Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Sydney – 1 November 2011

Members Present

Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), Martin Parkinson PSM (Secretary to the Treasury), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, John Edwards, Graham Kraehe AO, Catherine Tanna

Others Present

Guy Debelle (Assistant Governor, Financial Markets), Philip Lowe (Assistant Governor, Economic), Tony Richards (Head, Economic Analysis Department), Anthony Dickman (Secretary), Peter Stebbing (Deputy Secretary)

Financial Markets

Developments in Europe were again the dominant influence on financial markets in October. As optimism increased about the prospects for resolving Europe's current financial problems, many asset prices had recovered from their lows at the time of the previous Board meeting. The announcement of measures to support market liquidity in the euro area and better-than-expected economic data in the United States also helped to improve market sentiment.

Members noted that the changes to the European Financial Stability Facility (EFSF) proposed in mid 2011 had now been approved by all euro area countries. The approved facility had a lending capacity of €440 billion (some of which had already been committed). Subsequently, European policymakers had proposed several further measures to help restore confidence in European sovereign debt and banking systems, including a larger haircut on private-sector holdings of Greek debt, a substantial recapitalisation of European banks and an increase in the effective size of the EFSF to around €1 trillion through some form of leverage, though the details had not been finalised.

Share markets in the United States and the major European countries had risen by more than 10 per cent over the month. Bank share prices had also recovered strongly (except in Europe), notwithstanding the mostly lacklustre third-quarter results for the large global banks. The share prices for Australian banks had generally outperformed banks from other countries; all three of the major banks that were scheduled to report their annual reports by early November were expected to deliver strong results.

The improved sentiment in financial markets also saw government bond yields in the major advanced economies rise from their historic lows reached a month earlier. However, spreads on Italian sovereign bonds had widened significantly, as had those on French bonds, with the latter partly reflecting concerns about the fiscal costs of resolving Dexia.

Short-term funding costs for European banks remained relatively high and the market for unsecured borrowing in euros was effectively closed for some borrowers. This led the European Central Bank (ECB) to announce that it would provide unlimited funding to European banks at its policy rate for 12- and 13-month terms (against eligible collateral), thereby circumventing the strained interbank market. Overall, ECB lending to European banks had increased by around 40 per cent in the previous six months. Members observed that, together with the US dollar swap lines in place, these facilities should help ease funding pressures on European banks.

Members were informed that foreign exchange markets had remained volatile. The euro, Australian dollar and many other currencies traded in a wide range against the US dollar, with the Australian dollar moving through a 14 cent range over the month. In contrast, the Japanese yen had traded in a very narrow range against the US dollar until late in the month, when the yen reached a new high on 31 October, in nominal terms, thereby triggering aggressive intervention by the Japanese authorities and an immediate fall in the yen of around 5 per cent.

In monetary policy developments, the Bank of England announced that it would ease policy by conducting further quantitative easing in the form of purchases of UK government debt. Authorities in a number of emerging market countries had also eased policy over the past month, including in Brazil, Indonesia and Singapore, although the Reserve Bank of India had continued to tighten policy to stem inflation.

In Australia, there remained an expectation in financial markets that the policy rate would be reduced at this meeting. Beyond that, however, markets now expected that the policy rate would not be reduced as much as previously had been expected. Members noted that some fixed-term lending rates had been reduced, reflecting the decline in market rates.

Members were informed that while the total amount of bonds issued globally had been subdued over the past month, Australian banks had been able to conduct a number of unsecured bond raisings and had also issued mortgage-backed securities. In addition, they continued to access short-term markets onshore and offshore with comfort.

International Economic Conditions

Since the previous Board meeting, the economic data for the United States had been a little stronger than in earlier months, while the data for Europe had continued to soften. Consumer and business confidence generally remained quite low in most of the advanced economies.

Growth in Asia had remained solid, although it had moderated following the general tightening in macroeconomic policies over the past year, and there were also some early signs that the slowing in some of the advanced economies was having an impact in the region. The effects were most evident in exports, with the value of east Asian exports to the United States and the European Union broadly unchanged over the previous half year. Global demand for electronic goods had softened and, outside of China, there had been little growth in industrial production recently. Members noted that floods were having a significant effect on production in Thailand and that, in some industries, this was expected to flow on to production in other countries in the region. Notwithstanding the slowing in trade, growth in domestic demand across the region remained generally firm and the volatility in global financial markets did not appear to have had any noticeable effect on the availability of trade finance. There had been some easing of near-term inflation pressures across the region as a result of the recent declines in commodity prices, although inflation rates generally remained relatively high.

In China, the economy had grown at a solid 2.3 per cent pace in the September quarter and by 9.1 per cent over the year. While the annual rate was down from the unsustainably high pace coming out of the global recession, members noted that the authorities had been seeking some slowing, given the increase in inflation. Consistent with developments elsewhere in the region, growth in exports looked to have slowed, as had growth in investment. Credit conditions facing some sectors were very tight, most notably in the property market. In contrast, other sectors continued to grow very strongly, with, for example, sales of cars and household appliances recording large increases over recent months. Inflation looked to have peaked, with the year-ended rate edging down in September.

Recent data for the United States, including for the labour market, had shown a more positive tone than was the case around mid year. The initial estimate showed GDP growth of 0.6 per cent in the September quarter and 1.6 per cent over the year, suggesting that the marked slowing in the first half of the year was partly the result of temporary factors, including the increase in the price of oil and the effect of the Japanese earthquake. With corporate sector balance sheets in good shape, business investment had grown strongly in the September quarter and by 9 per cent over the year, and growth in capital goods orders had remained strong. Notwithstanding the recent falls in consumer confidence to very low levels, the growth rate of household consumption spending had picked up a little in the quarter, with the saving rate falling. However, public expenditure was 2½ per cent lower over the year, and members noted that the United States faced its own significant fiscal challenges.

In the euro area, conditions remained very subdued, with consumer and business confidence having fallen in recent months. The unemployment rate had risen by 0.1 percentage points to 10.2 per cent in September. Growth appeared to have slowed in Germany and France, the two countries that had driven the European recovery since 2009. The OECD had recently revised its 2012 euro area GDP growth forecast down from 2 per cent to just 0.3 per cent. Credit conditions appeared to be tightening, reflecting the problems in the European banking system, and members noted the very large fiscal adjustment facing many countries.

The prices of most exchange-traded commodities had increased a little over the past month, after sharp falls in August and September. However, the prices for iron ore had recently fallen sharply, after initial resilience relative to other commodity prices. Since its recent peak in September, the spot price in China had fallen by more than 30 per cent. Members noted that the global supply of iron ore had increased at a time when European demand had declined. In addition, while the official data for crude steel production in China had remained strong up to September, available data for October had shown a fall in production. Reflecting developments in commodity markets, Australia's terms of trade were likely to have peaked in the September quarter. The forecast for the terms of trade had been revised down, in line with the steep declines in iron ore prices, but the terms of trade were still expected to remain at very high levels.

Domestic Economic Conditions

The main economic news in the month had been the release of the CPI data for the September quarter. In underlying terms, inflation was lower than had been expected, with the various measures showing inflation of 0.3–0.5 per cent in the quarter. On a year-ended basis, underlying inflation was running at a little below 2½ per cent, the midpoint of the medium-term target. Headline inflation was 0.6 per cent in the quarter, or 0.4 per cent on a seasonally adjusted basis. The year-ended CPI inflation rate, at 3.5 per cent, was still being boosted by the large rise in fruit and fuel prices earlier in the year. As expected, there was a large rise in the price of utilities in the quarter, with this being offset by a decline in housing construction costs and a seasonal decline in pharmaceutical prices. The prices of tradable goods had fallen slightly in the quarter, after more significant falls around the turn of the year, which suggested that the effects of the earlier exchange rate appreciation were waning. Excluding the effects of fruit and vegetable prices, food price inflation had remained subdued.

Taken together, the information on inflation over the past two months suggested that there was less inflationary pressure in the economy than had been expected earlier in the year. While it remained possible that this was just the result of noise in the data, it was consistent with the softer growth in the non-mining economy and liaison reports that many firms felt that they had limited pricing power.

The recent data on economic activity had been a little more positive than in the previous couple of months, although conditions remained subdued in a number of sectors.

The unemployment rate ticked down to 5.2 per cent in September, after having risen by 0.4 percentage points over July and August. In the month, employment increased by around 20,000, although there had been little net employment growth over the past six months. Other indicators also pointed to a softening in the labour market over the course of 2011, with the Bank's liaison suggesting that firms were waiting to see evidence of stronger demand before hiring additional workers.

The retail trade data for July and August had also been stronger than in previous months. Members noted that there were divergent trends in retail sales, with weakness in the categories of department stores, household goods and clothing, footwear & accessories, but more strength in a range of categories such as food, cafes & restaurants, and other retailers. Survey measures of consumer confidence remained below average, despite some improvement in September and October.

The housing market remained subdued, with preliminary estimates suggesting another small decline in nationwide prices in September, to be around 3–4 per cent lower over the year. Growth in housing credit continued to run a little below growth in disposable income. There had been a noticeable pick-up in building approvals in August owing to a large rise in the apartments category, although this could be volatile from month to month.

Data for September indicated that growth in business credit remained subdued, although a little stronger than a few months earlier. Survey-based measures of business conditions were mostly around long-run average levels but conditions continued to vary significantly across industries. In September, business confidence had improved after the sharp fall in August, but it was still well below average. Conditions in parts of the construction sector remained quite soft. In contrast, conditions in the resources sector were very positive and, consistent with this, there has been strong growth in imports of capital goods. Iron ore exports had risen strongly over recent months, but the recovery in coal exports continued to be slower than earlier expected because of difficulties in removing water from flooded mines. Information from the Bureau of Meteorology suggested a growing risk of a wetter-than-usual summer, which could further delay the recovery in coal production.

The staff had undertaken a review of the forecasts ahead of publication of the November Statement on Monetary Policy. The forecasts for domestic growth had been revised lower reflecting the weaker global outlook, the decline in confidence and asset prices since August, and a downward revision to the outlook for coal production. Over the forecast period, domestic demand was expected to grow at an annual rate of around 4 per cent, with growth in imports substantially faster than this, owing to both the high exchange rate and the mining sector's relatively greater use of imported capital goods. Overall GDP growth was expected to be around 3–3½ per cent in 2012 and a little stronger in 2013. Correspondingly, the unemployment rate was expected to increase a little, before drifting lower again.

The outlook for the resources sector remained very strong, with mining investment expected to increase to around 7 per cent of GDP by 2013/14. In contrast, growth in the non-mining economy was expected to be below trend. The household saving rate was forecast to remain around its current level and growth in public demand was expected to be subdued. The sovereign debt problems in the euro area posed the most significant risk to the growth outlook.

The inflation forecasts had also been lowered, reflecting both the lower starting point and the modest downward revision to the forecast for output growth. Based on the current set of assumptions, inflation in underlying terms (excluding the effect of the carbon price) was expected to be around 2½ per cent in 2012, and to pick up a little in 2013, but still be consistent with the inflation target. This general outlook for inflation was conditional on aggregate wages growth remaining at around its current pace and a pick-up in productivity growth. The year-ended rate of CPI inflation was expected to fall below underlying inflation in early 2012, as banana prices fell to more normal levels. It was then expected to increase to around 3¼ per cent following the introduction of the price on carbon in mid 2012, before again declining.

Considerations for Monetary Policy

Recent information suggested a moderation in the pace of global growth compared with expectations earlier in the year. The US economy had picked up pace in the third quarter, but growth remained moderate and there was still significant spare capacity. The Chinese economy had slowed modestly, as the authorities there had intended, and inflation looked like it had peaked. Around the Asian region, output had recovered from the effects of the Japanese earthquake and domestic demand appeared to be still expanding at a good pace, but there were some early signs that exports to Europe had weakened. Commodity prices had generally declined over recent months.

European policymakers had made progress in their response to the sovereign debt and banking problems over the past month. This had been reflected in a more optimistic tone in financial markets compared with the previous meeting. But there were as yet many details to be confirmed as to how the various elements of the package would work. It was likely that economic conditions in Europe would weaken further over the period ahead, given the effects of the recent turmoil on confidence, likely tightness of credit supply and the need for further fiscal consolidation. As a result, the risks to the global economy still seemed to lie predominantly on the downside, notwithstanding the positive initial reception of the recent announcements.

Members considered the significance of the inflation data that had become available over the past month. While revisions had altered the earlier quarterly profile somewhat, the latest data suggested that after a pick-up in underlying inflation in the first half of the year, there had been a moderation more recently, notwithstanding ongoing large increases in utilities charges. CPI inflation had remained above 3 per cent on a year-ended basis, but was expected to decline significantly over the next few quarters, as prices fell for some key food products that had been affected by adverse weather earlier in the year.

Information on economic activity suggested that the pace of growth in demand and output outside the resources and related sectors was a little lower than had been expected earlier in the year. The revised staff forecasts pointed to the likelihood of overall GDP growth being close to trend over the next one to two years, and inflation being consistent with the 2–3 per cent target.

Financial conditions had already been easing somewhat, with a range of lending rates edging down over the past couple of months. Nonetheless, with overall credit growth remaining low, financial conditions on balance appeared to remain somewhat tighter than normal.

Members discussed whether the improved picture for inflation meant that it was no longer necessary to maintain the slightly restrictive stance of monetary policy that had been in place over the past year. A case could be made for leaving rates unchanged on the basis that, unless the world economy turned down in a serious way, the expansionary effects of the high terms of trade and the associated investment build-up would, in time, assert themselves more fully, even though recent conditions had been softer than expected. In that event, policy settings on the tight side of normal would be appropriate over the medium term. In the meantime, the expectation that policy might be eased was itself being reflected in a reduced level of market interest rates.

The case for an easing in policy was that there had clearly been material changes to the recent course of, and outlook for, underlying inflation over recent months, while the downside risks for the global economy had increased. While the financial conditions that had been in place over the past year had helped contain inflation pressures in the economy, with the change in outlook that stance was no longer necessary. A more neutral setting would, on this view, be compatible with achieving sustainable growth and inflation consistent with the target over the period ahead.

On balance, members concluded that it was appropriate for there to be a modest easing in the stance of monetary policy.

The Decision

The Board decided to lower the cash rate by 0.25 percentage points to 4.5 per cent, effective 2 November.