Statement on Monetary Policy – May 2008
Inflation in Australia picked up over the past year in an environment of limited spare capacity and earlier strong demand. In these circumstances, a significant slowing in the growth of demand from the rapid pace of 2007 will be needed in order to return inflation to the target over time. There are signs that such moderation is now occurring.
Whether or not this more moderate pace is sustained will depend on the net effect of a range of contrasting forces likely to be affecting the economy in the period ahead. Several factors, including a slowdown in global growth, continuing strains in world financial markets and tight domestic financial conditions, are working to dampen demand. Working in the other direction, a further increase in Australia’s terms of trade this year will provide a substantial stimulus to incomes and spending. Given the nature of these forces, their net effect is subject to significant uncertainty. On balance, the Board’s judgment at this stage is that growth in domestic demand will remain moderate this year, and that this will help to reduce inflation over time.
The slowing in the global economy has to date been most pronounced in the United States. Recent data have indicated little growth in the US economy in the March quarter, with consumer spending slowing and housing construction activity still a significant drag on growth. Falling house prices could continue to dampen the US household sector for a while yet, although expansionary monetary and fiscal policy measures taken in the recent period will help to support activity. Conditions in the other major advanced economies have also softened this year. In the euro area, business conditions and consumer sentiment have declined, although moderate growth in demand and activity is continuing. Japan similarly is experiencing softer conditions this year.
In contrast, growth in the developing world at this stage remains strong. The Chinese economy has continued to grow at a pace of more than 10 per cent, and indicators of spending and production around the rest of the east Asian region have showed little sign of slowing in recent months. Reflecting these varying developments, official and private sector observers are generally expecting below-trend growth in the world economy this year and next, with weak conditions in the major advanced economies being cushioned by relatively high growth in the developing world.
Sentiment in global financial markets has fluctuated considerably over recent months, reaching its low point in mid March around the time of the Bear Stearns rescue, and subsequently improving somewhat. The problems surrounding Bear Stearns added to liquidity strains already existing in global financial markets. In response, major central banks pursued a number of co-ordinated initiatives to ease the situation and, in the United States, the Federal Reserve made a significant set of further changes to its operating procedures in the money market.
A general improvement in global financial market sentiment since around mid March has been evident in several developments. While financial institutions continued to report large writedowns on credit products in their recent first quarter earnings results, this was accompanied in a number of cases by the announcement of large capital raisings. There has been less evidence recently of asset sales resulting from de-leveraging. The general shift in sentiment during this period has also been seen in rising government bond yields, a decline in credit default swap premia, and a firming in global share markets. Nevertheless, sentiment remains fragile.
The primary exception to this improvement has been in short-term money markets, where spreads remain at high levels in major countries. However, the Australian money market has been less affected by these global strains. While the spread between the bank bill rate and the expected cash rate in Australia is still noticeably higher than it was a year ago, it has narrowed recently to around 45–50 basis points from its peak of 80 basis points in mid March. Reflecting the recent improvement in market conditions, the Bank has been able to wind back the amount of funds provided in its domestic operations, with exchange settlement balances declining to less than $2 billion from around $5.5 billion at the end of March.
While global growth prospects have softened since last year, inflation remains a concern in many countries. Pressure has been particularly evident in prices of food and a range of resource commodities. Oil prices have risen further in recent months, and base metals prices have also been at high levels. The main factor behind the continued strength in resource commodity prices seems to be the strength of Chinese demand, in combination with a relatively limited supply response to the higher prices to date.
The contrast in economic conditions between parts of the developed world and the emerging economies has been reflected in the actions of central banks. In the United States, successive interest rate cuts in response to the economic slowdown have brought the fed funds rate down to 2 per cent, and interest rates have also been reduced in the UK and Canada. In contrast, central banks in a number of emerging economies including China, Brazil, India and South Africa have tightened policy in response to inflationary pressures.
In Australia, national accounts data confirmed that the economy grew strongly during 2007. GDP growth was 3.9 per cent over the year, while domestic demand grew at an unsustainably fast pace of 5.7 per cent. Australia’s economic expansion has continued over a prolonged period, and this has resulted in surplus productive capacity being progressively wound back. A range of indicators of capacity utilisation and labour market tightness all point to spare capacity now being very limited. These conditions, combined with the strong growth in demand that prevailed through to the end of 2007, have contributed to an increase in Australia’s inflation rate. Evidence of stronger inflation emerged in the second half of 2007, and the year-ended inflation rate rose further in the March quarter this year, both in terms of the CPI and underlying measures. The CPI increased by 1.3 per cent in the quarter and by 4.2 per cent over the latest year. While some pick-up in year-ended inflation had been anticipated, the March quarter result was higher than expected. Strong contributions came from food, fuel and housing costs, though the price increases were broadly based and encompassed both tradable and non-tradable items in the CPI.
While domestic sources of inflationary pressure have clearly increased over the past year, the rise in inflation has been partly a result of global factors, notably a general increase in commodity prices. Reflecting this, preliminary-stage producer prices rose by 7 per cent over the latest year. Since rising raw materials prices are a global phenomenon, it is not surprising that consumer price inflation rates have picked up recently around the world. Nonetheless, inflation in Australia has for some time been above the average for the advanced economies, and this margin has increased recently. This has reflected the much stronger demand conditions prevailing in Australia for most of the recent period.
Against this background, the Board has been seeking to slow the growth of aggregate demand in order to reduce inflation. To that end, the Board raised the cash rate on two occasions in the second half of 2007 as well as at its February and March meetings this year. Market developments since mid 2007 have added to the tightening in domestic financial conditions. Australian financial intermediaries have experienced increases in funding costs, which have been passed on to borrowers. Some tightening in credit standards for more risky borrowers has also occurred.
The available economic data for 2008 suggest that a significant moderation in domestic spending is now occurring. After strong growth last year, the volume of retail sales is estimated to have fallen slightly in the March quarter, and this has occurred against the background of a sharp decline in consumer sentiment. Indicators of housing construction activity have also fallen in recent months. In the business sector, surveys point to a noticeable fall in confidence in early 2008, though trading conditions at this stage are reported to have softened only modestly. Labour market indicators, at the time of writing, have for the most part remained strong in recent months, with employment continuing to expand in the March quarter and unemployment remaining close to recent lows.
Developments in financing activity and in the established housing market are generally pointing to more subdued demand this year. Housing loan approvals have fallen in recent months and, to a lesser extent, there has been a slowing in the growth of housing credit outstanding. In the established housing market, auction clearance rates have fallen from last year’s high levels, while average house prices in the capital cities slowed in the March quarter after strong rises through 2007. In addition, after a period of very rapid growth, finance to businesses has slowed noticeably in recent months. Hence, while it is still too early to gauge the full effects of the tightening in financial conditions, the evidence to date is that a noticeable restraining impact is being exerted on household and business borrowing and on overall domestic demand.
In assessing the outlook for demand and growth, an important countervailing consideration is the stimulus that will come this year from Australia’s rising terms of trade. Based on the latest contract negotiations for coal and iron ore, it is likely that the terms of trade will rise by around 20 per cent this year as the new contracts come into effect. This is well above the average increase over the past four years, and higher than appeared likely a few months ago. Given current capacity constraints and the large increases in investment that have already occurred, it is possible that the mining companies and governments that receive the revenue gains may find it more difficult than in previous years to make major expansions to their investment spending in the near term. Even so, the projected increase in Australia’s terms of trade represents a substantial boost to national income.
Hence, in summary, prospects for growth of the Australian economy and for inflation will depend on the net impact of several contrasting factors, including the slowdown in the major advanced economies, the ongoing turmoil in world financial markets, tight domestic financial conditions and, working in the other direction, the forthcoming stimulus from Australia’s rising terms of trade. Given the opposing forces at work, their overall net effect on demand and inflation is subject to considerable uncertainty. The recent evidence is that a significant moderation in domestic demand is now occurring. The full effects of the recent tightening in domestic financial conditions are yet to become apparent although, on the other hand, the stimulus from this year’s terms-of-trade increase is also still in the future.
On balance, the Board’s assessment is that a period of below-trend growth in the Australian economy is now in prospect. If sustained, this will mean a gradual easing in capacity pressures, which in turn can be expected to have a restraining influence on inflation over time. On this basis, while inflation is likely to remain high in the short term, it is forecast to start to decline towards the end of 2008, reaching a rate of around 2¾ per cent at the end of the forecast period. This assessment would need to be reviewed if the expected moderation in domestic demand does not occur, or if expectations of high ongoing inflation begin to affect wage and price setting.
At its most recent meeting, the Board considered whether the current stance of monetary policy was sufficiently restrictive to reduce inflation over time. On balance, the Board judged that the setting of monetary policy was appropriate for the time being. The Board will continue to monitor developments, and will make adjustments to policy as needed to ensure that inflation returns over time to the medium-term target.