Statement on Monetary Policy – February 2009
International Economic Developments
Global economic conditions deteriorated significantly in late 2008. The earlier slowdown in some advanced economies, which was generally concentrated in the housing and financial sectors, broadened to a severe global recession following the financial turmoil that ensued after the collapse of Lehman Brothers in mid September. As a result, the output of Australia’s trading partners, weighted by Australia’s export shares, is estimated to have declined by around 1¾ per cent in the December quarter (Graph 1).
The broad-based economic contraction in the industrialised countries, especially in recent months, can be seen across a range of indicators. Available GDP data for the United Kingdom and United States show declines of 1 per cent or more in the December quarter, while monthly activity indicators point to large contractions in Japan and in the euro area in the quarter. Industrial production in several major countries has weakened sharply in recent months, while surveys of business conditions and consumer confidence have declined to multi-decade lows (Graph 2).
At 1 per cent, the decline in December quarter GDP in the United States was the largest since 1982, with broad-based weakness across the economy. Both the manufacturing and non-manufacturing ISM indices declined to very low levels in late 2008, before recovering somewhat in January; manufacturing production fell by 10 per cent in the year to December (Graph 3). Consumption has been especially weak, partly driven by declines in household net wealth estimated at more than 15 per cent in 2008, and consumer credit contracted over the four months to November. Housing starts fell by 28 per cent over the two months to December, to be well below previous cyclical lows. The business cycle dating committee of the National Bureau of Economic Research declared in December that the United States has been in recession since December 2007.
A striking development during the past few months is that the downturn has spread to the emerging economies. Korea and Singapore recorded exceptionally large falls in output in the December quarter, while weakness in the second half of 2008 saw year-ended GDP growth in China slow to just under 7 per cent, around half its pace as at mid 2007. The decline in industrial production in some east Asian nations has been sharper than in the industrialised countries; over the three months to December, production fell by around 20 per cent in Korea and Thailand and by more than 25 per cent in Taiwan. Economic conditions have also worsened markedly in emerging Europe, and several countries in that region have sought financial assistance packages from the International Monetary Fund (IMF).
Much of the recent weakness in emerging economies appears to reflect the direct transmission of reduced actual and expected demand from the industrialised economies through the trade channel. The value of the other east Asia region’s exports is estimated to have fallen by around 25 per cent between September and December, only part of which can be attributed to valuation effects from exchange rate movements or falling commodity prices. Export values data for Korea and Taiwan in November and December showed falls that were by far the largest observed in a two-month period in these economies in over 20 years of monthly data, and Chinese exports and imports also showed large falls in the last few months of 2008 (Graph 4).
More generally, the Chinese economy experienced a pronounced slowdown in the second half of 2008, with particular weakness in construction, industrial production and trade. This slowdown has reflected both global influences and country-specific factors such as the authorities’ earlier efforts to prevent the economy from overheating. Year-ended growth in industrial production declined from 16 per cent in June to just under 6 per cent in December (Graph 5). Recent indicators of construction activity have also weakened, with a sharp decline in the growth of floor space under construction, partly in response to the stagnation in house price growth. However, measures of consumer demand such as retail sales have been surprisingly resilient.
The pronounced decline under way in global output reflects the confluence and intensification of a range of factors, some of which had been weighing on growth for some time. The most important recent factor was the upsurge in financial market turmoil in September and its apparent effect on the already weak level of consumer and business confidence. In many industrialised countries, especially the United States, financial institutions had been tightening lending standards to households and businesses for some time (Graph 6). However, the collapse of Lehman Brothers and widespread problems in other financial institutions saw a further major shock to the supply of credit, notwithstanding the aggressive actions of central banks globally to cut official rates and provide liquidity. This shock manifested itself, amongst other things, in disruptions to trade credit and insurance, as well as a tightening in lending for investment and consumption spending. The sharp decline in production may also reflect efforts by firms to reduce their inventory levels as demand has contracted and the cost and availability of working capital has deteriorated.
Developments during the latter part of 2008 also appear to have triggered a re-evaluation by households and businesses of the likely length and severity of the current downturn. In the household sector, there were large falls in retail sales during the December quarter in many large economies. The decline in spending has been especially large for big-ticket purchases that are relatively easily postponed, such as new cars (Graph 7). This weakness in household spending has reflected the direct impact of an array of headwinds, including reduced confidence, deteriorating income growth and sharp falls in financial and housing wealth. Since their respective peaks, house price declines of 10 to 20 per cent or more (depending on the measure used) have occurred in the United States and United Kingdom, while significant falls have also been observed in other developed economies including New Zealand, Ireland, Spain and several other European nations (Graph 8). Latest indications are that falls in both house prices and building activity are continuing in these countries and spreading to others.
Business conditions and hiring have also weakened markedly in a number of countries, with implications for household consumption and confidence. Business investment has softened, with recent large falls in the United States, Japan and Korea amongst other countries. Further falls in investment are likely in the near term, given the sharply worse outlook for global demand, increasing spare capacity, constraints on the availability of financing and trade credit, and the need to manage inventory levels. For employment, the recent deterioration has been especially severe in the United States, where firms cut their payrolls by almost 2 million in the four months from September to December 2008, a pace of deterioration that is comparable (as a proportion of the labour force) to that experienced in the severe 1981–82 recession. The unemployment rate stood at 7.2 per cent in December, the highest rate since early 1993. In the United Kingdom, the unemployment rate increased by almost 1 percentage point in the six months to November. Unemployment has also risen sharply in Spain and more moderately in Ireland, but has only recently begun to pick up in the rest of the euro area (Graph 9).
Headline and core inflation in most countries have shifted lower as output growth and global commodity prices have declined (Graph 10). The rapid fall in headline inflation is being primarily driven by the sharp recent declines in oil and some agricultural commodity prices, and thus overstates the moderation in underlying price pressures. Nevertheless, the pace of core inflation in many countries has declined markedly – for example, US consumer prices excluding food and energy were broadly unchanged over the four months to December and year-ended inflation excluding food has fallen sharply in China – suggesting the inflation pressures that were prominent in many economies up to mid 2008 have eased.
Policy responses and forecasts
In response to the deterioration in current and prospective economic conditions, central banks globally have moved aggressively to ease financial conditions and support credit growth, as discussed in detail in the ‘International and Foreign Exchange Markets’ chapter. In addition governments have enacted, or are in the process of finalising, substantial budget packages to support aggregate demand and production, over and above the operation of automatic fiscal stabilisers (Table 1).
At the federal level in the United States, the budget deficit increased by 2 percentage points of GDP in the year to September 2008, to be 3.2 per cent. US authorities are now debating a discretionary easing amounting to around 5 per cent of annual GDP over the course of 2009 and 2010. If enacted, this could see the fiscal deficit in 2009 reach its highest level in the post-war period – even before accounting for funding costs associated with the Troubled Asset Relief Program (TARP). In the United Kingdom, the public sector borrowing requirement is projected to rise to 8 per cent of GDP in the fiscal year to March 2010.
Many Asian nations have also announced substantial fiscal easings. In early November, Chinese authorities announced a stimulus package spread over 2009 and 2010, with most observers assessing the associated fiscal impulse to be in excess of 2 percentage points of GDP in 2009. Discretionary policy measures with an impact of over 2 percentage points of GDP have also been announced in Korea and Taiwan, while other governments in Asia and elsewhere have enacted generally smaller but still significant discretionary budget packages.
Despite this large monetary and fiscal stimulus, growth forecasts by both the IMF and private-sector analysts have been lowered substantially in recent months. After a significant unscheduled cut to its forecasts in November, the IMF further reduced its projection for world growth in 2009 (with countries weighted by GDP valued at purchasing power parities) by an additional 1¾ percentage points in late January, to only ½ per cent; world output based on market exchange rates is projected to contract by ½ per cent in 2009. If realised, this would make 2009 the weakest year for growth in the global economy in the post-war era. Relative to trend rates of growth, the IMF anticipates similar-sized slowdowns in the advanced and emerging groups of countries. The Bank’s forecasts, outlined in the ‘Economic Outlook ’ chapter, also assume a markedly weaker outlook for global growth in 2009. Thereafter, the recovery from 2010 is expected to be quite subdued, in line with the typical profile of recessions associated with major disruptions to credit and financial markets (Graph 11).
The large degree of synchronisation of the global downturn is evident in the high share of Australia’s trading partners that are expected to record growth in 2009 well below their trend rates. Following an unusually long period of uniformly strong economic performance around the world, almost all of Australia’s major trading partners are expected to experience growth rates of 2 percentage points or more below trend rates in 2009. This would represent the most synchronised downturn in Australia’s trading partners since the mid 1970s (Graph 12).
In line with this deterioration in global economic conditions and prospects, commodity prices are lower than at the time of the publication of the previous Statement. Much of this easing occurred in November and early December, with prices remaining broadly stable since then. Over the period, oil and base metals prices have moved noticeably lower, with developments mixed for coal, iron ore and rural commodities. Bulk shipping prices have shown tentative signs of stabilising after falling sharply over a number of months.
Spot prices for iron ore and coal – Australia’s two largest exports – are well below the 2008/09 contract prices. Adjusting for freight costs, the US dollar-denominated spot prices of iron ore and thermal coal are around 20 to 35 per cent below the current contract prices, although they have increased somewhat in recent weeks (Graph 13). The general weakness in these markets reflects the global slowdown in industrial production, particularly in the steel market. This has resulted in announced iron ore cuts equivalent to roughly 10 per cent of annual production by Australian producers, and production in Brazil has also been reduced. In addition, a number of metallurgical coal operators have revised down their planned production in 2009. Significant declines in the upcoming contract prices are expected for both coal and iron ore. Nonetheless, present expectations for the 2009/10 bulk contract prices would still leave US dollar export prices at a high level by historical standards and above the prices that prevailed as recently as early 2007/08.
Base metals and oil prices have recorded large declines. The RBA index of base metals prices has fallen by 25 per cent over the past three months, led by aluminium, copper and lead (Graph 14). Rising inventory levels have continued to put downward pressure on prices and, with the demand outlook soft, further cuts to production have been announced by base metals producers, including some Australian operators. In contrast, ‘safe haven’ flows have continued to support gold prices as conditions in financial markets remain strained. Oil has recently traded around US$40 a barrel, a level last seen in early 2005, after picking up to a record high of around $145 a barrel in mid 2008.