Statement on Monetary Policy – August 2009
International Economic Developments
Conditions in the world economy appear to have stabilised in recent months, after deteriorating sharply in the December and March quarters. Available data suggest that output in Australia’s trading partners increased slightly in the June quarter, after declining by over 3 per cent in the preceding half year (Graph 1). Global industrial production and international trade have recorded modest gains, after earlier very large declines, and there has been a general improvement in sentiment in financial markets, as well as among businesses and consumers (Graphs 2 and 3).
While these signs of stabilisation are encouraging, the large contraction in output over recent quarters has seen capacity utilisation fall to very low levels in many large advanced economies, with unemployment rising significantly, particularly in the United States and Spain (Graph 4). As a result, there has been a modest decline in underlying inflation in many countries, with further falls likely over the next year or so. In contrast, headline inflation has declined sharply in both the developed economies and China, largely due to the significant reductions in oil and food prices in the second half of 2008 (Graph 5). In a number of countries the price level has declined over the past year.
Looking across regions, there are some marked differences in recent economic performance. While conditions have generally improved in most countries, output in the United States and United Kingdom fell once again in the June quarter, and a further fall is likely to have occurred in the euro area. Conditions also remain weak in central and eastern Europe. In contrast, there has been a pronounced improvement in economic conditions in east Asia and India, where activity has generally risen strongly. In part, this is a result of substantial policy stimulus in many of these economies, as well as the dynamics of the inventories cycle (see ‘Box A: Inventories and the Business Cycle’).
Among east Asian economies, the rebound has been most marked in China. RBA staff estimates suggest that after quarterly growth slowed to around ½ per cent in the December quarter, it picked up to around 1½ per cent in the March quarter, and then accelerated to over 4 per cent in the June quarter (Graph 6 and ‘Box B: Some Aspects of China’s Recent Growth’). This sharp turnaround largely reflects the rapid impact of a major fiscal package announced in November together with a substantial easing of monetary conditions, in contrast to the restrictive conditions seen in early 2008. Measures implemented have included: increased public investment in infrastructure and reconstruction following the earthquake in the Sichuan province; incentives for households to purchase housing, automobiles and a range of other durable goods (especially in rural areas); and the easing of various credit controls, together with directives to banks to substantially increase their lending. Banks’ reserve requirement ratios have also been reduced and lending rates have been lowered significantly.
In response to these developments, credit growth in China has increased sharply, to an annualised rate of around 45 per cent over the six months to June (Graph 7). In addition, fixed-asset investment has risen by just over 30 per cent in the seven months since November, and demand for dwellings has grown strongly. Industrial production also picked up sharply over the four months to June, with particular strength in the production of automobiles – passenger car sales have risen by 75 per cent since December. The main area of continuing weakness is the export sector. While export volumes have stabilised in recent months, after falling by around one-quarter between October and February, demand for China’s exports remains weak – especially in the euro area, Japan and the United States, which together account for around 60 per cent of China’s final external demand.
Elsewhere in non-Japan Asia there has also been a strong rebound in activity in most countries over recent months, following earlier sharp contractions (Graph 8). In Korea, GDP rose by 2.3 per cent in the June quarter, after falling by 5 per cent in the December quarter and stabilising in the March quarter (Graph 9). In part, the rebound reflects the easing of both fiscal and monetary policy in late 2008, with the Bank of Korea cutting its policy rate from 5¼ per cent to 2 per cent between September and February, and the government introducing a series of front-loaded stimulus packages focused on infrastructure spending and direct support to the building industry. In Singapore, GDP grew by nearly 5 per cent in the June quarter after declining significantly in each of the previous four quarters.
There are also signs that the Japanese economy has begun to grow, following the largest contraction among the major economies over the December and March quarters. Industrial production has increased by 17 per cent over recent months, after falling by one-third between September and February. Export volumes have also begun to increase, although most of the growth has been in exports to China and other east Asia. Consumer spending has shown signs of picking up, supported by an array of fiscal measures. Notwithstanding these more positive signs, capacity utilisation remains at very low levels, business investment is very weak, and the unemployment rate is still increasing.
As noted earlier, outside Asia the extent of improvement in economic conditions has generally been more muted. In the non-Japan G7 economies output is estimated to have recorded another decline in the June quarter, albeit a more modest fall than in the two previous quarters. Private consumption continues to be weak, reflecting large falls in household wealth and ongoing efforts by individuals to consolidate their balance sheets and increase their saving. Business investment has also fallen markedly as firms have responded to the combination of increased uncertainty, a rapid rise in spare capacity, and much tighter financial conditions. In a number of major countries, including Japan, investment has fallen by 10 per cent or more since late 2008, with the ratio of investment to GDP at or approaching multi-decade lows.
In the United States, economic conditions remain weak, although there are growing signs of stabilisation. Business surveys for both the manufacturing and non-manufacturing sectors of the economy have improved noticeably over recent months, with both now at levels historically associated with broadly flat activity. While GDP fell by a further 0.3 per cent in the June quarter, this was a significantly smaller contraction than the 1½ per cent seen in both the December and March quarters (Graph 10). Exports also appear to have bottomed, in large part due to a rebound in exports to China. More positively, stabilisation of the housing market – which has been seen as a necessary condition for a sustained recovery – looks more likely, with housing starts recording a small rise and some measures of house prices increasing.
A significant factor continuing to weigh on the US economy is the weakness in consumption as households pay down debt. While car sales are being boosted by a car scrappage scheme, similar to those introduced in a number of European countries, spending on other goods and services is likely to remain subdued as a result of weak wage income growth. Although there are signs that the pace of job shedding has slowed, the unemployment rate increased to 9½ per cent in June, the highest level since the early 1980s (Graph 11). One factor helping to support domestic demand will be the sizeable fiscal stimulus measures currently in train, estimated to amount to around 4 percentage points of annual GDP, which will take effect over the 18 months to September 2010. To date, only a relatively small proportion of this discretionary easing has occurred, with the pace of spending expected to rise over the second half of the year and into 2010.
Economic activity in the euro area looks to be still contracting, although the pace of the decline has slowed, with the fall in output in the June quarter likely to have been much less than the 2½ per cent fall seen in the March quarter (Graph 12). Weakness remains relatively broad-based, with both retail sales volumes and business investment continuing to decline. While consumer confidence has risen a little over recent months, it remains at a low level, and the unemployment rate has increased to 9.4 per cent. The deterioration in the labour market is most pronounced in Ireland and Spain. In Germany, the unemployment rate has increased by only ¾ of a percentage point, despite very weak GDP outcomes, reflecting the impact of a government short-term work scheme. In the United Kingdom, GDP fell by 0.8 per cent in the June quarter, following a fall of 2½ per cent in the March quarter. The unemployment rate has increased significantly, but there are signs that house prices are stabilising.
Forecasts and policy responses
The IMF recently raised its outlook for world growth, reflecting the rebound in activity under way across Asia and the evidence of slowing in the pace of output decline in most developed economies. Similarly, OECD forecasts for the advanced economies have become less pessimistic. These modest upgrades represent a marked change from the preceding year, during which the growth projections of most forecasters were subject to frequent and substantial downward revision.
In its July update to the World Economic Outlook, the IMF forecasts a contraction in global GDP of 1.4 per cent in 2009 in year-average terms (with countries weighted by GDP at purchasing power parities, Table 1). Although March quarter outcomes were weaker than expected in a number of countries, the IMF has generally upgraded its expectations for activity in the second half of the year, with year-average growth revised up for a range of countries, most notably China and India. For 2010, the IMF raised its year-average growth forecast for the world economy by 0.6 percentage points to 2½ per cent. The RBA staff forecasts for global and trading partner growth, discussed in the ‘Economic Outlook’ chapter, are somewhat stronger than those of the IMF.
An important factor that has underpinned this improved outlook is the substantial easing of both fiscal and monetary policy that took place in many countries in late 2008 and early 2009, as well as efforts to strengthen the financial sector. As discussed further in the ‘International and Foreign Exchange Markets’ chapter, in many advanced economies official interest rates have been reduced to close to zero, and additional unconventional monetary and financial sector policies have also been implemented. The extent of fiscal easing in advanced economies, both through discretionary measures and from the effect of automatic stabilisers, is also the largest seen for many decades. There has also been a substantial easing of monetary and fiscal policy in a range of other economies (Graph 13).
The very large global policy response has significantly reduced the likelihood that the large falls in global activity seen over the December and March quarters will be repeated. Looking ahead, however, the resulting build-up in public debt is likely to pose significant challenges for many of the G7 (and some other) economies over the years ahead, with policy-makers needing to balance the risks of withdrawing the fiscal and monetary stimulus too early, against those arising from concerns about medium-term fiscal sustainability and price stability.
In line with improving economic sentiment, spot prices for both rural and resource commodities have strengthened since the previous Statement. Crude oil prices have risen by 30 per cent since April to US$70 per barrel, reflecting improved economic sentiment and a fall in US crude oil inventories (Graph 14). The RBA index of base metals prices has increased by 40 per cent over the past three months, with market participants attributing this to an improvement in the global economic outlook, Chinese demand and investment fund purchases. Nickel, in particular, has benefited from the rebound in Chinese stainless steel production, with prices rising by 65 per cent over the past three months.
Spot market prices for iron ore and coal have also increased over recent months on strong Chinese demand and tentative signs of a recovery in demand from other countries, with prices now above the level of the 2009/10 contracts settled between Japanese steel mills and Australian producers. Under those agreements the contract price for iron ore fines was reduced by 33 per cent (in US dollar terms, Graph 15), while the prices of premium forms of iron ore have seen larger reductions. Nonetheless, these agreements represent the second highest benchmark contract prices on record, with the average price 150 per cent higher than the average for the first half of the decade. Benchmark prices have not been agreed with major Chinese steel mills, which have sought larger reductions than those agreed to with Japanese and Korean mills. As a result an increasing proportion of purchases are taking place on the spot market. With most of the anticipated adjustment in bulk commodity prices now complete, the RBA’s index of commodity prices in July was 35 per cent below its September 2008 peak (in SDR terms), but 65 per cent above the average levels seen in the first half of this decade.