Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 7 December 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)
Conditions in financial markets over the past month were dominated by the situation in Europe, which had deteriorated markedly. The focus was initially on Ireland but it subsequently spread to Portugal, Spain, Italy and Belgium. Bond spreads in those countries widened to their highest levels since the inception of the euro.
Members were briefed on the support package for Ireland from the European Union and the IMF. A significant part of the package was earmarked to support the Irish banking system, which is very large relative to the size of the economy. Members discussed the causes of the current situation in Ireland, which included a leveraged residential and commercial property boom, and the very rapid growth in the Irish banking sector. Among other risks, they noted that the Irish banking system had become highly dependent on borrowing from the European Central Bank (ECB).
The contagion from Ireland that had spread to other parts of Europe reflected the financial inter-linkages in the form of interbank exposures, as well as the European sovereign debt holdings of the European banking system. Credit spreads in interbank funding markets had increased to their levels around the time of the Greek crisis in May, though they were still well below the peaks at the time of the collapse of Lehman Brothers. Members noted that the cost of funding the large US dollar asset positions held by European banks had also been rising.
Bond purchases by the ECB had resulted in euro area spreads declining in the days prior to the Board meeting, although some markets were very illiquid. Notwithstanding this decline, members noted that the level of bond yields in several peripheral euro area countries remained high relative to expected growth rates of nominal GDP.
Credit spreads outside Europe had not been particularly affected and bond issuance in the United States had continued apace, particularly for non-financial companies. Spreads on highly rated corporate bonds in the United States had been steady in recent months, while spreads on lower-rated bonds had narrowed.
Activity in the domestic securitisation market picked up during the month, including a large issue without support from the Australian Office of Financial Management.
Members noted the US Federal Reserve's decision to ease policy through further large-scale asset purchases. Speeches by FOMC members subsequent to the Fed's decision and better-than-expected US data had seen the market pare back its expectations of further policy measures by the Fed. This had contributed to a rise in government bond yields in the major markets over the past month. Financial market volatility had picked up as liquidity declined towards the end of the year. Illustrating the diverse economic fortunes at present, members noted that the authorities in China, India, South Korea and Thailand all tightened policy over the month.
Global equity prices had recovered to around the peak reached in April, but prices of financial stocks remained well below that level. Chinese equity prices had fallen as concerns grew about the prospect of further policy tightening in China.
In foreign exchange markets, the initial reaction to the Fed's policy announcement early in November was some further depreciation of the US dollar, but more recently the US dollar had experienced sharp moves in both directions. The euro had depreciated significantly against the US dollar over the past month. In the early part of November, the Australian dollar reached a new post-float high against the US dollar. Since then, reflecting the decline in risk appetite, the Australian dollar had depreciated against the US dollar, but it had appreciated against the euro to a new high. On a trade-weighted basis, the Australian dollar was around 2 per cent higher over the past month.
Members noted that mortgage rates had increased by more than the increase in the cash rate following the November meeting, such that mortgage rates were now slightly above their average since 1996. Currently, the market did not expect any change in monetary policy for the next few months.
International Economic Conditions
Members discussed how the financial turmoil in Europe could affect economic growth in that region. They noted that, for the euro area as a whole, the economic data continued to suggest moderate growth, though the differences across countries were large. Germany continued to outperform, with consumer and business confidence, and conditions in the labour market, considerably stronger than in the other European economies.
In China, attention was increasingly turning to the upside risks to inflation. Over the past year, the CPI was up by 4½ per cent, with food prices up by around 10 per cent. The authorities had responded by increasing the reserve requirements on banks and had announced a number of administrative measures to control price increases, but real interest rates remained low. The recent economic data continued to show robust growth in industrial production, investment and consumption, and there were some signs that merchandise exports were increasing again, after having fallen in earlier months.
Elsewhere in east Asia, the recent data had been mixed. The Japanese economy had recorded robust growth in the September quarter, though this was mainly driven by stimulus measures that had changed the timing of expenditure. More recent data in Japan had been quite soft, with most monthly indicators showing weakness in October. A number of other economies in the region had recorded declines in GDP in the September quarter, after large increases over the previous year. Industrial production and exports had been weak in the quarter, though the trade data for October suggested a significant pick-up in exports. Domestic demand looked to be growing solidly in most economies in the region.
Growth in the Indian economy remained strong, with GDP increasing by 10½ per cent over the year to the September quarter. Growth had been broad-based across sectors, with agriculture, manufacturing and services all expanding strongly over the year.
In the United States, the recent data had, on balance, been a little better than in earlier months. Most of the data for the labour market had suggested some improvement, though overall jobs growth in November had fallen short of expectations. Members observed that recent indicators of business investment, business conditions and household spending suggested that the economy was continuing to expand, albeit at a modest pace. The recent indicators for the housing sector, however, showed few signs of improvement. The household saving rate was well above the levels of the middle of the decade.
Reflecting the increased uncertainties about the global economy, base metals prices were lower over recent weeks. In contrast, the price of gold had risen. There had also been significant increases in the spot prices of the steel-making commodities, namely iron ore and coking coal, which were around 25 per cent and 10 per cent respectively above the December quarter contract prices, pointing to increases in contract prices for the March quarter. This was a stronger outcome than the staff had been expecting, and suggested upside risks to forecasts for the terms of trade and nominal income. The severity of the impact of the recent heavy rains in Queensland on coal production remained to be seen.
Domestic Economic Conditions
In the recent national accounts, GDP was estimated to have increased by 0.2 per cent in the September quarter and by 2.7 per cent over the year. Nominal GDP was up by 1.2 per cent in the quarter and 9.6 per cent over the year, boosted by the rising terms of trade, which had reached a new peak in the September quarter. Indeed, over the past decade, a significant part of the growth in real incomes had come from the terms of trade, with growth in standard productivity measures having slowed significantly relative to the 1990s.
The quarterly GDP outcome was a little softer than had been expected at the time of the November Statement on Monetary Policy. While the pick-up in business investment was proceeding in line with the forecasts, consumption growth had been weaker, as had dwelling investment. Overall, the expected rebalancing of growth from public to private demand looked to be occurring, though public demand remained strong. The accounts confirmed that conditions varied considerably across sectors, with manufacturing output having been flat over the first three quarters of 2010, in contrast to solid rises in output in the mining sector and of some professional services.
Other information received since the November meeting had been consistent with a strengthening in investment. Capital expenditure in the resources sector was estimated to have increased strongly in the September quarter, and investment intentions for 2010/11 continued to be very high. Members noted that there had also been further announcements confirming that several large resources projects were moving ahead. In contrast, outside the resources sector capital expenditure was broadly flat in the September quarter, and the outlook was considerably more subdued than for resources. There were still few signs that commercial construction was picking up. Business credit had fallen again in October, though broader measures of financing had been unchanged, and there was further tentative evidence that the availability of bank financing was easing for borrowers outside of the commercial property sector.
Spending and borrowing by the household sector remained subdued, with substantially revised estimates suggesting that the saving rate had returned to its level of the mid 1980s. While the Bank's liaison continued to suggest modest growth, there was a surprisingly large fall in the ABS estimate of retail spending in October. Retailers continued to report that households were cautious in their spending and significant discounting remained widespread. Measures of consumer confidence had fallen somewhat after the increases in interest rates in early November, though confidence was still at an above-average level. Members observed that the restraint being shown by households, and the pick-up in the saving rate, would help reduce the medium-term risk from household balance sheets after a long period when debt ratios had risen, and would help to make room for the expected increase in investment.
Household credit had grown at only a modest pace for several months. The established housing market had cooled, with house prices tracking broadly sideways since June. Auction clearance rates had recently fallen noticeably. In terms of housing construction, there was an increase in building approvals in October, following declines over previous months, though the rate of construction was still low.
In the labour market, conditions remained firm. Employment was estimated to have increased by a further 30,000 in October, and the participation rate had risen to its highest level on record, with the unemployment rate increasing to 5.4 per cent. Members discussed developments in the participation rate, including the upward trend in participation by workers in the 45–54 and over-55 year age groups. Employment intentions generally remained solid.
The wage price index for the September quarter confirmed that wage growth in the economy had picked up from the slow pace of last year. The outcome in the quarter had been boosted by the earlier decision on minimum wages; abstracting from this, wages looked to be growing at around their average pace over the past decade. Members noted that some pick-up in wage growth was likely in the period ahead. Nonetheless, overall price pressures remained relatively modest at present, reflecting discounting activity and exchange rate effects, and measures of inflation expectations remained consistent with the medium-term inflation target. Members discussed the outcome of the CPI review by the ABS.
Considerations for Monetary Policy
Members noted that the deterioration in the situation in Europe over the past month had increased the downside risks to the global economy. How this would ultimately play out, and the implications for Australia, were difficult to predict. It was possible that conditions could settle down, as they had after the episode of financial instability in May. Alternatively, an escalation of the current problems was not out of the question. If this prompted a fresh retreat from risk-taking in global financial markets, it would probably have more impact on Australia than any trade effect.
Developments in other parts of the world had been more positive. The US economy was growing at a modest pace. Recent data suggested that the Chinese and Indian economies were growing more strongly than expected, and prices for bulk commodities had strengthened over the past month.
Domestically, the Board's assessment of the central medium-term scenario was little changed from that made at earlier meetings. Employment growth remained strong and the expected pick-up in private investment looked to be broadly on track. Household consumption and borrowing, however, remained restrained despite high levels of confidence, and the saving rate had increased noticeably over the past few years. This restraint, if it continued, would provide some scope for investment to rise without causing aggregate demand to grow too quickly and inflationary pressures to build.
Following the Board's decision in November to lift the cash rate and the subsequent increases in lending rates, and taking into account the level of the exchange rate, monetary policy was judged to be mildly restrictive. Given the very high level of the terms of trade and the positive outlook for business investment, this policy setting was regarded as appropriate.
The Board decided to leave the cash rate unchanged at 4.75 per cent.