Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 4 September 2012
Glenn Stevens (Chairman and Governor), Philip Lowe (Deputy Governor), Martin Parkinson PSM (Secretary to the Treasury), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, John Edwards, Heather Ridout, Catherine Tanna
Guy Debelle (Assistant Governor, Financial Markets), Malcolm Edey (Assistant Governor, Financial System), Christopher Kent (Assistant Governor, Economic), Jonathan Kearns (Head, Economic Analysis Department), Anthony Dickman (Secretary), Peter Stebbing (Deputy Secretary)
International Economic Conditions
Members were briefed on the data that had been released over the past month, which pointed to a slight weakening in the global outlook. The indicators for economic activity in China were a little softer overall, after having appeared somewhat more positive in the previous month, while economic activity in the rest of Asia and the United States appeared to have expanded at a modest pace. Economic conditions remained weak in Europe. Against this background, there had been sharp falls in the prices of iron ore and coking coal more recently.
Members observed that data on economic activity in China had been a bit weaker of late. The manufacturing PMI fell back in August and the value of exports over the year to July was broadly flat. In July, consumption indicators remained quite strong in real terms and the growth of industrial production was steady, as the slowing in demand for materials for property construction, particularly for residential construction, had been offset by the ongoing expansion in infrastructure and manufacturing investment. Inflation had continued to decline, to be less than 2 per cent over the year to July.
Activity in the rest of Asia, including Japan, had softened, as weaker conditions in China and major developed countries had weighed on exports from the region, especially from the higher-income Asian economies. In India, the fact that inflation remained high in the face of a declining pace of economic growth might reflect structural impediments to growth.
In the United States, after slightly slower GDP growth in the June quarter, recent data had been more positive. Retail sales and payrolls employment picked up in July, and the housing market was improving gradually, albeit off a very low base. In contrast, economic activity in the euro area contracted further in the June quarter – and quite sharply in the southern European crisis economies – while more timely indicators suggested that conditions across the region remained very weak.
Members observed that spot prices for iron ore and coking coal had fallen sharply of late, largely reflecting weakness in China's steel market as well as an easing in a range of factors that had temporarily disrupted the supply of coking coal. Since mid June, iron ore spot prices had fallen by a little over 35 per cent and coking coal prices had fallen by almost 25 per cent. Members noted that these price falls were likely to be reflected relatively quickly in export prices, as an increasing share of iron ore was traded in the spot market and on short-term contracts over recent years. Overall, other commodity prices had been relatively flat over the past few months. The RBA index of commodity prices had declined by 7 per cent over the previous month (on the basis of spot price movements).
Domestic Economic Conditions
The June quarter national accounts data, scheduled to be released the day after the Board meeting, were expected to show the pace of output growth had been around trend, following strong growth in the March quarter.
Partial indicators suggested that consumption growth remained relatively strong in the June quarter, helped by government assistance payments to households, though members noted that some parts of the retail sector were facing quite challenging conditions. Retail spending had fallen in July, although liaison suggested that spending had picked up in August. Measures of consumer sentiment remained close to their long‑run average levels.
Conditions in the housing sector were subdued, but there were tentative signs of an improvement. Building approvals had increased strongly in the June quarter, and fell back in July, but remained a little higher than earlier in the year. Loan approvals for new dwellings and first-home owner grants had also risen in recent months. Dwelling prices had increased slightly over the previous three months in Sydney and Melbourne and were broadly unchanged in other cities, with turnover remaining low.
Members noted that the large Australian producers of iron ore had achieved record levels of production in the first half of the year, and production was expected to increase further over the coming year. Thermal coal shipments increased sharply from New South Wales in July as new capacity came on line, while temporary factors had weighed on exports of coking coal from Queensland, though there were reports of a slowing in demand as well.
After a surge in mining investment in the March quarter, growth in business investment was estimated to have moderated in the June quarter. However, the latest ABS capital expenditure survey, which was conducted in July and August, suggested that the outlook for investment over the current financial year remained very strong, notwithstanding a more recent reassessment by some resource companies of the prospects for projects to which they had not yet committed. If the fall in the iron ore and coking coal prices were to be sustained, it could lead to somewhat lower mining investment, but given the large LNG and other mining investment projects already under way, the staff still expected there to be a substantial increase in resource investment over the next year or so.
Members were informed that investment outside the mining sector, which had been subdued up to the June quarter, was expected to remain subdued during the current financial year. In line with this, survey measures of business conditions had eased a little in July and remained below average. At the same time, however, business credit had picked up during 2012 and was growing at its fastest pace in over three years.
Employment in July continued to expand at around the same pace as that of the working-age population and the unemployment rate had remained steady at 5¼ per cent. Members noted that the number of unemployment benefit recipients had increased. Leading indicators of labour demand had softened a little further, though they were consistent with modest employment growth over coming months.
Members observed that the pace of wage growth increased a little in the June quarter after having eased slightly in the March quarter. The wage price index increased by 1.0 per cent in the quarter to be 3.7 per cent higher over the year. Wage growth was strongest for skilled professions and for workers in Western Australia more broadly. Growth was moderate in industries more directly exposed to household consumption expenditure.
There was little new information on prices over the past month. Liaison suggested that the introduction of the carbon price had not yet had a significant effect on downstream price pressures, with only isolated examples of suppliers attributing price increases to the carbon price. There was no evidence that the carbon price had raised medium-term inflation expectations.
Members began their discussion of financial markets with the observation that the improved sentiment in global markets over August had largely reflected growing expectations that the European Central Bank (ECB) would announce significant policy measures following its meeting on 6 September. Uncertainty about those measures, as well as about several other upcoming decisions in Europe and the United States, had contributed to low turnover in most financial markets. In particular, the German Constitutional Court was due to rule on the legality of the European Stability Mechanism (ESM) on 12 September, on which date the Netherlands would also hold national elections, while the follow-up audits of Spanish banks and the next review of Greece by the troika of official agencies (ECB, European Commission and International Monetary Fund) were also in prospect. Members noted that market pricing embodied expectations of further concrete action from policymakers.
Members were briefed about the ECB's concern that the large risk premia in some European bond yields, reflecting the possibility of a euro area break-up, were hampering the transmission of its monetary policy. Given this concern, the ECB had indicated the possibility of purchasing shorter-term sovereign debt to reduce yields, but only if the European Financial Stability Facility (EFSF) and ESM also purchased sovereign debt issued by these governments (which would entail some conditionality). As a result, Spanish and Italian bond yields of shorter maturity had declined significantly. At the same time, yields on debt issued by many of the major sovereigns remained at historically low levels, as did those on government bonds in Australia.
Equity markets generally rose in August, although turnover was very low, as had been the case in most other financial markets. Members noted that the US share market had recovered to around the levels it reached in early 2012, to be around 10 per cent below its pre-crisis peak of late 2007. In contrast, the Chinese equity market had declined further, to be at its lowest level in more than three years.
Activity in foreign exchange markets was also subdued in August, with the euro appreciating modestly. While the Australian dollar depreciated slightly over the past month, it remained near its recent highs, despite significant falls in some commodity prices and a weaker outlook for the global economy. Members noted that most model-based estimates of the currency generally placed a large weight on the terms of trade. With the terms of trade still high by historical standards, these models suggested that the Australian dollar may have been somewhat overvalued, but not substantially so, although members also noted the significant uncertainty that surrounded this assessment.
Members noted the sizeable corporate issuance over the past month, particularly in the United States, which in part had reflected investors seeking yield given the extremely low rates on offer from sovereign debt. Australian banks had continued to have ready access to wholesale markets, including offshore wholesale markets. Banks' term deposit rates were a little lower but remained elevated, while there was little change in banks' lending rates over the month.
The Board's decision to leave the cash rate target unchanged at 3.50 per cent in early August had been widely anticipated, with money market yields little changed at that time and over the rest of the month. Members observed that market pricing suggested that no change in the cash rate was likely at the September meeting, but that the cash rate was expected to be reduced to around 3 per cent by the end of 2012.
Members were briefed on the Bank's half-yearly assessment of the financial system.
Overall, risks to global financial stability remained elevated, mainly reflecting the ongoing economic and financial problems in Europe. Although fears of a liquidity crisis in the euro area had eased earlier in the year following the ECB's large-scale lending to banks, concerns about the resilience of sovereign and bank balance sheets in the euro area persisted. Outside the euro area, the major banking systems had generally continued on a slow path to recovery in recent quarters, while the Australian banking system remained in a relatively strong position.
Members noted developments in several broad indicators for banks, including share prices, profits and indicators of asset quality, which reflected these general themes. Bank share price indices in countries such as Canada and Australia had performed more strongly in recent years than those in the United States and United Kingdom, which in turn had outperformed those in the euro area by a clear margin. While asset quality measures had generally improved outside the euro area, the underlying profitability of the major banking systems in countries such as the United States remained subdued, and it was only in a few advanced economies (including Canada and Australia) where large banks continued to earn returns on equity close to pre-crisis levels.
In general, the Australian banking system remained well placed to service the needs of the Australian economy. Members noted that pressures in wholesale funding markets had eased since late last year and the large banks had further reduced their use of offshore wholesale funding as growth in deposits continued to outpace growth in credit. While the Australian banks remained exposed to swings in global financial market sentiment associated with the problems in Europe, the changes in their funding, liquidity and capital positions over recent years suggested their resilience to these swings had improved.
Members were briefed on trends in Australian banks' asset performance. The ratio of non-performing loans had continued to decline, though the improvement was only gradual, reflecting the difficult conditions being experienced in some parts of the business sector. Banks' bad and doubtful debt charges had declined more substantially since the peak of the crisis period but now appeared to have troughed, and this had contributed – along with higher funding costs and lower credit growth – to a slower rate of profit growth in recent reporting periods. This had prompted a renewed focus on cost containment but, at this stage, it had not spurred an undue increase in risk-taking by banks.
Members noted that the household and business sectors in Australia had continued to display a relatively prudent approach towards their finances in recent quarters. Many households continued to prefer saving and paying down existing debts more quickly than required, which had contributed to household credit growth being more in line with income growth in recent years. While there remained some isolated pockets of weakness, aggregate measures of financial stress were relatively low.
For the Australian business sector, a period of deleveraging had been followed by a pick-up in business borrowing, although businesses' overall recourse to external funding remained below historical averages. While the uneven conditions in the business sector had contributed to the weaker performance of banks' loan portfolios in recent years, business balance sheets were in good shape overall and profitability remained solid.
Considerations for Monetary Policy
Information that became available over the past month pointed to slightly softer conditions in many parts of the global economy. Ongoing weakness in the advanced economies appeared to be weighing on exports from Asia, although a number of indicators of activity for the US economy were a little more positive over the past month. A month earlier, members had noted that there were some tentative signs that Chinese growth might be stabilising at a more sustainable pace. However, the most recent data had been a touch weaker, and this had been accompanied by a sharp decline in spot prices for iron ore and coking coal. If sustained, this decline would imply a larger fall in the terms of trade than the staff had earlier forecast, though the terms of trade would still remain high by historical standards.
The staff forecasts had been for resource investment to peak some time in 2013/14, at around 9 per cent of GDP. Recent announcements curtailing projects were likely to have only a small effect on the expected profile for mining investment in the near term. However, members observed that concerns about current high costs and a softening in commodity prices may have implications for resource projects still under consideration.
The Australian dollar had depreciated slightly over the past month, but remained close to its post-float high. Members discussed the possibility that the high level of the exchange rate was weighing more heavily on the economy than might be expected. Overall, despite the ongoing structural change, the unemployment rate had remained relatively low to date.
The main news on inflation over the past month had been that wage growth had picked up a little in the June quarter. The pace of growth varied somewhat across industries and regions, and was higher for those more closely connected to the resource investment boom. The Bank's forecasts for inflation had been based on domestic costs remaining contained, through some moderation in wages, ongoing downward pressure on margins and a sustained improvement in productivity growth.
Since the last change to monetary policy in June, the Board had concluded that the stance of monetary policy resulting in interest rates being a bit below average was appropriate, given low inflation and the weaker outlook for growth globally. Developments since the previous Board meeting suggested that the global economy remained subject to significant downside risks. Of particular note this month was the recent sharp decline in some bulk commodity prices. At the same time, though, the domestic economy appeared to be growing at around trend pace and there were signs that the effects of earlier reductions in the cash rate were still working their way through the domestic economy.
The current assessment of the inflation outlook continued to provide scope to adjust policy in response to any significant deterioration in the outlook for growth. At this meeting, the Board judged that, with inflation expected to be consistent with the target and growth close to trend, but with a more subdued international outlook than was the case a few months ago, the stance of monetary policy remained appropriate.
The Board decided to leave the cash rate unchanged at 3.50 per cent.