Statement on Monetary Policy – November 2007 Introduction

Recent data have continued to indicate strong growth in the Australian economy, with demand and activity rising faster than trend, confidence high and labour market conditions tight. In recent quarters these conditions have been accompanied by an increase in underlying inflation.

Growth of the Australian economy has for some time been assisted by strong global demand and high commodity prices. Supportive conditions appear likely to continue, though some moderation in the pace of global expansion is now occurring, partly as a result of recent strains in financial markets. In the United States, the sharp downturn in the housing sector is weighing on growth, and may do so for a while longer. Nonetheless, other parts of the US economy have so far been resilient, with recent outcomes for aggregate output and employment remaining relatively strong. The Japanese and euro area economies have been slowing recently, though moderate growth appears to be continuing. In contrast, the major developing countries, especially China, are growing rapidly, and indeed have strengthened further since the start of the year. The net effect of these contrasting trends is that world growth in 2008 is likely to moderate, though most official and private-sector observers still expect the pace to remain higher than average.

Global financial markets have experienced a period of significant volatility over the past three months, as the strains emanating from the sub-prime debt market in the US spilled over, particularly to other credit markets. There was also considerable volatility in share markets and currency markets.

For some time, it had been apparent that markets had held an optimistic view on risk, with spreads at historically low levels. In early August there was a marked reassessment of that view, which saw risk premia on many financial instruments rise significantly. There was also a sharp tightening in the terms at which intermediaries were willing to provide funding to each other, which saw short-term money market rates spike higher. These concerns in large part stemmed from uncertainty as to the size of the exposure that financial institutions had to structured credit instruments, either directly or indirectly through lines of credit to various off-balance sheet vehicles. Central banks, including the RBA, responded to these pressures by injecting a substantial amount of funds into money markets. These actions were designed to ensure that markets continued to function as normally as possible as the re-pricing of risk occurred. They were not intended to change the stance of monetary policy. As conditions subsequently improved, these injections of liquidity were gradually unwound.

Since August, sentiment in financial markets has improved although it remains fragile. The Federal Reserve's decision to reduce its policy rate by 50 basis points at its September meeting contributed to a marked easing in the strains in financial markets, but concerns have reappeared at various times, particularly about the extent of the exposure of large financial institutions to the affected credit instruments. Investment banks that were holding inventories of these instruments have sustained substantial valuation losses. Some institutions which were particularly reliant on credit markets for short-term funding have also been significantly affected.

The major development in currency markets has been the large depreciation of the US dollar against every major currency except the yen. The dollar has fallen to multi-year lows on a trade-weighted basis as well as against a number of other major currencies including the euro, the Canadian dollar, the pound and the Australian dollar. Thus far the depreciation of the US dollar has been orderly and has helped boost output in the US economy. The Australian dollar has traded in a very large range over the past three months, but has recently reached multi-year highs.

Domestically, credit market conditions have generally been less affected throughout the episode, and recently have improved by at least as much as in other countries. In recent weeks, a number of mortgage-backed securities have been issued, albeit at spreads which are around 30 basis points higher than earlier in the year. Bond issuance has also returned to more normal levels, but again at higher spreads. This increase in funding costs for banks has been passed on to business borrowers and riskier housing loans, but at the time of writing, no major institution had changed its benchmark home lending rate in response to these pressures. Money market rates also rose in response to the publication of the September quarter CPI.

Notwithstanding the recent credit market strains, strong global demand has continued to support high commodity prices. World oil prices have risen further in recent months while base metals prices have remained at high levels, though they have come off the peaks they reached earlier in the year. Prospects for coal and iron ore prices appear to have strengthened, with analysts generally expecting further large increases in contract prices for these commodities next year. The general run-up in commodity prices over recent years has provided a substantial stimulus to domestic incomes and spending. Australia's terms of trade have increased by 40 per cent over the past four years, their largest cumulative increase since the early 1950s. This has added around 1½ percentage points per annum over this period to the growth of Australia's real gross domestic income.

During 2007, the pace of growth in demand and output in Australia has increased. The latest national accounts show that GDP grew by an estimated 4.3 per cent over the year to the June quarter, with the non-farm economy growing by 5.2 per cent. Even allowing for an element of volatility in these estimates, it is clear that the non-farm economy has been growing at a faster-than-trend pace. Recent data suggest that considerable momentum continued in the September quarter. Retail sales posted a further large rise in the quarter, and employment continued to expand. Business surveys report that trading conditions in the quarter were well above average.

While growth of the non-farm economy remains strong, conditions in the farm sector have deteriorated over recent months. A lack of rainfall, particularly in the eastern states, has led to sharp downward revisions to expected crop yields. Inflows to the Murray-Darling system are running close to record lows for the second successive year, which is likely to mean severe cutbacks in water allocations to irrigators. These developments are resulting in subdued farm output for a second year in a row.

Domestic demand has continued to grow strongly, with consumption, business investment and public spending all making significant contributions. In total, domestic demand grew by more than 5 per cent over the year to the June quarter, well above the trend growth in the economy's productive capacity. A significant part of the increase in demand continues to be met by imports. At the same time, there has been a modest pick-up in the growth of export volumes, notwithstanding recent declines in rural exports.

Housing loan approvals declined in August and September and household credit growth moderated, partly due to the effect of the August increase in interest rates, though the slowing in credit may also reflect some unwinding of superannuation-related borrowing in June. Despite these indications of softer demand for housing credit, the market for established houses has remained buoyant in most parts of the country. Nationally, house prices rose by around 10 per cent over the year to the September quarter. Price rises have been particularly strong in Melbourne, Brisbane and Adelaide. Sydney prices have also picked up recently, though the lower end of the market remains flat. Auction clearance rates in Sydney and Melbourne have stayed high in recent months, consistent with strong demand at the upper end of the market where auctions are most prevalent.

Business credit posted another strong increase in September to be growing at an annual rate of 26 per cent over the past six months, its fastest pace since the late 1980s. Some of the recent pick-up could reflect borrowers turning to their bankers due to tougher conditions for direct debt raisings in the capital markets.

The continued strength in demand and activity at this stage of a long expansion has brought the Australian economy to a position where productive capacity is stretched and labour market conditions are tight. While growth in labour costs has been contained at this stage, and high levels of investment are adding to productive capacity in some sectors, aggregate demand has been growing at a pace that has put upward pressure on underlying inflation.

Both the June and September quarter CPI data showed larger underlying price increases than in the previous two quarters. Measures of underlying inflation in the September quarter were around 0.9 per cent in the quarter and 3 per cent over the year. The headline CPI figures were lower as a result of a number of temporary influences. The quarterly CPI increase of 0.7 per cent was held down by a change to the treatment of child care rebates, which reduced the CPI by 0.2 per cent; the annual CPI increase was additionally affected by earlier sharp movements in petrol and banana prices, both of which were lower in the September quarter 2007 than a year earlier. Given the recent quarterly outcomes, it is likely that both the CPI and underlying measures of inflation will be above 3 per cent on a year-ended basis by early next year.

The Bank's forecasts have for some time incorporated the view that there was likely to be upward pressure on inflation as a result of strong demand and tight capacity. The September quarter CPI provided some additional confirmation of that view, and it suggested that the trajectory of underlying inflation was a little higher than previously projected. Price increases in the non-tradables sector have been running at relatively high rates and they picked up in the September quarter, reflecting increases in a range of services prices. To date, there has been relatively little dampening effect on final traded goods prices from the higher exchange rate, and the experience of recent years has been that such effects tend to be relatively muted.

In summary, the economic situation under consideration by the Board at its recent meetings has been one in which the key domestic data on prices, demand and activity were pointing to the likelihood of stronger medium-term inflation pressures. In formulating its response to these domestic trends, the Board has also given careful attention to international developments, and particularly to the strains in global credit markets. These strains were most pronounced in the period around the Board's September meeting. Hence, while domestic factors were suggesting stronger inflationary risks during this period, international market conditions were adding to uncertainties about the global outlook.

By the time of the Board's November meeting, global market conditions were somewhat more settled. The general assessment of conditions was that the global economy, though slowing, was still likely to grow at an above-average pace, led by strong growth in China and other parts of Asia. The Board also noted that, in Australia, the tightening in credit conditions resulting from the global turmoil had been relatively contained, and hence that the effect of these developments on domestic growth was likely to be modest. The September quarter CPI data, which became available for that meeting, provided additional evidence that domestic inflation pressures had strengthened. Weighing up these international and domestic factors, the Board judged that a further increase in the cash rate was needed in order to contain inflation in the medium term.

In the short term, as noted, both headline and underlying inflation are likely to exceed 3 per cent on a year-ended basis as a result of high CPI outcomes that have already occurred. Looking further ahead, and taking into account the recent monetary policy decisions along with other factors such as the higher exchange rate and the expected moderation in global demand, the Bank projects that inflation will settle at a rate a little below 3 per cent over the next two years. Somewhat lower outcomes could eventuate if global economic conditions prove to be weaker than expected, which might occur if there were further significant disturbances in global financial markets. But it is also possible at this stage of a long economic expansion that inflation will be more difficult to contain, particularly if domestic demand does not moderate.