Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 1 March 2011
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 (Secretary), Peter Stebbing (Deputy Secretary)
Members were briefed on the Bank's half-yearly assessment of the financial system. Banking systems in the major countries had generally recovered further over the past six months as macroeconomic conditions improved and balance sheets continued to strengthen. Banks in parts of Europe remained under strain, however, with their recovery undermined by weak economic growth, fiscal strains and exposures to troubled property sectors. The Australian financial system had continued to perform significantly better than most others in the developed world, consistent with high balance-sheet quality and the relatively strong domestic economy.
Large banks in the major developed countries had continued to be profitable, although profit levels and returns on equity remained lower than prior to the crisis. A further reduction in provisions for bad loans had provided significant support for profits in recent periods, offsetting a moderation in trading income from the elevated levels seen in 2009.
Nevertheless, provisions and loan-loss reserves remained well above historical averages across all major banking systems as banks continued to deal with a large amount of troubled property-related exposures. Funding also remained a point of vulnerability for many banks as they sought to improve their funding structures and cope with the need to refinance government-guaranteed debt over the next few years.
In Australia, profits and returns on equity had recovered to near pre-crisis levels for the largest banks as bad debt expenses declined, with contributions also coming from growth in net interest income as well as insurance and funds management activities. Overall, non-performing asset levels – mainly reflecting troubled commercial property exposures – had stabilised over the past year; while flooding and other recent natural disasters would reduce short-term profits in some parts of the financial sector, the overall impact was expected to be limited.
Capital and liquidity positions of Australian banks had been bolstered further, and the banks were well placed to meet the more stringent Basel III requirements to be phased in over the next several years. One factor contributing to stronger liquidity positions was the slower rate of credit growth, which, in combination with faster deposit growth, had continued to ease wholesale funding pressures on banks. Reliance on short-term wholesale debt, in particular, had fallen from around a third of total bank funding in 2007 to around a fifth at present.
The household and business sectors in Australia did not appear to be under financial stress, though both continued to show more caution in their borrowing behaviour, as evidenced in slower rates of credit growth over the past couple of years. Members saw this as a welcome development, particularly as household debt remained at a historically high level and debt-servicing requirements had recently increased with the rise in interest rates. Members also noted that some sectors (for example, small property developers) continued to experience difficulty in accessing funds.
Members were briefed on recent international work on regulatory reform to strengthen financial systems, including the identification of systemically important financial institutions.
International Economic Conditions
Information becoming available on the international economy over the past month had been broadly in line with developments in previous months. The data suggested that the world economy was continuing to grow at an above-trend rate, though the pace of growth remained uneven across economies. Most of Asia continued to expand strongly and the US economy was strengthening. There had also been a marked increase in international trade over recent months, particularly in Asia, and measures of business sentiment had improved further in a number of countries.
The continued improvement in the world economy had put upward pressure on commodity prices. While prices of rural and most mineral commodities had been broadly unchanged over the previous month, the political turmoil in the Middle East and North Africa had further boosted oil prices. Members noted that while there was little domestically sourced inflation in the advanced economies, owing to considerable excess capacity, the recent increases in commodity prices had resulted in a renewed focus on inflation risks globally.
Some of the usual data on activity in the Chinese economy were not available because of the Spring Festival. However, imports of iron ore had increased significantly in January. Chinese exports were also estimated to have grown strongly, with recent data indicating strength in shipments to the major advanced economies as well as to elsewhere in Asia. CPI inflation was running at nearly 5 per cent over the year to January. Until recently, the pick-up in Chinese inflation had been largely accounted for by higher food prices, but non-food inflation had risen to 2.6 per cent, its fastest year-ended pace since 2001. The rise in inflation had occurred across a range of goods and services. The People's Bank of China had increased interest rates again in early February, and reserve requirements on the banking system had also been raised again. Credit growth remained firm, although there was some evidence that the authorities' efforts to slow credit expansion were having an effect.
The GDP data for other economies in east Asia had confirmed that output expanded at a solid pace in the December quarter, after a broadly flat outcome in the previous quarter. The exception was Japan, where private consumption fell sharply, partly as a result of the expiration of subsidies for a range of consumer goods. The more recent data on industrial production and international trade suggested that momentum in the region, including in Japan, had picked up somewhat at the end of 2010 and in early 2011.
In the United States, business conditions had continued to strengthen. Business surveys suggested that the outlook for the labour market had improved significantly, though this was yet to be reflected in the payrolls data. Conditions in the household sector were more mixed. Measures of consumer sentiment had improved somewhat and consumer credit had risen in recent months after declining for more than two years. However, members observed that the housing market remained weak, with prices declining over recent months.
The euro area had continued to grow at a moderate pace in the December quarter, although there remained large differences in the pace of growth across member states. Conditions had been strongest in France and Germany, with business confidence in Germany around the highest level in over 20 years. Output had contracted in some of the smaller economies, including Greece, where GDP was 6½ per cent lower over the year. Headline inflation in the euro area had risen to 2.3 per cent over the year to January, and the European Central Bank expected that rising energy and commodity prices would keep inflation above the 2 per cent target for much of 2011. Inflation in the United Kingdom was expected to increase to above 4 per cent in the near term and to remain above target until 2012.
Domestic Economic Conditions
The effect of the floods on the economy was becoming evident in the regular flow of data. Coal shipments from Queensland ports had declined sharply in January, consistent with the staff's earlier expectations. The staff continued to expect that the floods could take around ½ percentage point off growth in each of the December and March quarters, though ongoing problems in de-watering coal mines meant that the downside risks for the March quarter appeared larger than at the time of the February meeting. While Cyclone Yasi had a large impact on agricultural production in north Queensland, the effect on aggregate production in the national economy was expected to be small.
Most business surveys showed a deterioration in current conditions in January, and there was a substantial reduction in hours worked in Queensland. However, business confidence in late January had bounced back after falling in the previous survey taken in early January. Housing loan approvals were estimated to have fallen significantly in January, partly reflecting delays in processing applications and the disruption to the Brisbane housing market.
Retail sales data had shown subdued spending in late 2010, including a small fall in real spending for the December quarter. Liaison with retailers had suggested some improvement in conditions in early 2011, with sales data for January released during the Board meeting showing moderate growth in the month. Consumer confidence had softened in early 2011 to be only modestly above average levels, although it was difficult to determine how much of this decline was due to the floods and the cyclone. While households' perceptions about their own financial position were a little below average, their perceptions about employment prospects and buying conditions for major durable goods were still above average. Members observed that one factor contributing to subdued household spending was the earlier significant fall in wealth, especially in equity holdings.
The caution in the household sector was also apparent in the housing market, where nationwide measures of dwelling prices had been broadly stable for some time and auction clearance rates were close to average levels. Housing credit continued to expand at a rate that was much slower than in earlier years and a little below recent growth in household disposable income. In contrast, business credit had continued to decline modestly in recent months, with repayment rates remaining quite high.
Members discussed the outlook for investment. Recent capital expenditure data suggested a small increase in business investment in the December quarter. Importantly, firms were planning a significant increase in investment in 2011/12, particularly in the resources sector, although the outlook for commercial building construction had also improved. In contrast, the capital expenditure survey suggested little growth in spending on plant and equipment outside the mining sector over the next year or so. Members observed that the forecast growth in the resources sector, especially for LNG, would take investment in that sector to a level that was unprecedented as a share in GDP.
There had been another solid rise in employment in January, with the unemployment rate remaining at 5 per cent. Forward-looking indicators of employment from surveys and liaison pointed to solid employment growth over the coming year. Wage growth had picked up over the second half of 2010, with the quarterly outcomes for the wage price index back at around their average rate for the 2005–2007 period. Wage outcomes had been stronger in the mining sector.
The staff's inflation forecasts had been reviewed to take account of the effect of Cyclone Yasi on fruit and vegetable prices, particularly banana prices. With around three-quarters of Australia's banana crop destroyed and imports not permitted, banana prices were rising significantly. While the effect was smaller than that following Cyclone Larry in 2006, it was expected to add just under ½ percentage point to CPI inflation, spread over the March and June quarters. As a result, headline inflation for the year to June 2011 was forecast to be 3 per cent, up from 2½ per cent before the cyclone. As banana prices would return to normal levels later in the year, year-ended headline inflation over much of 2012 could be expected to be a little lower than was the case previously.
Members began their discussion on financial markets by noting that markets had been relatively stable over the past month. Markets were becoming more confident that monetary policy tightening would occur in the euro area and the United Kingdom in coming months, following the publication of data showing higher inflation. On the other hand, markets still did not expect an increase in interest rates in the United States until the first part of next year. In Asia, monetary policy had been tightened in China and Indonesia over the past month, though policy settings in Asia generally remained accommodative.
There had been some rise in yields in global bond markets early in the month, reflecting more positive data on the global economy, but yields had fallen back as concerns about developments in the Middle East and North Africa intensified. Spreads between yields on bonds of the smaller euro area governments and German bonds were broadly unchanged over the past month, remaining at relatively high levels. Government bond yields in Australia had generally been more stable than in other markets.
Corporate bond spreads in the United States and the euro area had narrowed further over the past month, particularly on lower-rated debt, and corporate bond issuance globally had been strong since the beginning of the year. Issuance of covered bonds in Europe had been particularly strong.
Locally, there had been issuance of residential mortgage-backed securities without the support of the Australian Office of Financial Management and yields had been below those in recent deals; these were further signs of recovery in the securitisation market. Kangaroo bond issuance had also remained strong.
Equity markets globally had risen solidly over the past month before the political turmoil in the Middle East and North Africa saw equity prices decline somewhat. Members noted that overall price/earnings ratios were generally at no more than average levels. This was also the case for the Australian market, where the recent reporting season had highlighted diverse outcomes; the mining companies and the banks had recorded strong results, while retailing companies had generally fallen short of expectations and/or downgraded earnings predictions.
Foreign exchange markets had been relatively stable over the past month, with little movement in the major currencies, including the renminbi, against the US dollar. The Australian dollar had moved in a fairly narrow range. There had been a significant decline in the NZ dollar following the Christchurch earthquake.
Considerations for Monetary Policy
Members considered that developments over the past month had not materially altered the outlook for the economy and monetary policy. The global economy was still recording solid growth, notwithstanding differences across the major regions. Upward pressure on commodity prices was continuing. Global financial conditions remained accommodative, though some key countries in Asia had been responding to higher inflation by tightening policy.
Domestically, the recent extreme weather events were now being reflected in some measures of economic activity. The effects of Cyclone Yasi would also add to CPI inflation in the short run, but the effects were likely to be reversed later in the year. Members confirmed that the Board's approach would be to look through temporary effects caused by extreme weather events and to continue to set monetary policy based on the medium-term outlook for growth and inflation. Overall, the economy appeared to be growing at close to its trend rate and the outlook for inflation over the year ahead was consistent with the target.
Interest rates on loans were slightly above average, a level reached after the monetary policy decision taken in November 2010. Members judged that this mildly restrictive stance of policy continued to be appropriate. The Board therefore decided to leave the cash rate unchanged.
The Board decided to leave the cash rate unchanged at 4.75 per cent.