Statement on Monetary Policy – August 2008
International Economic Developments
World economic growth has continued to moderate in the period since the May Statement, with measures of household and business confidence now at quite low levels in the major developed economies (Graph 1). Stresses in credit and equity markets have continued, and are being reflected in a slowing in lending growth in the major economies. However, consumer price inflation has increased further, reducing the scope for monetary authorities to lean against the economic slowdown (Graph 2).
Activity in the United States remains weak as financial turbulence continues to weigh on growth. The rate of growth in Europe and Japan has slowed and business sector indicators have deteriorated, narrowing the dichotomy that had existed for some time between relatively resilient measures of business sector activity and generally weak indicators of household spending and sentiment. The slowing in activity in developed economies has occurred against the backdrop of a further pick‑up in inflation, although in most countries this pick-up has thus far been driven primarily by increases in oil and food prices.
In contrast to the developed economies, activity remains strong in most emerging markets, especially the oil-exporting nations that have been the beneficiary of the sharp rise in crude oil prices over recent years. Nonetheless, there are signs that the rate of growth in China, India and other parts of east Asia has moderated somewhat, due in part to the dampening effect of slowing growth in the developed world on these countries’ export sectors. In a number of emerging market economies, price pressures have become more broad‑based, with consumer price inflation rising markedly even after abstracting from increases in oil and food prices.
Reflecting these developments, the IMF forecasts published in July show global growth of around 4 per cent in both 2008 and 2009 (Table 1). These forecasts were slightly stronger for 2008 than those published in April – reflecting better-than-expected growth in the March quarter – but little changed for 2009. If achieved, these growth rates would be well below the strong outcomes seen in recent years, but still above the global growth rates recorded during the slowdown in the early part of this decade. The Bank’s forecasts for the domestic economy assume a similar outlook for global growth in 2008, but a weaker outlook for 2009 than both Consensus and the IMF (see the ‘Economic Outlook’ chapter for details).
Major developed economies
Conditions in the United States remain weak, with continuing falls in employment, housing market activity and consumer sentiment over recent months. The preliminary June quarter national accounts suggest that GDP growth was a little stronger than in the previous two quarters (Graph 3), although growth in domestic demand remained weak. Exports continued to grow strongly, supported by the weaker US dollar.
Private consumption spending during the June quarter was supported by the federal government’s economic stimulus package, with around US$92 billion of tax rebates, or 0.9 per cent of annual household disposable income, paid to households between late April and the end of July. However, the impact of this stimulus is expected to fade in coming months. Despite the stimulus, consumer confidence is very low, and a period of household balance sheet repair now appears to be underway, as consumers adjust to higher inflation, rising unemployment and sizeable declines in financial and housing wealth (Graph 4).
Labour market conditions are generally soft. The unemployment rate has risen by 1.3 percentage points from its low in early 2007, to 5.7 per cent in July. Payrolls employment has declined in each month since the start of the year, although job losses to date remain concentrated in the construction and manufacturing sectors and have occurred at a relatively mild pace by the standards of previous downturns (Graph 5).
Activity in the housing sector continues to be especially weak. The stock of unsold homes remains high and house prices continue to decline, with the precise size of the nationwide fall varying amongst the different measures. The Case‑Shiller house price index is now 18 per cent below its peak in mid 2006, but this measure only covers houses sold in 20 major cities and appears to be overstating movements in the broader market. The more geographically representative purchase‑only house price measure of the Office of Federal Housing Enterprise Oversight (OFHEO) suggests a more modest decline thus far from its peak, of around 5 per cent. However, this measure is likely to be understating the overall national decline due to its exclusion of home sales with sub‑prime financing, where the extent of market distress appears to be greatest. The median house price measure produced by the National Association of Realtors shows a total decline to date of 12 per cent since late 2005.
Increases in food and energy prices have contributed to a rise in consumer price inflation to 5.0 per cent in the year to June, the highest rate seen since the early 1990s (Graph 6). However, unit labour cost growth has moderated over the past year and the Federal Reserve expects inflation to moderate later this year and next.
In Japan and the euro area, conditions have weakened recently following unexpectedly strong growth in the March quarter. In Japan, business investment intentions for the current fiscal year have deteriorated as sentiment has continued to decline, especially among small‑ and medium‑sized firms. Household sentiment also remains very weak and residential investment has remained low.
In the euro area, the pace of growth in industrial production has declined sharply in recent months and there are indications that the strength of the euro is hampering exports. Retail sales growth and household sentiment are low, and housing activity in a number of countries has deteriorated significantly. Developments in the UK housing market have also been negative; the Nationwide House Price Index is down by around 10 per cent from its peak in October 2007 and housing loan approvals are well below the levels seen during the early 1990s recession. Nevertheless, consumer price inflation in Europe has risen, resulting in concerns that high headline inflation might become embedded in inflation expectations and wage growth. Year‑ended consumer price inflation has reached 4.1 per cent in the euro area, and 3.8 per cent in the UK. The ECB raised its policy rate by 25 basis points in early July.
Other major trading partners
After a very rapid expansion in 2006 and 2007, growth in China has recently slowed somewhat. Year-ended growth has declined from a peak of over 12 per cent in mid 2007 to around 10 per cent in the June quarter of this year. While part of the slowdown can be attributed to a series of natural disasters (major snowstorms, the earthquake in Sichuan province and recent floods in southern China), it also reflects a pronounced fall in the growth of export volumes to the major developed economies (Graph 7). Nevertheless, indicators of domestic demand generally remain strong. Nominal spending on fixed-asset investment increased by 30 per cent over the year to June and retail sales volumes are estimated to have grown by around 16 per cent over the same period. In India, the pace of expansion has also declined slightly from the rapid rates of recent years, and industrial production growth has shown a more marked slowdown over the past few months. Despite this slowing, wholesale price inflation has recently increased, to be almost 12 per cent in year-ended terms in June.
Elsewhere in the Asian region, growth appears to have remained solid in the first half of 2008, albeit also below the strong pace of recent years. Over the six months to May, industrial production growth in east Asia (excluding China) slowed significantly. Although growth in export values from this region has picked up over the same period, slowing world growth is likely to weigh on export volumes growth in the period ahead. Having provided a strong impetus to economic activity in 2007, domestic demand growth in east Asia (excluding China) no longer appears to be running above trend, and is being affected by a deterioration in the terms of trade in most countries, with rising prices for energy eroding households’ real purchasing power (Graph 8).
Consumer price inflation has risen in many east Asian economies, with year-ended inflation above 9 per cent in Indonesia, the Philippines and Thailand. Recent decisions by a number of countries – including China, Indonesia, Malaysia and Thailand – to scale back the extent of their subsidies for a range of petroleum and energy products are expected to result in further increases in consumer prices in the near term. Core inflation measures – which generally abstract from the sharp rises in the prices of food and energy – have also risen markedly across much of east Asia in recent months. With real interest rates low or negative in many Asian countries, even measured using core inflation, various central banks have become concerned about the risk of higher inflation becoming entrenched. Since the May Statement, interest rates have been increased in India, Indonesia, the Philippines, Taiwan and Thailand.
Growth in the New Zealand economy has slowed sharply since the start of the year. GDP contracted in the March quarter and recent indicators suggest that activity remained subdued in the June quarter. Retail sales in April and May combined were weak and conditions in the housing market have continued to deteriorate, with house sales in June more than 50 per cent below end-2006 levels and the value of housing loan approvals down 30 per cent over the year to July. Year-ended CPI inflation rose to 4 per cent in the June quarter. Despite expectations that inflation will increase further in the near term, the Reserve Bank of New Zealand cut the cash rate by 25 basis points in late July, citing a deterioration in the international financial environment and the risk of a further weakening in domestic activity.
Developments in commodities markets have been mixed in recent months. Oil prices rose to nearly US$150 per barrel in early July, close to double the level of a year earlier, although they have since fallen back to around US$119 per barrel, which is around the same level as at the time of the May Statement. Nevertheless, prices remain around 60 per cent above the average level in 2007, reflecting a combination of strong demand from developing economies, a muted supply response and the depreciation of the US dollar.
The RBA’s index of commodity prices (which excludes oil) has risen by an estimated 35 per cent (in SDR terms) since the beginning of the year, mostly reflecting the increased contract prices for coal and iron ore, and has increased by more than 160 per cent over the past five years (Graph 9). Abstracting from coal and iron ore prices, the index would be down modestly since the time of the May Statement but around 80 per cent higher over the past five years.
Australian producers have negotiated an average 85 per cent increase in 2008/09 contract prices for iron ore with Asian steel mills (applied retrospectively from April). Spot prices are currently well above 2008/09 contract prices (Graph 10). The outlook for coal prices has also strengthened in recent months. Although some of the developments that led to the sharp increase in contract prices earlier this year – averaging around 125 per cent for thermal coal and 220 per cent for coking coal – were transitory, the ongoing lack of spare capacity in these markets has left them extremely tight. Broad-based strength in energy prices, coupled with uncertainty surrounding supply, has contributed to strong increases in thermal coal prices on the spot market, which are currently 30 per cent above the new contract price.
The RBA index of base metals prices has decreased by 15 per cent over the past three months, driven by falls in nickel, zinc and lead prices. Prices of these three metals are now roughly 60 per cent below their peaks, as the acute shortages that led to the dramatic increases in prices in 2006 and 2007 have been alleviated to some extent. In contrast, copper and aluminium prices are near historically high levels. Although aluminium inventory levels remain relatively high at present, recent production disruptions coupled with high energy prices have heightened concerns about the cost and availability of future supply. Overall the base metals component of the RBA index is currently around 30 per cent below the peak seen in May 2007.
Rural commodity prices were mixed over recent months, with gains in beef and sugar prices broadly offsetting weaker wheat and wool prices. Beef export prices to the United States have risen strongly since April, reflecting a tight domestic market, as well as growing competition from alternative export markets. Wheat prices have eased somewhat over the past three months on expectations of a strong increase in global production this year.