Statement on Monetary Policy – February 2007
Domestic Economic Conditions
Most of the data released since the last Statement suggest the non-farm economy has expanded at a moderate pace, although the effect of the drought on the farm sector has weighed on growth of the economy as a whole. Employment grew by 0.8 per cent over the three months to January and by 3.0 per cent over the year. Business surveys suggest that trading conditions remained buoyant in the December quarter, and that capacity utilisation remained around the highest levels on record. The latest national accounts, which are for the September quarter of 2006, indicate that non-farm GDP increased by 0.6 per cent in the quarter and by 2.6 per cent over the year, supported by the run-up in resource-related investment and growth in export activity in response to the large increase in commodity prices in recent years (Table 6). In contrast, conditions in the farm sector were weak due to the drought; farm GDP was estimated to have fallen by 10 per cent in the quarter. The continuing pattern of subdued growth in GDP and strong growth in employment has implied that measured productivity growth has remained weak. In general, the divergence between GDP data and a number of other indicators discussed in the November Statement has continued.
While farm GDP could fall by around 20 per cent in 2006/07, directly subtracting around one-half of a percentage point from GDP growth, conditions in the rest of the economy are expected to remain solid. Moderate growth in household consumption should continue, and housing construction activity is expected to gradually strengthen, supported by firm underlying housing demand. Business investment is projected to remain high as a share of GDP, but it is likely to grow at a significantly slower pace than that seen in recent years. In addition, with continuing strong world growth and the completion of several large resource sector investment projects in 2006 and 2007, exports should increase over the coming period, although in the near term higher resource exports will be offset by a decline in the volume of rural exports.
Growth in household spending picked up modestly during 2006, but remained below the pace of a few years ago. Household consumption increased by 2.8 per cent over the year to the September quarter, and more timely data indicate that real retail sales increased strongly in the December quarter, to be around 4 per cent higher over the year (Graph 31). Liaison with retailers indicates that spending growth has been broad-based across classes of expenditure, with signs of recovery in some areas of discretionary spending. Retailers generally attribute the strengthening in sales to strong employment outcomes and the fall in petrol prices. Motor vehicle sales also picked up moderately in the second half of 2006 after a period of weakness. Measures of consumer sentiment are above long-run average levels, although lower than the peaks recorded several years ago.
The recent pick-up in household spending may indicate some slowing in the process of household financial consolidation. For an extended period from the mid 1990s to 2003 – roughly coinciding with the housing boom – growth in spending ran ahead of growth in household income. In contrast, for most of the period since early 2004, growth in consumption has been below that of household income and hence the net household saving ratio has increased, although it is still slightly negative. This has also coincided with a period when growth in household debt has been running below the high levels seen in the late stages of the housing boom. Nonetheless, the debt-to-income ratio has continued to increase, along with the household interest payments ratio, which rose to 11.3 per cent in the September quarter reflecting in part the recent increases in interest rates (Graph 32). Still, as spelled out in the September 2006 Financial Stability Review, household balance sheets appear healthy, with household net worth rising steadily in recent years due to growth in the value of both housing and financial assets.
The various indicators of housing construction show a strengthening in activity occurred through the first three quarters of 2006 (Graph 33). Dwelling commencements in the September quarter were 7 per cent higher than in late 2005, while dwelling investment was 2 per cent higher over the same period. The pick-up reflected increased building of houses and growth in alterations & additions; construction of apartments continued to fall. There is only limited information available for the December quarter, but data for building approvals and sales of new homes suggest some slowing in activity, following the increases in interest rates during 2006.
Average nationwide house prices rose through 2006 – the APM mix-adjusted measure suggests growth of around 1 per cent in the December quarter and 6 per cent over the year – although there were significant differences across states. Prices were broadly flat in Sydney over 2006 and rose modestly in most other capitals. The exceptions were Perth and Darwin which saw very strong price growth, although recent data suggest that the pace of growth in Perth – where prices rose by around 80 per cent over the past three years compared with growth of only about 3 per cent in the rest of the country – may have slowed significantly late in the year (Table 7, Graph 34). Nationwide apartment prices were flat over the year to the December quarter, with soft conditions in the larger markets of Sydney and Melbourne offset by growth in the other capitals, particularly Perth.
Looking over a longer horizon, average capital city house prices have grown by around 175 per cent since the mid 1990s; prices outside the capital cities have risen by a broadly similar magnitude. This has taken the ratio of house prices to household incomes to a level which is well above its historical average. This increase has been sharply at odds with developments in rents; the ABS measure for average nationwide rents increased by around 35 per cent over the same period and data from the state Real Estate Institutes suggest overall rents increased by around 60 per cent. The result has been an approximate doubling in price-rent ratios or a halving in rental yields (see also ‘Box B: Recent Developments in Housing Prices’, Statement on Monetary Policy, August 2005). With rents unusually low compared with the cost of buying a house, it might be expected that households’ demand to live in rental properties would be strong. At the same time, it would not be surprising if investors’ willingness to supply additional rental property might be subdued in the face of the combination of low rental yields and limited prospect of capital appreciation given the current high level of prices.
The result has been that conditions in residential rental markets have tightened, with the national vacancy rate now around its lowest level since the early 1980s (Graph 35). According to the state Real Estate Institutes, vacancy rates in all capitals are well below their long-run average levels (Table 8). The low vacancy rates are contributing to growth in rents and should boost dwelling construction over the medium term. Over the year to the December quarter, the CPI measure of nationwide rents increased by 3.7 per cent, its fastest pace of growth since 1991. However, information on new rental contracts suggests significantly larger rent increases, which are yet to pass through into the broader ABS measure for the total rental stock.
Business conditions in the non-farm sector are favourable. Private-sector surveys suggest that aggregate conditions remained above long-run average levels in the December quarter, although below the peaks recorded in 2004 (Graph 36). The ACCI-Westpac and AIG surveys suggest that business conditions in the manufacturing sector have picked up over the past quarter or two, to be above average levels, and the most recent Sensis survey indicates that conditions for small & medium-sized firms have improved. The NAB survey reported that capacity utilisation has remained around its highest level on record (Graph 37).
Business profits continued to expand in 2006, although growth eased from the rates seen in 2005 (Graph 38). Profits increased by around 6 per cent over the year to the September quarter and – at 30 per cent of GDP – the profit share was around record levels. The divergence between mining and non-mining profit growth has narrowed recently. Rising material and labour costs, combined with slower growth in commodity prices, are resulting in a slowing in mining profit growth from the exceptional rates recorded in recent years. Business surveys generally indicate that firms’ profit expectations remain close to or above long-run average levels, and equity analysts expect reasonable growth in earnings of non-resource companies in the 2006/07 reporting year (for details see the ‘Domestic Financial Markets and Conditions’ chapter).
Reflecting these favourable conditions, business investment has been strong. Although the pace of growth in investment moderated during 2006, declining to 4 per cent over the year to the September quarter compared with average annual growth of more than 15 per cent over the four years to end 2005, the level of investment is high (Graph 39). Even without further growth, this is boosting the size of the capital stock. The ABS estimates that the business sector’s net capital stock grew by 6 per cent in 2005/06, compared with average annual growth of 4 per cent over the past 25 years. This should help, in time, to alleviate some of the capacity constraints reported in recent years.
Looking ahead, the capital expenditure (Capex) survey’s fourth reading of firms’ spending plans for 2006/07 suggests moderate growth in spending on machinery & equipment. In addition, forward-looking indicators suggest that non-residential construction activity will remain at a high level over coming quarters. The pipeline of engineering work yet to be done increased in the June and September quarters as commencements of new projects ran ahead of construction activity (Graph 40). However, labour and equipment shortages have slowed progress on some projects, and rising construction costs have reportedly prompted some new projects to be delayed.
Conditions in the rural sector remain very weak. The 2006 wheat crop is estimated by the Australian Bureau of Agricultural and Resource Economics (ABARE) at 9.7 million tonnes, less than half the average of the past five years, reflecting the exceptionally dry conditions in mid and late 2006. Forecasts by ABARE suggest that farm GDP will fall by around 20 per cent in 2006/07 (for details on the impact of the drought, see the November 2006 Statement on Monetary Policy ). While January rains in some agricultural regions and recent movements in the Southern Oscillation Index have provided tentative signs of a prospective improvement in climatic conditions, significant follow-up rains will be necessary to improve the overall outlook for 2007/08. Furthermore, while during previous droughts the decline in output has usually been followed by a sharp recovery in production once seasonal conditions return to normal, in the current episode low levels of stored water and soil moisture may slow the pace of the eventual recovery, especially for irrigated crops.
Australian Government Budget
The Mid-Year Economic and Fiscal Outlook (MYEFO) for 2006/07, released in December, showed a small increase in the expected Australian Government cash surplus compared with that projected in the May Budget, to $11.8 billion or 1.1 per cent of GDP (Graph 41). The upward revision largely reflected reduced expenditures; expected taxation revenues are broadly unchanged from the Budget estimates. Estimates of the aggregate budget deficit of the states in 2006/07 have been revised slightly higher in the states’ mid-year reviews, reflecting in large part a forecast increase in capital expenditure in the year (Graph 42). Given the already-high level of investment activity occurring in the economy, it may prove difficult to implement all these plans in the short term.
Export values expanded strongly in 2006, reflecting further growth in prices and a modest lift in volumes (Graph 43). The value of resource exports grew by around 15 per cent over the year, mostly attributable to higher prices. There have been strong increases in volumes of LNG and iron ore exports, and a pick-up in oil exports after a long period of decline (Graph 44). This has reflected new projects coming on line, including the Darwin LNG compression plant and the Enfield oil project on the North West Shelf. For iron ore, there have been expansions in mine capacity in the Pilbara, and a significant increase in port and rail capacity (Graph 45). However, increases in exports of these commodities have been partly offset by falls in some non-ferrous metals and ores, and broadly flat coal exports. Although there has been a moderate increase in transport capacity for coal over the past two years, exports have been hindered by disruptions in production and reliability issues in the transport chain. Looking ahead, growth in the volume of overall resource exports is expected to pick up solidly over the coming year, supported by the completion of a number of additional projects and a further easing in infrastructure bottlenecks, especially in the case of coal.
Rural export volumes are estimated to have increased by around 3 per cent over 2006, reflecting strong demand for Australian beef from Japan and Korea and the large 2005 cereals crop. Looking ahead, the drought is expected to reduce exports of cereals, wool, canola, dairy and cotton, although wheat inventories remaining from the 2005 crop should help to moderate the size of the decline in wheat exports.
The volume of manufactured exports is estimated to have increased by around 4 per cent over 2006. With surveys suggesting that sentiment among manufacturers has picked up and global demand expected to remain strong, growth in manufactured exports should continue into 2007. Service exports volumes also appear to have increased solidly over 2006, including a boost in the December quarter due to the influx of visitors for the Ashes cricket series.
The volume of imports rebounded sharply in the December quarter after falling in the September quarter, to be around 10 per cent higher over the year (Graph 46). Although year-ended growth has eased from the high rates recorded in 2004, the current pace of growth is consistent with continued solid growth in domestic demand. The growth in the December quarter was broad-based, with strength in imports of consumption, capital and intermediate goods.
The growth in import volumes is likely to partly reflect the upward drift in the real exchange rate which, at 17 per cent above its post‑float average, is around its highest level for 20 years (Graph 47). While the elevated level of the real exchange rate is having a dampening effect on some non-resource sectors of the economy, at an economy-wide level it is likely that this is being offset by the boost to national income generated from the high level of the terms of trade, which are around 40 per cent above their post‑float average.
The latest current account data are for the September quarter, when the deficit narrowed to 4.8 per cent of GDP as a sizeable decline in the trade deficit more than offset an increase in the net income deficit (NID). The NID has widened in recent years reflecting larger net payments on equity due to strong profits of Australian firms, particularly in the mining industry, and the rise in interest payments from increases in world interest rates and the stock of foreign debt. While monthly exports and imports data indicate that the trade deficit widened in the December quarter, it remains well below the levels recorded a year or two ago. Assuming the NID stayed close to its September quarter level of 4.3 per cent of GDP, the December quarter current account deficit is estimated to have been around 5¾ per cent of GDP.
The number of employed persons increased by 3 per cent over the year to January, with growth strong in both full- and part-time employment. The increase in employment during the past year was accompanied by a fall in the unemployment rate to a 30-year low of 4.5 per cent (Graph 48). The participation rate is also around the highest level on record, boosted in recent years by the large increase in participation by older workers (for further discussion, see the November 2006 Statement on Monetary Policy).
Employment growth has been broad-based, with the goods and services sectors both making strong contributions to year-ended growth. While mining employment has gained much attention, over the past year employment growth was also high in construction, finance & insurance, and wholesale trade.
Vacancies data suggest that demand for labour remains high, both nationally and across the states. The ABS measure of job vacancies increased by 5.9 per cent in the three months to November and, at 1.5 per cent, the nationwide vacancy rate is at its highest level since the 1970s (Graph 49). Businesses continue to report difficulties recruiting suitable staff, especially in the business services, mining and non-residential construction sectors.
Regional economic developments
A noteworthy feature of the domestic economy in recent years has been divergences in state performance. These divergences have been most pronounced in measures of spending, especially dwelling and business investment. This is unsurprising given the historically large rise in commodity prices, which has attracted both capital and labour to the resource-rich states. However, measures of spending provide an incomplete picture of state activity since they exclude flows associated with interstate and international trade, which are very significant in magnitude. State trade flows are captured by estimates of gross state product. While these data are only available annually and are published with a considerable lag, they suggest that measures that take into account trade flows between the resource-intensive and other states considerably reduce the magnitude of the divergent outcomes observed in final demand over recent years.
Employment growth has been firm across the states, and recently there has been some convergence in outcomes, with annual employment growth in New South Wales increasing and that in Western Australia slowing as employers have found it harder to find suitable labour (Table 9). There has also been a broad-based reduction in unemployment rates in recent years. Similarly, the composite measure of business conditions in the NAB survey – which reflects firms’ responses on trading conditions, profitability and employment – shows that conditions in the non-farm economy remain above average in all the mainland states.