Statement on Monetary Policy
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Developments so far in 2004 suggest that the international economic climate is continuing to improve. In Australia, growth remains solid, and a turning point appears to have been reached in the housing market after the overheated levels of late last year, though it is still unclear how this will evolve. These developments suggest a lessening of the main risks to the Australian economy, and improve the prospects for more balanced growth in the period ahead.
International events in recent months have been dominated by the US economy, where stronger employment data have helped to confirm that the recovery is becoming more firmly established. With business investment and profits growing strongly and business confidence high, the US recovery has now broadened well beyond its initial reliance on consumer spending. Another important development in the US has been a pick-up in the latest inflation figures. While core inflation remains low at this stage, it is looking increasingly likely that the downward trend evident over the past year or two has ended. As discussed below, financial markets viewed these events as bringing forward the likely timing of monetary policy tightening in the US.
Data from other parts of the world, with the exception of the euro area, also point to increased momentum in recent months. China’s economy is growing at an exceptional pace, prompting the Chinese authorities to express concerns about overheating and to take action aimed at restraining the growth of bank lending. The Japanese economy is enjoying its strongest growth for a decade, and other parts of east and south Asia are also experiencing strong economic conditions, helped in part by the growth in China, the US and other export markets. In addition, these countries, which effectively form part of a ’dollar bloc’, are receiving considerable stimulus from low interest rates and from the lower US dollar. Conditions in the euro area remain disappointing, though they are probably consistent with modest growth in GDP (Gross Domestic Product ) in the first quarter of 2004, about the same as in the two previous quarters.
Taken together, these developments confirm that the global economy has picked up significantly over the past year. This situation has put upward pressure on international commodity prices, many of which have increased considerably over this period, particularly in the resources sector, a trend that will benefit Australian exporters.
The main factor influencing financial markets in recent months has been changing assessments of the timing of the first interest rate increase by the US Fed. Earlier in the year, the prospects for a rate increase seemed to diminish after the publication of relatively weak job numbers. Over the past month, expectations of a rate increase have been brought forward again. This started with the release of a strong March employment report, and was reinforced by the subsequent publication of other strong economic data and a relatively large increase in the CPI (Consumer Price Index). Markets now think that there is some chance that the Fed will raise rates at its late June meeting, and have fully priced in a move by the time of its mid-August meeting.
Talk of US monetary tightening over the past month prompted a rise in market interest rates in Australia, particularly for longer-term securities, and a fall in the exchange rate of the Australian dollar. However, markets have taken the view that any flow-through of rises in US interest rates to Australia should be limited, as Australian rates are already close to normal levels. The normalisation of interest rates by the Fed is therefore expected to result in a narrowing of the interest rate differential between the two countries, especially at the short end. The exchange rate has declined recently and is now around 9 per cent below its mid-February peak against the US dollar; in trade-weighted terms it has fallen by a smaller amount, as some of the fall against the US dollar has been a reflection of recent US dollar strength.
Economic data in Australia indicate that the economy has continued to grow solidly in 2004, in line with the outlook described in the February Statement. Household spending has been strong over the past year, though easing a little in the most recent months. Consumer confidence is close to its highest level in a decade and consumer spending is likely to continue to be supported by rising employment and real wages. In the housing construction industry, forward indicators continue to suggest a mild easing in activity later in the year, though its extent will be mitigated by a large stock of work yet to be done and strong demand for renovations. Broader indicators of the growth of the economy have remained firm in 2004. Employment has registered further sizeable gains, continuing a run of generally strong figures since around the middle of last year, while the unemployment rate has fallen further. Business surveys reported above-average conditions in the March quarter, though down a little from the end of last year.
Present indications are that overall growth of the economy is likely to remain strong, with the mix between domestic and external sources of growth shifting to a more sustainable position over time. The growth of domestic demand, though still strong, is likely to ease from the unusually rapid pace seen in the past couple of years. At the same time, with international data indicating a significant expansion in most parts of the global economy, a more favourable environment for export growth is emerging. Consistent with this, export volumes have resumed growth from the trough reached in the June quarter of 2003, though this is partly attributable to the recovery in rural exports from drought-affected levels.
The main source of risk to the export outlook apparent in the recent period has been associated with the appreciation of the exchange rate, and particularly the rapid appreciation that took place during 2003 and into the early weeks of this year. Had it continued, this posed the risk of significantly dampening the effects of the global recovery on Australia’s export performance. But, with the exchange rate having drifted lower recently and the prospect of US interest rates starting to return to normal, this risk now seems less severe than a few months ago. A further risk, which seems to have increased recently, is that persistent dry conditions in a number of parts of the country may set back prospects for further recovery in the farm sector.
Australia’s inflation rate for the present is still being held down by the effects of last year’s exchange rate appreciation. In the March quarter the CPI increased by 0.9 per cent and by 2.0 per cent over the year. While this outcome was slightly higher than expected, the annual inflation rate has declined over the past year from a peak of just over 3 per cent. There continues to be a sharp contrast between externally and domestically sourced inflation pressures. Reflecting the exchange rate appreciation, prices of tradable items declined over the latest year, while domestically sourced inflation pressures remained relatively strong, with prices of non-tradable items continuing to rise at an annual rate of around 4 per cent. The Bank’s assessment remains that the pass-through of these exchange rate effects will dampen inflation a little further over the coming year and that inflation will then start to increase gradually as these effects fade. Inflation is now expected to decline to around 1¾ per cent at the end of this year, rising to around 2½ per cent by the end of 2005.
The other major source of risk to the general economic outlook in Australia is associated with developments in credit growth and in the housing market. The run-up in credit growth and the associated boom in house prices in recent years presented two implications for the economy: they tended to boost growth in the short term, but carried the risk of a damaging correction if they continued too long.
With the heat now coming out of the credit and housing markets, this risk has diminished over recent months. Housing finance approvals peaked at around $15 billion a month in October, and have since declined to around $12 billion recently. This is still a very high level and will need to fall much further to bring the growth of housing credit back to a reasonably sustainable pace. Nonetheless it is encouraging that housing finance has at least begun the process of correcting from the exceptionally high levels reached last year. There are also recent indications that house prices may have reached their peak. After the rapid increases recorded during 2003, available indicators for the March quarter 2004 point to falling prices in most of the major cities, although much of the information is still preliminary at this stage. In addition, auction clearance rates remain well down on a year ago, suggesting that vendors’ price expectations are not being met.
Following the two increases in the cash rate at the end of 2003, the Board considered at its subsequent monthly meetings whether there was a case to increase rates further. One consideration was that, with the cash rate having been increased by a total of 100 basis points since mid 2002, the amount of monetary stimulus to the economy was now significantly reduced. A further consideration was the unfolding adjustment in housing finance and house prices. As has been discussed in previous Statements, the medium-term risk associated with overheating in this part of the economy had been taken into account in the decisions to raise the cash rate late last year. While this factor was not the principal driver of policy, it had been an important reason to avoid unnecessary delay in moving the cash rate back up to a more normal position. The adjustment now underway in housing finance reduces this source of risk to the economy, but it is still too early to predict how it will unfold.
It is advantageous that this adjustment is occurring at a time when the broader macroeconomic situation is favourable. The Australian economy is growing solidly and inflation for the present is relatively low, though likely to rise next year. The international recovery has gained strength, which will be helpful to Australia’s exporters, and the risks to the export sector from the rapidly rising exchange rate have lessened.
Overall then, while the risks to the economy have not gone away entirely, developments over recent months suggest that the chances of achieving well-balanced growth and a more restrained pace of credit expansion have improved. In these circumstances the Board decided at its recent monthly meetings to hold the cash rate unchanged. In its deliberations on monetary policy, the Board will continue to monitor all these developments and make adjustments as required, with a view to achieving sustainable growth in the medium term with low inflation.
The material in this Statement on Monetary Policy was finalised on 5 May 2004.