Statement on Monetary Policy
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The global economy entered a period of slower growth towards the end of last year, which has continued into 2003. While this has been generally expected to be temporary in nature, concerns about the loss of momentum were for a time amplified by uncertainties related to the situation in Iraq. In particular there seemed a significant risk in the early months of the year that there would be a prolonged conflict and, consequently, a sustained period of high oil prices which might further hamper world growth. The relatively quick resolution of the conflict during April, and the associated decline in oil prices, has thus removed a significant risk factor for the global economy.
With these uncertainties now largely resolved, attention is again focused on the underlying prospects for growth in the major economies. At this stage, while modest growth appears to be continuing, there are few signs that the pace is picking up yet. The US economy, after quite a promising performance in the early phase of its recovery, slowed towards the end of last year and has broadly maintained this slower pace into 2003. The household sector has generally remained quite resilient through the recovery to date, and the economy is receiving considerable stimulus from monetary and fiscal policies. The main factor continuing to constrain growth is the condition of the business sector, where spending in the past couple of years has been dampened by low profitability and an overhang of capacity. While these imbalances are gradually being wound back, it is uncertain how long this process will take before generating the conditions for a sustained pick-up in business investment.
The performance of other parts of the world economy has remained disappointing in the recent period, though the non-Japan Asian region has been an important exception to this. In the euro area there has been only very modest growth over the past year. The Japanese economy had a better performance during much of 2002, largely as a result of strong export growth, but this does not appear to have been sustained. In contrast the non-Japan Asian region has generally performed strongly and, in particular, the two largest economies in the region, China and Korea, have continued to record a good pace of growth underpinned by domestic demand. Other economies in the region have also performed relatively well, though the outbreak of severe acute respiratory syndrome (SARS) has had an effect in some economies, notably Hong Kong, Singapore and China.
Developments in international financial markets have broadly reflected the evolving prospects for the global economy. In recent months markets have been heavily influenced by the unfolding events in Iraq, as these prompted shifting assessments of the global economic risks. Sentiment deteriorated in the early months of the year as markets focused on the risks of a prolonged conflict, but there has subsequently been a noticeable improvement in sentiment as these concerns were resolved. As a result the declines in equity prices and in bond yields that occurred in the lead-up to the war have generally been reversed. Looking through these relatively short-lived movements, equity prices and bond yields have been broadly stable since late last year in most of the major markets, but they remain well below their levels of mid 2002.
Australian financial markets have been affected by many of the same factors influencing global markets and, as in other markets, equity prices and bond yields first fell then rose over the past couple of months. However, the overall movement in bond yields and equity prices over the past year has been noticeably smaller in Australia than in the US and in some other major countries. This is likely to have reflected the relative strength of the Australian economy and, consistent with that, smaller adjustments in market expectations about the future path of short-term interest rates. Another important development in recent months has been the appreciation of the Australian dollar. In trade-weighted terms this has brought the currency back to around its post-float average, after a number of years when it had been well below that level.
The Australian economy has continued to perform relatively well against the background of a difficult international environment. While growth declined to a 3 per cent pace during 2002, much of that slowing was attributable to the impact of the drought. Growth of the non-farm economy, which in these circumstances gives a better indication of the underlying trend, remained strong at almost 4 per cent during the year, though this pace is likely to have eased a little during the early part of 2003. The overall pace of non-farm growth has been sufficient to generate a decline in unemployment, bringing the unemployment rate to a level of just over 6 per cent in recent months.
A feature of Australia’s growth performance in the recent period has been the sharply contrasting influences of domestic and external demand. With aggregate exports declining over the period since mid 2001, the external sector has acted as a significant drag on growth. This effect has been offset by an exceptionally rapid expansion in domestic demand. Total domestic demand expanded by 7 per cent during 2002, while private demand grew by almost 8 per cent, which was close to its fastest pace in the past two decades. One consequence of the combination of strong domestic demand and a weak external sector has been a substantial widening of the current account deficit over the past year.
The overall performance of the Australian economy has been underpinned by the strong condition of the business sector, which has largely avoided the imbalances that constrained growth in the US and other major economies in recent years. In particular, profitability of Australian businesses has remained high, and balance sheets are generally in sound shape with businesses in aggregate carrying relatively low levels of debt. In these circumstances businesses proved well placed to expand their investment spending over the past year from what had been a relatively low base. Indications are that the current upswing in business investment has some way yet to run. Business surveys suggest that further expansion in aggregate investment is planned over the next year or so, and there is a large volume of work outstanding in a range of resource and infrastructure projects which will continue to support growth in activity in the period ahead. While indicators of general business sentiment have eased in recent months, possibly reflecting temporary war-related concerns, they have generally remained at levels consistent with good growth of the economy.
Household spending also grew rapidly last year, with both consumption and housing investment contributing strongly to growth. There are signs of consumption slowing in the early part of 2003, though the extent of any slowing should be limited, given that consumer confidence remains high, while household incomes continue to be supported by rising employment and real wages. In the housing sector, forward indicators of building activity have been pointing to a downturn for some time now. This is expected to be fairly gradual, as activity is underpinned by a backlog of unfinished work and strong demand for renovations.
In contrast to the business sector, households have markedly increased their use of debt in recent years. This has been largely housing-related, though it appears also to have contributed to the funding of household consumption spending. Although loan approvals for housing have levelled out in the past few months, they remain at a high level consistent with housing-related credit growth of over 20 per cent, which will not be sustainable in the longer run.
Apart from the weak external conditions, the main factor holding back growth of the Australian economy in the recent period has been the effect of the drought. However, prospects for the rural sector have improved in recent months following widespread rainfall in February. While there have been some significant regional variations in the extent of follow-up rains, conditions are improving in a number of regions and current indications are that there should be a rebound in rural production in 2003/04.
Broader growth prospects for the Australian economy will depend both on the evolution of international conditions and on the extent to which domestic demand slows from its recent very rapid pace. The most likely scenario for the global economy involves a continued modest recovery, and hence a gradual lessening of the impact on Australia’s export sector. At the same time, it would be surprising if the recent very rapid growth in domestic demand were to be maintained for long, and indeed it would not be desirable that demand should continue to outstrip the growth of the economy’s productive capacity by such a large margin for an extended period. Indications are that there has been an easing in the pace of domestic demand so far in 2003 and that this is likely to continue in the near term. Hence the prospects are for a more balanced composition of growth emerging in the period ahead, with less reliance on domestic demand and a smaller drag from the external sector. This will probably entail some overall slowing in the non-farm economy in the near term, although the impact on GDP should be cushioned by the expected rebound in the farm sector.
Australia’s inflation rate as measured by the CPI has gradually drifted upward in the recent period to reach an annual rate of 3.4 per cent in the March quarter. Part of this movement has reflected temporary factors including sharp increases in petrol prices, driven by developments in international oil markets, and in vegetable prices, associated with the drought. Various underlying measures designed to abstract from extreme price movements are giving somewhat lower measures, and the Bank’s assessment is that underlying inflation has moved up to around 2¾ per cent. Hence there has been slightly more inflationary pressure than was envisaged at the time of the February Statement, when underlying inflation had been expected to remain stable at around 2½ per cent.
Looking forward, there are forces acting in both directions on underlying inflation though, on balance, inflation pressures appear likely to ease slightly in the period ahead. While there has been some pick-up in aggregate wage growth over the past year, as well as in other business costs, these pressures have at this stage remained quite modest. Inflation expectations remain relatively stable, and moderating demand pressures combined with the appreciation of the currency should have a dampening effect on costs and prices. Taking these influences into account, underlying inflation is expected to ease back to the middle of the target range over the remainder of this year and to remain at that level into 2004. If oil prices remain around current levels, petrol prices should reverse the bulk of their March quarter increase, which should bring the CPI more closely into line with underlying measures later this year. The risks around this inflation outlook are judged to be evenly balanced at present.
As discussed in detail in the main body of the Statement, financial conditions remain supportive of growth in spending and activity, with the general level of interest rates still close to historical lows. Households and businesses are clearly not constrained by the cost and availability of credit, and indeed credit to the household sector is continuing to grow rapidly.
In assessing the required stance of policy at its recent meetings, the Board has taken into account the shifting prospects for the global economy as well as the various other influences affecting the domestic growth and inflation outlook. Internationally, the Iraq situation appeared for a time to pose a significant downward risk to the global outlook, though this risk has since dissipated. Nonetheless the global environment remains a difficult one, and the expected improvement in export growth could be slow in coming. Domestically, while the recent CPI suggested slightly more inflation pressure than had been expected, inflation still seems likely to ease to around the middle of the target over the coming year. In these circumstances the Board judged that it would be prudent to maintain the current moderately expansionary setting, and hence has left the cash rate unchanged, pending further reassessment of economic developments in Australia and abroad.
The material in this Statement on Monetary Policy was finalised on 7 May 2003.