Statement on Monetary Policy
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The Australian economy has remained resilient in the face of the slowdown in world growth that occurred during 2001. Real GDP increased at an annual rate of 4 per cent over the first three quarters of 2001, and indications to date suggest growth continued at a good pace in the December quarter. The relatively strong performance of the Australian economy during the current global downturn has reflected, at least in part, an absence of the structural imbalances which have been associated with cyclical downturns in the Australian economy in the past. For example, with the level of business investment quite moderate, there has been no accumulation of widespread over-capacity such as had occurred in some previous cycles. In addition, wage and inflationary pressures have remained contained, which allowed domestic policy settings to be eased last year to support growth in the face of the contractionary effects of the world recession.
Nevertheless, there are clear signs that the world growth slowdown is affecting the Australian economy. After a period where the external sector had made a substantial contribution to output growth, it reduced growth in the second half of 2001, as demand fell in most of Australia’s major export markets. The synchronised nature of the current international slowdown has limited the scope for Australia’s exporters to divert sales to other markets, although the low level of the exchange rate has continued to help exporters. A factor assisting the Australian economy over recent years has been the favourable trend in the terms of trade. Australia’s commodity prices have increased in foreign-currency terms and, even more so, in terms of Australian dollars, since their trough in 1999, providing a significant boost to export incomes over much of that period.
While the world recession has reduced the volume of exports, domestic demand has strengthened. Household spending has continued to grow at a solid pace, despite a subdued labour market, and consumer confidence in recent months has been high. Further increases in household wealth, together with moderate increases in incomes and the boost to spending power from lower petrol prices and interest rates, have underpinned the growth in consumption. As long as the labour market remains relatively weak, however, there is some risk that consumption growth may moderate in the period ahead.
The rebound in the housing sector provided a boost to growth over the second half of 2001, although even abstracting from the contribution of that sector, the economy has been expanding at a solid pace. Forward indicators of housing activity indicate that this boost to growth is likely to fade in the second half of 2002 and activity in the sector may even decline, though the size of any downturn should be significantly smaller than that experienced in the second half of 2000.
There is some prospect that the effect of any slowdown in the housing sector on domestic demand will be counterbalanced by a pick-up in business investment. Activity in the non-residential construction sector is clearly picking up after remaining subdued for the past couple of years, boosted by a number of large infrastructure projects. Surveys of business confidence suggest that it has rebounded from its post-September lows, and indicators of investment intentions are pointing to a pick-up in investment in some sectors, most notably mining. Should the international outlook improve in coming months, a more broad-based pick-up in investment and hiring intentions may become evident.
Over the past few months, there have been a number of indications of a more positive outlook for the world economy. This is particularly the case in the United States, but there are also signs of recovery in a number of east Asian countries. The US national accounts reported marginally positive growth in the December quarter, a stronger result than most had expected. Consumer and business sentiment have improved from their post-September lows and businesses have been able to clear at least some of their excess inventories. There has also been some recovery in sentiment evident in Europe. The information and technology sector, which had been an important contributing factor in the initial stages of the global downturn, is showing signs of stabilisation with ITC equipment spending edging slightly higher in the US and a pick-up in production in some east Asian countries.
Against this background, the downgrades to international growth forecasts that had continued throughout 2001 appear to have ceased, and most observers expect a recovery in the global economy to get under way during the course of 2002, underpinned by the expansionary policy settings now in place. Nevertheless, at this stage it appears that such a recovery is likely to be modest, and would still imply a substantial degree of excess capacity for some time ahead. While the US economy appears to have stabilised, existing imbalances may constrain the strength of its recovery for some time. The most significant risk to a sustained recovery in the world economy may lie with Japan, where there is some possibility that the economy could deteriorate sharply in 2002. Continued weakness in the Japanese economy may limit the recovery in other Asian countries.
The improving world outlook has been reflected in a number of ways in financial markets: expectations of further monetary easing have been scaled back sharply in most countries; longer-term interest rates have risen; credit spreads on corporate debt have narrowed again; and share markets have recovered strongly from their post-September lows. These features have been common to all major countries, with the exception of Japan where markets remain gloomy about the economic outlook. Conditions in emerging markets have also generally improved recently; the default by Argentina on its sovereign debt and its subsequent devaluation did not spill over into adverse consequences for other markets.
The improvement in economic prospects has meant that recent high-profile corporate collapses in the US have had a limited impact on markets. Nonetheless, there is a feeling of wariness in markets about the possibility of more negative surprises, which has led to falls in share prices. There has also been a lot of questioning of the adequacy of accounting and corporate governance arrangements.
In Australia, signs of increased confidence in financial markets have, in many respects, been more pronounced than in other countries because of the continuing relatively good growth of the Australian economy. This relative economic strength has been reflected most clearly in the performance of the domestic share market, which remains close to its peak; markets in other countries are generally down 20–30 per cent from their early 2000 levels. There has been a resumption of portfolio equity flows into Australia from abroad, after a period in 2000 when such investment had largely ceased. Together with increased inflows into Australian dollar bonds (particularly by Japanese retail investors), this has helped to steady the exchange rate over most of the past year, after the sharp fall that occurred during 2000 and early 2001.
Underlying inflation in the December quarter was broadly in line with the outlook presented in the November Statement, which had indicated that inflation would exceed the target for a temporary period before declining to around the middle of the target range. In the quarter, the CPI was boosted by sharp increases in the prices of a number of items, particularly some food products, which are likely to be relatively transient. Working in the other direction, the CPI was reduced by declining petrol prices. Both the CPI and underlying measures show inflation on a gradual upward trend over the past few years, with the underlying measures picking up from a little below 2 per cent in 1999 to around 3¼ per cent currently. This pick-up has reflected a rebuilding of margins in response to the depreciation of the exchange rate and other cost pressures, including the rise in petrol prices that occurred during 2000.
These factors are unlikely to result in an inflation rate which stays above the target for an unacceptable time. The exchange rate has been relatively stable since early 2001 in trade-weighted terms. Hence, while the earlier depreciation has clearly placed upward pressure on prices in the tradables sector, the effect on the rate of inflation can be expected to diminish over time. The growth of wage costs remains moderate, and productivity growth appears to have returned to the strong pace evident over the second half of the 1990s, after a cyclical slowdown in 2000. These trends point to growth of unit labour costs at a rate consistent with attainment of the inflation target in the medium term. Moreover, with inflation expectations firmly anchored, and labour market conditions relatively subdued at present, there is little likelihood that wage pressures will increase in the period ahead.
Of a more immediate nature, the fall in petrol prices over the past year has eased cost pressures on business, although some cost pressures still remain including rising insurance premiums and electricity charges. Indicators of upstream price pressures have also been suggesting slower overall growth in input costs in recent quarters. Given all these factors, the Bank’s assessment is that inflation is currently at or near its peak and that it will decline to around the middle of the target over the year ahead, both in terms of the CPI and in underlying terms. The assessment as to underlying inflation is broadly the same as that presented in the November Statement, although the risks around this outlook now appear more evenly balanced, rather than being weighted to the downside.
The stance of monetary policy was progressively eased over the course of 2001 as the extent of the slowdown in world growth became apparent. This easing continued in December, when the cash rate was reduced to its lowest level in almost 30 years, bringing the cumulative reduction in the cash rate to 200 basis points. As a result of these reductions over the past year, policy settings are now clearly expansionary and supporting growth in the domestic economy.
At its February meeting, in view of the recent changes in the balance of risks for the global economy and for domestic inflation, the Board decided to leave the cash rate unchanged. While the global economy remains weak at present, there have been a number of more promising signs in recent months. In the final months of 2001, the main risks to the world outlook were clearly on the downside, with consequent risks for the Australian economy. In recent months these risks appear to have lessened, as confidence around the world has improved and signs of stabilisation have emerged. Hence, while a significant global recovery in 2002 is not yet assured, it does appear more likely than was the case a few months ago. Downside risks to the global economy include the fragility of the Japanese economy and the possibility that more adverse news could emerge in coming months about the US corporate sector. On the other hand, the stimulatory policy settings now in place in the major countries may engender a stronger recovery than currently envisaged. All of this will have important implications for Australia, since a solid global recovery would clearly make it easier for the Australian economy to maintain its recent strength. As always, the Bank will continue to assess these medium-term developments with a view to promoting sustainable growth consistent with the inflation target.
The material in this Statement on Monetary Policy was finalised on 7 February 2002.