Statement on Monetary Policy – May 2006
The Australian economy is continuing to benefit from favourable international conditions. The global expansion is proceeding at a strong pace and is broadly based across the world’s main economic regions. Growth in the United States economy is now showing further strength after a temporary dip late last year. In Japan the indications are that the recovery is gathering momentum, and there are encouraging signs that the economy has emerged from the debt-deflation spiral of the past decade or more. In China and other parts of Asia the already rapid pace of growth appears to have picked up further recently. Overall, the world economy is likely to expand at a faster-than-average pace in 2006 for the fourth successive year, and most observers expect this to continue in 2007.
The strong global expansion in recent years has been accompanied by sustained upward pressure on a range of international commodity prices. An important aspect of this has been the rise in world oil prices. Concerns about possible supply disruptions have at times contributed to these oil price fluctuations, but for the most part the upward trend has been a consequence of strong global demand. As a result, expectations of world growth have generally remained strong throughout the period when oil prices have been rising.
More generally, the strength of the world economy over recent years has underpinned substantial increases in a wide range of other commodity prices in the resources sector. As a major resources exporter, Australia is one of the countries that most benefits from these developments. Over the past three years, Australia’s terms of trade have increased by more than 30 per cent, and this has had a significant expansionary effect on domestic incomes and spending. Recent indications are that the upward pressure on world commodity prices has continued. Prices of the base metals included in Australia’s commodity price index have increased by an average of more than 50 per cent over the past year, building on the already large increases that had occurred over previous years. At the same time, indications from the current contract negotiations for Australia’s coal and iron ore exports are that prices of these bulk commodities in aggregate will remain close to record highs.
Against the background of the strong global economic expansion, interest rates in the major economies have been increasing. Most of the major central banks are now in the process of normalising their official interest rates from the unusually low levels that they reached earlier in the decade. In addition, long-term market rates have been rising recently in response to the continuing strong economic news. In Australia, market interest rates have also been increasing, in response to a combination of strong global economic trends and firmer domestic data. Market interest rates moved upwards across the yield curve in Australia during the recent period such that, by the time of the May Board meeting, the market was fully pricing in a rise in the cash rate in the coming months, with a 50 per cent probability that it would occur at the May meeting itself. Also noteworthy has been the buoyancy of the Australian share market. Australian share prices have increased by 11 per cent since the start of the year, outperforming the main share markets overseas.
The Australian economy has been operating for some time with rather limited spare capacity. During the course of a sustained expansion, now in its fifteenth year, Australia’s unemployment rate has been substantially reduced, and unused productive capacity re-employed. The unemployment rate has been broadly steady over the past year at an average of just over 5 per cent, its lowest since the 1970s. Business surveys and liaison reports continue to indicate that labour market conditions are tight and that the economy as a whole is operating at a high level of capacity utilisation. Businesses have been reporting that lack of suitable labour was a bigger constraint on their activities than more traditional concerns about the adequacy of demand or sales.
Growth of the Australian economy over the past couple of years has been influenced by a combination of factors including strong commodity prices, which are contributing to a favourable climate for business investment, and a process of balance-sheet adjustment taking place within the household sector, which has been constraining consumption. As a result, the economy has undergone a marked shift in the composition of growth, with the overall growth in demand now being mainly driven by business investment rather than household spending. Since the middle of 2002, business investment has increased at an average annual rate of 14 per cent. Investment in the resources sector has been the fastest growing component, but the growth has been broadly based across industries. Although some easing from these unusually high growth rates can be expected, prospects for expansion in business investment remain favourable. Strong profitability and rising share prices are indicative of good business conditions, confidence in most sectors is high, and the recent further increases in a range of commodity prices will provide continued stimulus to the resources sector.
The boom in business investment has been accompanied by a slowing in household spending, which helped to contain the overall growth in domestic demand. Consumption growth peaked around the end of 2003 and has since slowed to a little below trend, mainly reflecting a period of balance-sheet adjustment in which households have shown a reduced appetite for additional debt. Nevertheless there are some signs that consumer spending may be starting to pick up. Notwithstanding higher petrol prices, retail sales have been stronger over the past three months and consumer sentiment has been above average. Employment has picked up recently, which should support household incomes.
Australia’s export performance over recent years has been disappointing, considering the favourable international conditions. While export earnings have increased substantially, this has to date been mainly a result of higher prices rather than growth in volumes. Nevertheless, there are some early signs that volume growth in resource exports is beginning to pick up, flowing from the substantial investment undertaken in that sector in recent years.
The net effect of these factors is that domestic demand has continued to grow at a solid pace over the past couple of years, though down from the unsustainably high rates seen earlier in the decade. GDP growth has been below trend recently but appears likely to pick up, given the continued growth in domestic spending, the stimulus from Australia’s rising terms of trade, and the likelihood of a recovery in export volumes. Overall, the Bank’s assessment is that demand and output growth over the next year or two are likely to converge to a pace broadly in line with the growth of the economy’s productive capacity. This outlook implies that the economy will continue operating at a relatively high level of capacity utilisation, although strong business investment will undoubtedly contribute to capacity expansion over time.
Recent trends in credit growth indicate that households and businesses have continued to find it attractive to borrow at prevailing interest rates. After touching a low point in the September quarter, the growth of household credit has picked up over the two most recent quarters. Business credit growth has continued to trend upwards. A factor that is likely to have contributed to the overall strength of credit growth has been the continuing compression of lending margins by financial intermediaries over recent years, reflecting competition among lenders. As a consequence, although the cash rate has been close to its historical average, interest rates paid by borrowers have remained below average.
The combination of strong global conditions, tight capacity and solid demand growth in the domestic economy has added to inflationary pressures. Wages growth, though not accelerating further recently, is higher than it was a year ago. Producer price indices continued to rise quickly in the March quarter, reflecting the general strength in international commodity prices. Consumer price inflation has to date been well contained but in the March quarter was higher than expected, with the CPI rising by 0.9 per cent in the quarter and by 3.0 per cent over the year. The latest quarterly figure was boosted by seasonal factors (health and education costs) while petrol price increases contributed significantly to the annual figure. Abstracting from the influence of extreme movements in individual prices, underlying CPI inflation is estimated to have risen to around 2¾ per cent, a rate it had not been expected to reach until the second half of the year.
The Bank’s assessment of the outlook as presented in the February Statement was that underlying inflation would increase only modestly and would most likely level out at a rate of 2¾ per cent. This forecast reflected the upward pressure on inflation stemming from the pick-up in labour and materials costs, while recognising that global disinflationary forces would help to contain prices in the tradables sector. In reviewing the outlook to incorporate the March quarter inflation data and other domestic and international news, the Bank’s assessment was that, other things equal, the medium-term inflation risks were increasing. However, taking into account the expected dampening effect of the May policy tightening, the forecast for underlying inflation is broadly unchanged at 2¾ per cent. In the short term, headline CPI inflation can be expected to be noticeably higher than that figure, as recent increases in fuel prices are recorded in the index in the next quarter.
In summary, the economic situation reviewed by the Board has for some time been one in which international conditions have been favourable to growth in Australia, the economy has been operating with limited spare capacity, and underlying inflation has been forecast to increase gradually. In these circumstances, the Board had taken the view that the next move in interest rates was more likely to be up than down, and this was signalled in the Bank’s policy statements.
The Board’s judgment at its May meeting was that the flow of recent information strengthened the case for an increase in the cash rate. International data continued to suggest strong prospects for the global economy, with forecasts having recently been revised upwards. Domestic indicators were consistent with a solid outlook for demand and activity, while credit growth was strengthening and local equity markets had been buoyant. While underlying inflation had generally been quite stable over the previous couple of years, there were a number of signs that the prevailing conditions were starting to add to inflationary pressures.
Taking account of this information, the Board’s assessment was that inflationary risks had increased sufficiently to warrant an increase in the cash rate. The Board will continue to monitor developments and make such adjustments as required to promote sustainable growth of the economy with low inflation.