in intermediated business credit.
With official interest rates in the major economies likely to be on hold for the foreseeable future, the focus of markets had been on developments in central bank balance sheets. During the month, the Federal Reserve announced that the repayments of principal on its agency securities would be reinvested into US Treasuries, so that its balance sheet would not contract. The Bank of Japan also announced an extension of its longer-dated liquidity provision.
While bond yields in the largest economies had declined sharply, spreads on bonds issued by some smaller European countries had widened again. Contributing to this in Ireland was a sovereign ratings downgrade, amid concern about the amount of guaranteed bank debt maturing in the near future and the announcement that the Government had made a further significant capital injection into one of the large Irish banks. In Greece, the first quarterly review of the support program from the European Commission, ECB and IMF had been completed, indicating that the program was on track. Members noted the significant amount of financing that Greek banks were receiving from the ECB and the challenges the Greek economy was facing.
In the Australian bond market, there had been a sizeable amount of issuance in August by banks and foreign institutions. There had also been continued issuance in the residential mortgage-backed securities market. Investor demand for the shorter-dated tranches had been quite strong. The Australian Office of Financial Management had supported issuance of such securities by purchasing most of the longer-dated tranches.
Global equity markets had been mixed over the month, and Australian share prices had shown little net change since the previous Board meeting. The domestic company reporting season for the first half of 2010 had been generally positive. Aggregate underlying profits had increased solidly, while headline profits were bolstered by a marked decline in write-downs. Profits were particularly strong in the resources sector, while financial stocks had also fared well.
In currency markets, the focus had been on the Japanese yen, which was close to historical highs in nominal terms. However, in real effective terms the yen was not at a particularly high level, reflecting the long period of deflation experienced in Japan. Nevertheless, Japanese policy-makers had expressed their concern about the elevated level of the yen. Locally, the Australian dollar had risen after the release of the strong GDP data.
Members were briefed on the Bank's half-yearly assessment of the financial system. Notwithstanding the issues stemming from the fiscal problems of some European economies, the health of the large international banks had mostly improved. Investor sentiment had been bolstered by the euro area support package and the results of the banking system stress test. Conditions in the Australian financial system remained significantly stronger than in most other countries. Members noted that exposures of Australian banks to the fiscally stretched euro area economies were very small.
Even though bank share price indices in the major developed countries had generally fallen somewhat over the past six months, reported profitability and capitalisation of banking systems had improved. Many large banks in the United States, euro area, United Kingdom and Japan had recorded profits over recent reporting periods, though profits were generally still well below pre-crisis levels. In a number of cases, the flow of provisions for bad loans appeared to have peaked. However, bank lending in the major economies remained very soft.
The Australian banking system continued to be in a relatively strong condition. Having remained profitable during the crisis, the largest banks had seen a pick-up in profitability over the past half-year, reflecting increased interest income and a decline in bad and doubtful debt charges. The rate of non-performing assets appeared to have stabilised, and was at a level far below the peak following the early 1990s recession, with significant write-backs of earlier provisioning now occurring as asset quality improved. The earlier pick-up in non-performing assets had been mostly in business lending, and non-performing loans to the household sector were relatively low. Members noted that non-performance rates for housing loans were far below those seen in the United States and some European countries.
The banking sector's capital position had been bolstered by actions in recent years to increase the level of capital through a combination of new equity issuance and dividend reinvestment plans. Banks had also moved to strengthen their liquidity positions by lengthening the term structure of their wholesale liabilities.
The aggregate financial position of the household and business sectors remained sound, with the stronger economy boosting wage incomes and profits. Indicators of financial stress in the household sector remained low compared with previous downturns and international experience. Households appeared to be taking a more cautious approach to their finances, with the household debt-to-income ratio broadly stable over the past few years, after a decade when it grew rapidly. Banks had also taken a relatively cautious approach to lending in the post-crisis environment, with a significant fall over the past year in the proportion of new housing loans with loan-to-value ratios over 90 per cent. Measures of the financial health of the corporate sector were favourable, with gearing and interest payment ratios close to the lowest levels in three decades. Businesses had relied significantly on equity issuance and internally generated funds over the past few years. Debt funding availability now appeared to be improving somewhat after a marked tightening in supply in 2008 and 2009, though credit availability for some sectors, including commercial property, remained constrained.
Members were briefed on recent international work on regulatory reform to strengthen financial systems and Australia's representations on the matter.
Considerations for Monetary Policy
Members noted the increase in concerns over the past month about the outlook for the US economy and government debt in some European countries, which was weighing on market sentiment globally. However, at the same time there had been further evidence that the Australian economy had solid momentum and that firms expected to increase investment significantly over the period ahead. Prospects in the resources sector were especially positive, and the increase in investment in this sector would have significant flow-on effects to the broader economy. Members observed that previous investment booms and increases in the terms of trade had posed significant challenges for economic policy, and that high levels of resource utilisation were likely to put pressure on inflation.
The central scenario remained for the Australian economy to grow at trend pace, or a bit above, over the next few years. This forecast incorporated quite a subdued outlook for the main G7 economies and around trend growth in Asia, with domestic demand in Asia playing a more important role than it had done historically. Members noted the risks to this outlook, including that the recent loss of momentum in the United States could develop into a renewed downturn or that the moderation of growth in China and east Asia could prove to be larger than currently expected. If these risks eventuated, or if there were new financial shocks, another round of extreme risk aversion could result, with adverse implications for the global economy.
While policy had to be alert to these risks, members considered that if the central scenario came to pass it was likely that higher interest rates would be required, at some point, to ensure that inflation remained consistent with the medium-term target. For the immediate decision, there had been no significant change in the overall outlook, with conditions looking a little stronger domestically than they had at the previous meeting, but looking a little weaker internationally. With the economy currently growing at around its trend rate, underlying inflation having moderated and lending rates at around average levels, the Board's assessment was that the current setting of monetary policy remained appropriate for the time being.
The Board decided to leave the cash rate unchanged at 4.5 per cent.