Statement on Monetary Policy
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The period since mid 2003 has been marked by a significant pick-up in the global economy. The improvement has been led by the United States but also occurred in varying degrees in the other major economic regions. Associated with these developments the Australian economy has also strengthened during this period. These trends were evident at the time of the November Statement and have received further confirmation from the economic data in subsequent months.
The US economy has clearly gained strong momentum since around the middle of last year. Consumer spending continues to be an important driver of recovery, boosted by tax cuts, low interest rates and improving consumer confidence. At the same time, the recovery has become more broadly based over the recent period, with business investment now expanding, business confidence high and profits rebounding strongly. While conditions in the labour market have lagged behind other parts of the economy, there have been some more encouraging signs in that area recently as well. The US recovery is thus looking increasingly firmly established, and it continues to be supported by highly expansionary policy settings.
The east Asian economies have also experienced stronger conditions since mid 2003. The region is clearly benefiting from the recovery in the US but in addition is generating solid growth in domestic demand, with the Chinese economy taking on an increasingly important role in driving growth across the region. In Japan the modest cyclical upswing over the past year appeared to gather pace towards the end of the year. Among the major economic regions of most importance to Australia, only the euro-area economy continues to under-perform, although a mild recovery now seems to be occurring there as well.
The global pick-up in demand and activity has generated strong upward pressure on a range of commodity prices over recent months, notably for oil, gold, base metals and a number of rural commodities. As discussed below, this is contributing to upward pressure on the Australian dollar. Reflecting its very rapid rate of expansion and low exchange rate, the Chinese economy now appears to be entering a period of rising inflation, albeit from a low starting point. Among the major economies, however, inflation remains subdued for the present.
Global financial markets entered 2004 in a bullish mood, with market sentiment underpinned by signs that the world economic recovery is gathering pace. Major equity markets have risen further, and appetite for risk has increased, with spreads on corporate and emerging market bonds falling to levels not seen for several years. Despite the pick-up in global growth, markets are not anticipating changes in official interest rates by the three major central banks in the months immediately ahead; however, some wording changes in the Fed’s late January announcement caused markets to believe that a tightening by the Fed may not be as far in the future as earlier thought. In Australia, the announcement in early December of the second increase in the cash rate target came as little surprise to financial markets, which had already priced in such a move.
Events in global foreign exchange markets have been dominated by the depreciation of the US dollar against all the major currencies that freely float against it. At the same time, Asian central banks have continued to intervene heavily in foreign exchange markets to prevent their currencies from appreciating against the US dollar. In this environment the Australian dollar has appreciated strongly against the US dollar and against currencies of the non-Japan Asian region over the past year, though it has been relatively stable against other major floating currencies. This has meant a significant appreciation of the Australian dollar in trade-weighted terms.
The more general forces that have influenced the exchange rate over the past year or so have been the relative strength of the Australian economy, the associated yield differential in favour of Australian dollar assets, and the continued improvement in Australia’s terms of trade, which are now at their highest level in more than 25 years. On a trade-weighted basis, the exchange rate has appreciated by around 20 per cent over the past year. A significant part of that movement is a return to normal from an exceptionally low starting point. Nevertheless, the appreciation has continued to an extent that has in recent months brought the exchange rate noticeably above its long-run average. Hence the appreciation of the exchange rate is reducing the stimulus to the Australian economy from the other external forces currently at work.
In line with the improvement in global conditions, the Australian economy has picked up significantly since around the middle of last year. The national accounts recorded a strong pace of growth in the September quarter, and more recent information indicates that this strength has subsequently been maintained. Consumer spending expanded at a pace well above average in the second half of 2003, and consumer confidence has remained high, rising further in January to its highest level since 1994. Most business surveys have continued to report above-average conditions, with the NAB survey of non-farm businesses reporting that conditions in the December quarter were at their strongest in a decade. Demand for labour has increased, with employment rising solidly over recent months and the unemployment rate continuing to trend down.
Overall, the growth of the economy has been driven by well-above-average growth in domestic spending, while the main factors that were holding back growth, particularly in the period up to around mid 2003, were the drought and the unfavourable international environment. These negative factors, however, are now being reversed. With improved rainfall in most areas, farm production is adding significantly to growth. Reflecting the strengthening international environment, Australia’s export earnings have begun to increase gradually after their decline in the first half of 2003. In light of these trends and the more promising global outlook, the prospects are that the Australian economy will continue to grow at a strong pace during 2004. Exports are likely to continue their gradual recovery as a result of stronger trading-partner growth, even though progress in this area will be dampened to some extent by the higher exchange rate now prevailing, and also by capacity constraints in the resources sector. Domestic demand growth is likely to moderate a little but remain quite strong.
Australia’s recent inflation performance has been marked by contrasting influences from domestic conditions and the exchange rate. In the December quarter the CPI increased by 0.5 per cent, and by 2.4 per cent over the year, down from an annual rate of around 3 per cent a year earlier. Inflation in the non-traded sector of the economy remains relatively high, at over 4 per cent, reflecting the overall strength of the domestic economy, strong demand conditions in the housing sector and continuing cost pressures in some service industries. At the same time, the overall inflation rate is being held down by the gradual pass-through of the exchange rate appreciation, with prices of tradable items in the CPI declining slightly in recent quarters.
The experience of recent years has been that these exchange rate effects have tended to be smaller than initially expected, but even so, it is likely that the dampening effect from the exchange rate still has some way to run. As a result, inflation is likely to decline further over the coming year, and could fall as low as 1½ per cent, before returning to around 2½ per cent in 2005 and then continuing on a gradually rising trajectory. The monetary policy strategy needs to take this longer-term trajectory into account, since a continually rising exchange rate cannot be relied upon to hold inflation permanently below a rate consistent with its domestic determinants.
In its deliberations in the final months of 2003 the Board took into account the fact that policy had for some time been relatively expansionary. Interest rates were clearly below relevant averages and strong demand for credit confirmed that borrowers found these interest rates highly attractive. As economic conditions continued to strengthen, both in Australia and internationally, it became increasingly apparent that such an expansionary policy setting was no longer needed, and that it would add to medium-term inflation risks if maintained for too long a period.
An additional consideration in this environment was the risk to the economy posed by the build-up of household debt and the associated increases in house prices. While this was not the principal driver of policy, it did argue for avoiding undue delay when a case for moving to a less expansionary setting emerged on broader macroeconomic grounds. Given all these considerations, as explained in the November Statement, the Board decided at its November meeting to raise the cash rate by 25 basis points. At the time of its December meeting, the available information confirmed the assessment that a less expansionary policy setting was needed, and the cash rate was therefore raised by a further 25 basis points, to 5.25 per cent.
In the period since the December meeting, the Board has continued to assess how developments in all these areas have influenced the balance of risks facing the Australian economy. The macroeconomic data becoming available since the December meeting have confirmed the assessments made at that time – namely, that the Australian economy is growing strongly, and that the global pick-up underway since mid 2003 has become more firmly established. In this environment the overall prospects are still for continued strong growth of the Australian economy in the year ahead.
Information from credit and asset markets during this period has provided some tentative indications that the pressures in these markets may be starting to ease. This has been evident both in a decline in housing loan approvals, and in a slowing of the growth in house prices and declining auction clearances. Even so, it is too early to be confident that this represents a definitive change in trend. A further development taken into account was the additional appreciation of the Australian dollar since December, including a period when it was rising particularly quickly in early January. The higher exchange rate will hold down inflation in the short term, though this effect will eventually wear off. At its February meeting the Board weighed up all of this information and its implications for the balance of risks for the economy and the medium-term inflation outlook. Although the bulk of the evidence was still suggesting that the stance of policy remained mildly accommodative, the Board decided to hold the cash rate unchanged at its February meeting while continuing to monitor how these various factors evolve over the period ahead.
The material in this Statement on Monetary Policy was finalised on 5 February 2004.