Statement on Monetary Policy – August 2007
Domestic Economic Conditions
Economic activity has continued to grow strongly in recent quarters. Real GDP was estimated to have increased by 1.6 per cent in the March quarter, following growth of 1.1 per cent in the December quarter, to be 3.8 per cent higher over the year (Graph 33, Table 7). These data reflected broad-based strength in private demand. Growth in the non-farm sector was especially strong, at 4.6 per cent over the year; in contrast, farm output was around 20 per cent lower than a year earlier. The stronger-than-expected result for the March quarter, combined with robust growth in the December quarter, suggests a marked step-up in the pace of economic growth, after a period of softer outcomes over 2004/05 and 2005/06 during which growth ran at an average annual rate of 2.6 per cent. However, just as earlier growth estimates appeared to be understating the strength of output growth, it is likely that the data for the past two quarters somewhat overstate the true strength of growth.
Recent data suggest that economic activity remained firm in the June quarter, although GDP growth is likely to be more moderate than reported in the December and March quarters. Retail trade was broadly flat and sales of motor vehicles increased modestly in the quarter, employment growth has remained solid and survey measures of business conditions have strengthened.
Looking forward, conditions in the non-farm economy are expected to remain strong. Household consumption will be supported by strong growth in household incomes – due to growth in employment and real wages along with the tax cuts announced in the Federal Budget – and rising household wealth. Housing construction may be weaker in the next quarter or so, but is expected to pick up gradually over time as the market responds to the growing shortage of dwellings. Business investment is expected to grow solidly and the high level of investment will continue to provide a sizeable boost to the capital stock. The completion of several new mining projects, combined with robust global demand and an easing in domestic infrastructure bottlenecks, should continue to support strong growth in resource exports. Rural exports are likely to remain weak in the near term, although recent rainfall throughout New South Wales, South Australia and Victoria, and the prospect of more normal rainfall over the second half of the year, should help support a recovery in farm production and exports in 2007/08.
The financial position of the household sector strengthened further during the first half of 2007. Real household disposable income grew by 2.1 per cent in the March quarter, and by 6.4 per cent over the year, mainly reflecting the firm growth in labour income. Households’ net worth has continued to rise as the increase in the value of household assets has exceeded the increase in their debt; house price growth has been firm and despite the recent correction in the share market Australian equity prices were up by around 8 per cent for the year to date at the time the Statement was finalised. As discussed in the March 2007 Financial Stability Review, most households are coping well with their higher debt obligations. While there has been some increase in loan arrears and other indicators of financial distress, they are generally still at low levels.
The healthy financial position of households has been reflected in strong growth in household spending. Household consumption grew by 1.5 per cent in the March quarter, to be 4.2 per cent higher over the year, up from growth of 2.7 per cent over the previous year. Nonetheless, as it has since 2004, consumption grew more slowly than household disposable income, continuing the gradual reduction in the rate of household dissaving (Graph 34). More recent data suggest the pace of consumption growth softened somewhat in the June quarter, with real retail sales broadly flat in the quarter to be 3.6 per cent higher over the year. Motor vehicle sales to households rose modestly, increasing by 0.7 per cent in the quarter after a period of strong growth earlier this year. Liaison contacts continue to report broad-based growth in consumer spending, buoyed by the rises in labour income and wealth. The recent increase in petrol prices is reported to be having little dampening effect on spending, and consumer confidence has increased in recent months.
Dwelling investment has been broadly stable as a share of GDP over the past year, after a period of gradual decline since 2003 (Graph 35). While construction activity picked up in the March quarter, building approvals fell moderately in the first half of the year, which points to some weakness in dwelling investment over the next couple of quarters. However, in recent years dwelling investment has been stronger than would have been suggested by the number of building approvals.
Looking further ahead, the pace of residential construction activity is expected to gradually pick up, as the number of houses and units being built is currently well short of estimates of underlying demand for new housing. Over the year to the March quarter, 147,000 dwellings were completed. There is some uncertainty regarding the precise level of completions needed to meet the demand resulting from population growth, declining average household sizes and demolitions, although based on the recently released 2006 Census this underlying demand for new dwellings appears to be around 175,000. The growing shortfall in the construction of new dwellings is clearly evident in the rental market, where the vacancy rate, at 1.4 per cent, remains close to its lowest level for at least 30 years. The dwindling stock of vacant rental properties is contributing to rapid growth in rents. The 1.6 per cent increase in the CPI measure of rents in the June quarter was the largest since the late 1980s and the annual increase in rents, at 5.2 per cent, was well above the rate of underlying inflation (Graph 36). Data from industry sources point to growth in rents for new tenancies well above the average increase measured by the CPI. This increase in the growth of rents should provide support for dwelling construction activity in the medium term.
Average nationwide housing prices continued to grow at a firm pace in recent months, with stronger growth in house prices than in unit prices. According to ABS data, nationwide house prices grew by 3 per cent in the June quarter to be 9 per cent higher over the year (Table 8). House prices increased in all of the state capitals, with the exception of Perth, where prices fell somewhat. The ABS data are broadly in line with other measures of house prices calculated using different methods (Graph 37). The APM mix-adjusted measure rose by around 7 per cent over the year, while the Residex repeat-sales indicator suggests that prices rose by 8 per cent. The RP Data/Rismark hedonic index, which takes into account the characteristics of each property sold (such as the location, and the number of bedrooms and bathrooms) also indicates that nationwide house prices rose by around 7 per cent over the year.
Auction clearance rates in Sydney and Melbourne have increased further over the first half of 2007 to be above their historical averages (Graph 38). The pick-up in clearance rates reflects the strength of the property market in the more expensive suburbs, in which auctions are most prevalent. Auctions are less common in the other capital cities, but clearance rates in both Brisbane and Adelaide have also increased over the past 18 months in line with the pick-up in these property markets, while in Perth clearance rates have fallen over the past year paralleling the cooling property market.
Business conditions in the non-farm sector have strengthened recently. Private-sector surveys suggest that across different sectors and firm sizes, aggregate conditions picked up in the June quarter, to be well above long-run average levels (Graph 39). Surveys and the Bank’s liaison also indicate that capacity utilisation remains at a high level in most industries, particularly in the mining and construction sectors.
Recent data on private business profits and investment have been affected by the reclassification of Telstra from the public to the private sector in the March quarter following its sale, with offsetting changes in public sector profits and investment. Abstracting from this reclassification, the national accounts indicate that business profits grew by around 11 per cent over the year to the March quarter and, at 32 per cent of GDP, the profit share was at its highest level since the mid 1970s (Graph 40). Profit growth over the year was driven by non-mining corporations. While mining profits remained at a high level, their growth slowed considerably as commodity price growth eased and input costs rose. Farm sector profits weakened considerably over the year due to the drought. Overall, business surveys indicate that firms’ expectations of profitability remain at or above long-run averages, and equity analysts estimate solid earnings growth for listed companies over the full financial year (for details see the ‘ Domestic Financial Markets and Conditions’ chapter).
Given the high level of profitability, supportive financial conditions and the healthy state of business balance sheets, firms have faced few restraints in funding their investment plans. Abstracting from the reclassification of Telstra, new business investment increased by around 3 per cent in the March quarter, to be 4¼ per cent higher over the year. The level of investment remains high as a share of GDP following average annual growth of 15 per cent over the previous four years (Graph 41). Hence, even with slower growth, the high level of investment should continue to support higher than average growth in the capital stock and hence add to the growth of productive capacity (Graph 42).
Looking ahead, the capital expenditure (Capex) survey’s second estimate of firms’ spending plans in 2007/08 indicates further moderate investment growth. Low prime office vacancy rates, especially in Brisbane and Perth, and sharp rises in rents and capital values indicate that there is strong demand for commercial property (Graph 43). Other forward-looking indicators also suggest that non-residential construction activity will remain firm in coming quarters. In addition, the recent rapid growth in public spending on construction could be further bolstered by budgeted increases in capital spending by public corporations. While the labour market has been able to accommodate strong growth in non-residential construction in recent years, reports of labour shortages and the expected recovery in housing construction cast some doubt as to whether all of the planned construction-related spending will be feasible. (‘Box C: Developments in the Construction Sector’ discusses recent trends in activity and employment in the construction sector in more detail.)
The Australian Government Budget for 2007/08, tabled in May, showed a significant upward revision to the estimated underlying surplus in 2006/07 relative to the mid-year estimates (Table 9). As with previous years, the upward revision largely reflected higher-than-expected individual and corporate tax revenues, which more than offset new expenditures. The surplus is expected to be a little lower in 2007/08 reflecting policy announcements. Collectively, the state Budgets, handed down over May and June, are projected to show a slightly larger deficit in 2007/08, due to increased infrastructure spending and slower growth in revenues. State government trading enterprises also plan to increase capital expenditures, particularly in New South Wales and Queensland.
Conditions in the rural sector have improved noticeably in recent months. Most of the major cropping regions of south-eastern Australia have recorded above average rainfall so far this year, although rainfall in parts of Western Australia has been less favourable. Based on information from the Australian Bureau of Agricultural and Resource Economics (ABARE) and other rural organisations, farm output is expected to rise by around 20 per cent in 2007/08, mainly reflecting a recovery in the wheat crop and other cereals (Table 10, Graph 44).
The expected rebound in farm output is somewhat smaller than those following previous droughts, primarily reflecting the cumulative impact of several years of below average rainfall. This has led to water storage levels falling to historical lows, and water allocations for irrigators in the Murray-Darling Basin being reduced significantly. Despite the improvement in rainfall so far this year, inflows to the Murray River system and non-metropolitan water storage levels have increased only modestly, in part because soil moisture levels had been low (Graph 45). However, with almost half the annual inflows to the Murray River system typically occurring between July and October, water allocations in the Murray-Darling Basin for 2007/08, and the size of the farm recovery, will depend heavily on rainfall and run-off in coming months.
Export values and volumes are estimated to have been broadly flat in the June quarter, to be around 3 per cent higher over the year. The effects of the drought continued to weigh on rural export volumes, which fell by 15 per cent over the year. In contrast, notwithstanding a slowing in the June quarter, there has been broad-based growth in non-rural export volumes, which have been growing at an annual pace of around 6 per cent (Graph 46).
Resource export volumes have grown solidly in recent quarters. Iron ore export volumes rebounded in the June quarter, after cyclone-related disruptions in the Pilbara region in the March quarter (Graph 47). In contrast, coal exports fell by around 5 per cent in the June quarter due to severe storms in the Hunter Valley, although this followed a sharp rise in March quarter coal exports as the Poitrel mine in the Bowen Basin came online. More broadly, coal exports continue to be hindered by infrastructure and other problems. The growth in export volumes of LNG and oil has been robust in recent quarters, due to increased production from the Enfield oil project on the North West Shelf and the Darwin LNG plant. The completion of a number of new mining projects over the coming year, coupled with some easing of infrastructure bottlenecks, suggests further strong growth in resource export volumes in the period ahead.
Following a period of protracted weakness over the first half of the decade, manufactured and services export volumes have been expanding since early 2006, led by strong growth in pharmaceuticals and travel services. Surveys suggest that sentiment has improved among manufacturers and the outlook for trading partner growth remains favourable. While the Bank’s liaison with firms suggests the recent appreciation of the currency has not yet affected manufactured and services exports to a great degree, if sustained the higher exchange rate is likely to restrain exports in coming quarters.
Import volumes grew modestly in the June quarter, although this follows very strong growth in the December and March quarters. Over the past year, imports have increased by around 10 per cent due to solid domestic demand.
The current account deficit narrowed to 5.9 per cent of GDP in the March quarter, with the trade deficit declining slightly and the net income deficit (NID) remaining broadly steady at 4.5 per cent of GDP. The widening in the NID over recent years has reflected both higher net equity payments, due to the strong profitability of foreign‑owned enterprises operating in Australia, and higher net interest payments, due to rises in interest rates and the stock of net debt.
The real exchange rate is currently around 25 per cent above its post-float average (Graph 48). Other things equal, this would be expected to be contractionary for the economy, slowing exports as well as activity in import-competing sectors. However, the high exchange rate has coincided with a high level of the terms of trade, which in the June quarter were around 45 per cent above their post-float average. For the economy as a whole, the negative effects of the high level of the exchange rate are likely to be more than offset by the boost to national income (and hence demand) from the stronger terms of trade.
Employment has continued to grow strongly, increasing by 21/2 per cent over the year to July. Growth has been concentrated in full-time employment in 2007, and has been broad-based across industries. In July the participation rate was at its highest level in many decades, at 65 per cent, and the unemployment rate remained at a generational low of 4.3 per cent. Over the coming quarters, the new welfare-to-work policies may result in modest increases in both the labour force participation and unemployment rates as existing welfare recipients enter the workforce.
Increases in employment can be drawn from the pool of unemployed persons, from an increase in the participation rate or from growth in the working age population. Given the significant decline in the pool of unemployed earlier in the current expansion, over recent years the rise in the participation rate has contributed more to employment growth than has the fall in the unemployment rate (Graph 49). The pace of growth in the working age population has also gradually increased in recent years, with migration playing an important role (see Statement on Monetary Policy, May 2007, ‘Box B: Developments in Labour Supply’). Data from the Labour Force Survey suggest that employment of recent immigrants accounted for around one-third of aggregate employment growth over the year to the June quarter, the highest contribution since the late 1980s.
Labour market conditions continue to be robust across all the states (Table 11). In the three months to July, Western Australia and Queensland continued to have the highest participation rates and the lowest unemployment rates. However, the unemployment rates in all states were close to their lowest levels in the current expansion.
The strength of the labour market is also evident in the high level of job vacancies. Nationally, the ABS measure of job vacancies reported an increase of 3.9 per cent in the three months to May and 9.0 per cent over the year, resulting in a vacancy rate of 1.5 per cent, the highest since the mid 1970s.Consistent with this, firms report in liaison that labour shortages have tightened over the past year and that these shortages are constraining output.