Statement on Monetary Policy – February 2008
The international economy
While there is considerable uncertainty over the outlook for the world economy, our baseline assumption is that GDP growth in Australia’s major trading partners will slow significantly in 2008, following four years of well-above-average growth. Growth in the G7 economies is forecast to be noticeably below its average rate (Graph 75). While growth in the emerging economies is also expected to moderate in 2008, it is forecast to be around average, with domestic demand growth staying strong despite a slowdown in export growth. Given that the emerging economies – particularly China, India and some of the smaller economies in east Asia – account for a large share of Australia’s merchandise exports, total growth in our major trading partners is expected to be only slightly below its long-run average rate. Overall, GDP growth in our major trading partners is assumed to slow from around 5 per cent in 2007 to around 3¾–4 per cent in 2008 and 2009. These forecasts are a little lower than the recent IMF forecasts and more significantly below the January Consensus forecasts.
Despite the slowing in the world economy, Australia’s terms of trade are forecast to rise in the near term (Graph 76). This outlook is largely driven by expected large increases in coal and iron ore contract prices in mid 2008, reflecting ongoing strength in commodity demand from Asian countries, particularly China. The effect of these increases is forecast to be partially offset by declines in base metals and rural export prices from their recent high levels. Together, these developments imply that the terms of trade will reach fresh highs in mid 2008, before declining somewhat due to the slowing in global growth and as demand and supply respond to the current high commodity price levels.
The forecasts for the domestic economy are based on the technical assumption that the cash rate will remain at its current level of 7.0 per cent through to the end of the forecast period (June quarter 2010). The forecasts incorporate an effect from developments in credit markets over the past six months. Lending rates have increased and some modest further contractionary effect is expected from tighter lending standards and reduced access to capital markets. The forecasts assume that the exchange rate remains around its current level.
The large rise in the terms of trade in recent years and projected further increase in 2008 are expected to continue to support domestic activity over the forecast period. Nonetheless, the outlook has softened since the previous Statement as a result of the tightening in financial conditions and downward revisions to the forecasts of global growth. Growth in non-farm GDP is expected to slow from the strong rate of 4½ per cent seen over the year to the September quarter 2007, to around 2¾ per cent over 2008 and 3 per cent over 2009. With farm sector output expected to recover over the next year or so, total GDP growth is forecast to be stronger than non-farm growth over 2008, at around 3¼ per cent. Given the recent and projected strong growth in the capital stock, these rates of output growth imply some easing in capacity pressures in the economy. Excluding growth in production in the mining and farm sectors, where outcomes are predominantly driven by changes in supply, average annual output growth over the forecast period is expected to be around 2½–2¾ per cent.
The slowing in growth is expected to be spread over most of the major expenditure components of GDP. Announced tax cuts over coming years and the tight labour market should continue to support household income and consumption growth, although higher interest rates, lower confidence and negative wealth effects from recent falls in equity markets are forecast to weigh on consumer spending. Dwelling investment is expected to recover gradually in response to strong demand, as reflected in rising rents and house prices. Nevertheless, the tightening of credit market conditions is likely to restrain the recovery in that sector. Business investment growth is expected to slow, although the forecasts imply that business investment will remain at a high level as a share of output, which would ensure strong growth in the capital stock and help ease capacity pressures in the economy. Public demand growth is also projected to moderate somewhat from the relatively strong pace of recent years. Exports are expected to grow solidly, largely due to a pick-up in resource exports, although growth in export volumes in the near term will be restricted by the fall in rural production due to the drought.
Employment growth is expected to slow from its recent strong pace, reflecting the forecast slowing in output growth and the relatively tight conditions – the low rate of unemployment and high participation rate – on the supply side of the labour market. Overall, employment is forecast to grow by a little under 1½ per cent in year-ended terms over the forecast period, a little below the growth rate of the working-age population. The unemployment rate is forecast to increase modestly.
The inflation outlook is affected by opposing forces. The strong growth in demand, output and employment in recent years has resulted in a reduction of spare capacity in the business sector and the labour market (Graph 77). This has contributed to a pick-up in cost pressures and pricing power, with a rise in underlying inflation to around 3½ per cent over the past year. However, the worsening of the global outlook and the turmoil in financial markets are expected to result in some moderation of domestic growth. The forecasts described below represent the most likely central path reflecting both these effects.
The inflation forecasts have been revised upwards following the high December quarter outcome. Underlying inflation is forecast to be around 3½ per cent over the year to the December quarter 2008 (Table 15). The forecast of a continuing high level of underlying inflation reflects the expectation that pressures on capacity will remain for some time. Indeed, in the near term, it is likely that the year-ended rates of underlying and headline inflation will rise somewhat from current levels, reflecting the succession of large quarterly increases in the three latest quarters.
Underlying inflation is expected to fall gradually in 2009 and beyond, to around 3 per cent at the end of the forecast period in mid 2010, with CPI inflation forecast to follow a similar pattern. This reflects the forecast moderation in demand growth and a gradual easing in capacity pressures which are expected to reduce the pricing power of businesses and alleviate wage pressures. Over the next year, the recent pattern of subdued tradables inflation and very strong non-tradables inflation is forecast to continue. However, further out in the forecast period, the dampening impact of the appreciation of the exchange rate can be expected to wane, and tradables inflation could be expected to contribute a little more to overall inflation. Hence the forecast slowing in overall inflation will require a significant slowing in non-tradables inflation, which will depend on a noticeable easing of capacity pressures in the domestic economy.
Risks to these forecasts can be identified in both directions. A further deterioration in the outlook for global growth represents the main source of downside risk to the forecasts for domestic activity. In particular, if the weakness in the developed world were to lead to a more marked slowing in China and the other developing Asian economies than currently assumed, it is likely that the outlook for the Australian economy and commodity markets would deteriorate significantly. This would be expected to lead to some easing in growth of domestic incomes, spending and activity, and hence some further moderation in inflation over time. In addition, there is also a risk that the current dislocations in capital markets could worsen and result in a significant reduction in credit to households and businesses, which could lead to a more considerable slowing in domestic growth.
There are also upside risks to the domestic growth and inflation forecasts. It is possible that the boost to the terms of trade over recent years will provide a larger ongoing stimulus to the domestic economy than has been assumed, and that domestic demand does not slow as much as forecast. If demand were to be stronger than expected, the forecast easing in the inflation rate would be unlikely to eventuate with the current policy settings. Most importantly, if it is not reversed reasonably quickly, the recent pick-up in inflation carries the risk of generating an upward drift in inflation expectations, which could feed back into wage- and price-setting behaviour.