Statement on Monetary Policy – May 2009
Activity in the international and domestic economies has been weaker than was envisaged in the February Statement. The Bank’s revised forecasts for the Australian economy show a fall in GDP in the first half of this year, and a recovery beginning in late 2009. With output expected to remain below trend for an extended period, the inflation forecasts have also been revised down. Underlying inflation is expected to decline gradually to around 1½ per cent by end 2011. As in past Statements, the forecasts do not incorporate any effects from the Government’s Carbon Pollution Reduction Scheme.1
The international economy
The recent weak outcomes for the world economy imply a downward revision to the 2009 year-average forecast for global growth. The magnitude and synchronisation of the contractions in output and trade seen in the December and March quarters reflect a substantial decline in confidence, particularly among businesses, following the extreme events in financial markets in September 2008. This loss of confidence and the significant rise in risk aversion magnified the slowing that was already underway in the major advanced economies flowing from the problems in the US sub-prime mortgage market.
Given the unprecedented nature of the current circumstances, any set of forecasts is inevitably subject to a high degree of uncertainty. That said, the Bank’s central forecast is based on the view that the signs of stronger growth in China and early signs of stabilisation in east Asia and the United States will prove durable, as the extraordinary fiscal and monetary policy measures and the efforts to resolve the problems in the US financial system begin to have greater effect. Accordingly, modest growth in the advanced economies is expected to resume around the end of this year, following an overall contraction in G7 GDP of over 5 per cent. Average growth in Australia’s non-G7 trading partners is expected to be somewhat stronger, reflecting both a slightly earlier recovery of some east Asian economies and the stronger performance of China and India. In year-average terms, output in Australia’s major trading partners is projected to contract by around 2¾ per cent in 2009 on an export-weighted basis, compared with growth averaging around 5 per cent in 2006 and 2007 (Graph 81). These forecasts are a little weaker than implied by the forecasts released by the IMF in late April.
The recovery in world growth in 2010 and 2011 is assumed to be relatively subdued, in contrast to the strong bounce-back typically seen after earlier recessions. This is consistent with past experiences in the aftermath of financial crises. An additional element constraining the recovery will be the pressures on budget positions of some of the major advanced economies, which may require fiscal consolidation at an early stage in the recovery.
The weakness in the world economy has been reflected in a softening in commodity markets. Recently agreed contracts for coal prices entail falls of 45–60 per cent relative to the 2008/09 contracts, although prices remain above the levels of the 2007/08 contracts. Iron ore export prices are also expected to fall significantly, but to remain high by historical standards. These falls mean that a significant decline in Australia’s terms of trade is taking place, which will weigh on domestic incomes over 2009 (Graph 82). Nonetheless, while a terms of trade decline of around 20 per cent is expected through 2009, this would still mean that the terms of trade are 40 per cent above the average level that prevailed between 1980 and 2000.
As usual, the forecasts are prepared based on a number of technical assumptions. These include the cash rate and exchange rate remaining at their current levels, and oil prices broadly in line with near-term futures pricing. The forecasts also incorporate fiscal policy decisions announced in late 2008 and early 2009, and some impact from the early stages of the implementation of the national broadband network program. In addition, some modest additional stimulus from the 2009/10 federal budget has been assumed.
Indicators of domestic activity, information from the Bank’s liaison program and business surveys all suggest that the economy has been contracting since late 2008. A significant contraction in GDP is estimated for the first half of 2009, with the peak-to-trough contraction in GDP a little smaller than during the recession in the early 1990s. The economy is forecast to begin to grow from late 2009, although the recovery is expected to be gradual, partly reflecting the slow recovery in global demand (Table 16). In year-average terms, GDP is forecast to decline by ½ per cent in 2009/10 before growing by 2¼ per cent in 2010/11.
Factors that would suggest a less severe recession here than in many other countries include the bigger decline in interest rates to end-borrowers, the healthier state of the financial sector, Australia’s export mix (a relatively low share of exports of capital goods and high-value manufactures, where global trade has fallen most), the recent recovery in the Chinese economy, and the exchange rate depreciation in the second half of 2008.
On the other hand, Australia’s terms of trade have fallen significantly. The combination of a contraction in real GDP and the sharp fall in the terms of trade implies a significant fall – around 5 per cent – in nominal incomes over the first half of 2009. Of course, part of the income losses will be shared with foreign investors, just as the preceding gains were. In addition, the impact on the level of real production in the economy will be partly dampened by the depreciation of the exchange rate that has occurred since mid 2008. Nevertheless, just as the run-up in the terms of trade in recent years was stimulatory for the economy, the current fall will be a contractionary force. The effect on the domestic economy is through a number of channels, including reduced business investment as a result of lower profitability and less demand for commodities, and falls in household wealth and consumption as a result of falls in the equity prices of resource companies. Reduced government revenues from company taxes will also have implications for government finances. Given that significant falls in bulk commodity prices have been expected since late last year, some of these effects are already being felt, although there will also be significant ongoing effects.
Growth in household spending is expected to remain subdued over much of the forecast period, given the deterioration of the labour market and large decline in household net worth over the past year. This implies a higher household saving rate over the forecast period relative to recent years, albeit below the level recorded in the December quarter. Consumption spending has been supported in the first half of 2009 by the government payments to households, but is forecast to soften as the labour market deteriorates. Growth in consumption is expected to return to more normal rates by late 2010 as the economy recovers. Dwelling investment is contracting significantly in the first half of 2009, although the increases in first-home buyer grants and the significant falls in borrowing rates are expected to contribute to some growth in dwelling investment from late 2009.
Business investment is forecast to fall significantly, particularly over the next year. Consistent with the recent weakness in capital imports, building approvals and commencements, non-residential building and spending on plant and equipment are estimated to have begun to decline in the first half of 2009. Particular weakness is expected for large construction projects such as offices and warehouses where, in addition to the weak level of demand, developers are having greater difficulty accessing finance. The falls in commodity prices and resource share prices are also expected to result in a significant scaling-back of mining-related investment. Given the substantial amount of work in the pipeline, engineering construction appears likely to remain at high levels in 2009, but to fall significantly in 2010. Offsetting part of this expected weakness, announced public investment plans for education, rail, road and communications infrastructure spending are likely to provide significant support in the coming period.
Exports of resources, manufactures and services are also forecast to contract through most of 2009. However, given the depreciation of the exchange rate from earlier peaks and the large build-up of production capacity in recent years, non-rural exports are expected to grow strongly towards the end of the forecast period once global growth recovers.
Reflecting the slowing in domestic activity, conditions in the labour market have weakened since late 2008. Business survey measures of hiring intentions have declined to their lowest levels since the early 1990s, and job advertisements have continued to fall. In trend terms, employment is now contracting and the unemployment rate rising, with a further deterioration expected in coming quarters.
Relative to the February Statement, the inflation forecasts incorporate a weaker outlook for global and domestic growth, a higher exchange rate and higher oil prices. The net effect has been a downward revision to the inflation forecasts.
Underlying inflation has begun to moderate in year-ended terms, albeit from quite high levels, and further easing in price pressures is expected as excess capacity increases. With the unemployment rate projected to rise significantly, labour costs can be expected to abate; evidence from business surveys and liaison suggests that this may already be underway. Measures of inflation expectations have declined significantly since mid 2008, which should also contribute to the projected decline in inflation pressures.
While a significant decline in underlying inflation is expected, this decline is forecast to be gradual. Price pressures for non-tradables goods and services have been significant and broad-based in recent years, and have begun to clearly moderate only in the past two quarters. It will take time for rising spare capacity in the domestic economy to translate fully into lower non-tradables inflation. Further, inflation in tradable goods prices picked up in the March quarter, and this firmer pace is likely to continue for at least the next year, reflecting the sharp increase in import prices following the exchange rate depreciation in the second half of 2008. Overall, year-ended underlying inflation is expected to decline to a low of around 1½ per cent in 2011.
The near-term profile for year-ended CPI inflation will be significantly affected by movements in a few CPI components. In particular, the large falls in petrol prices and the ABS estimate of deposit & loan facilities prices from their peaks in the September quarter 2008 will together subtract up to 2 percentage points from inflation in the year to the September quarter 2009, when year-ended CPI inflation is expected to fall to below 1½ per cent. However, these particular effects should drop out of the calculation of the annual rate by early 2010, after which CPI inflation is forecast to move in line with the forecast for underlying inflation.
Given the speed with which the outlook has deteriorated over the past six months and the extraordinary policy responses that have followed, these central forecasts are subject to a number of significant near-term risks. One is that further bad news emerges about the US and European financial systems, undermining the gradual recovery in confidence and causing a further increase in risk aversion. If this were to occur, the scope for policy-makers in many advanced countries to take further steps to restore confidence may be constrained by the already large fiscal deficits and the fact that interest rates in many countries are already close to zero. Another downside risk is that the recent signs of recovery in China do not turn out to be durable.
In the other direction, significant policy stimulus has been put in place in many countries and there has been a more positive tone in financial markets recently. There is some possibility that as signs of stabilisation emerge, and the lack of confidence and risk aversion that has characterised the world economy over recent months is reversed, firms that have delayed investment plans will decide to move forward more quickly than currently expected, contributing to a stronger global recovery.
- For further details, see ‘ Box C: Climate Change Mitigation Policy and the Macroeconomy’ in the February 2009 Statement on Monetary Policy.