Statement on Monetary Policy – May 2008
Domestic Economic Conditions
The December quarter national accounts confirmed the picture of strong growth in the Australian economy through 2007, driven by rapid growth in domestic spending. Real GDP rose by 0.6 per cent in the December quarter, to be 3.9 per cent higher over the year, while domestic final demand increased by 5.7 per cent over the year (Graph 33, Table 6). However, more recent information, including from the Bank’s business liaison, suggests that there has been a noticeable slowing in the pace of growth in demand and output over the past few months in response to the tightening in financial conditions. Consumer and business sentiment have fallen sharply. Retail sales declined slightly in real terms in the March quarter, motor vehicle sales and home-building approvals have fallen, and there has been a cooling in the established housing market. There are also indications of a slowing in the rate of growth in household and business borrowing. In the labour market, conditions have thus far remained tight. Very large increases in contract prices for iron ore and coal are in prospect, which will provide a considerable boost to national income. Following some good rainfall in recent months, the outlook for the rural sector has also improved.
The tightening in financial conditions and reduced confidence about future economic conditions have resulted in households reining in their spending on consumption and housing in the early part of 2008. While consumption grew strongly through 2007, more timely indicators suggest a noticeable slowing in the March quarter (Graph 34). Real retail sales fell by 0.1 per cent in the quarter to be 3.1 per cent higher over the year, after growth of around 5 per cent in 2007. In the Bank’s liaison with retailers, it was reported that sales had been particularly soft in the month of March, although this was not apparent in the published ABS data, which take account of the effect on monthly sales of the precise timing of Easter. Nevertheless, retailers report that trading conditions generally remained subdued in April, while motor vehicle sales to households have also softened recently, falling by 2.5 per cent in the three months to April. Measures of consumer sentiment have fallen significantly to be about 10 per cent below average in April, suggesting that households have become more cautious about the future and less willing to spend.
Although consumer spending has moderated, the financial position of the household sector remains sound. The tight labour market has supported real household disposable income, which rose by 6.4 per cent over 2007 and is likely to have increased again in the March quarter given continued strong employment growth (Graph 35). Household net worth has grown rapidly in recent years, rising by around 10 per cent over 2007, although it is likely to have fallen in the March quarter given the significant decline in equity markets. While household indebtedness is high by historical standards, relatively few households are in arrears on their loans, with non-performing loans accounting for around 0.4 per cent of the value of housing loans on banks’ domestic books in March. There are, however, some areas of greater stress, as outlined in the March 2008 Financial Stability Review, and loan arrears are likely to rise as the economy slows. The aggregate rate of household saving has increased over the past few years.
While house prices rose strongly in 2007, the housing market has softened in early 2008. This is particularly evident in the auction market with clearance rates having fallen, especially in Sydney and Melbourne where they are now at below-average levels (Graph 36). House price growth has also slowed noticeably, with ABS data showing that capital city house prices rose by 1 per cent in the March quarter, down from average quarterly rates of around 3 per cent in 2007 (Table 7). For Australia as a whole, other measures of house prices, such as the RP Data-Rismark hedonic measure, the APM composition-adjusted measure, and the Residex repeat-sales measure show a similar picture. However, there was considerable variation across the different measures for individual capital cities in the March quarter, making it harder to assess recent city-level house price movements. Over the year to the March quarter, house prices in Adelaide, Brisbane and Melbourne increased by around 20 per cent, Sydney experienced more moderate growth of around 6 per cent, and Perth prices were broadly flat after roughly doubling from mid 2003 to late 2006.
Housing finance data also indicate that the tightening in financial conditions has affected demand for housing. The flow of new loan approvals has fallen noticeably since the first half of 2007, while growth in the stock of housing credit has slowed from an annual rate of nearly 14 per cent in early 2007 to around 11 per cent in March. The recent pace of housing credit growth is around the slowest since the early 1990s, although it is still a bit stronger than would be expected given the extent of the fall in loan approvals (Graph 37). This suggests that net housing loan repayments have fallen over the period, possibly partly because households’ capacity to make excess repayments has declined as interest rates have risen, although it is difficult to draw firm conclusions about this given the volatility in the data.
Housing construction activity remains relatively subdued. Dwelling investment rose by 1.6 per cent over 2007, but remained below its 2004 peak, and leading indicators suggest new dwelling construction is likely to remain soft for some time. The number of approvals declined by 6½ per cent in the March quarter with weakness in both houses and the medium-density sector (Graph 38). Revisions to the data have significantly increased the level of approvals for the period from December to February, and approvals now show a steady decline over this period rather than an initially reported sharp fall in December. The Bank’s liaison with builders suggests some further softening is likely over coming months as the full effect of higher interest rates is felt.
Housing rental markets across the country are facing increasing pressure from the growing shortfall in the supply of new dwellings relative to underlying demand. Vacancy rates are at historical lows at just over 1 per cent; a rate of around 3 per cent is generally considered to indicate a reasonably balanced rental market. The CPI measure of rents rose by 7.1 per cent over the year to the March quarter, which is the largest increase in that measure since late 1989, while data from the state Real Estate Institutes suggest that rents for newly negotiated agreements have grown by 13½ per cent over the past year.
Private-sector surveys suggest that business conditions have weakened over the past few quarters although they remain relatively strong (Graph 39). Consistent with above-average conditions and the strength of the labour market, the NAB survey reported that non-farm capacity utilisation is still close to record high levels. Business confidence fell significantly in the March quarter, though it should be recognised that confidence measures tend to be quite volatile and often are not a good guide to future developments.
Businesses’ internal funding remained strong at the end of 2007, with the aggregate profit share close to a three-decade high, at 31 per cent of GDP (Graph 40). Total private-sector profits grew by around 7 per cent over 2007, following growth averaging 10 per cent over the previous two years. Profits outside of the mining sector drove growth, with mining sector profits easing from very high levels due to slower growth in commodity prices over the period, continuing cost pressures and the stronger Australian dollar. Looking ahead, equity analysts have lowered their profit forecasts in recent months, consistent with the easing in business conditions reported in the private-sector surveys. However, mining sector profits are likely to rise sharply around the middle of this year given the very large increases in coal and iron ore contract prices that are in prospect.
On the external funding side, the cost of debt funding has increased substantially since mid 2007 and businesses’ access to capital markets has been much reduced. Bank lending standards have also been tightened. Although businesses continued to source funds through banks at a rapid pace over the second half of 2007, the pace of growth in intermediated borrowing has slowed in recent months, as discussed further in the ‘Domestic Financial Markets and Conditions’ chapter.
New business investment rose by 0.6 per cent in the December quarter to be around 8 per cent higher over 2007 as a whole (abstracting from the reclassification of Telstra). Growth in the quarter was driven by increased spending on machinery & equipment while investment in building & structures declined (although this is a volatile series reflecting the inevitably lumpy nature of the work). Looking through this volatility, much of the growth in investment over the past three years has come from buildings & structures, particularly heavy engineering construction related to the mining sector. This has resulted in business investment as a share of GDP being around its highest level since the late 1980s (Graph 41). By boosting the growth rate of the capital stock, this investment is significantly expanding the productive capacity of the economy (for further details see ‘Box B: Investment and the Productive Capacity of the Economy’, February 2008 Statement on Monetary Policy).
Notwithstanding the recent increase in business funding costs and slowing in the pace of business borrowing, the near-term outlook for business investment remains strong, largely due to the positive outlook for the mining sector. The most recent capital expenditure survey, which was taken in January and February, pointed to strong growth in firms’ spending on buildings & structures in 2007/08 and solid growth in spending on machinery & equipment, while early indications were that investment would continue to expand in 2008/09. Much of this growth was expected to be resource or infrastructure-related, reflecting the large pipeline of work that has commenced but is yet to be done (Graph 42). Project-based indicators suggest that more large engineering projects (particularly in the mining, transport and utilities sectors) are due to commence in the near future. Nevertheless, the further tightening in financial conditions in the early part of this year, coupled with recent declines in business confidence, may mean some scaling-back of the investment intentions signalled in the capital expenditure survey.
A significant amount of office construction is also in the pipeline, although the outlook has become more uncertain due to the ongoing stresses in global financial markets. While conditions in the office property market remain very tight – the latest data from Jones Lang LaSalle point to a further fall in the national vacancy rate in the March quarter to 3.7 per cent, its lowest level since the late 1980s (Graph 43) – the higher cost of funding, difficulties refinancing short-term debt, and the sharp swing in sentiment against highly leveraged companies have all weighed on investor demand. As a result, national capital values are estimated to have been broadly flat in the March quarter, after rising by almost 80 per cent over the previous three years, and some office construction projects have reportedly been delayed. Nevertheless, the fundamentals underpinning the office property market remain favourable, with strong demand and only very limited vacant office space resulting in strong growth in rents.
While conditions in the rural sector remain weak, the outlook has improved somewhat in recent months. The Bureau of Meteorology predicts that over coming months (the winter planting period) most agricultural areas in Australia have at least an even chance of above-average rainfall. Given this outlook, there is a good probability of significantly higher cereals output than in 2007 and that graziers will rebuild livestock numbers. While there has been good rainfall over the first four months of the year, flows into the Murray-Darling river system have been lower than is usual for that time of the year and the extent of the rebound in production remains highly dependent on good winter rainfall.
Export volumes are estimated to have increased solidly in the March quarter, to be around 3 per cent higher over the year, with growth in non-rural exports more than offsetting the sharp fall in rural exports due to the drought (Graph 44).
Resource export volumes are estimated to have risen solidly in the March quarter. Floods in Queensland in January and February disrupted mine production and the transport network resulting in a fall of 7 per cent in the volume of coal exports in the March quarter (Graph 45). These supply problems have contributed to the dramatic increases in spot prices for coal. Iron ore export volumes rose strongly in the quarter, partly reflecting a relatively mild cyclone season in Western Australia. Coal exports should recover in coming months from the flood damage, and the first iron ore shipments from Fortescue Metals’ Pilbara project are expected this month. Further ahead, the volume of resource exports is likely to grow strongly as mine and infrastructure expansion boost overall capacity, and export values will jump sharply when the very large increases in coal and iron ore contract prices take effect (for more details, see the ‘International Economic Developments’ chapter).
Services export volumes are estimated to have fallen in the March quarter, to be little changed over the year. Exports of travel services have slowed noticeably since mid 2007, following a period of solid growth underpinned by strength in education exports. After declining in the December quarter, manufactured exports are estimated to have risen in the March quarter to be around 5 per cent higher over the year, reflecting increased exports of transport equipment.
Import volumes are estimated to have increased by 3½ per cent in the March quarter to be around 11 per cent higher over the year. While the strength in imports over the past year or so is not surprising given the strong growth in domestic demand in 2007, the growth in the March quarter suggests that domestic demand may not have been quite as soft as some of the recent indicators had implied.
The current account deficit widened to 7.0 per cent of GDP in the December quarter, and seems likely to have risen further in the March quarter given stronger growth in import values than in export values in the quarter. Assuming no change in the net income deficit, the increase in the trade deficit implies a current account deficit of around 7½ per cent of GDP.
The real trade-weighted exchange rate has risen slightly to be 27 per cent above its post-float average (Graph 46). While the appreciation of the exchange rate over recent years has adversely affected some parts of the traded sector, the economy as a whole has benefited from the associated increase in Australia’s terms of trade. Indeed, over the past few years, Australia has experienced an extraordinary run-up in the terms of trade (Table 8). Once the increases in annual iron ore and coal contract prices take effect around mid-year, the terms of trade are projected to be around 65 per cent higher than five years ago.
Labour market conditions remained strong in the March quarter with no sign at this stage of slowing in employment growth. Employment increased by 0.8 per cent in the March quarter and by 2.8 per cent over the year (Graph 47). Over the past two years, full-time employment growth has been particularly strong and outpaced the growth of part-time employment, whereas over the past couple of decades part-time employment has usually grown more quickly. The participation rate was unchanged through the March quarter, at 65.2 per cent, which is the highest rate on record. The unemployment rate reached a new multi-decade low in February, but increased a little in March, to stand at 4.1 per cent. The divergence between the strong labour market and the softening in some of the other domestic data is likely to partly reflect the fact that employment generally lags changes in spending and activity slightly.
Employment growth has been strong across a wide range of industries. Over the year to the March quarter, manufacturing, property & business services, retail and health & community services were among the fastest growing sectors. As discussed in ‘ Box B: Regional Economic Performance’, labour market conditions have remained strong across the states.
Some recent easing in the forward-looking indicators of the labour market provides tentative evidence that conditions might have begun to soften. Job vacancies as measured by the ABS survey of employers fell slightly in the three months to February, although the vacancy rate remained close to its three-decade high (Graph 48). The ANZ measure of job advertisements remained broadly flat in the three months to April, and growth in the SEEK measure slowed in the March quarter. The ANZ and SEEK measures of newspaper and internet vacancies have been significantly affected by changes in the way vacancies are advertised in recent years, which complicates their interpretation as indicators of labour demand. Nevertheless, the various business surveys also report that firms’ employment intentions have eased, although the demand for labour remains relatively strong.