Statement on Monetary Policy
February 2003
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Introduction
After a promising start in the early part of 2002, the global recovery lost momentum towards the end of the year. Most of the major economies showed little or no growth in the final months of the year, although there have remained areas of relatively strong performance among the smaller and medium-sized economies, notably in parts of east Asia. Australia, too, has continued to perform quite strongly, though prospects will depend importantly on how quickly the momentum in the major economies is regained.
Whether the recent weakness in the major economies signals a sustained setback to the global recovery, or represents a more temporary pause in growth, remains to be seen, and in this respect the US economy will remain an important driver of global trends. Despite posting good growth on average in the first three quarters of 2002, the US still appears to be hampered to some extent by the imbalances that had earlier pushed the economy into recession. In particular, business profits are still weak, and corporate balance sheets remain in relatively poor condition. On the other hand, household spending has been quite resilient, and macroeconomic policies are providing considerable stimulus. In addition to the sharp reductions in official interest rates since early 2001, fiscal policy has made a strong contribution to spending growth over the past two years, with an additional package likely to add further to growth in the year ahead. It may well be that these measures are sufficient to generate a self-sustaining expansion. Certainly they have been well timed, in the sense of providing a powerful stimulus at around the low-point in the economic cycle.
Among the other main economic regions, growth has generally been disappointing. The euro area has grown only very modestly over the past year, and has shown little sign of generating any pick-up in domestic demand, though the recent reductions in official interest rates by the European Central Bank (ECB) will provide some stimulus. The Japanese economy, despite being weighed down by longstanding structural problems, experienced some export-led growth during the first three quarters of 2002, but turned down again in line with the weaker global conditions towards the end of the year. The main exceptions to the generally disappointing international picture have been in east Asia, with China and Korea in particular both continuing to grow strongly.
The weakening in world economic growth in the closing months of 2002, reinforced by the uncertainties over Iraq, was reflected in three main developments in global financial markets: renewed weakness in equity prices, falls in bond yields, and a further decline in the US dollar. It also led to the resumption of monetary easing by a number of central banks, including importantly both the US Federal Reserve and the ECB. For the industrial countries as a whole, official interest rates are at average levels not previously seen in the post-war period.
Some of these recent international developments have had direct effects on Australian financial markets. Domestic long-term interest rates, which tend to be heavily influenced by those in the US, have fallen noticeably, for example. There has also been a tendency for markets to price in some possibility of an easing in domestic monetary policy, perhaps reflecting the tendency towards easing that seems to be apparent globally. In addition, the Australian dollar has risen against the weakening US dollar, though not against other major currencies, so the trade-weighted value of the Australian dollar (the most appropriate measure of the exchange rate) has risen only modestly. On the other hand, the Australian share market, while it has weakened a little, continues to be much more robust than most share markets overseas; the relative strength of the local economy has no doubt been a factor in this.
The Australian economy has continued to expand at a good pace in the recent period, despite the continued drag from the weak world economy and the drought. This outcome reflected continued strong growth in domestic demand, though the pace moderated somewhat in the second half of last year. The ongoing expansion of the economy has been sufficient to generate a further strengthening of the labour market, with the unemployment rate declining significantly during 2002. Another consequence of the strength in domestic demand, against the background of the weak global economy, is that Australia’s current account deficit has widened significantly.
The business sector in Australia appears to be in much better shape than its counterparts abroad. Profitability is relatively high, and most surveys report that businesses are viewing current conditions as quite favourable. Notwithstanding some high-profile corporate failures during the past couple of years, businesses in aggregate are carrying low levels of debt, have strong internal funding, and have generally avoided the mistakes of over-investment that have characterised past business cycles. Against this background, it is not surprising that business investment is contributing strongly to expenditure growth at present or that employment is continuing to expand. Forward indicators of investment intentions and projects underway confirm that there are good prospects for further growth. The main risk to a continuation of these favourable trends would arise if there were a significant deterioration in confidence about future conditions associated with the international outlook. However, there is little indication that this is occurring at present; although there have been some signs of diminished confidence recently based on evidence from business surveys, they have generally been quite modest.
Household spending has also been contributing strongly to growth in the recent period, though the pace slowed to some extent in the second half of last year. The major determinants of consumer spending are supportive of continued growth. Consumer confidence remains above average, while real wage increases and strong employment growth have boosted household incomes in aggregate, though incomes in the rural sector have deteriorated sharply. Household borrowing has also continued at a rapid pace, a process that has been associated with rising housing prices.
The other major driver of the growth of domestic demand has been the upswing in housing construction. In some respects this has followed the pattern of a conventional housing cycle, though an important additional factor over the past couple of years was a much sharper run-up in investor demand than had been observed in earlier cycles. As has been discussed in previous Statements, this process has been closely inter-related with the increases in housing prices seen in recent years, with new investors being drawn to the market by expectations of continued capital gains.
Putting aside these short-run effects on household expenditures, the run-up in housing prices and associated expansion in housing-related debt were a source of concern for most of the past year, given the potential of such a process to remain disconnected from fundamentals and develop into a significant imbalance over time. These risks, however, appear to have eased somewhat in recent months. There is some evidence that investor activity, which had been a major driver of the market over the past two years, has moderated. Conditions of oversupply have led to cancellation of a number of multi-unit construction projects due to a lack of buyer interest, and there are signs that market pressures on housing prices have eased.
The Australian economy in aggregate looks set to continue to grow at a good pace although slower than last year. Indications are that the housing construction cycle will peak some time around the middle of this year, which would entail a slowing in domestic demand from its recent rapid pace. On the other hand, the weak external conditions are probably exerting close to their maximum negative impact on non-rural exports. Hence barring a renewed deterioration in the global outlook, the external sector should provide some offset to the slowing in domestic demand over time, which would represent a desirable rebalancing of growth. At some point, too, it must be expected that rural conditions will improve, though the timing of that event is of course highly uncertain.
Australia’s inflation rate in the second half of 2002 evolved broadly in line with the near-term outlook presented in recent Statements. During the year to December 2002 underlying inflation was around 2½ per cent, having declined from just over 3 per cent at the end of the previous year. The main factor contributing to the decline in underlying inflation appears to have been the fading of the impact of the exchange rate depreciation that took place over the period 1998–2000. In addition to this impact from the traded goods sector, there was some easing in wage costs and upstream price pressures during much of 2002, though this appeared to have run its course by the end of the year. The Bank’s current assessment is that underlying inflation is likely to remain close to its recent level of 2½ per cent over the next 18 months. This represents a slight downward revision to the forecast presented in the previous Statement.
CPI inflation, at 3 per cent over the past year, has been slightly higher than underlying measures, reflecting a number of sector-specific influences including airfares, insurance costs, oil prices, and the impact of the drought on food prices. While the latter two factors will remain in the CPI inflation rate for a while yet, they are expected to reverse over time, so that CPI inflation returns to the underlying rate over the forecast horizon. The risks around this inflation forecast are judged to be evenly balanced.
As discussed in the main body of the Statement, financial conditions at present are moderately expansionary, in that the level of short-term interest rates is below medium-term historical benchmarks, and finance is readily available to businesses and households. Under normal circumstances, conditions of above-average growth in domestic demand such as those prevailing over the past year would have suggested a case for moving to a less expansionary setting, in order to avoid contributing to inflationary risks. However, the case for doing so progressively weakened through the second half of 2002 as risks to the global recovery increased.
At the time of the February Board meeting, it was clear that the international outlook had not improved, with incoming information generally confirming the loss of momentum in the major economies late last year and a general increase in geopolitical uncertainty. There is thus a risk that the recent international weakness will become more protracted and will weigh more significantly on growth in Australia than it has done to date. In these circumstances, the Board judged that the best course was to leave the cash rate unchanged, while continuing to monitor the direction of the global and Australian economies.
The material in this Statement on Monetary Policy was finalised on 6 February 2003.
