Statement on Monetary Policy
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After a strong year in 2004 the world economy retains momentum, with growth continuing to be led by the United States and China. Recent data for the US have confirmed that the economy is expanding at a good pace and is generating solid gains in employment. China’s economy has become an increasingly important driver of world growth, with last year’s growth outcome of nearly 10 per cent exceeding most expectations. In other parts of the world, including Japan and the euro area, the economic recovery is continuing, though at a slower pace than in the first half of 2004. Despite some slowing, growth remains quite strong in most of the smaller east Asian economies. The tsunami disaster is unlikely to have a major impact on aggregate GDP in the Asian region but will reduce growth in the short term in Indonesia and Thailand, as well as in some smaller economies on the Indian Ocean rim. Overall, most observers expect growth of the world economy, though not as strong as last year, to continue in 2005 at an above-average pace for the third successive year.
The strong global economy has contributed to upward pressure on commodity prices in the past couple of years. One important aspect of this was the sharp rise in oil prices, which peaked in October last year. While the rise in oil prices was seen as primarily a consequence of strong global demand, supply disruptions also played a role, and much attention last year was focused on the possible impact that higher prices might have on global economic performance. With oil prices in recent months having fluctuated in a range somewhat below their October peak, risks to the global economy from that source appear to have lessened.
Prices of a range of other mineral commodities have generally remained firm or increased further over recent months. For Australia, this is providing a significant stimulus to national income and spending, with the prospect of more to come. World prices of Australia’s base metals exports are now around 40 per cent higher than they were two years ago. For iron ore and coal, substantial increases in contract prices are set to take effect later this year, building on the already sharp increases of last year. In addition to boosting incomes and spending in Australia, the effects of rising commodity prices are also being seen in producer prices more generally.
In international financial markets the main development recently has been the continued decline in the US dollar. In the final three months of last year the US dollar declined by 8 per cent against the euro and 7 per cent against the yen, to be around its lowest level in the past decade. Since the beginning of 2005, the US dollar has recovered somewhat against the euro, but has remained around its recent lows against the yen and other Asian currencies. Movements in the US dollar have continued to be the major influence on the Australian dollar over the past few months. The domestic currency has generally traded in a range of US76 to US79 cents, and is around the middle of that range at present. The Australian dollar’s movement against other floating currencies has been modest.
Given the strength of the US economy, the Federal Reserve has further tightened monetary policy and financial markets expect this to continue. Even so, US government bond yields have remained remarkably stable at around 4¼ per cent. In Australia, market yields, particularly at the short end, have risen since early December, reflecting stronger employment and prices data.
Most economic data in Australia have continued to suggest strong conditions recently. Particularly noteworthy in recent months has been the performance of the labour market, with employment posting a series of big increases and the unemployment rate declining to its lowest level since the 1970s. In addition, most business surveys reported conditions that were at high levels throughout 2004, while consumer confidence has been close to record levels. The high level of confidence was also reflected in the Australian share market, which outperformed the markets of all other major countries during 2004. Overall, while the national accounts had reported a surprisingly weak outcome for growth in the September quarter, the range of other available information suggests that the economy was in a strong condition through last year and is likely to have maintained a good pace of growth entering 2005. With a favourable international environment, high levels of confidence domestically, and further rises in the terms of trade adding to national income, the prospects are that demand conditions will continue to encourage growth in the period ahead.
Given these conditions, a key issue for the Australian economy will be the extent to which the ongoing growth of demand might give rise to capacity constraints and, consequently, upward pressure on wage and price inflation. With the expansion now in its fourteenth year, there is clearly much less spare capacity available than was the case in its early stages. The general performance of the economy in 2004, when production was unable to keep up with the strength of global and domestic demand, is suggestive that capacity constraints may be becoming more important.
The clearest indication of emerging pressures on capacity has been in the disappointing performance of exports to date, which has been associated with a widening of Australia’s current account deficit. While there has been a modest recovery in export volumes from the trough reached in mid 2003, this has so far only lifted exports back to around their level at the start of the decade. One factor likely to have contributed to this disappointing performance is the strong growth of domestic demand over recent years, which may have adversely affected manufactured and service exports. Additionally, there are a number of areas in the mining sector where supply bottlenecks have held back export growth recently, though there are indications that capacity expansions in that area are now in train.
Inflation outcomes during 2004 were higher than had been expected at the start of the year. The CPI increased by 0.8 per cent in the December quarter and by 2.6 per cent over the year. This was boosted by rising petrol prices, so that underlying measures were somewhat lower, generally around 2¼ per cent over the year. For the past couple of years, underlying inflation has been held down by the lagged effects of the exchange rate appreciation that took place during 2002 and 2003, but the maximum impact from that source has now passed. Hence it is likely that underlying inflation has now reached its low point and that it will start rising during 2005. Domestically-sourced inflation has been running faster over the past couple of years and there has been a significant pick-up in domestic producer prices recently, associated with rising materials costs and strong demand pressures in some sectors. At this stage, the overall rise in inflation over the next two years is forecast to be gradual, with inflation in both headline and underlying terms expected to be around 3 per cent by the end of 2006. However, given the firm demand conditions in prospect, the possibility that wage and price pressures will build more quickly cannot be ruled out.
The adjustment in the Australian housing market during 2004 should assist prospects for sustainable economic growth, with the decline in house prices and new lending during much of the year alleviating the overheating which had previously been apparent in that part of the economy. More recently, there have been some signs of prices and finance levelling out, or possibly rising. Data on house prices for the December quarter were a little firmer than earlier in the year, and the demand for housing finance picked up towards the end of the year. It is too early, however, to tell whether these latest developments represent a significant change in trend.
The cooling in the housing market during 2004 was associated with an easing in credit growth to the household sector from the exceptionally high rates seen in the previous year. Nevertheless, the growth of credit to both the household and business sectors remains high, with aggregate credit growth still running at an annual rate of 12 per cent over the six months to December 2004. The overall strength in demand for credit, combined with the fact that interest rates remain slightly lower than the average of recent years, continues to suggest that the current policy setting is not inhibiting the growth of the economy.
In its recent policy deliberations the key focus of the Board has been on whether continuing strength of demand conditions would give rise to significant inflation pressures. At its December meeting, as in earlier months, the Board judged that a further tightening of monetary policy would probably be required in due course, but that there was no need for action in the short term. Information becoming available over the subsequent two months for the February meeting tended to confirm the strength of both domestic and international demand, and gave early signs of a pick-up in inflation, as had been expected.
At this stage, the Board’s judgement is still that this pick-up in inflation will be quite gradual, with inflation reaching 2½ per cent this year and 3 per cent next year. Nonetheless, continued pressure on raw materials prices, evidence of capacity constraints in some sectors and reports of higher employment costs – notwithstanding the steadiness to date of aggregate series for wages – constitute a risk that this forecast could prove to be too low. On balance, the Board decided at its February meeting to leave interest rates unchanged, while noting that the likelihood of further monetary tightening being required in the months ahead had increased. The Board will continue to monitor developments over coming months and will respond as necessary to ensure that rising inflation does not jeopardise the sustainable expansion of the Australian economy.
The material in this Statement on Monetary Policy was finalised on 3 February 2005.
ISSN 1448–5133 (Print)
ISSN 1448–5141 (Online)