Statement on Monetary Policy – May 2007
International Economic Developments
The world economy grew at its fastest rate in more than 30 years in 2006, and has continued to grow at a firm pace in early 2007. The expansion has been quite broad-based, with an upturn in Europe and Japan and ongoing strength in China and India. In its April World Economic Outlook, the IMF forecasts world growth to ease only modestly in 2007 and 2008, to around 5 per cent. Emerging economies are forecast to continue to grow strongly in 2007 while weaker growth is expected for the major developed countries (the G7 economies), mainly reflecting a slowdown in the United States (Graph 1). However, most forecasters are expecting that the US slowing should be reasonably temporary and are assuming that the current headwinds from the housing sector will not spread too much to other sectors or countries. East Asia, which receives more than half of Australia’s exports by value, is expected to account for around two-fifths of global growth in 2007.
Sustained global GDP growth in recent years has boosted capacity utilisation, as borne out in surveys of business conditions and by the tightness of labour markets. Unemployment rates have fallen significantly in most major developed economies. In the English-speaking countries and Japan, unemployment has been declining for the past three to four years. The decline in the major countries in the euro area is more recent, but unemployment has now fallen to its lowest rate in more than a decade (Graph 2). The continued absorption of global capacity has seen core inflation drift upward in several major countries, and central banks remain concerned about upside risks to inflation.
One effect of the sustained strong growth in the world economy has been the sharp rise in commodity prices over the past few years, reflecting in part China’s increased contribution to world growth and the relatively resource-intensive stage of its development. Commodity prices have risen further in the past three months and market participants are now expecting commodity prices will stay high for longer. As Australia is a large producer of commodities, the stronger outlook for commodity prices has been one of the reasons that the Australian dollar exchange rate has recently reached a 22-year high on a real trade-weighted basis (for more details on recent movements in the Australian dollar, see the ‘International and Foreign Exchange Markets’ chapter).
Major developed economies
Growth in overall activity in the major developed economies is expected to weaken somewhat in 2007, as the pace in North America moderates to below trend. However, growth in Japan is expected to continue at around the same rate as last year and the expansion in Europe is forecast to continue, albeit less rapidly than in 2006.
Growth in the US economy has already slowed, due mostly to a downturn in housing construction and auto-related manufacturing. Real GDP increased by 0.3 per cent in the March quarter, and by 2.1 per cent over the year (Graph 3). The recent slowdown follows several years of above-trend growth in the United States, during which excess labour and capital resources were re‑absorbed, and the recent moderation should help to reduce the inflation pressures that were building early last year.
Activity in the US housing market has continued to weaken in early 2007. Residential investment declined by 4.6 per cent in the March quarter and by 17 per cent over the year. The supply of unsold houses has remained high, and there has been a slowing in the growth of house prices (Graph 4). In response to the recent increase in loan delinquencies, many lenders have tightened credit standards, although there are few indications that creditworthy borrowers are being affected and payment distress appears to be largely confined to the sub-prime market (for further details, see the ‘International and Foreign Exchange Markets’ chapter). Recent indicators suggest housing demand is still weak, with home sales falling in March and housing starts and permits remaining at low levels since the start of the year. Residential investment is expected to decline further.
Household consumption increased by 0.9 per cent in the March quarter and by 3.4 per cent over the year. Consumption has been supported by growth in household incomes and has remained firm, despite slowing house price growth. Household income growth has been supported by the strong labour market, with payrolls employment rising by 180,000 jobs in March and the unemployment rate returning to a cyclical low of 4.4 per cent (Graph 5).
Business investment increased slightly in the March quarter, to be 3.2 per cent higher over the year. Equipment investment has been surprisingly weak, given that capacity utilisation is at high levels. Corporate profits remain high, balance sheets are healthy and the cost of capital is low, suggesting that financing conditions are supportive of continued growth in investment.
Reflecting movements in energy prices, CPI inflation slowed through the second half of 2006 and has recently picked up a little, to be 2.8 per cent over the year to March (Graph 6). Over the same period, core inflation has eased, to a year-ended rate of 2.5 per cent. While the Federal Reserve continues to forecast that inflation will ease as activity and growth in housing costs soften, it remains concerned about possible upside risks to that outlook, especially given the tightness of the labour market.
The expansion in Japan has continued at a solid rate and growth has been broad-based. GDP increased by 1.3 per cent in the December quarter and by 2.5 per cent over the year, with a strong pick-up in domestic demand and a contribution to growth from exports. Growth in consumption has been supported by the conditions in the labour market; the unemployment rate was at an 8-year low of 4.0 per cent in March, and surveyed employment indicators suggest the outlook remains positive (Graph 7). Growth in business investment has been strong and capacity utilisation was at a high level in the March quarter, particularly for the manufacturing industry. Given healthy corporate balance sheets, investment growth for medium and large firms is expected to be solid in 2007 according to the Tankan survey.
Despite strong growth, a tight labour market and indications that the economy is operating at high levels of capacity utilisation, consumer price inflation remains negative (Graph 8). Excluding food and energy, year-ended inflation was –0.4 per cent in March. Upstream price pressures have moderated in recent months, with year-ended growth in corporate goods prices easing to 2.0 per cent in March.
In Europe, economic growth was strong in 2006, although its pace may have slowed a little recently. GDP in the euro area increased by 0.9 per cent in the December quarter to be 3.3 per cent higher over the year, the fastest rate of year-ended growth in six years (Graph 9). Growth was fairly well distributed across the region. In particular, there has been a marked improvement in growth in both Germany and Italy, with growth over the year to the December quarter of 3.7 per cent and 2.8 per cent, compared with average growth of around ½ per cent for both economies over the previous four years.
Consumer spending slowed in Germany in early 2007, following a pull-forward of sales into late 2006 ahead of January’s increase in the VAT. However, improving labour market conditions and consumer sentiment are expected to support consumption in the period ahead. The euro area unemployment rate has continued to decline, reaching 7.3 per cent in February. Business conditions also remain positive, with the European Commission measure of business sentiment at its highest level since the survey began in 1985, helped by ongoing strong export demand.
Headline inflation has been steady at just below the ECB’s 2 per cent reference value (Graph 10). Core inflation has continued to trend upward, to be 1.9 per cent over the year ended in March. At its March meeting, the ECB raised its repo rate by 25 basis points to 3.75 per cent and noted that the risks to inflation remained on the upside, citing in particular risks associated with the current round of wage negotiations.
Growth in the United Kingdom was solid in the March quarter, with GDP rising by 0.7 per cent. More generally, household spending and buoyant business investment have been leading demand growth in recent periods. Consumption has been supported by increases in house prices and a tight labour market. Headline inflation rose to 3.1 per cent in March, above the Bank of England’s target range, but is expected to fall back.
Growth in Australia’s other major trading partners is expected to continue to be strong in 2007, due mainly to continued rapid growth in China and India and solid growth in the rest of east Asia.
In China, GDP increased by 11.1 per cent over the year to the March quarter. Growth in investment has picked up and appears to have been a major contributor to recent GDP growth. Exports also increased sharply in the March quarter, as a change in export tax rebates from April caused a pull-forward of exporting activity. In response to the continued strong demand conditions, the People’s Bank of China tightened policy again in March and April, raising the reserve requirement ratio and the benchmark lending and deposit interest rates.
Growth in corporate goods prices has continued to run ahead of consumer and export price inflation. Over the year to March, corporate goods prices increased by 4.2 per cent, reflecting a pick-up in raw materials prices, strong growth in labour costs and an increase in food prices due to drought conditions in China (Graph 11). Consumer prices increased by 3.3 per cent over the year to March, although excluding food (one-third of the index) consumer inflation is estimated to have been only 1.4 per cent. Evidence on Chinese export prices is more mixed, with Hong Kong data suggesting that prices of imports from China have grown by around 3 per cent over the past year, while US data suggest that prices of imports from China are still falling. Overall, the limited pass-through of corporate goods price inflation to China’s non-food consumer and export prices reflects continued strong productivity growth, rapidly increasing capacity and global competition.
GDP in the rest of east Asia (excluding Japan) increased by 4.8 per cent over the year to the December quarter, with firm growth in domestic demand and a small contribution from exports. Growth in industrial production and exports appears to have slowed a little recently, with growth in both ITC-related and capital goods exports easing in line with slower growth in business investment in the United States (Graph 12). However, favourable labour market conditions are expected to support growth in consumption in the region, and business investment is also expected to remain firm. Preliminary estimates of March quarter GDP for Korea and Singapore show these economies have continued to expand at a solid pace. Inflationary pressures remain contained, with year-ended inflation for the region at 2.5 per cent over the year to March.
Growth in India has been strong with real GDP increasing by 8.6 per cent over 2006, reflecting strength in domestic demand. Upstream price pressures have increased; at 6.5 per cent over the year to March, wholesale price inflation was around its highest rate in two years. Concerns about capacity constraints led the Reserve Bank of India to tighten policy further in April.
In New Zealand, GDP increased by 0.8 per cent in the December quarter, driven by a strong pick-up in domestic demand. Consumption growth was solid in the quarter, buoyed by lower petrol prices, renewed strength in the housing market and continued favourable labour market conditions. Growth in dwelling and business investment also picked up. More recently, retail sales were reported to have increased by 6.3 per cent over the year to February and house price growth has continued to be strong. Year-ended consumer price inflation held broadly steady at 2.5 per cent in the March quarter, although most of the Reserve Bank of New Zealand’s (RBNZ) measures of underlying inflation were running at higher rates. The RBNZ tightened monetary policy at its March and April meetings, citing concerns about the recent pick-up in domestic demand.
Commodity prices and the terms of trade
Commodity prices have remained high in 2007 so far, as supply has struggled to keep up with the strong global demand for commodities. The RBA’s index of commodity prices (ICP) increased by 4.5 per cent (in SDR terms) over the three months to April, bringing the increase over the past four years to around 90 per cent (Graph 13, Table 1). The persistent strength in base metals prices continues to be the main driver of the increase in the ICP; the base metals price index has risen by 16 per cent over the past three months, and has more than trebled over the past four years. High commodity prices have continued to boost the terms of trade, which are estimated to have increased by around 2 per cent in the March quarter.
As has been the case for several years, base metals prices over the past three months have been much stronger than had been expected by most analysts. While futures markets continue to suggest that prices are likely to soften over the next two years, this has translated into expectations that prices will be higher than previously forecast in the medium term (Graph 14). The recent price increases reflect the tightness in base metals supply, with global stocks at very low levels. Global growth is expected to remain buoyant, which could see base metals prices remain at high levels for some time yet, notwithstanding the anticipated supply coming on line.
Nickel and copper prices have driven the increase in base metals prices over the past three months, both rising by nearly 35 per cent (Graph 15). The rise in nickel prices has reflected strong demand, delays in a number of supply projects and low global stocks, which now cover three weeks of consumption compared with an average of around nine weeks over the 1990s. Stocks of copper have also declined.
The oil price (for West Texas Intermediate) rose by 17 per cent over the three months to April, and is currently trading around US$65 per barrel. The rise was driven by strong demand for petrol and concerns over possible supply disruptions from the Middle East and Nigeria.
Since the previous Statement, steaming coal benchmark contract prices for 2007/08 have been settled at a premium of around 5 per cent over 2006/07 prices, in line with the higher spot prices since the start of the year (Graph 16). Soft coking coal contract prices were also settled higher than last year’s prices. However, the overall effect of the bulk contract negotiations on the ICP and the terms of trade in 2007 is expected to be roughly neutral, as the rise in steaming and soft coking coal contract prices and the 9½ per cent increase in iron ore prices will be offset by the 15–20 per cent fall in hard coking coal contract prices.
Rural commodity prices fell by 2.5 per cent over the three months to April, as beef prices declined due to seasonally weak demand from Japan. Partially offsetting this was a rise in wool prices, reflecting in part continuing concerns about the impact on production of the drought in Australia.