Statement on Monetary Policy – May 2006
International Economic Developments
World economic growth remained strong in early 2006. The US economy has resumed a solid pace of growth following the weak December quarter outcome. The economic recovery in Japan, Australia’s largest export destination, is also gaining strength. Rapid growth continues in China, now Australia’s second most important export destination, while growth in the rest of east Asia remains solid, supported by the upswing in the global ITC sector. Strong growth is continuing in other emerging markets, and conditions remain supportive of recovery in the euro area. Reflecting this favourable situation, the IMF’s latest forecasts, from the April 2006 World Economic Outlook (WEO), are for world growth to maintain its well-above-average pace in 2006 and 2007 (Graph 1, Table 1). Growth in 2006 is forecast to be among the strongest rates in the past 30 years. Weighting countries according to their importance for Australian exports, growth in Australia’s trading partners is also expected to remain strong.
Despite continued solid growth in the world economy and high commodity prices, inflation thus far has generally remained contained. Nevertheless, as the global economy’s spare capacity progressively diminishes, energy prices stay high and inflationary risks mount, central banks around the world have been tightening monetary policy. Persistently high oil prices have also contributed to the widening global current account positions, as oil-producing countries have been saving much of their extra revenue.
Oil prices have risen in 2006, and in early May traded at around US$74 per barrel, which is above the previous peaks seen in September 2005 following the damage from Hurricane Katrina in the Gulf of Mexico (Graph 2). Recent increases have been attributed to concerns about potential disruptions to supply from the Middle East and Nigeria. Iran is the world’s fourth-largest oil producer, so disruptions there could significantly reduce global supply; around one-quarter of the world’s oil trade passes through the Straits of Hormuz between Iran and Oman. Long-term futures prices have also touched record highs and suggest that market participants expect prices to stay high for an extended period.
Resource commodity prices more generally have also risen substantially in recent months, particularly for metals. Although supply disruptions have played a role for some of these commodities from time to time, the longer-term price increases mainly reflect strong global demand, both for portfolio holdings and industrial use (see the chapter on ’Foreign Trade and Capital Flows’ for further details).
Although actual or expected disruptions to oil supply can explain much of the short-term movements in oil prices, as with other resource commodities, the longer-term upward trend in prices is still substantially the result of the strong growth in world demand over recent years. Nevertheless, higher oil prices would be expected to result in some reduction in global growth relative to what might have been possible had the supply of oil been more responsive. IMF estimates suggest that a 10 per cent increase in oil prices would tend to reduce global growth by around 0.10–0.15 percentage points, although the effect would be expected to differ across countries and regions.1 In particular, the recent strength in the price of oil and other commodities is expansionary for a net energy and resource exporter such as Australia.
The US economy entered 2006 with solid momentum, having grown at an above-trend pace over the previous two years. In the March quarter, domestic demand growth rebounded strongly from the temporary weakness of the previous quarter, with real GDP expanding by 1.2 per cent in the quarter, to be 3.5 per cent higher over the year (Graph 3). Net exports subtracted slightly from growth in the March quarter, and in nominal terms the trade deficit remained at 6.2 per cent of GDP. Thus the US current account deficit is likely to have stayed close to its previous record of 7.0 per cent of GDP in the March quarter.
Consumption grew by 1.3 per cent in the March quarter, partly reflecting a recovery in auto sales from their sharp fall in the December quarter. Consumption growth continues to be supported by firming labour market conditions, and consumer sentiment is at above-average levels. However, the fillip from rapidly rising house prices may fade in the period ahead, as growth in house prices is likely to slow. In recent months, the 30-year fixed mortgage rate has drifted higher and demand for housing appears to have passed its peak; home sales are well down from recent highs.
Business investment also picked up in the March quarter, following a surprisingly soft December quarter outcome, to be 9 per cent higher over the year. Core capital goods orders rose in the March quarter. The outlook for investment is favourable: financing conditions are accommodative; corporate profits are at a historically high share of GDP; and business sentiment remains above long-run average levels. Capacity utilisation in the industrial sector is at a 5½-year high.
Reflecting the healthy state of the business sector, the labour market remains buoyant. Non-farm payrolls increased by nearly 600,000 in the first three months of 2006, to be 1.6 per cent higher over the year to March (Graph 4). Along with this strong growth in employment, the unemployment rate fell to a five-year low of 4.7 per cent in March, and average hourly earnings growth has picked up. Weekly initial jobless claims and surveyed employment intentions all point to a continuation of these trends.
Energy price fluctuations have resulted in relatively high and volatile headline producer and consumer price inflation in the past couple of years (Graph 5). In underlying terms, however, inflation has remained moderate, with core CPI inflation around 2 per cent in March. Strong productivity growth has tended to offset the effect of rising wages on unit labour costs. Nonetheless, with the economy operating at a high level of capacity utilisation and ongoing strength in energy and other commodity prices, the Federal Reserve has continued to tighten monetary policy. At its March meeting, the Federal Open Market Committee raised the fed funds rate by a further 25 basis points to 4.75 per cent. The policy statement continued to highlight upside risks to inflation and signalled that some further policy firming may be required.
The Japanese economic recovery has continued to build, with the rise in consumer prices seen in recent months suggesting that the economy is emerging from its extended period of deflation (Graph 6). In this context, following its March meeting, the Bank of Japan (BoJ) announced the end of the quantitative easing policy and returned to using the short-term interest rate as the operating target for monetary policy. (For more details see the ’International and Foreign Exchange Markets’ chapter in this Statement.) The BoJ stated that it will set policy so as to ensure medium to longer-term price stability, consistent with inflation in the approximate range of 0 to 2 per cent, although it said that this should not be interpreted as an inflation target. The change in policy framework is expected to have little immediate effect on economic activity, with the short-term interest rate remaining at zero for the time being.
Real GDP increased by 4.3 per cent over 2005, the highest year-ended rate of growth in almost 15 years (Graph 7). The economy has been expanding for more than three years, with growth now broadly based across domestic and external demand. Conditions are conducive to an enduring expansion, with the corporate sector in good shape and the benefits flowing through to the labour market (for further details see ’Box A: Recovery in Japan’).
Business investment increased by 7.7 per cent over 2005. In the March quarter, industrial production increased, to be around 3 per cent higher over the year; merchandise exports were 18 per cent higher over the year, boosted by the global ITC recovery. Forward-looking indicators of investment are suggestive of continued growth. Machinery orders remained on an upward trend in early 2006, and investment intentions were again revised upwards in the March quarter Tankan survey. Employment indicators, such as surveyed hiring intentions and job vacancies as measured by the offers-to-applicants ratio, are also consistent with a positive outlook. Buoyed by the strong labour market, conditions in the household sector have continued to improve; consumption grew by 3.5 per cent over the year to the December quarter, the fastest pace of growth in almost nine years, and consumer sentiment is high.
China’s rapid economic expansion is providing a substantial impetus to growth in the east Asian region and elsewhere. Real GDP grew by 10.2 per cent over the year to the March quarter. The recently released Five-Year Plan forecasts somewhat slower annual average growth of 7.5 per cent for 2006 to 2010, and introduces measures to promote sustainable growth, such as improved environmental protection and energy-efficiency targets. The People’s Bank of China raised benchmark lending rates in late April.
The revisions to the national accounts following the 2005 census involved a large increase in the services sector’s share of GDP (from 32 per cent to 41 per cent in 2004), but only relatively minor changes to the expenditure component shares of GDP. The estimated investment share of GDP therefore remains very high by international standards, and recent growth in investment is still outpacing that of consumption. Year-ended growth in urban fixed-asset investment picked up to 33 per cent in March, while retail sales grew by 13½ per cent over the same period. Annual growth in exports has picked up in recent months to around 28 per cent, compared with 21 per cent for imports; the monthly merchandise trade surplus was above US$10 billion in early 2006, compared with a monthly average of US$8.4 billion in 2005.
Inflation remains subdued in China, despite strong economic growth, high commodity prices and several years of annual wage growth of around 15 per cent. In fact, inflation has been trending down, reaching 0.8 per cent for consumer prices and 2.5 per cent for producer prices over the year to March. Strong productivity growth, as workers move from the rural sector to the industrial sector, has apparently offset higher input costs.
Growth in the rest of east Asia remains solid, supported by strengthening demand for ITC goods and continued rapid growth in China. Real GDP increased by 1.6 per cent in the December quarter and by 5.8 per cent over the year (Graph 8). The more ITC-exposed economies expanded most rapidly, while growth was slowest in Indonesia and Thailand. Other important drivers of growth were the continued expansion of the biomedical sector in Singapore, and the Hong Kong services sector, which has been benefiting from ties with the rest of China.
This overall strength has continued into 2006, with year-ended growth in industrial production and merchandise exports for the region of 11 per cent and 16 per cent in February. Indicators of demand for ITC products remain favourable, suggesting the sector should continue to support growth. Domestic demand also remains solid across most of the region, driven by positive labour market conditions, recent gains in asset prices and low real interest rates. The recovery in domestic demand continued in the March quarter in Korea, the largest economy in the region and the fourth-most important destination for Australia’s exports. GDP in Korea grew by 1.3 per cent in the quarter, to be 6.1 per cent higher over the year. Business investment has been surprisingly weak for the region as a whole, particularly given increasing capacity utilisation, but this is partly attributable to political uncertainty in some countries. Monetary policy has been tightened towards more neutral settings across the region over the past year in response to demand and inflation pressures. Inflation has trended up a little in most countries in the region, but remained low overall in early 2006.
Domestic demand remains the main driver of the rapid growth in India. GDP grew by 1.5 per cent in the December quarter, to be 7.7 per cent higher over the year, with particular strength in the construction and services industries. Growth in industrial production has also been rapid, at 8.8 per cent over the year to February. Wholesale price inflation has moderated in recent months, to be 4 per cent over the year to March.
Economic growth has slowed in New Zealand. Real GDP expanded by 1.8 per cent over the year to the December quarter but was flat over the second half of 2005 (Graph 9). Consumption and investment growth both eased in late 2005, and preliminary indicators suggest domestic demand has slowed further in 2006. The softening in the economy has been felt in the labour market, with year-ended employment growth slowing to 1.6 per cent over 2005, down from 4.4 per cent a year earlier. Unemployment nonetheless remained at a multi-decade low of 3.6 per cent in the December quarter. Rapid house price growth has boosted consumption in recent years, but this effect is likely to wane. Year-ended median house price growth eased to 7.7 per cent in March, down from highs above 17 per cent during 2005 and the lowest rate in almost three years. Consumer price inflation moderated in the December and March quarters, but it remained above the RBNZ’s 1 to 3 per cent target band, at 3.3 per cent over the year to the March quarter.
Growth in the euro area eased in the December quarter, but conditions remain supportive of recovery. GDP increased by 0.3 per cent in the quarter and by 1.8 per cent over the year (Table 2). A flat outcome in Germany, the region’s largest economy, reflected weak consumption. Growth was also weak in France and Italy, but remained strong in Spain and the Netherlands. Despite the December quarter weakness, euro area growth is expected to pick up in 2006, with the region displaying buoyant business sentiment and improved consumer confidence (Graph 10). In addition, corporate profitability has increased further and investment growth remains relatively strong.
Conditions in the business sector continue to improve, with high levels of confidence supported by an improvement in exports. Given continued strength in external demand, merchandise exports have picked up further, increasing by 13 per cent over the year to February. Industrial production has also picked up, increasing by 3.2 per cent over the year to February; the pick-up has been driven largely by Germany, but has become more broad-based in recent months. Credit growth has also increased significantly in recent years. Survey data continue to suggest a positive outlook in the business sector, with most measures of sentiment increasing further in 2006. The German Ifo business climate index has been particularly strong, suggesting renewed optimism in the German economy.
In contrast, conditions in the household sector remain lacklustre, with year-ended growth in retail sales easing to 1.1 per cent in February. Nonetheless, most observers expect consumption to strengthen eventually, given the gradual improvement in the labour market; at 8.2 per cent in February, the unemployment rate has fallen ¾ percentage point over the past year and a half. As measured by the European Commission, consumer confidence has been just above its long-run average since December.
Headline consumer price inflation stood at 2.4 per cent in April, while underlying inflation remained relatively stable at 1.3 per cent in March. The ECB tightened policy again in March, with a second 25 basis point increase in its benchmark rate, bringing it to 2.5 per cent; the announcement expressed confidence in the region’s recovery in output growth and concern over the upside risks to price stability.
After slowing in 2004, consumption growth in the UK has recovered since mid 2005, supported by above-average consumer sentiment and a pick-up in house prices, which increased by around 6 per cent over the year to March. GDP increased by 0.6 per cent in the March quarter and by 2.2 per cent over the year. Businesses are benefiting from strong profitability and increased external demand. Measures of business sentiment are above long-run averages and growth in the value of exports exceeded 14 per cent over the year to February, although manufacturing production remains weak. Headline consumer price inflation has eased, to be 1.8 per cent in March, and is likely to remain contained in 2006 despite scheduled increases in utilities prices.
- This estimate is broadly in line with the May 2004 estimates from the IEA, IMF and OECD that an increase in oil prices from US$25 to US$35 per barrel (a 40 per cent increase) would reduce global GDP by around 0.5 per cent.