Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 2 February 2016
Glenn Stevens (Governor and Chair), Philip Lowe (Deputy Governor), John Akehurst, John Edwards, Kathryn Fagg, John Fraser (Secretary to the Treasury), Allan Moss AO, Heather Ridout AO, Catherine Tanna
Guy Debelle (Assistant Governor, Financial Markets), Christopher Kent (Assistant Governor, Economic), Alexandra Heath (Head, Economic Analysis Department)
Anthony Dickman (Secretary)
Domestic Economic Conditions
Members began their discussion of economic developments by focusing on the domestic economy. They noted that conditions in the labour market had improved while GDP looked to have continued growing at a below-average pace over 2015. The unemployment rate declined to 5.8 per cent in December, employment grew at an above-average rate over 2015 and the participation rate was on an upward trend. The national accounts for the September quarter, released the day after the previous meeting, indicated that GDP growth had picked up as expected in the September quarter, partly because net exports had rebounded following weather-related disruptions in the June quarter. More recent data on activity and trade suggested that output growth had eased in the December quarter and remained below-average in year-ended terms.
Members noted that there had been further evidence of activity rebalancing away from the resources sector towards non-resource sectors. Output growth in the services sector, particularly household services, had been strong. The relatively labour-intensive nature of this growth suggested that compositional change may help to reconcile a rise in employment growth to an above-average rate, on the one hand, and output growth remaining below average, on the other. Also, low growth in labour costs was likely to have contributed to an improvement in Australia's international competitiveness and encouraged businesses to employ more labour than otherwise. Members observed that growth in goods-related production appeared to have picked up recently, but remained modest.
Turning to developments in the household sector, members noted that growth in household consumption had increased in the September quarter to be close to its decade average in year-ended terms. Growth was expected to be similar in the December quarter, based on recent retail sales data, indications from the Bank's retail liaison that trading conditions had improved in the Christmas and post-Christmas sales period, and surveys suggesting that perceptions of households' own finances remained above average. Household consumption growth had been supported by low interest rates, lower petrol prices and increasing employment, despite relatively subdued household income growth. These factors were expected to support a further increase in consumption growth over the forecast period.
Members observed that although the saving ratio had been declining, recent revisions to national accounts data suggested that this decline was not as pronounced as previously thought. As a result, the saving ratio had remained close to 10 per cent over the past five years, which was a significant step up from its average over the previous two decades but not particularly high from a longer-run perspective.
Dwelling investment had increased strongly over the year to the September quarter and further growth was anticipated, albeit at a gradually declining rate. This was consistent with building approvals, which were at a high level, although lower than in early 2015. Members noted that some other indicators of dwelling investment, including loan approvals for new construction, had been more positive in recent months. Information from liaison contacts indicated that demand for high-density housing in Sydney, Melbourne and Brisbane had been sufficient to absorb the increase in the supply that had come onto the market, whereas demand had been somewhat weaker in Perth, which had experienced a decline in prices and rents for apartments over the past year. To date, there had not been any substantive signs of financial distress from developers, but there had been an increasing number of projects put on hold, particularly in areas where there were concerns about potential oversupply. Conditions in the established housing market more generally had eased in recent months. Housing prices had declined a little from September 2015 and auction clearance rates had fallen from very high levels to around their long-run averages.
Housing credit growth overall had stabilised at around 7½ per cent, following a period of rising growth since late 2012. Growth in credit to investors in housing had declined, offset by an increase in growth in credit to owner-occupiers. This was consistent with the larger increase in mortgage rates for investors and the strengthening of banks' non-price lending terms in response to earlier supervisory actions.
As expected, mining investment had fallen sharply in the September quarter and further large falls were anticipated. Members noted that the largest subtraction from GDP growth from falling mining investment (net of imports) was expected to occur in 2015/16. Resource export volumes had continued to rise over 2015 as more projects reached completion. Iron ore exports, particularly to China, had remained at a high level and were expected to continue to make a positive contribution to GDP growth over the forecast period. The ramp-up in LNG exports was expected to gain pace over the course of 2016, although some projects had experienced delays in bringing production on line. The scope for additional growth in coal exports appeared limited, given the low level of coal prices. Meanwhile, net service exports had risen further in response to the earlier depreciation of the exchange rate and were expected to continue supporting GDP growth over the forecast period.
The forecast for Australia's terms of trade had been revised down a little as a result of lower commodity prices over recent months. Members recognised that the outlook for commodity prices and the domestic terms of trade would depend on the outlook for the Chinese construction and industrial sectors – and global industrial activity more generally – and on the responsiveness of the supply of commodities to the decline in prices seen to date. Oil prices had fallen markedly over recent months in response to further increases in supply, though weaker demand was likely to have had some effect as well. Current low oil prices were having a marked effect on capital investment across the industry, particularly in countries with high production costs. Members noted that further increases in supply were expected over time from countries such as Iran, but that lower prices were likely to put more pressure on higher-cost producers.
Non-mining investment had been little changed over the previous year. Indicators of future non-residential building activity, including the stock of work yet-to-be-done and private non-residential building approvals, had declined to relatively low levels. In contrast, survey measures of non-mining business conditions and capacity utilisation had remained above their long-run average levels and growth in business credit had picked up over 2015. Non-mining business investment was forecast to pick up in the second half of the forecast period, reflecting the increase in domestic demand and competitiveness from the depreciation of the exchange rate to date.
Members noted that underlying inflation had increased to around ½ per cent in the December quarter, to be about 2 per cent in year-ended terms, which was much as had been expected. The consumer price index (CPI) had increased by 0.4 per cent (in seasonally adjusted terms) in the December quarter, following the low outcome in the previous quarter, to be 1.7 per cent higher over 2015. This relatively low annual rate partly reflected lower fuel prices as well as the decline in some utilities prices in the September quarter.
Non-tradables inflation (excluding utilities) edged down in the December quarter to be below its inflation-targeting average in year-ended terms. Inflation in new dwelling costs had eased over the past couple of quarters, from its very strong pace in early 2015. The general decline in domestic inflationary pressures was consistent with heightened competitive pressures, declines in the cost of business inputs, such as fuel and some regulated utilities, and low wage growth owing to spare capacity in the labour market.
The prices of tradable items (excluding volatile items and tobacco) increased in the December quarter to be slightly higher over the year. Members noted that, although the depreciation of the exchange rate had been passed through to the prices of imports ‘across the docks’, the prices of consumer durables in the CPI had risen by less than expected from historical experience. One explanation was that upward pressure from the depreciation of the exchange rate had been offset over recent quarters by heightened competitive pressures, including from new entrants in some parts of the retail sector. Nevertheless, gradual pass-through of the exchange rate depreciation was expected to place further upward pressure on the prices of tradable items over the next few years.
Members noted that the forecast for GDP growth was little changed compared with the usual range of uncertainty. The forecast for the unemployment rate had been lowered, consistent with the recent unanticipated strength in the labour market, yet the level of the unemployment rate and the prevalence of low wage growth suggested that there was still spare capacity in the labour market. Members noted that the strength of employment over the past year in conjunction with below-average GDP growth created some uncertainty about the outlook for the labour market. Underlying inflation was forecast to remain low over the forecast period, underpinned by the expectation that domestic inflationary pressures would remain subdued, although the effects of the exchange rate depreciation on consumer prices would exert some upward pressure on inflation.
International Economic Conditions
Members noted that growth in Australia's major trading partners had been a bit below its decade average over 2015 and was expected to remain around this pace over the forecast period. The US, Japanese and euro area economies had continued to expand over 2015, while growth in the rest of Asia, most notably China, had slowed. Growth in global industrial production and trade volumes had generally been weak, although services-sector activity had been more resilient. Lower oil prices and accommodative monetary policies in most economies were expected to continue supporting global growth. Globally, inflation had remained low and well below most central banks' targets.
As had been the case for some time, growth in China was expected to ease further over the forecast period. To date, the moderation of growth had largely been the result of lower investment growth as a consequence of excess capacity in heavy industry and the large stock of unsold housing, while activity in the services sector had been relatively resilient. However, a range of longer-term structural factors, such as declining growth in productivity and in the urban working-age population, were also playing a role. Although deflationary pressures persisted in the industrial sector, housing prices had increased slightly over the past year, largely owing to increases in the larger cities. Members noted that the potential interaction between slowing growth, low inflation and high – and increasing – levels of debt was an important source of uncertainty around the outlook for the Chinese economy. Members agreed that the authorities still had scope to respond if the economy turned out to be much weaker than expected. However, any sharp slowing in economic activity in China could spill over to other economies in the region and adversely affect commodity prices, including those that are important for Australia.
Industrial activity and exports in Japan and the rest of the east Asian region had been subdued, in part reflecting the region's exposure to the Chinese economy. As a result, GDP growth was expected to be below its decade average in the rest of east Asia in 2015. Members noted that Japanese and euro area GDP had only recently returned to 2008 levels. In contrast, the US economy had been growing at an above-trend pace for some time, which had contributed to the significant decline in the US unemployment rate. Private consumption had been the key driver of expenditure growth in the United States, supported by improvements in the labour market and lower oil prices. Overall business conditions and activity had been generally positive, although the industries most exposed to oil prices and the appreciation of the exchange rate had experienced subdued conditions. Members observed that unemployment rates had also declined in Japan and the euro area. While nominal wage growth remained low in most economies, according to some measures it had risen in both the United States and Japan. In the three large advanced economies, inflation remained low.
The first tightening of US monetary policy in nearly 10 years and a further easing of monetary policy in the euro area and Japan had taken place since the previous meeting. Members noted that, although the tightening of US monetary policy was widely expected and absorbed by markets, including in emerging economies, the divergence in monetary policy between the United States, on the one hand, and the euro area and Japan, on the other, had continued to influence exchange rates.
In December, the Federal Open Market Committee had projected around 100 basis points of tightening during 2016, but at that time market pricing embodied only 50 basis points and since then expectations had been scaled back further, with markets currently not pricing in any further increase until the end of 2016.
The European Central Bank (ECB) announced a package of measures in December to ease policy further, including lowering the interest rate on its deposit facility to ‒30 basis points, citing concerns about the downside risks to the inflation outlook. The package of measures was, however, less stimulatory than markets had expected, which led to a sharp appreciation of the euro. The ECB had subsequently indicated that there was a possibility of further stimulus being announced at its next meeting in March, and markets had priced in another cut in the deposit rate at that time. The Bank of Japan (BoJ) surprised markets in late January with a reduction in the rate of interest on marginal reserves to −10 basis points, the first time this rate had been negative. The introduction of a new tiered system of interest rates was designed to minimise the effect of negative interest rates on the banking system. The current pace of balance sheet expansion by the BoJ was expected to continue over 2016, with total assets projected to equal around 90 per cent of GDP by the end of the year. Japanese government bond yields fell sharply after the monetary policy announcement by the BoJ, reaching a new low of 5 basis points.
Members noted that there was little volatility in financial markets immediately following the much-anticipated increase in the federal funds rate. Sentiment deteriorated early in the new year as concerns about China intensified and there were renewed declines in oil prices. These developments contributed to sharp declines in equity and corporate bond prices, declines in sovereign bond yields and depreciations of the currencies of a range of commodity exporters. Spreads on non-investment grade corporate bonds issued by energy and other resource-related companies increased sharply following the falls in oil and other commodity prices.
One aspect of market concern was uncertainty about the Chinese authorities' intentions for the future value of the renminbi, which had depreciated against the US dollar but had remained relatively stable in trade-weighted terms over the past year. Large capital outflows from China and the associated significant decline in Chinese foreign exchange reserves in the past few months, as well as asset sales by the sovereign wealth funds of oil-producing nations, appeared to have contributed to market volatility. Members noted the challenges for the Chinese authorities in managing the exchange rate in the face of depreciation pressure from private capital outflows.
Global share prices fell by almost 10 per cent over January, with a strong correlation with the fall in oil prices. Chinese equity markets fell particularly sharply amid uncertainty about the economic outlook and the possible policy reactions of the authorities. Australian equity prices also fell, although not to the same extent as overseas markets, with prices of resources sector shares having fully retraced all the gains relative to other sectors of the market over the past decade and a half. There was a small fall in Australian equity prices over 2015.
In foreign exchange markets, sizeable movements in exchange rates had been prompted by the deterioration in risk sentiment and divergence in monetary policy stances in the major economies. There had been a significant depreciation of the yen following the policy announcement by the BoJ. The currencies of most Asian and Latin American emerging market economies had continued to depreciate over the past couple of months. The Australian dollar had depreciated slightly against the US dollar and on a trade-weighted basis over the previous two months.
Funding costs for Australian banks had increased a little from their low levels recently, reflecting higher short-term wholesale funding costs both in offshore and domestic markets. The cost of new long-term wholesale funding had also increased, but remained below the cost of maturing debt. Members noted that an important issue was the extent to which higher wholesale funding costs led to a rise in deposit rates.
Domestically, members noted that pricing in financial markets indicated that there was no expectation of a change in the cash rate at the present meeting.
Considerations for Monetary Policy
In considering the stance of monetary policy, members noted that recent domestic data had, on balance, been positive and judged that there were reasonable prospects for growth to increase gradually over the forecast period while maintaining inflation close to target. Employment growth over 2015 had been stronger than earlier expected and the starting point for the forecast for the unemployment rate was around ½ percentage point lower. Inflation continued to be relatively low, with underlying measures of inflation at about 2 per cent over 2015. Growth in labour costs also remained quite subdued.
There continued to be evidence that very low interest rates were supporting growth in household consumption and dwelling investment and that the depreciation of the exchange rate was boosting demand for domestic production as it adjusted to the evolving economic outlook. Resource exports had continued to make a significant contribution to growth. Although commodity prices and mining investment had fallen further, the drag on GDP growth from this source was expected to lessen a little over 2016/17. Members observed that leading indicators of investment intentions had continued to suggest that there was little prospect for a pick-up in non-mining business investment in the near term, although surveys of business conditions were at above-average levels and the pace of lending to businesses had picked up. Credit growth to households remained at a moderate pace, albeit with a change in composition between investors and owner-occupiers, following supervisory changes to emphasise prudent lending standards.
Data on international economic conditions suggested that growth in Australia's major trading partners was likely to be sustained around its current pace. The recent increase in financial market volatility owed in part to uncertainty about the outlook for global economic growth, particularly China, much of which arose from concerns about the capacity of policymakers to respond effectively to the array of challenges they faced. Members noted that global growth would be supported by accommodative monetary policies and lower oil prices, but that inflation generally continued to be lower than central banks' targets. In addition, funding costs for high-quality borrowers remained very low.
Based on the available data and the forecasts for economic activity and inflation, members judged that it was appropriate to leave the cash rate unchanged at an accommodative setting. Over the period ahead, new information would enable the Board to assess whether the recent improvement in labour market conditions was continuing and whether recent financial market turbulence presaged weaker global and domestic demand. The Board noted that the outlook for continued low inflation may provide scope for easier monetary policy, should that be appropriate to lend further support to demand.
The Board decided to leave the cash rate unchanged at 2.0 per cent.