Statement on Monetary Policy
November 2004
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Introduction
The Australian economy has continued to perform well during 2004, maintaining a solid pace of expansion and low inflation. Business and consumer confidence are at high levels, and there has been some scaling back in the year to date of the excesses in the housing market that had threatened to disrupt the economy last year. The economy has benefited from a generally favourable international environment and rising commodity prices. The sharp rise in oil prices over recent months has emerged as a possible dampening factor for global growth, but the effects at this stage are difficult to predict.
For the international economy, the current year has been a period of further recovery, though growth has eased from its rapid pace earlier in the year. The recovery in the United States, now entering its fourth year, appears well entrenched. Business investment and consumer spending are continuing to expand strongly and business confidence remains relatively high. Employment is increasing at a steady pace, though not as rapidly as earlier in the year. Other parts of the global economy continue to experience generally strong conditions. In Japan, business surveys report that conditions improved further in the September quarter to be at around their best in a decade. The Chinese economy is expanding rapidly and has become an important driver of overall global growth. Despite a modest slowing since the start of the year, the Chinese authorities remain concerned that the economy is in an overheated condition, and this prompted a rise in official interest rates in October to supplement the earlier tightening in credit controls. Growth in the smaller east Asian economies has been strong over the past year, though the pace appears to have eased recently, while the euro area is continuing its gradual recovery.
An important feature of the current economic upswing is that it has been associated with broadly based increases in commodity prices. At the global level, attention has focused particularly on the rise in oil prices and the possible impact this might have on global economic performance. The rise in oil prices has been, to a significant degree, a consequence of global economic strength rather than of disruptions to supply, though supply factors have clearly also played a part. It is to be expected that the rise in oil prices will dampen growth of the global economy and boost consumer prices relative to what would otherwise have been the case, but the size of these effects will depend importantly on the extent to which the recent increases are sustained.
While the rise in oil prices this year has attracted the greatest attention, there have also been strong price increases for a wide range of other mineral commodities. The RBA base metals index, for example, has increased by almost 30 per cent in foreign currency terms over the past year, and there have been substantial increases in coal and iron ore prices. For a commodity exporter such as Australia this represents a significant boost to the terms of trade and is thus providing a stimulus to incomes and spending. As discussed below, rising commodity prices have also begun to put some upward pressure on prices more broadly.
Financial markets have generally taken the view that the negative impact of rising oil prices on global economic activity will more than outweigh any inflationary impact. Thus rising oil prices over recent months have resulted in falling bond yields and reduced expectations of monetary tightening. Yields on 10-year bonds in the US have fallen back to around 4 per cent, a decline of about 70 basis points since mid year, and similar movements have occurred in bond markets in other countries. This is an unusual development against the background of early-cycle rises in official interest rates. Rising oil prices have also contributed to a lacklustre performance by the US share market, which has shown little net change since the start of 2004 despite strong economic growth in the US. Reflecting the overall negative sentiment in US financial markets, the US dollar has resumed the depreciating trend that began in early 2002.
In Australia, while the yield curve has flattened in line with developments in international markets, other financial prices have suggested a more buoyant sentiment. In particular, the Australian share market remains very strong, significantly outperforming those in other countries this year, and the Australian dollar has risen substantially over recent months. A common theme affecting both the share market and the exchange rate has been the strength in global commodity markets. Other economies with heavy exposures to commodities – Canada, New Zealand and South Africa – are also doing well and their currencies have also risen more than most against the US dollar.
The most recent economic data in Australia indicate that the economy is continuing to perform strongly. Business surveys have generally reported above-average conditions in the September quarter, in some cases suggesting that conditions were close to their best in a decade. Similarly, consumer confidence has been at near-record levels for the past four months. Retail sales figures, although unexpectedly soft in July and August, picked up in September, and it is likely that household spending is continuing to be boosted by the tax cuts and increased benefit payments announced in the May Budget.
Conditions in the labour market are also firm. Employment increased strongly in September, following some softer figures in the previous three months, with the unemployment rate remaining around 5½ per cent. Looking through the recent monthly volatility, labour market conditions continue to reflect a strongly growing economy, with employment having grown by 2.5 per cent over the past year. The bulk of this increase has been accounted for by full-time jobs. Prospects for further employment growth appear to be good, with business surveys suggesting that hiring intentions are at high levels.
The overall growth of the economy has remained highly dependent on domestic demand, with the expected recovery in exports slow to develop. While rural and services exports have picked up over the past year, capacity constraints have continued to hamper exports from the resources sector. However, strong growth in investment in that sector over the past couple of years should see significant additional productive capacity starting to come on stream over the year ahead. At the same time, as noted above, the economy is benefiting from sharp increases in commodity export prices, and this has contributed to the growth in domestic incomes and spending.
Inflation in Australia remains relatively low, though signs of upward pressure are now beginning to emerge in some areas. CPI inflation was 2.3 per cent over the year to the September quarter, down marginally from the previous quarter, with most underlying measures running slightly below the headline figure. In addition, despite reports of shortages of labour, aggregate wages growth remains under control at this stage. Over the past couple of years, the trend in underlying inflation has been one of gradual decline, reflecting the lagged impact of the exchange rate appreciation that took place during 2002 and 2003. However, this trend appears now to have largely run its course, and underlying inflation is likely to start rising next year as the impact of the earlier appreciation fades. Inflation in the non-tradables sector of the economy remains relatively high, though it has eased recently as a result of a slowing in housing construction costs. Producer price figures for the September quarter were higher than expected, with rising global commodity prices contributing significantly to upstream price increases.
Currently it is expected that underlying inflation will rise gradually to around 2½ per cent by the end of 2005 and slightly higher by mid 2006. Headline CPI inflation will remain higher than underlying measures in the coming year, reflecting the effect of higher petrol prices. While this outlook is similar to that presented in the August Statement, it is apparent that the trough in inflation will not be as low as had been expected at the beginning of the year, when both headline and underlying measures had been forecast to decline to a trough of 1½ per cent by the end of this year. In part this upward revision has reflected the lower exchange rate prevailing over much of the period since then.
Developments in credit and housing markets point to a continuation of the adjustment apparent since the early part of the year. Available data for house prices in the September quarter have again indicated flat or declining prices in most cities and at the national aggregate level. The adjustment to date has been an orderly one, so that the risk of an uncomfortably sharp decline in house prices does not appear to be large, though equally there does not appear much risk of a renewed upsurge at present. In addition to this adjustment occurring in the housing market, there has been a welcome slowing in household credit in recent months, following the earlier declines in loan approvals.
In summary, then, the information becoming available over recent months has continued to indicate a favourable combination of circumstances for the Australian economy. In particular, while business conditions have remained strong, inflation declined further in the September quarter and wage increases at an aggregate level have been well contained. Although financial conditions remain moderately accommodative, the excesses in house price inflation and household borrowing that were apparent last year have been reduced, with a consequent easing of the risk of disruption to the economy from those sources. In these circumstances the Board did not see a case for monetary policy to be tightened when it reviewed the policy setting at its three most recent monthly meetings. In light of the economic data becoming available during this period, the Board’s decisions to hold the cash rate unchanged were well anticipated and provoked no reaction in financial markets.
Looking ahead, the international economic environment is likely to remain supportive of growth in Australia, with the global recovery well established and strong commodity prices providing a firm underpinning to the Australian economy. Although inflation in Australia is relatively low at present, it is expected to begin rising gradually next year, and the recent strength in upstream price pressures is consistent with this outlook. Accordingly, while there is no pressing need for higher interest rates at this stage, it continues to appear likely that the economy will require higher interest rates at some stage of the current expansion. The Board will continue to monitor developments and to make such adjustments to policy as may be required to promote sustainable growth of the economy with low inflation.
The material in this Statement on Monetary Policy was finalised on 4 November 2004.
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