Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 2 August 2011
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, John Edwards, Graham Kraehe AO, Catherine Tanna
David Gruen (Executive Director – Domestic, Macroeconomic Group, Treasury) attended in place of Martin Parkinson PSM (Secretary to the Treasury) in terms of section 22 of the Reserve Bank Act 1959.
Guy Debelle (Assistant Governor, Financial Markets), Philip Lowe (Assistant Governor, Economic), Tony Richards (Head, Economic Analysis Department), Anthony Dickman (Secretary), Peter Stebbing (Deputy Secretary)
Members began their discussion with a review of financial markets.
Concerns over sovereign debt both in Europe and the United States continued to buffet financial markets over the past month. Early in July, concerns about debt in smaller countries in the euro area spread to Italy and Spain, causing government bond yields in those countries to rise to their highest levels since the inception of the euro in 1999. Concerns also spread to Belgium and, to a lesser extent, France.
It was against this backdrop that the European Union agreed on a new rescue package for Greece. While all the details were not yet apparent, it involved additional funding from the EU and the IMF, a lengthening of the maturities of the EU loans and a significant lowering of the interest rate, to around 3½ per cent under current conditions. Members noted that similar adjustments were to be made to the rescue packages for Ireland and Portugal. It was envisaged that private-sector bondholders would participate in the rescue package by rolling over or exchanging their Greek debt into bonds of longer maturities, which would effectively translate into a ‘haircut’ for bondholders of around 20 per cent. While the package would mean that Greece would not need to access the market for new funding until 2014, its ultimate effect on Greece's overall indebtedness remained unclear.
Members noted that the reaction in financial markets to the new package initially had been favourable – with spreads on euro area sovereign debt retracing part of their earlier rise – but that this had subsequently faded.
The other major factor affecting financial markets over the past month was the difficulty the US political system had in reaching an agreement to increase the US Government debt ceiling, with agreement reached only the day before the ceiling would have become binding. Also unsettling markets was speculation that the United States could lose its AAA credit rating.
There was little movement in Treasury yields prior to the agreement being reached, with market liquidity thin as participants awaited the outcome of the negotiations. Yields fell following the agreement, though this was also in the context of weaker US economic data released at the time.
Members observed that the largest impact of this uncertainty had been in currency markets, where the US dollar had depreciated against most other currencies, reaching multi-year lows in a number of cases. This was particularly stark in the case of the Swiss franc, which was viewed as a ‘safe haven’ from the perceived economic problems in both the United States and Europe. The Swiss franc had appreciated against the US dollar by around 5 per cent in the past month and 30 per cent over the past year. The Australian dollar had also appreciated strongly and rose further following the release of the CPI data in late July to reach multi-decade highs against the US dollar and on a trade-weighted basis.
Global equity markets, too, had been buffeted by these developments. Bank shares were particularly affected, with European bank shares faring the worst. Movements in the Australian equity market were similar.
Money markets, in contrast, had experienced only relatively modest effects from the tensions in the United States and Europe. While rising over the month, spreads on short-term market debt remained considerably lower than the levels reached in 2008. US money market funds had reduced their exposure to European banks, both by not rolling over debt issued by these banks as it became due and by shortening the maturity of any debt that was rolled over. Australian banks benefited from this development, with the US money market funds purchasing more of their debt instead.
Domestic credit markets overall remained largely unaffected by these offshore developments. Issuance by Australian banks remained strong over the past month, onshore as well as offshore, and their funding costs and lending rates were little changed.
In reviewing changes in monetary policy settings around the world, members noted that the European Central Bank had increased its policy rate in July, as expected, though the likelihood attached by market participants to further increases had been scaled back. There was no market expectation of any policy rate increase in the United States and the United Kingdom in the period ahead because of weaker-than-expected data. In contrast, monetary policy had been tightened further in Brazil, China and India, as well as in some other smaller economies, over the past month.
Market expectations about monetary policy in Australia had fluctuated in a wide range. While the European and US debt concerns had seen the market price reflect a greater probability of future easing, this was reversed following the release of the higher-than-expected CPI for the June quarter. For this meeting, the market expected no change in the cash rate.
International Economic Conditions
The pace of growth in the global economy had slowed in the June quarter. In the case of Asia, the slowdown appeared to reflect, at least partly, disruptions to supply chains following the Japanese earthquake and tsunami. However, there had also been a broader slowdown in a number of advanced economies, including the United States. Confidence had been adversely affected by the sovereign debt problems in Europe and the debate over the debt ceiling in the United States. While the central scenario of most forecasters remained for global growth to be average, or a bit above, over the next year or so, the downside risks had increased.
The Chinese economy had continued to grow strongly in the June quarter, and most of the monthly indicators suggested that growth remained firm. The main exception was the trade data, with the volume of imports showing no growth over the past nine months or so, and exports declining in May and June after earlier strong growth. Inflation had continued to pick up, reaching 6.4 per cent over the year to June. While prices for food, especially pork, had contributed significantly, non-food inflation was at its highest level in a decade.
In Japan, economic activity was picking up as the supply-side problems eased, although a full recovery of industrial production was not expected until after the summer. There was also some pick-up evident in industrial production elsewhere in Asia, including a significant rebound in vehicle production in Thailand, where Japanese manufacturers account for the bulk of production. In economies other than Japan, consumption growth remained firm and unemployment rates were still trending down. Year-ended core inflation rates had moved higher and monetary policy was gradually being tightened across the region.
The recent US national accounts confirmed that the economy had slowed materially in 2011. Growth in the June quarter had come in below expectations and growth in the March quarter had been revised down significantly. The earlier data had also been revised to show a deeper recession than earlier estimated, with the latest estimates showing that output had not yet returned to its pre-crisis level. The unemployment rate had picked up recently, with growth in private-sector employment weak and further falls in public-sector employment. Despite some easing in energy prices, consumption growth remained weak and members noted that the debate about public finances appeared to have further depressed household confidence. One bright spot in the US economy, however, was that business investment was continuing to pick up, supported by strong profitability. Core inflation had risen in the first half of 2011, in part reflecting second-round effects from earlier increases in commodity prices.
The recovery continued in the larger euro area countries, although unemployment rates in most countries remained high. Concerns about the Greek fiscal situation had eased a little for the time being, although members noted that Greece still faced a very significant task in improving its competitiveness and public finances.
Members discussed the downside risks to global growth, in particular those risks stemming from the fiscal problems in the United States and Europe. It was possible that these could play out in a disruptive manner, leading to a marked rise in global risk aversion, as had occurred in 2008. While the financial exposures were better understood than in the earlier episode of private-sector debt problems, there would be less scope for monetary and fiscal policy to be eased in many of the large economies in the event of a marked slowing in global growth.
The prices of oil, base metals and bulk commodities had tended to strengthen over the previous month, but were still modestly below their peaks earlier in the year. Overall, Australia's terms of trade had reached their highest level on record in the June quarter and were now expected to increase further in the September quarter, before declining gradually as more global capacity in iron ore and coal came on line.
Domestic Economic Conditions
The main economic news over the past month had been the inflation data. In the June quarter, the CPI had increased by 0.9 per cent, to be 3.6 per cent higher over the year. Measures of underlying inflation were running at 2½–2¾ per cent over the year, which was higher than in 2010.
The year-ended headline inflation rate continued to be boosted by increases in the price of fruit, in particular banana prices, which were nearly five times their pre-cyclone level. However, vegetable prices had fallen in the quarter as production recovered after the floods. Petrol prices had also risen in the quarter and the CPI measure of deposit & loan facilities – which would be removed from the CPI in the September quarter – was also estimated to have risen significantly. Utilities prices fell slightly in the quarter, reflecting seasonal factors, but would increase strongly in the September quarter. There had been larger-than-expected increases in a wide range of retail goods in the June quarter, notwithstanding the appreciation of the exchange rate and subdued level of consumer spending. While it was possible that this was a result of changes in the timing of discounting, it might also reflect cost pressures coming from an increase in global prices, as well as higher costs for a range of domestic inputs at a time when productivity growth was low.
There had been further evidence of cautious behaviour in the household sector. While there had been no official data on retail sales since the July meeting, the staff's liaison suggested that retail spending had been weak since mid May. Measures of consumer confidence had declined recently and were now below average. Housing credit growth had slowed further and the rate of credit card debt repayment had picked up. Housing price data suggested that nationwide prices had fallen slightly over recent months, to be down by around 2 per cent over the past year. Members noted that some of the developments in the household sector over recent years, most notably the significant increase in the saving ratio from the low rates seen in the early 2000s, had reduced the medium-term vulnerabilities of the economy. In addition, they observed that, in contrast to these various signs of household caution, there had been very strong growth in overseas travel by Australians over recent months.
Survey-based measures of business conditions remained around long-run average levels, although there were very significant differences across sectors, and measures of confidence had fallen to below-average levels. While business credit had fallen over the past couple of months, members observed that lending to unincorporated businesses had been rising gradually since early in the year. Imports of capital and intermediate goods had been quite strong in recent months, consistent with a pick-up in investment in the resources sector. Members noted that the past month had seen the announcement of final investment approval for another large LNG project. The data on coal shipments from Queensland for June had shown a significant pick-up, although industry sources indicated that coal production may not return to normal levels until early in 2012.
The unemployment rate had held steady at 4.9 per cent in June. Employment growth had clearly slowed from the rapid pace over much of 2010 and the unemployment rate was no longer falling. The forward-looking indicators continued to point to moderate employment growth over the period ahead, although the staff's liaison with businesses indicated some caution in hiring plans.
Members were briefed on the updated staff forecasts. The growth forecast for 2011 had been lowered to 3¼ per cent, 1 percentage point lower than the May forecast. This revision mostly reflected the delayed recovery in coal production, with the remainder largely accounted for by weaker growth in consumption. With some of the recovery in coal production pushed out to 2012 and investment picking up strongly, growth was expected to be around 3¾ per cent in both 2012 and 2013. Mining investment was expected to increase from its already elevated level of around 4 per cent of GDP to more than 6 per cent in 2012/13, and the terms of trade were forecast to remain very high, although down from current levels. Growth in consumption was expected to remain relatively subdued, with some further increase in the household saving ratio expected over the coming year. Members observed that significant structural adjustment was likely over coming years given the high level of the exchange rate relative to its average over the past decade or so.
In terms of inflation, the recent outcomes provided further evidence that the disinflationary influences stemming from the late 2008 slowdown had passed. However, subdued household demand and the appreciation of the exchange rate were likely to exert some dampening influence on inflation in the period ahead. In preparing the forecasts, the staff had included the estimated effects of the Government's intention to introduce a price on carbon, which was expected to add around 0.7 percentage point to headline inflation in the second half of 2012, with a smaller effect on underlying inflation. Incorporating these effects, underlying inflation was forecast to be 3 per cent or a little higher over the next few years. The rate of CPI inflation was expected to be above 3 per cent at the end of the forecast period.
Members recognised that the effects of instability overseas could pose a downside risk to the domestic economy. Of the domestic risks, the main uncertainty was the behaviour of households, as saving could increase further in an environment of uncertainty. Members also noted the importance of productivity outcomes for growth and inflation. Australia's productivity growth over the past five to ten years had been weak, with growth in output largely accounted for by growth in the factors of production. Growth in incomes had been held up by the rise in the terms of trade over this period. However, with the forecasts suggesting that the terms of trade were likely to be subtracting from income growth over coming years, a significant pick-up in productivity growth would be required to sustain real income growth around the rates seen in recent decades. Members noted that the task facing monetary policy in future would become more difficult if a continuation of poor productivity growth were combined with an expectation of growth in nominal wages and profits at the same sorts of rates seen over the past two decades.
Considerations for Monetary Policy
Members noted that the global economy was continuing to expand, though growth was unbalanced between regions, and there had been some slowing in the pace of growth in recent months. Significantly, the downside risks had become more pronounced recently. There was considerable uncertainty about how persistent the current slowdown would turn out to be; when the fiscal problems in Europe and the United States would be resolved; and what effect the ongoing market volatility would have on the global economy. At the same time, commodity prices were remaining high and this was feeding through into higher rates of global inflation.
Domestically, there were significant divergences between sectors. Activity in parts of the economy was subdued, with consumers remaining cautious and business confidence having fallen somewhat. This was being mirrored in limited appetite for debt by both households and businesses. The appreciation of the exchange rate and the withdrawal of fiscal stimulus were also contributing to softness in various parts of the economy. In contrast, the boom in the resources sector was benefiting some other sectors. Overall, members noted that surveys suggested that business conditions, in aggregate, were around the average level of the past two decades and that the unemployment rate was at a low level.
The recent inflation data had been higher than expected. Year-ended CPI inflation had increased, partly reflecting the extreme weather events earlier in the year. As these effects reversed, CPI inflation was expected to decline. Measures of underlying inflation had also picked up, and it was reasonable to conclude that the earlier easing in underlying inflation had run its course. While recent year-ended figures remained consistent with the 2–3 per cent target, members believed there were grounds for concern about the medium-term outlook for inflation, given the relatively limited spare capacity in the economy, the widespread increase in cost pressures, including in imported goods, and the relatively low rate of productivity improvement.
Members considered whether the recent information warranted further policy tightening. The argument for tightening further was that underlying inflation had started to pick up and the central projection in the staff forecasts envisaged it rising above the target range during the forecast period.
The case against tightening at this meeting was that the downside risks to demand had probably increased, as a result of the acute uncertainty in global financial markets over the recent period. If the financial market turmoil continued, it could further weaken household and business confidence. This in turn could weaken the outlook for demand relative to the central forecast and, over the medium term, dampen the inflation outlook.
In considering the current stance of policy, members noted that although interest rates were only a little above average, credit growth had slowed over recent months and was very subdued by historical standards. Asset prices had softened and the exchange rate was high. While various other factors were affecting these variables, taken together they suggested that financial conditions were already exerting a reasonable degree of restraint.
Having considered all these factors, members judged that it was prudent to leave the setting of monetary policy steady at this meeting, and to continue to assess the outlook for growth and inflation at future meetings.
The Board decided to leave the cash rate unchanged at 4.75 per cent.