Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 3 May 2011
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), Martin Parkinson PSM (Secretary to the Treasury), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, Graham Kraehe AO, Warwick McKibbin, Catherine Tanna
Guy Debelle (Assistant Governor, Financial Markets), Philip Lowe (Assistant Governor, Economic), Tony Richards (Head, Economic Analysis Department), Anthony Dickman (Secretary), Peter Stebbing (Deputy Secretary)
International Economic Conditions
The global economy had continued to grow solidly in the early part of 2011, notwithstanding the effects of the Japanese earthquake. Growth in China and the rest of emerging Asia had remained strong, which was continuing to underpin high commodity prices. The rise in food and fuel prices over the past year was pushing up headline inflation rates globally, prompting a gradual tightening in monetary policy in a number of economies. The IMF was still forecasting above-trend growth for the global economy, albeit with significant differences between the rates of growth expected for the advanced and emerging economies.
It remained difficult to gauge the overall economic effects of the disasters in Japan, although it had become clear that they would be more serious than was the case following the Kobe earthquake in 1995. While black-outs were no longer occurring, electricity supply would be constrained during the summer months, and it was still uncertain to what extent Japanese consumer behaviour would be affected by the nuclear power problems. The economic data that were available for the month of March showed major declines: industrial production fell by 15 per cent, retail trade and exports both declined by 8 per cent, and survey-based measures of business conditions and consumer confidence declined sharply. There were also reports that supply-chain problems were constraining production in other parts of the world, particularly in the automobile industry.
In contrast, the pace of growth in China had remained robust. GDP grew by around 2 per cent in the March quarter and most of the timely indicators of activity – including industrial production, exports and retail sales – suggested that the economy was continuing to grow strongly. Members discussed the further rise in Chinese inflation. Food price inflation remained elevated and there were increasing signs that higher raw material prices were feeding through into higher prices for a range of consumer goods. In response, the authorities had continued with a range of measures to contain price increases for particular goods and services, including the announcement by the People's Bank of China of further increases in interest rates and reserve requirements.
Demand was also growing strongly in other east Asian economies and in India. March quarter GDP data for Korea, Singapore and Taiwan had been quite strong. Headline and core inflation rates had risen across the region.
The recovery was continuing in the United States, although March quarter GDP growth had been somewhat below expectations. Consumption growth had slowed a little, which was likely in part to reflect the effect of the significant increase in gasoline prices on household budgets. Consumer confidence remained low and the housing market was still very weak. In contrast, measures of business conditions were positive. Information on the labour market was mixed: while most of the recent data, including the payrolls reports, had suggested that the improvement was continuing, initial jobless claims had increased recently. Members observed that the need to put fiscal policy on a more sustainable footing continued to affect confidence in the outlook for the US economy.
While overall economic conditions in Europe had mostly firmed, there continued to be a wide variation in performance within the region. Higher commodity prices had led to a noticeable pick-up in headline inflation rates in the euro area, as well as in the United States. Recent data on activity in the United Kingdom had remained relatively soft.
Oil prices had increased further since the April meeting, with the price of Tapis crude rising to around US$130 per barrel. The prices of Australia's bulk commodity exports had also risen, with annual benchmark contract prices for thermal coal exports settling at around US$130 per tonne, a little above what had been expected, and spot iron ore prices had also moved higher. In contrast, the prices of some food items had declined over the past month, as global supply concerns had eased, although prices remained high.
Members discussed the implications of recent developments in commodity prices for global inflation. While the depreciation of the US dollar was one factor behind the increases, prices had also risen significantly in terms of other currencies, largely reflecting strong growth in demand, especially from the emerging economies. Members noted that monetary policy remained accommodative in most countries, which was adding to pressure on commodity markets. In this environment, global inflation risks appeared to have moved to the upside. In some countries, higher commodity prices were also acting as a negative supply shock and reducing real incomes at a time when activity remained quite subdued.
Domestic Economic Conditions
The main economic news over the preceding month had been the release of the CPI, which increased by 1.6 per cent in the March quarter, with the year-ended rate of inflation rising to 3.3 per cent. The March quarter outcome had been boosted by large price rises for a few items. There had been a 15 per cent increase in fruit and vegetable prices, a consequence of the extreme weather conditions earlier in the year. More recent data from wholesale markets suggested that the prices of some fruit and vegetables had already fallen back, although banana prices were expected to contribute further to inflation in the June quarter. Fuel prices rose by nearly 9 per cent in the quarter, electricity prices increased by 5 per cent, and there were large seasonal increases in the prices of health and education services. Members noted that some further large increases in electricity prices were scheduled. Partially offsetting the rises in these various items, the appreciation of the exchange rate had contributed to falls in the prices of many imported retail goods. The price indices for clothing and footwear, furniture, household appliances and audio-visual equipment had all fallen over the year to the March quarter.
The underlying measures of inflation – at 0.7–0.9 per cent in the quarter – were a little higher than expected, although looking through the volatility in the quarterly numbers, the outcomes over the past six months had been in line with expectations last November. On a year-ended basis, underlying inflation had remained at 2¼ per cent, down from a peak of a little over 4½ per cent in 2008.
There had been only a limited amount of data on domestic activity released since the previous Board meeting, but this had had a slightly more positive tone than earlier in the year when natural disasters dominated the news. Business conditions, as measured by the NAB survey, recorded a significant rise in March to above-average levels, and business credit rose by 1 per cent in the month, the strongest outcome since late 2008. While there had been no new official data on retail sales since the previous meeting, the staff's liaison suggested modest growth in volumes over the past month or so.
The unemployment rate had declined to 4.9 per cent in March, its lowest level in more than two years. Employment was estimated to have risen solidly in the month after no net growth over the previous three months. The participation rate remained close to its record high and average hours were gradually picking up. Forward-looking indicators continued to point to fairly solid labour demand in the period ahead.
Conditions in the housing market remained subdued, with prices in most cities either flat or down over the past few months. Auction clearance rates in Sydney and Melbourne had been at below-average levels in recent months. Members observed that growth in housing credit had slowed in recent months, while building approvals and home loan approvals had also softened in 2011. While this partly reflected the effect of the Queensland floods, conditions had softened in most other states as well in the wake of the increase in housing loan interest rates in November.
In the resources sector, liaison continued to point to a larger contraction in coal production in the March quarter than had earlier been expected, reflecting problems in removing water from flooded mines. As a result, there was a high likelihood that GDP had declined in the March quarter. In contrast, domestic demand was likely to have grown solidly in the quarter.
Members were briefed on the updated staff forecasts. Notwithstanding the divergences between regions, the world economy was expected to grow at a modestly above-trend pace over the next few years. Australia's terms of trade were expected to rise by around 10 per cent over the March and June quarters, to be more than double their average level in the 1990s, before falling back a little over the forecast period as additional global supply of resources came on line.
As had been the practice over the past couple of years, the domestic forecasts were based on the assumption that the cash rate moved in line with expectations implied by market pricing. The medium-term outlook for the domestic economy remained similar to that discussed over the past year or so, although the growth forecasts had been lowered a little owing to the further appreciation of the exchange rate and its effect on trade-exposed sectors. Nonetheless, for most of the forecast period, growth was expected to be at, or above, trend, underpinned by a boom in investment and the income boost from the very high level of the terms of trade. As a result, the unemployment rate was expected to continue to decline gradually. In the short term, the quarterly profile for GDP would be significantly affected by the floods, with a significant bounce-back in coal production expected in the June and September quarters. Members also noted the prospect of significant fiscal consolidation over the next couple of years.
The moderation in inflation looked to have run its course. Given the March quarter outcome, the forecast for underlying inflation over 2011 had been lifted a little to around 3 per cent. For 2012, underlying inflation was expected to remain around that level, with the gradual pass-through of the exchange rate appreciation providing a partial offset to rising inflation pressures for non-traded items. By the end of the forecast period, underlying inflation was expected to be above 3 per cent. Headline inflation was forecast to remain above underlying inflation for the remainder of 2011, largely owing to higher fruit and vegetable prices. It was then expected to be below underlying inflation for much of 2012, as banana prices returned to more normal levels.
In terms of risks, members noted the challenges for policy-makers internationally in dealing with the pick-up in global inflationary pressures. Sovereign debt concerns, both in Europe and the United States, remained an additional risk for the global economy. Domestically, one area of uncertainty was the behaviour of the household sector and whether the recent cautiousness of households would continue. Another uncertainty concerned the tightening of the labour market and whether a pick-up in wages in the resources sector would spill over into significant pressure on wages elsewhere in the economy. Members observed that the behaviour of households and the labour market would be important determinants of the outcome for inflation over the next few years. In addition, it would be important that inflation expectations remained anchored and that economic policies were conducive to productivity growth.
Concerns about sovereign creditworthiness had come to the fore again in financial markets, with Portugal having sought assistance from the European Union and the IMF. While any assistance package was likely to be similar in size and terms to those for Greece and Ireland, members noted that it could be delayed because of growing opposition to such rescue packages in other parts of Europe. Increased speculation about a restructuring of Greek debt late in April saw spreads on peripheral debt widen further to new highs. However, sovereign debt markets had not been affected when Standard & Poor's placed the credit rating of the US Government on negative outlook, given that markets were already well aware of the state of the US Government's fiscal position.
Members observed that the depreciation of the US dollar had accelerated in recent weeks, falling to a record low on a trade-weighted basis. In part, this reflected the fact that US monetary policy was still being eased, with the Fed continuing to buy US government debt, whereas monetary policy had been tightened in a number of other countries. The euro appreciated to its highest level in nearly 18 months after the European Central Bank raised its policy rate from the low it had been at for two years. Many emerging market currencies had also risen to historically high levels against the US dollar as the authorities in those economies tightened monetary policy to curb inflationary pressures. The renminbi had appreciated against the US dollar by less than most other currencies, resulting in a decline in China's trade-weighted index.
The Australian dollar had appreciated to a fresh post-float high against the US dollar. On a trade-weighted basis, the currency was at its highest level since 1985 and had appreciated by 6 per cent since the start of the year. While this partly reflected the general depreciation of the US dollar, the Australian dollar had tended to rise more than most other currencies. An important influence had been purchases by other central banks seeking to invest their official reserve assets.
Global equity markets had a quieter month after the volatility caused by the Japanese earthquake in March. US share prices had risen in response to corporate earnings reports that were generally better than expected, though share prices for several large US banks declined, mainly because the composition of their earnings was not viewed as favourably by the market. Members noted that the local share market had tended to underperform other markets, in part reflecting the effect of the exchange rate appreciation.
There had been sizeable issuance of mortgage-backed securities in the local securitisation market during April from a range of financial institutions. As in March, these issues required relatively little support from the Australian Office of Financial Management and were generally at narrower spreads, reflecting the extent of demand. Corporate bond issuance had also been strong, both onshore and offshore, with a wide range of companies borrowing at relatively narrow spreads.
Market expectations of monetary policy tightening in Australia had shifted higher after the release of the CPI, though markets did not expect a rise in interest rates at the current meeting.
Considerations for Monetary Policy
Members noted that the data becoming available for Australia were being significantly affected by earlier floods and Cyclone Yasi. The inflation rate had been boosted by a large increase in fruit and vegetable prices, and it was quite likely that GDP would be shown as having contracted in the March quarter because of the disruption to production in the mining sector. As discussed at the previous meeting, members remained of the view that it was appropriate to look through the temporary effects on inflation and growth and to set policy based on the medium-term outlook.
Recent data confirmed above-trend growth in the world economy, which was boosting commodity prices. In turn, this was supporting real incomes in Australia and leading to very high levels of investment in the resources sector. The outlook for economic activity remained largely unchanged. While there were many uncertainties about the world economic outlook, the central scenario was for a continuation of above-trend growth. Growth in Australia was expected to be relatively strong over the next few years, with the unemployment rate moving lower.
The recent CPI outcome had been higher than expected, although this followed an unusually low figure in the preceding quarter. While underlying inflation was currently in the lower half of the target band, it looked to have troughed and was expected to increase, over time, from there. The recent appreciation of the exchange rate and a continuation of the relatively high saving ratio by households would help to contain some of the inflationary pressures coming from the resources boom. Nonetheless, the staff forecast was for underlying inflation to be in the top part of the target band over the next couple of years and, based on the interest rate path implicit in recent financial market pricing, above 3 per cent towards the end of the forecast period.
Members viewed the current mildly restrictive stance of monetary policy as remaining appropriate, with recent rises in the exchange rate likely to have further tightened conditions, particularly in some sectors of the economy. Members noted that the significant divergences between different sectors of the economy presented challenges for policy-making, but that monetary policy had to be set for the needs of the overall economy. In this respect, members judged that if economic conditions continued to evolve as expected, higher interest rates were likely to be required at some point if inflation was to remain consistent with the medium-term target. Members agreed to continue to assess carefully the evolving outlook for growth and inflation at future meetings.
The Board decided to leave the cash rate unchanged at 4.75 per cent.