Statement on Monetary Policy – February 2008
International Economic Developments
Growth in the world economy has slowed in recent months as the credit market turmoil and tightening in financial conditions in the major developed economies have started to weigh on the household and corporate sectors in those economies. However, conditions in the emerging-market economies, particularly China and the smaller east Asian countries, have thus far remained strong.
There is significant uncertainty as to the likely size of the eventual impact of recent financial market tensions on economic activity in the United States and other developed economies, and the effect this will have on the rest of the world. This uncertainty is evident in the larger-than-usual spread of analysts’ forecasts in the January Consensus Economics survey. Half the forecasters expected US GDP growth in 2008 of more than 2 per cent in year-average terms, while a number of other forecasters expected growth of around 1 per cent, which would probably imply a couple of quarters of contracting economic activity. More recently, an increasing number of forecasters appear to be taking the latter view, and it is likely that the period of weak growth in the US economy will be accompanied by a noticeable slowing in some of the other major developed economies.
Slower growth in the developed world can be expected to have some impact on growth in the developing countries through both trade and financial channels. There is little sign of the recent financial turmoil itself being a problem for the emerging east Asian economies, which are not major borrowers in international capital markets, although recent falls in their equity markets could dampen sentiment. The current expectation is that the bulk of the impact will be through the trade channel, particularly as these economies have high degrees of trade openness. While slower export growth is expected to weaken GDP growth in east Asia somewhat, domestic demand is expected to remain solid in the region in 2008. Some slowing in the pace of growth in China is expected and may in fact be welcomed by the Chinese authorities, particularly as they have recently ramped up their policy efforts to slow growth and inflation.
Overall, both private and official forecasts are for a period of weak growth in the G7 countries in 2008, although growth in emerging economies is expected to remain relatively strong. The Consensus forecasts of world growth (on a purchasing power parity basis) imply a modest slowing, from 4.9 per cent in 2007 to 4.4 per cent in 2008. However, these forecasts are from early January and so do not take account of more recent developments. The latest IMF forecasts, released on 29 January, are for world growth to slow to 4.1 per cent in 2008, which would be roughly in line with the average since the beginning of the decade (Table 1). The Bank’s forecasts for the domestic economy presented in the ‘Economic Outlook’ chapter assume that world growth slows to a pace somewhat below trend, which is weaker than the IMF forecasts.
Major developed economies
In the United States, conditions in the housing market have deteriorated further and there are some signs that this weakness is spilling over into other areas of spending. In the December quarter, GDP grew by 0.2 per cent, although in year-ended terms growth remained firm at 2.5 per cent due to the stronger outcomes recorded earlier in the year (Graph 1). Household consumption, business investment and exports increased in the quarter, while dwelling investment again fell sharply. Sentiment indicators suggest that the deterioration in household and business conditions seen over the latter part of last year continued into January (Graph 2).
In the housing sector, starts and permits are now down by more than 50 per cent from their peaks around the end of 2005 (Graph 3). The stock of unsold homes has remained high and house prices are falling; in late 2007 the Case-Shiller measure of house prices, which covers houses sold in 20 major cities, was 9 per cent below its mid-2006 peak and the pace of decline has been increasing. The Federal Reserve’s Senior Loan Officer Survey also reports that an increasing number of banks have tightened their mortgage lending standards for both sub-prime and prime borrowers.
A key risk to the outlook for the US economy is that weakness in the housing market will feed through to a more significant slowing in household consumption spending. Until recently, consumption growth had been strong, supported by increasing wealth and solid growth in household wages and employment. However, consumption slowed noticeably during the December quarter, household wealth has been affected by the weakness in house prices and the stock market, and the labour market has weakened in recent months. Monthly growth in payrolls employment has slowed to around 40,000 jobs in the three months to January from around 100,000 in the previous three months and around 170,000 a year ago. The unemployment rate has risen by 1/2 percentage point over this period (Graph 4). The softening in the labour market has been largely due to falling employment in the construction and manufacturing industries, although in the past few months employment is also down in the financial services industry.
In response to weakening conditions in the US economy, the authorities have proposed a fiscal stimulus package worth US$146 billion (1.1 per cent of GDP), which includes tax rebates for households and incentives for businesses to invest. In addition, the Federal Reserve cut the federal funds rate by 25 basis points in December and by a further 125 basis points in January. While the Fed has acknowledged that some inflation risks remain, the expected slowdown in economic growth was considered to pose the greater risk to the economy. The sharp pick-up in headline inflation in recent months is mostly due to higher oil and food prices; core CPI inflation has risen more modestly, to 2.4 per cent over the year to December (Graph 5).
In other major developed countries, economic conditions have also weakened after a period of quite strong growth, although to date this trend is more apparent in the survey data than in the official macroeconomic indicators. In Japan, domestic conditions appear to have softened, with business sentiment weakening and conditions in the household sector deteriorating. The unemployment rate rose slightly in the December quarter and consumer sentiment has fallen sharply (Graph 6). In the euro area, tighter bank lending standards and the appreciation of the euro are expected to weigh on growth. Retail sales fell by 0.7 per cent over the year to the December quarter and export growth has slowed. Business and consumer sentiment have fallen, although as of January they remained at or above average levels. Conditions in the UK economy have also moderated in recent months, particularly in the housing market. The Bank of England responded by cutting its policy rate by 25 basis points in early December.
Other major trading partners
In contrast to the major developed economies, growth has remained strong across the Asian region, including in China, India and the smaller east Asian economies. China’s economy has continued to grow strongly, with GDP estimated to have increased by 11.2 per cent over the year to the December quarter (Graph 7). Available indicators suggest that the expansion of the domestic economy continued to make a significant contribution to growth. Nominal spending on fixed-asset investment increased by 20 per cent over the year to December and retail sales volumes are estimated to have grown by around 15 per cent over the same period. The value of imports also grew by 25 per cent over the year to December, outpacing export growth which slowed to 22 per cent over the same period. Slower growth of exports to the United States and Japan over the past year has been partly offset by a pick-up in exports to Europe. In India, strong growth has continued, with GDP rising by almost 9 per cent over the year to the September quarter and industrial production growing at a similar pace over the year to November.
Strong growth has also continued elsewhere in the region. Growth in industrial production in east Asia (excluding China) remained solid at 10 per cent over the year to December, partly reflecting continued strength in ITC production (Graph 8). Growth in the value of exports from east Asia has also continued to be rapid, as slower growth to the major developed economies has been offset by increased exports to China and other emerging economies. Preliminary estimates suggest that in the December quarter GDP growth remained strong in Korea. While GDP is estimated to have fallen in Singapore in the quarter, this largely reflected a sharp fall in pharmaceutical production, which is a particularly volatile sector owing to frequent changes in the product mix.
Inflation has continued to rise in east Asia, driven by increasing prices of food and other commodities. In China, headline CPI inflation was 6.5 per cent over the year to December, which is around its highest rate in more than a decade. While this has mostly been driven by food prices – which account for around one-third of the CPI basket – there are some tentative signs that price pressures are starting to become more widespread. Excluding food, inflation picked up a little in December, although it remains relatively low at 1½ per cent over the year (Graph 9). Reflecting concern about the rapid pace of growth and inflation, the Chinese authorities have made further efforts to tighten monetary policy via tighter credit controls and increases in the banks’ reserve requirement ratio and interest rates, as well as a faster pace of appreciation of the renminbi. Recently, price controls were also introduced for fuel, transport and some food items. Inflation has continued to pick up in the rest of east Asia, driven by higher food and energy prices and core inflation has risen somewhat in recent months.
Commodity prices generally remain at very high levels. Over the past three months, the RBA’s index of commodity prices was little changed, as weaker base metals prices have been offset by higher prices for rural commodities and gold. The index is around 6 per cent higher (in SDR terms) than a year ago and around 80 per cent higher than four years ago (Graph 10).
The RBA index of base metals prices has fallen by 13 per cent over the past three months, with most of the fall occurring during November. All base metals except aluminium recorded sizeable falls. Concerns about the slowing in world growth and the turmoil in global financial markets have weighed on base metals prices, and an improvement in supply conditions of some metals has also contributed to the easing in prices. Despite the recent weakness, in real terms base metals prices generally remain well above their levels of a few years ago, and futures markets suggest this will remain the case for some time. Gold prices have increased by more than 30 per cent over the past year to around US$900 per ounce, underpinned by strong growth in investor and consumer demand. Gold prices have now surpassed their previous nominal peak in 1980 and are at their highest level in real terms in more than 20 years.
Rural commodity prices rose by 4 per cent over the three months to January, supported by further strength in wheat prices. Although global wheat production appears to have picked up in the 2007/08 season, inventories have remained low, and wheat prices have risen by around 50 per cent since mid 2007 (Graph 11). Prices for crops used in the production of biodiesel and ethanol, such as canola and sugar, have also risen strongly over recent months, partly reflecting the high level of oil prices.
In contrast to base metals, coal and iron ore markets tightened considerably over the second half of 2007. Weather-related disruptions to production, constraints on the speed at which supply can be expanded, and the depreciation of the US dollar have contributed to expectations that contract prices for coal and iron ore will increase sharply this year. Market analysts are generally forecasting iron ore, coking coal and thermal coal contract prices to rise by 40–50 per cent for the year starting April 2008 (Graph 12). Given that these commodities account for nearly one-fifth of the total value of Australian exports, these price rises, if realised, would amount to a 7 per cent boost to the terms of trade around the June quarter.