Statement on Monetary Policy – May 2007
Domestic Economic Conditions
Growth in the non-farm economy ended 2006 at a relatively strong pace. Non-farm GDP was estimated to have risen by 1.4 per cent in the December quarter, lifting year-ended growth to 3.5 per cent (Graph 33, Table 6). The strength in output growth implied a pick-up in measured productivity growth after an extended period of apparent weakness. Recent data suggest that the economy has continued to grow in the early part of 2007. Retail trade rose at a firm pace in the first two months of the year, and employment also expanded at a healthy rate. Business surveys show strong trading conditions in the March quarter. One area of weakness is the farm sector, where the drought has resulted in sharply lower production and incomes. Farm GDP is estimated to have fallen by around 20 per cent over the second half of 2006, directly subtracting 0.6 percentage points from overall GDP growth, while farm incomes have fallen even more significantly. Growth in the resource-rich states of Western Australia and Queensland has continued to outpace that in the rest of the country though the gap may be narrowing (see ‘Box A: Regional Economic Performance and Population Flows’).
While some further weakness in farm production is expected in the near term, weather forecasters are expecting a return to at least average rainfall, which would help support some recovery in farm output in 2007/08. Elsewhere in the economy, conditions are generally expected to remain strong. Growth in household consumption seems likely to remain firm, supported by strong labour market conditions, recent increases in household wealth and strong consumer confidence. While housing construction may decline further in the next couple of quarters, it is expected to begin to pick up towards the end of 2007 given low vacancy rates and other indications that housing construction has been running below underlying demand for some time. Business investment is expected to grow at a modest pace compared with the rapid rates seen in recent years, but given its high level should continue to provide a considerable boost to the capital stock. The completion of several large mining projects and continued strength in world demand should see additional growth in resource exports, although a further fall in rural exports is expected in the near term.
Growth in household spending picked up noticeably towards the end of 2006, but remained well below the rapid pace of a few years ago. Household consumption increased by 1.2 per cent in the December quarter, to be 3.8 per cent higher over the year. More timely data indicate that retail spending has continued to grow at a firm pace in early 2007, with nominal retail sales in January and February 1.6 per cent higher than in the December quarter and 6.7 per cent higher over the year (Graph 34). Motor vehicle sales to households were particularly strong in early 2007, after gradually gaining strength through 2006, rising by 6 per cent in the March quarter. Liaison with retailers and household service providers also suggests that broad-based growth across classes of expenditure has continued in 2007. Measures of consumer sentiment have recovered strongly in recent months to be well above long-run average levels.
Household spending has been supported by strong conditions in the labour market and increases in wealth. Robust growth in employment and real earnings has contributed to growth in total real household disposable income over recent quarters, more than offsetting the impact on the incomes of rural households of the drought (Graph 35). The net worth of households – the difference between their assets and liabilities – has continued to increase as buoyant financial markets have boosted the value of households’ equities and superannuation holdings, and house prices have shown moderate growth. Household debt growth picked up slightly in the March quarter, though it remains below the rates recorded in the middle of last year. Nevertheless, as discussed in the March 2007 Financial Stability Review, the majority of households are coping well with the higher levels of debt.
After a mild downturn starting in mid 2004, dwelling investment showed a modest recovery in the second half of last year. The pick-up mostly reflected growth in alterations & additions, with a moderate recovery in house construction and further falls in building of units. In the latter part of last year, building approvals weakened, and point to the likelihood of renewed declines in housing investment in the next couple of quarters (Graph 36). However, a number of factors suggest that dwelling investment is likely to be somewhat stronger than indicated by the number of building approvals. First, alterations & additions, which account for nearly half of total dwelling investment, are not showing the same signs of weakness. Robust growth in household income and wealth is underpinning spending on upgrading the quality of the existing housing stock, just as it has boosted consumption spending. In addition, with the run-up in housing prices, transaction costs associated with moving have risen, which has increased the attractiveness of renovating relative to moving. Second, houses being built now are on average larger and of a higher quality than in the past, so a given number of approvals now leads to a greater volume of construction work.
For the past couple of years the number of houses and units being built has not kept pace with the underlying demand for new housing that results from factors such as population growth, declining household size and demolitions. In 2006, 142,000 dwellings were built, with a similar number likely to be built this year. This compares with estimates for underlying demand that are typically around 160,000–175,000 a year, although these estimates of underlying demand might be overstated to the extent that the increased cost of housing has dampened demand. The effect of the shortfall in the construction of new dwellings is most clearly evident in the rental market. According to data from the state Real Estate Institutes, the rental vacancy rate has fallen from nearly 4 per cent in 2002 to around 1.3 per cent at the end of 2006. This is the lowest level since data were first collected in 1978, and compares with an average vacancy rate of just under 3 per cent over this period. The growing shortage of available rental dwellings is contributing to faster growth in rents, which in turn should help lift returns to investors and hence add to dwelling construction over the medium term. The CPI measure of nationwide rents increased by 1.4 per cent in the March quarter, and by 4.4 per cent over the year, faster than the overall rate of inflation (Graph 37).
Average nationwide housing prices have continued to show modest growth, with house prices growing slightly faster than unit prices. The APM mix-adjusted measure indicates that average metropolitan housing prices were broadly unchanged in the March quarter although they were 5 per cent higher over the year (Table 7). Recent data indicate that the median house price in Perth has edged closer to that in Sydney, which remains the most expensive in Australia despite falling by 8 per cent since its peak (Graph 38). However, Perth prices appear to have stabilised following an extended period of strong gains. Other housing price series constructed using different methods currently show broadly similar movements nationwide. The Residex measure, which tracks repeat sales of individual properties, rose by 2 per cent in the quarter and by 7 per cent over the year. The recently developed hedonic index from RP Data/Rismark, which takes into account the characteristics of each property sold (such as the location, and the number of bedrooms and bathrooms), suggests that nationwide housing prices rose by 1 per cent in the March quarter, to be 5 per cent higher over the year. Auction clearance rates have increased in Sydney and Melbourne in recent months, presenting a slightly stronger perspective of the housing market than is apparent in the price data (Graph 39). This may partly reflect the relative strength in the top-end of the market in which auctions are more common; disaggregated price data for both of these cities suggest that the more expensive suburbs have been experiencing stronger price trends than the less expensive ones.
Business conditions in the non-farm sector have remained favourable. Private-sector surveys suggest that across sectors and firm sizes, aggregate conditions were above long-run average levels in the March quarter (Graph 40). Surveys report that business conditions in the non-farm sector generally picked up in the quarter, though conditions in the manufacturing sector apparently eased slightly. Firms also continue to report high levels of capacity utilisation in most industries (Graph 41).
According to the national accounts, business profits grew by 6.3 per cent over the year to the December quarter (Graph 42). The profit share – at 30 per cent of GDP – remained close to its 30-year high. Notwithstanding this, business profit growth has moderated over the past year, predominantly reflecting an easing in mining profit growth from the exceptional rates recorded in 2005. While demand for resources remains strong, rising materials and labour costs and slower growth in resource prices have begun to weigh on earnings growth (Graph 43). In addition, a sharp fall in farm income due to the drought has subtracted from aggregate business profits. Outside of the mining and farm sectors, profit growth strengthened in the second half of 2006, in line with the pick-up in household demand and a slight moderation in input cost growth from its recent highs. Business surveys generally indicate that firms’ expectations of profit growth remain around long-run averages, and equity analysts expect reasonable growth in earnings for non-mining companies over the full financial year (for details see the ‘Domestic Financial Markets and Conditions’ chapter).
Businesses appear well placed to fund investment given the high level of profits, supportive financial conditions and, as discussed in the March 2007 Financial Stability Review, the generally good shape of business balance sheets. Although growth slowed to 2 per cent over 2006, business investment is at a very high level as a share of GDP following average growth of 16 per cent over the four years to the end of 2005 (Graph 44). While growth in non-residential construction has slowed from the rapid rates recorded in recent years, it is at its highest share of GDP in the almost 50 years for which data are available, to a large extent reflecting the expansion in mining infrastructure in response to higher mineral prices. In contrast, machinery & equipment investment has contracted somewhat, with drought conditions prompting a sharp fall in spending by the farm sector in recent quarters, combined with a decline in spending by manufacturers and a lull in lumpy items such as new aircraft.
Looking ahead, the capital expenditure (Capex) survey’s first estimate of spending plans for 2007/08 points to moderate growth. In addition, forward-looking indicators suggest that non-residential construction activity will remain firm in the coming quarters. The pipeline of work yet to be done is at a high level relative to the current pace of activity, particularly for engineering construction (Graph 45). Public investment has also been growing rapidly, both at the Commonwealth and state & local government levels. However, labour and equipment shortages combined with rising construction costs continue to hamper progress on some projects. Overall, the high level of investment together with favourable business conditions should support continued strong growth in the capital stock and help to ease capacity constraints in some sectors.
Conditions in the rural sector remain difficult. The Australian Bureau of Agricultural and Resource Economics (ABARE) is forecasting farm output for 2006/07 to fall by around 20 per cent, driven by a 60 per cent decline in the 2006/07 winter crop. Most agricultural areas remain drought-declared, water storage levels are at historic lows and water allocations to irrigators in the Murray-Darling basin may need to be cut further. However, most agricultural districts have recorded around average rainfall since the start of the year, and there are some early indications that weather conditions may improve over the course of 2007. Weather forecasters have suggested that there is a slightly higher than usual chance of a La Niña event developing in coming months, which would typically bring with it above-average rainfall across the eastern half of the country. In previous droughts output has rebounded strongly once seasonal conditions have returned to normal, but given the extended period of low rainfall, and low soil moisture and stored water levels, any recovery on this occasion may be more muted.
Export earnings rose in the first two months of 2007, to be 2½ per cent higher than in the December quarter and 11 per cent higher over the year (Graph 46). All major components of exports increased, except for rural goods, which have been affected by the drought. There is likely to have been some weakness in exports during the month of March owing to cyclone-related disruptions to iron ore and oil exports. Overall, with export prices estimated to have risen only slightly, export volumes appear to have increased firmly in the March quarter, following growth of around 4 per cent over 2006.
Recent increases in resource exports largely reflect increases in the volume of iron ore, coal, LNG and metals (Graph 47). This continues the gradual recovery in the volume of resource exports, with annual average growth picking up from 1.3 per cent in the five years from 2000 to 2004, to 4.4 per cent in the past two years (Table 8). As foreshadowed in a special chapter on resource exports in the February 2005 Statement, much of this pick-up in growth has been due to increases in the production of commodities that had contributed most to the weakness in the early 2000s. Some resource exports – notably oil, LNG, metals and gold – have seen firm growth as additional supply capacity has come on line. Recent increases in mining capacity – including in the Pilbara in Western Australia and Bowen Basin in Queensland – should boost exports of iron ore and coal in the coming quarters. However, overall resource export volumes have grown only moderately in recent years despite the strength of global demand and mining investment. In part this seems to have reflected a number of disruptions to production due to bad weather and various accidents, as well as existing operations needing to be shut down in order for new capacity to be brought on line. In addition, depletion of reserves at existing operations has been an issue for some commodities, most notably in the case of oil.
Nevertheless, resource export growth has been broadly comparable to the corresponding stage of the mining boom in the late 1970s and early 1980s. On that occasion, mining investment rose for six years, but it took a further one to two years after the peak in investment before there was significant growth in resource export volumes (Graph 48). In the current boom, mining investment has increased for five consecutive years, with increases in mine capacity and transport infrastructure expected to result in a significant lift in aggregate resource exports over the next two years – in particular metal ores, metals, coal and oil.
Manufactured and service export earnings increased strongly over the year to February. Surveys and liaison also indicate that manufacturing exports are growing at a firm pace. However, rural exports have been weighed down by the drought. Recent data point to further weakness in rural exports in the March quarter, largely reflecting lower exports of cereals. After declining by more than 30 per cent in the December quarter, the volume of wheat exports has fallen by a further 25 per cent in the first two months of this year.
Import volumes increased strongly in the December quarter and over 2006, driven by firm growth in domestic demand (Graph 49). Recent data indicate that the value of imports continued to rise in the March quarter. The strength in imports in the past two quarters has been broad-based, with imports of consumption goods picking up further in the March quarter, consistent with the recent retail trade figures.
The recent appreciation of the Australian dollar has brought the real exchange rate to around 21 per cent above its post‑float average (Graph 50). By itself, this would be expected to be contractionary for the economy, restraining growth of exports and boosting import growth. However, the appreciation has taken place in the context of a strong world economy and a marked increase in Australia’s terms of trade. For the economy as a whole the restrictive effects of the high real exchange rate are likely to be more than counterbalanced by the boost to national income from the high terms of trade, which at the end of 2006 were 42 per cent above their post‑float average.
The current account deficit widened to 5.9 per cent of GDP in the December quarter reflecting increases in both the trade deficit, resulting from strong import growth, and the net income deficit (NID). At 4.4 per cent of GDP, the NID stood at its highest level since 1990. Interest payments on debt owed abroad have increased strongly reflecting rises in both interest rates and the stock of Australia’s foreign debt, while equity payments remain high due to strong profitability of fully or partly foreign-owned enterprises operating in Australia, mainly in the resource sector.
Employment grew by an above-average 2.7 per cent over the year to March. Growth was concentrated in full-time employment and was broad-based across industries, with construction, wholesale trade, hospitality and finance & insurance making especially strong contributions over the past year. As discussed in previous Statements, a significant part of the increase in demand for labour has been accommodated by an increase in the participation rate. An additional source of labour supply has been migration. Box B: ‘Developments in Labour Supply’ discusses the contribution of these factors to employment growth in recent years.
The unemployment rate was at a generational low of 4.5 per cent in March. This conventionally-measured unemployment rate does not take into account the willingness of employed people to work more hours. An hours-based measure of underemployment, or labour underutilisation, accounts for this by combining the additional hours that both the unemployed and the underemployed would like to work. This broader measure of underemployment is higher than the standard unemployment rate, as usual, though it has followed a similar trend in recent years and has also reached its lowest level in over 25 years, reflecting the tight labour market conditions (Graph 51).
Another indicator of labour-market tightness is the number of job vacancies reported by the ABS (Graph 52). This series, which is from a survey of businesses rather than a count of advertisements that might be subject to double-counting, confirms the current tightness of the labour market. The recent increases in the vacancy rate are consistent with indications from liaison contacts that labour shortages have intensified further in recent quarters and, in some cases, are constraining output.