Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney - 5 July 2011
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), Martin Parkinson PSM (Secretary to the Treasury), John Akehurst, Roger Corbett AO, Graham Kraehe AO, Warwick McKibbin, Catherine Tanna
Members granted leave of absence to Jillian Broadbent AO in terms of section 18A 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.
Developments in Greece had again been the main factor influencing markets over the past month. Pessimism had been the dominant theme until late June. Sentiment improved after further fiscal measures were formulated and passed by the Greek parliament. The new package was necessary for the next tranche of official funds to be provided under the original EU and IMF program. There was continuing uncertainty about how the funding gap for 2012 would be filled, given Greece's inability to raise funds in bond markets at present. (The original support program had assumed that Greece could raise around €25 billion in the market from 2012.)
Members were briefed on some of the options under consideration for closing that funding gap. Part would come through further budget measures and additional official assistance, while part would come through participation by current bond holders in a debt rollover. The latter appeared to face some hurdles, however, including the need to avoid any such proposal being characterised as a debt default. An uncontrolled default could be damaging for the global economy, particularly if there were contagion to other countries in Europe and a significant loss of confidence in the ability of policymakers to manage the fall-out.
Reflecting the concerns about Greece, the yield spread between German Bunds and sovereign bonds of those European countries receiving financial assistance from the EU and IMF – Greece, Ireland and Portugal – all reached new highs. Spreads on 10-year Italian and Spanish government bonds also reached their widest levels in around 15 years.
Despite these movements, there was little sign of the tensions in the wider global money markets that had been evident in May 2010, when the Greek fiscal concerns first came to the fore, or in 2008 after the failure of Lehman Brothers. Members noted that spreads in the interbank market were little changed. The problems in Greece had combined with softer global macroeconomic data to cause government bond yields in the major markets to decline to their lowest levels this year, although yields had risen again in recent days on the passage of the Greek austerity package.
Members observed that the Federal Reserve had completed its second program of asset purchases and had reaffirmed its intention to maintain its balance sheet at the current size for the period ahead. For Europe, the market believed that the ECB was almost certain to raise its policy rate at its meeting later in the week. Other central banks, including in Brazil, China, India and South Korea, had tightened monetary policy further over the past month.
Global equity markets had fallen further on the Greek concerns and weaker-than-expected data in a number of countries, before reversing those declines following the passage of the Greek austerity package. European bank share prices had been particularly affected by these developments. The Australian share market had been primarily driven by these global factors.
Members also discussed the volatility in foreign exchange markets, which had remained elevated. By and large, the US dollar, Japanese yen and Swiss franc (along with the renminbi) had moved broadly together against the euro and most other currencies, including the Australian dollar.
Australian credit markets continued to be relatively unaffected by the global uncertainty over the past month. Issuance by Australian banks, both secured and unsecured, had remained solid and pricing had not materially changed.
Members noted that market pricing indicated that no change in the cash rate was expected at this meeting.
International Economic Conditions
The pace of growth in the global economy had eased over the past few months, although this partly reflected the Japanese supply-chain disruptions, which would probably lessen over the months ahead. While the IMF had made a small downward revision to its outlook for world growth in 2011, its central forecast was still for growth to be at, or above, average in both 2011 and 2012. Downside risks had, however, increased, particularly because of the fiscal and banking problems in Europe.
The Chinese economy continued to expand at a solid pace. Growth in investment and exports remained strong, while growth in industrial production and retail sales had moderated in recent months. The efforts of the authorities to slow demand through tighter monetary policy and administrative controls were having an effect, with growth in credit and property prices slowing noticeably over the past year. The year-ended inflation rate had risen to 5.5 per cent in May, driven by higher non-food inflation, and recent increases in pork and other food prices were likely to result in further increases in overall inflation. Members observed that the rise in inflation implied that real interest rates were at low or negative levels.
In Japan, gradual progress was being made towards easing the supply-chain disruptions following the earthquake and tsunami. Industrial production rose strongly in May, and manufacturers expected another large increase in production in June. Output in the automotive industry, where the supply-chain disruptions had been most acute, appeared likely to return to normal more quickly than earlier expected, although the supply of electricity in the Tokyo region would be a constraint on production during the summer months. Retail trade had grown in April and May, but consumer confidence remained at low levels, despite some recovery in May.
Elsewhere in east Asia, there had been a general softening of the industrial production and trade data in April. This appeared to be largely the result of disruptions to trade in intermediate goods resulting from the problems in Japan, and there were indications of a pick-up in some countries in May.
The difficulties in Europe, particularly Greece, remained a significant downside risk for the global economy. Despite the passage of legislation to implement new austerity measures, Greece had some way to go to resolve its fiscal problems and reduce its high domestic cost structure.
In the United States, a range of indicators suggested that growth had moderated in recent months. The recovery in consumption had lost momentum, which members attributed in part to households adjusting to higher oil prices. The housing sector remained extremely weak and the pick-up in employment had been disappointingly slow. As in many countries, the recent industrial production data had been affected by supply-chain problems in the automotive industry, although machinery and equipment investment had been growing solidly.
The prices of most commodities had fallen recently, although they generally remained at high levels owing to ongoing strong demand driven by growth in Asia. The prices of base metals and oil had fallen through June, as had the spot price for iron ore, although there had been some recovery in prices as the news on Greece had improved. There had also been a decline in the prices of some rural commodities, although members observed that wool had been an exception. Notwithstanding the recent declines in most commodities, Australia's terms of trade for the June quarter were likely to have been the highest on record.
Following the earlier surge in commodity prices, which had boosted year-ended headline inflation around the world, the recent decline in commodity prices, including food prices, was flowing through to a short-term easing in inflation pressures in some countries. Nevertheless, with global growth having been quite strong, underlying inflation was still trending up in many countries, including the United States. In emerging economies, inflation remained uncomfortably high, particularly in India and China. In Europe, inflation remained above the ECB's target, and well above target in the United Kingdom.
Domestic Economic Conditions
The multi-speed nature of the Australian economy was clearly evident in recent economic data. The resources sector remained strong, as did some service sectors. However, household cautiousness and the high exchange rate were having a dampening effect on a number of other sectors. Supply-chain disruptions, due to events in Japan, had also caused a fall in motor vehicle production and sales. Survey measures of overall business conditions and confidence showed significant differences across industries, but overall conditions remained around their long-term averages.
The unemployment rate had held steady at 4.9 per cent in May and had been around this level for about six months. Employment growth had slowed from the rapid pace in 2010, partly due to slower growth in the estimated working-age population. There had been some decline in the number of vacancies and job advertisements, although the overall vacancy rate remained at a high level. Employment growth was strong in the mining and business services sectors, and also in household services such as health and education. However, employment was flat or falling in manufacturing and goods distribution. The strong demand for mining-related occupations had led to increased wages pressures in some of these areas, but these pressures remained fairly localised. Overall growth in wages was running around the rate seen prior to the downturn, although the weak growth in measured productivity meant that unit labour costs looked to be rising strongly.
The household sector continued to be cautious in its spending and borrowing behaviour. Following a solid rise in April, data for retail sales for May had shown a fall, although imports of consumption goods (excluding motor vehicles) had been strong over the past couple of months. Despite official data recording quite strong growth in disposable income and overall measures of consumer sentiment being around their long-run average, households' perceptions about the state of their finances remained well below average. There had been little growth in nominal wealth over the past year, with housing prices having softened and equity prices lower recently. Members observed that this was in contrast to the experience of much of the past two decades. Housing credit growth had eased further, to its slowest pace in many years, although housing loan approvals had picked up in April and May.
The housing market remained soft, with nationwide measures of prices recording another small fall in May, although with some differences among cities. Mortgage arrears rates had risen over recent months, although they were still much lower than in most other countries. Arrears rates had increased the most in Western Australia and Queensland, where house prices had been falling after large run-ups in previous years. Members observed that this was similar to the pattern seen in Sydney following the rapid growth in house prices in the early 2000s: households that entered the market around the peak in prices, when lending standards were less stringent, had been more likely later to experience difficulties. In contrast, the arrears rates for borrowers who purchased their home in 2009, when lending standards were tighter, were not particularly high compared with earlier cohorts, despite these borrowers experiencing a significant increase in interest rates since they took out their loans.
The outlook for investment continued to be very strong, driven by the mining sector. Some companies were reporting rising costs in resource investment projects. A number of large LNG projects were under construction or progressing through the approvals process, and there was a high level of spending on projects to expand production capacity for iron ore in the Pilbara. Consistent with this, capital imports had trended higher over recent months. In contrast, investment in the non-mining sector remained soft, with signs yet to emerge of a pick-up in non-residential construction.
The recovery of coal exports from the Queensland floods was taking significantly longer than earlier expected, and the return to full capacity could be delayed to early 2012. In contrast, iron ore exports had already bounced back from the weather-induced weakness seen in the March quarter. The recovery in coal and iron ore exports was expected to boost GDP growth significantly over the next few quarters. Nonetheless, the delay in the recovery of coal production plus continuing signs of cautiousness on the part of households meant that growth in 2011 was likely to be lower than had been expected a couple of months earlier.
There had been little new information on inflation over the past month, with the June quarter CPI to be released on 27 July.
Considerations for Monetary Policy
While the central scenario for the world economy showed robust growth over the coming year, global growth had slowed in the June quarter. The downside risks associated with a possible adverse European financial shock looked more significant than had been the case a few months ago. Whether the slower global growth would persist was unknown. Growth in China had slowed somewhat, although it remained strong overall.
Members noted that with households remaining cautious and the impact of earlier fiscal measures abating, growth in aggregate demand was not showing signs of a further pick-up yet. The pace of employment growth had for some months been more moderate than had been the case in 2010, and the overall labour market was therefore not tightening significantly further at present. A number of indicators were consistent with overall growth at around average pace with noticeable differences between sectors. The delays in the recovery of coal production and supply-chain disruptions resulting from the Japanese earthquake and tsunami also meant that GDP growth through 2011 was unlikely to be as strong as earlier forecast, with some of the recovery being pushed into the early part of 2012.
Notwithstanding this, members considered that the continuing strong economic performance of Asian economies meant that the medium-term outlook for the Australian economy remained strong. The prices of Australia's main commodity exports were at elevated levels, and very strong growth in investment, led by the resources sector, was still expected over the next couple of years.
The extent to which these forces would strain the economy's productive capacity over time would be a key determinant of inflation. Members noted, however, that the flow of recent information suggested both that there was more time to assess the likely strength of inflationary pressures in Australia and that it would be prudent to use that time. Members noted that the CPI outcome for the June quarter, to be published later in the month, would be important in helping to shape views about inflation, and therefore the future path of interest rates. Accordingly, members considered that the current mildly restrictive setting of monetary policy remained appropriate.
The Board decided to leave the cash rate unchanged at 4.75 per cent.