Statement on Monetary Policy – February 2007 Introduction

Australia's economic performance during 2006 continued to be marked by strong growth in incomes and employment. Capacity utilisation remained high and there was a pick-up in underlying inflationary pressures in the first half of the year. These developments took place against the backdrop of above-average global growth and high commodity prices.

Recent indications are that the world economy is continuing to grow strongly. The US economy has remained robust, and concerns that a downturn in the housing sector would significantly dampen activity have not so far been borne out. Information on other parts of the world remains consistent with expectations of strong aggregate growth. The Chinese economy has continued to expand at a double-digit rate, with recent policy measures having had some success in encouraging a shift from investment to consumer spending. In Japan, despite more moderate growth recently, improving conditions in the business sector and the labour market point to good prospects for further expansion. Growth in the rest of east Asia has remained firm, and in the euro area the indications are that a moderate pace of expansion is continuing. Overall, most observers expect world growth in 2007 to be a little below last year's pace, but still above trend.

A number of countries have experienced upward pressure on underlying inflation over the past couple of years. Although at this stage global inflation remains relatively low, the strong pace of growth in demand has been putting increased pressure on productive capacity in many countries. Against this background, central banks around the world continued to wind back the accommodative stance of monetary policy that characterised the early part of this decade. Most have now returned interest rates to levels that are close to normal, though an important exception to this has been Japan, where official rates are still very low.

Despite the increases in interest rates, 2006 was a buoyant year in global financial markets. Debt and equity markets were strong and market volatility generally was low. Share markets recorded their fourth year in a row of strong returns. Government bond yields have remained low, as have credit spreads. Given the run of strong market performances in recent years, it is not surprising that there are signs of increased appetite for risk. This is most visible in the marked increase in merger and acquisition activity, particularly leveraged buyouts, in many economies. Domestic markets have largely reflected these international trends. The share market rose by about 20 per cent last year which, as in other markets, was the fourth strong rise in a row. This was, however, broadly in line with the increase in profits, resulting in little change in the price-earnings ratio. Bond yields rose a little, but have remained low relative both to historical standards and to the current level of short-term rates. The Australian dollar rose by 4 per cent in trade-weighted terms through 2006 but this was partly reversed during January.

The Australian economy has continued to benefit from strong global commodity prices. Australia's terms of trade have increased by more than 30 per cent over the past three years, and they are now estimated to be at their highest level since the early 1950s. This has been an important source of growth in incomes and spending.

Domestic demand has continued to grow at a firm pace over the past year, though it has moderated from the unsustainable rates seen earlier in the decade. Business investment has, until recently, been the fastest growing component of domestic spending, increasing at an average annual rate of 14 per cent over the three years to mid 2006. The increases in investment were led by the resources sector but were nonetheless quite broadly based, with above-average rates of growth being reported in most industries during this period. While it now appears that growth in investment is moderating, the level of investment remains high and hence continues to add strongly to the nation's capital stock. This cumulative lift in the level of investment has been an important part of the economy's response in recent years to the combination of strong domestic demand, high commodity prices and tight capacity.

Consumer spending has generally shown moderate growth over the past couple of years, though there were signs that it strengthened in the December quarter. Spending continues to be underpinned by growth in household disposable incomes, which in turn have been boosted by rising employment and real wages. Of the other components of domestic demand, spending on housing construction has contributed only modestly to growth recently, while public-sector demand has grown at an above-average rate over the past year. Overall growth in domestic demand is likely to be at or a little below trend in the period ahead.

Increases in interest rates over the recent period have encouraged some moderation in households' demand for finance, with the level of mortgage interest rates now a little above its average of the past decade. The value of housing loan approvals has declined since the middle of last year, and household credit growth has eased back to a rate of around 1 per cent a month. Demand for finance in the business sector has also moderated somewhat, though business credit growth remains well above its average of recent years.

As has been the case for some time, the growth in Australia's aggregate output in the recent period has been below that of domestic demand. A significant part of the growth in demand has been met by imports, while there has been only a moderate pick-up in exports. Growth of the non-farm economy over the year to the September quarter was thus a little below trend, at 2.6 per cent. In the short term, growth in overall GDP will continue to be affected by the drought. Farm output is expected to fall by around 20 per cent in the current financial year, which would directly reduce GDP growth by around half a percentage point, with some additional indirect effects flowing on to other parts of the economy.

Notwithstanding the estimated below-average growth in aggregate output, strong labour market conditions have persisted into the new year. Employment posted large increases in recent months, to be around 3 per cent higher over the past year. Job vacancies have increased further and the unemployment rate is around a 30-year low. Strong demand for labour is also confirmed by a range of business surveys and liaison reports. Although regional differences exist, the strength of the labour market has been widespread around the country, with most states over the past year recording strong employment growth and declining unemployment rates.

Over the past couple of years, high aggregate capacity utilisation has been associated with a pick-up in wage and price pressures. Underlying consumer price inflation picked up from around 2½ to around 3 per cent, while growth in the wage price index also picked up by around ½ percentage point. A range of indicators such as the unemployment rate and business survey results continue to suggest that capacity usage is relatively high. But the recent period of more moderate growth in demand and output, coupled with capacity expansions as a result of strong investment, should be helping to alleviate these pressures somewhat. Aggregate wages growth has stopped increasing recently, though it remains higher than average. In addition, data on producer and consumer prices for the December quarter give some support to the view that inflation pressures may have been contained after picking up noticeably in the first half of last year.

Abstracting from fluctuations in oil prices, producer price indices continued to show strong increases at the preliminary and intermediate stages of production, reflecting the strength of a range of raw materials costs. However, these measures of upstream inflation are no longer accelerating, and recent declines in oil prices, if sustained, will help to contain the growth in input costs overall. The consumer price index declined slightly in the December quarter, having been affected by a sharp fall in petrol prices and by the partial unwinding of the earlier spike in banana prices. Given these influences, a low CPI outcome in the quarter had been widely expected, and does not of itself constitute evidence of any broad-based easing in inflation pressures. Nonetheless, measures which abstract from volatile price movements suggest that underlying inflation moderated. Consumer prices in underlying terms are estimated to have increased by ½ per cent in the December quarter and by 3 per cent over the past year. While the annual figure is still relatively high, underlying inflation in the second half of 2006 was below that in the first half.

Through 2006, monetary policy responded to evidence of rising inflation pressures with a series of increases in the cash rate. At its most recent meetings the Board has considered whether this sequence of measures would be sufficient to contain inflation pressures in the medium term, or whether some additional tightening might be required. As set out in the previous Statement, the situation following the November meeting was that underlying inflation had increased to around 3 per cent but was tentatively forecast to decline somewhat in the period ahead. In the Board's judgment, the new information available for the February meeting, and in particular the December quarter CPI figures, suggested grounds for a little more confidence in this forecast.

With the economy still operating at a high overall level of capacity utilisation, it remains possible that the upward pressure on inflation that was evident for much of last year could re-emerge. Nonetheless, given the currently available information, the Board judged that the most likely prospect was that underlying inflation in the medium term would be a little below its recent rate, and in these circumstances decided to hold the cash rate unchanged at its February meeting. The Board will continue to monitor incoming data and adjust monetary policy as required to ensure that inflation remains satisfactorily contained.