Statement on Monetary Policy
Download the complete
Only the first chapter of this Statement is available in HTML, and is provided below.
The global economic upswing is continuing in 2005 with growth being led mainly by the United States and China. In the US a broadly based recovery is now in its fourth year, and it has been accompanied by a gradual upward drift in core inflation. The rapid expansion in China has shown little sign of abating and other parts of non-Japan east Asia have generally been experiencing satisfactory growth. In contrast, the performance of the Japanese and euro area economies over the past year has been disappointing. Overall, while the world expansion remains geographically uneven, most official and private-sector forecasts at this stage are that world growth will continue at an above-average pace this year, though not as strongly as in 2004.
The Australian economy has for some time been operating with strong demand conditions and a high level of capacity utilisation. The December quarter national accounts continued the pattern of previous quarters, showing weak growth in GDP alongside above-trend growth in domestic demand. The outcome for GDP growth contrasted with a number of other indicators – in particular the rapid growth in employment and the favourable conditions reported in business surveys – which suggested that the economy had been growing strongly during 2004. As is often the case, it is not possible to find a neat reconciliation of these various sources of information. Nonetheless, it is clear from the national accounts that demand growth remained faster than average during 2004 but that, to a large extent, this was met by rising imports and declining inventories rather than by commensurate growth in output. This pattern is consistent with other indications that the economy has been operating at a level closer to full capacity than for some time, and that supply has been unable to keep pace with the growth of demand. A consequence of the gap between spending and production growth over recent years has been a widening of Australia’s current account deficit, although other factors are also likely to have contributed including an appreciation of the exchange rate.
Indicators of economic conditions so far in 2005 suggest that the combination of firm demand conditions and high capacity utilisation continued in the early months of the year. The labour market remained firm in the March quarter, with employment posting further large increases and the unemployment rate remaining at its lowest level since the 1970s. Figures for retail sales showed a pick-up in the March quarter and other indicators of consumer demand such as motor vehicle sales and imports of consumer goods were up strongly in the quarter. Business surveys in the March quarter indicated softer conditions, though they generally remained well above average. The surveys also continued to report that businesses have been operating at high levels of capacity utilisation. In these circumstances it is not surprising that business investment has contributed strongly to the overall growth in demand during the past year, and indicators of investment intentions suggest that it will continue to do so.
An important influence on the economy at present is the boost to domestic income flowing from rising international commodity prices, particularly for mineral resources. Rising export prices boosted Australia’s terms of trade by around 10 per cent during 2004, and a similar increase is likely to be recorded during 2005 as the recent round of increases in bulk commodity contract prices takes effect. This represents an important source of stimulus for the economy, with the current run-up in the terms of trade being the largest since the early 1970s. The rising terms of trade will boost demand and activity through a number of channels, including by providing ongoing encouragement to investment activity in the resources sector.
Much of the information on the domestic economy at this stage predates the March decision to increase the cash rate. Information on the impact of the cash rate increase is still quite limited, although there are some early signs that it is starting to have a dampening influence on demand. Consumer sentiment according to the Westpac-Melbourne Institute survey declined sharply in March, and showed only a slight pick-up in April. To keep this in perspective, sentiment is still above average, having come down from near-record levels earlier in the year. In the business sector, the monthly NAB survey indicated that conditions declined a bit further in March. In the housing market, the indications are that conditions have remained subdued in recent weeks. Overall, while the available evidence is still tentative, it is possible that the most recent tightening could have a larger short-term impact on spending and sentiment than has typically been the case in the past.
Drawing these various pieces of information together there is some evidence to suggest that domestic demand is now in the process of slowing from the above-average pace seen in 2004. However, given the generally favourable environment for business investment and ongoing stimulus to incomes from the rising terms of trade, any slowing in demand from last year’s pace at this stage seems likely to be relatively mild.
Financial markets have undergone a substantial change in direction during the period since the February Statement, notwithstanding the generally positive global outlook described above. The change in sentiment was evident most clearly in equity markets though to some extent also in money and bond markets. During February and early March, rising confidence about growth prospects for the world economy was reflected in further strength in global equity markets. Thereafter, however, market sentiment began to weaken on concerns that the further step-up in oil prices would hold back world economic growth. These concerns were subsequently reinforced by some US data releases which, while solid, were less than the rather optimistic expectations embodied in market prices. World equity markets, including the Australian market, have since weakened by around 5 per cent. These market fluctuations may, of course, represent an over-reaction to short-term movements in the economic data, but it is possible that they are signalling some genuine easing in the pace of global expansion since the March quarter.
Global bond yields also rose over the February/March period but, like share markets, have since retreated. The Federal Reserve has continued on its well-telegraphed path of gradually normalising interest rates, with tightenings in March and early May. In Australia, the early March tightening, which lifted the cash rate by 25 basis points to 5.5 per cent, had been fully anticipated and its announcement caused little reaction in markets. Expectations of a further rate rise persisted for a time but have since receded, in line with the broader change in market sentiment.
Increases in global commodity prices, combined with strong demand conditions domestically and capacity constraints in some parts of the economy, have contributed to significant upstream price pressures in Australia during the past year. This was particularly evident in the second half of 2004, when producer price indices accelerated at all stages of production. In the March quarter these pressures appeared to ease off somewhat. Nonetheless, over the past year rapid increases in producer prices have been observed in areas that are closest to capacity limits, notably in the construction sector, and in products that are highly sensitive to rising raw materials costs such as steel and plastics.
Consumer price inflation has been relatively steady over recent quarters at an annual rate of around 2½ per cent. In the March quarter, the annual CPI inflation rate was 2.4 per cent, with underlying measures also close to that figure. For some time, underlying CPI inflation has been held down by the lagged effects of the exchange rate appreciation that took place during 2002 and 2003, while domestically sourced inflation has been higher. Given the pick-up in upstream prices over the past year and the waning of the drag from exchange rate effects, underlying inflation remains likely to increase gradually in the period ahead. However, if domestic demand pressures ease appreciably, it is possible that increases in upstream costs will to some extent be absorbed into profit margins rather than flowing into consumer prices. Taking these factors into account, the Bank’s forecast is that underlying inflation will increase gradually from its current level to around 3 per cent by the end of next year. This is broadly the same as the forecast presented in the February Statement, although the upside risks to this forecast identified in February may have receded. In the short term, headline CPI inflation will be pushed higher than underlying measures by the recent increases in petrol prices.
Financial conditions at this stage do not seem to have been inhibiting the growth of credit and spending, although it is too early yet for the available credit data to reflect any impact from the recent policy tightening. The March tightening, in conjunction with earlier adjustments in 2002 and 2003, has brought the cash rate to a level that is broadly in line with its average over the low-inflation period since the early 1990s. Interest rates of financial intermediaries are still a little below average, as a result of margin compression during that period. Over recent months household credit growth has been fairly steady at around 1 per cent per month, or an annual rate of around 13 per cent, which is still strong by historical standards though down from the peak reached in 2003. At the same time, business credit growth has been gradually strengthening.
The Board’s decision to increase the cash rate in March was taken against the background of strong demand pressures combined with a significant pick-up in upstream prices during the second half of 2004. As had been set out in the February Statement, consumer price inflation was forecast to increase gradually to the top of the target band, with the risks to that forecast judged to be weighted to the upside.
The information becoming available since March has provided some limited evidence that demand pressures are now easing, though whether this will be sufficient to contain inflation to an acceptable level still remains to be seen. At its April meeting the Board considered the case for a further tightening but decided to wait for additional information on inflation and for early indications of the impact of the March decision. In the event, March quarter prices data indicated that upstream price pressures had eased somewhat and that consumer price inflation remained relatively contained. Other information taken into account at the time of the May meeting included the shift in sentiment in financial markets. At the same time, it was recognised that the global expansion and rising terms of trade would provide ongoing support to the Australian economy in the period ahead.
The Board’s assessment of this information at its May meeting was that inflation remained likely to increase gradually from its current level of around 2½ per cent, but that upside risks to this forecast had receded, partly as a result of the March tightening. This assessment of course remains subject to review as new information becomes available. Based on previous cyclical experience, it would be surprising if interest rates did not have to increase further at some stage of the current expansion. Nonetheless, given the tentative signs of easing in domestic demand pressures, the Board judged that there was a case to hold the cash rate steady for the time being, to allow further time to assess the strength of inflationary pressures. The Board will continue to monitor developments and make adjustments to the policy setting as required to ensure that Australia’s economic expansion is not jeopardised by rising inflation.
The material in this Statement on Monetary Policy was finalised on 4 May 2005.
ISSN 1448–5133 (Print)
ISSN 1448–5141 (Online)