Statement on Monetary Policy – November 2008
The outlook has changed significantly since the time of the August Statement. Conditions in financial markets, both globally and domestically, have worsened in a number of key aspects. This has prompted measures to provide support to financial institutions in some of the major economies, as well as measures to guarantee bank liabilities both domestically and abroad. There has also been a significant deterioration in the outlook for global growth. Commodity markets have weakened materially, which has contributed to a sharp depreciation of the Australian dollar. Monetary policy has been eased in many countries, and expansionary fiscal measures have also been taken in some countries.
Overall, the domestic growth forecasts have been revised down, reflecting the deterioration of the global outlook and price falls in commodity markets. The extent of the weakening in growth will be moderated, but not fully offset, by the easings that have occurred in monetary and fiscal policy and by the large depreciation of the exchange rate. Inflation is forecast to fall gradually from its current elevated level, returning to the Bank’s medium-term target range in 2011.
As previously, these forecasts do not incorporate any effects, particularly on inflation, from the Government’s Carbon Pollution Reduction Scheme (CPRS). Once the precise details of the CPRS are determined, which will influence the starting price of carbon and its trajectory over time, the Bank will incorporate estimates of initial and ongoing effects of the CPRS into its forecasts.
The international economy
The international environment has weakened considerably. Global equity prices are around 20 per cent lower since the August Statement and 38 per cent lower than their peak in October 2007 (Graph 86). Credit spreads have widened in global financial markets, and financial institutions have tightened lending standards. These developments will have a significant contractionary effect on the global economy, and will exacerbate the slowdown already evident in many countries in the monthly indicators of real activity.
The Bank’s forecasts incorporate a projection that, on an export-weighted basis, year‑average growth in Australia’s major trading partners will slow sharply from around 3¾ per cent in 2008 to around 2¼ per cent in 2009. This compares with average growth of 5¼ per cent in 2006 and 2007. Weighted by output at market exchange rates, trading partner growth is projected to be below 1 per cent in 2009, which would generally be considered a global recession. A gradual recovery is projected for 2010.
Economic activity in the United States and Europe is expected to contract further in the near term. Growth in the emerging economies of Asia is forecast to remain stronger than in the leading developed economies, but it too will slow markedly from the rapid rates of recent years due to weakening external and domestic demand (Graph 87). Growth in China has already slowed, and in 2009 is expected to be well below the levels seen in recent years. These projections for global growth in 2009 are below the latest published Consensus and IMF forecasts, especially for the Asian region.
Commodity prices have fallen sharply recently, which is expected to lead to a larger decline in Australia’s terms of trade than had previously been assumed (Graph 88). Recent falls in base metals and rural prices will be reflected almost immediately in Australia’s export prices. In addition, spot prices for coal and iron ore – which currently make up a third of the value of exports – have fallen steeply. Spot prices are now below the current contract prices, mainly reflecting slowing demand, particularly in the steel industry. With global growth expected to remain weak for some time, and supply expected to pick up due to the high level of mining investment over recent years, contract prices in US dollar terms are assumed to decline significantly from mid 2009 for coal and iron ore exports. Nevertheless, given the earlier large run-ups and the recent depreciation of the exchange rate, prices of many commodities in Australian dollar terms are likely to remain at comparatively high levels.
The forecasts for the domestic economy are based on the technical assumption of a cash rate of 5.25 per cent throughout the forecast period to June quarter 2011, although they allow for some reduction in bank deposit and lending rates to reflect the impact of the recent government guarantees of liabilities of authorised deposit-taking institutions. As usual, the forecasts are also based on the technical assumption that the price of oil and the level of the exchange rate remain around current levels throughout the projection period.
In addition to their effect on household and business confidence, the recent global developments are expected to feed through into the domestic economy through two main channels. First, the fall in the stock market has significantly reduced household wealth, which will dampen household spending. Although estimates of the effect of wealth on consumption spending are subject to a high degree of uncertainty – some estimates suggest that a change in household wealth of one dollar results in a long-run change in consumption of around 4 cents – the fall in wealth that has occurred is sufficiently large to have a material effect on household spending over the coming period.
Second, as noted earlier, some unwinding of the boom in commodity prices, which significantly boosted incomes and demand over the past five years, appears to be occurring. The unwinding of much of the recent price increases is expected to result in a scaling-back of mining-related investment. A number of resource companies are reconsidering their capital expenditure intentions for 2009, and smaller mining firms in particular are likely to cut back their investment. Reduced spending in the resources sector would flow through into slower activity in other sectors of the economy.
Overall, growth in non-farm GDP is expected to slow from 2.5 per cent over the year to the June quarter 2008 to around 1 per cent over the year to the June quarter 2009. The expected global recovery, the recent exchange rate depreciation and easier monetary policy should contribute to a subsequent gradual pick-up in growth, to around 3 per cent over the year to the June quarter 2011 (Table 14). With farm sector output partly recovering from the drought over 2008/09, total GDP growth is forecast to be somewhat stronger than non-farm growth over the next year or so. These rates of output growth imply a significant easing in capacity pressures in the economy. The Bank’s forecasts for growth in 2008 and 2009 have previously been well below most private-sector forecasts, but the latter have recently been lowered significantly and are now relatively close to the revised Bank forecasts.
Much of the softening in growth is expected to be felt in a slower pace of domestic spending. Household spending is expected to grow only modestly over the next year, although there will be some stimulus in the December and March quarters from the one-off payments in the Government’s fiscal package. Growth in household spending is expected to gradually pick up later in the forecast period as the effects of the fall in household wealth ease. Dwelling investment is expected to be boosted over 2009 by the increase in the First Home Owner Grant scheme and by the decline in interest rates.
Business investment is forecast to gradually fall over most of the forecast period. Whereas the forecasts in the August Statement previously contained only weakness in non-residential building, lower commodity prices and restricted access to finance are now expected to also flow through into investment more broadly in the resources sector and elsewhere. Business investment has recently been very high as a share of the economy This share would be expected to fall back to more average levels over the forecast period. Public demand growth is expected to be moderate as a result of some fiscal consolidation by state governments, although the federal government’s plans for infrastructure spending are expected to support public investment from mid 2009.
Weak demand in Australia’s major trading partners is expected to weigh on export growth. However, this will be offset to some extent by the sharp depreciation of the Australian dollar and strong increases in resource exports following the ramp-up in mining investment in recent years. Towards the end of the forecast period, non-rural export growth is expected to strengthen to its fastest pace in a decade. Import growth will be subdued throughout most of the forecast period in line with the expected weak pace of growth in domestic demand.
In line with the forecast slowing in domestic activity, labour demand is expected to ease significantly during the next two years, following a period of considerable strength in recent years. The level of employment is forecast to be broadly flat over 2009 before employment growth picks up gradually as the economy recovers, and the unemployment rate is expected to rise over the forecast period.
Relative to the August Statement, the inflation forecasts incorporate a weaker outlook for global and domestic growth and lower oil prices, but a significantly lower exchange rate. The net effect has been a modest upward revision to the inflation forecasts.
The current elevated level of underlying inflation is mostly a reflection of high inflation in the non-tradables component of the CPI, where prices rose by 6.1 per cent over the year to the September quarter. While there are specific items (such as the housing and financial services components) that have grown particularly rapidly, the breadth of the price increases suggests that the strong pace of non-tradables inflation is largely a reflection of the high level of resource utilisation over recent years. Some decline in non-tradables inflation can be expected in the period ahead as the economy slows and capacity pressures ease, but it is likely that there will be significant inertia in this component.
In contrast, tradables inflation has been quite low in recent years, especially for measures that exclude petrol and food. Indeed, import prices in mid 2008 were lower than six years earlier, due to the significant appreciation of the Australian dollar from 2002 to mid 2008, and to a lesser extent to the low level of inflation in global manufactures over this period. However, with the recent large depreciation of the exchange rate, import prices are expected to rise sharply and tradables inflation will gradually increase.
The combination of rising tradables inflation and slowly declining non-tradables inflation is likely to keep underlying inflation at close to its current year-ended rate in the near term. Over time, however, overall inflation is expected to gradually fall, with the significant slowing in global and domestic activity implying a further easing of capacity pressures, and some reduction in the pricing power of businesses (including the extent to which firms can pass on higher prices for imports). Wage pressures are also likely to abate. Inflation expectations have moderated, and the falls in the prices of oil and other commodities will also help to dampen inflationary pressures.
Overall, underlying inflation is expected to remain at around 4½ per cent over the year to December 2008 and then to decline gradually, reaching 3¼ per cent by mid 2010 and 2½ per cent by mid 2011. Recent falls in petrol prices and a possible fall in the financial services component of the CPI are expected to contribute to a fall in CPI inflation in the near term, but CPI inflation would subsequently be expected to move broadly in line with the forecast for underlying inflation (Table 14).
These central forecasts reflect a judgment as to the net effect of a number of powerful influences, some contractionary and some stimulatory, on the Australian economy. Given the recent changes to the external environment – as reflected in sharp falls in financial and commodity markets and large downward revisions to the global growth forecasts – as well as the large depreciation of the exchange rate, the extent of uncertainty surrounding the forecasts is larger than usual.
With the ongoing stresses in financial markets, it is possible that the deterioration in the external environment could continue. Even if this did not occur, the effects on domestic activity of the deterioration that has already occurred could be deeper or more persistent than expected in this outlook. In particular, a more rapid unwinding of the resources boom than has been assumed would have significant negative effects throughout the economy, resulting in softer growth in domestic incomes and spending. If so, there would be a quicker moderation in inflation. Furthermore, there is a risk that developments in capital markets could result in a sharper than foreshadowed reduction in the availability of credit to Australian households and businesses, thereby exacerbating the slowing in domestic activity.
On the other hand, the global economy could rebound faster than currently anticipated. Governments and central banks around the world have responded to the market turmoil and global slowdown with numerous policy initiatives, and further actions may well be forthcoming. In addition, the recent sharp falls in commodity markets could prove to be overdone. If so, the slowing in the domestic economy, especially in the resources sector, could be smaller than forecast here, and the decline in inflation would be more modest.