Statement on Monetary Policy – May 2009
International Economic Developments
The global economy is currently experiencing an unusually severe recession, with world GDP contracting sharply in the December and March quarters (Graph 1). Output is estimated to have declined by around 4 per cent over the year to the March quarter in the G7 economies and by around 3 per cent for Australia’s major trading partners as a whole. Governments and central banks around the world have responded with substantial stimulus measures, and recently there have been some signs that conditions are beginning to stabilise, with China in particular showing clear signs of recovery.
The current downturn in the world economy has been unusually widespread and synchronised across both industrialised and emerging economies. Australia’s major trading partners are all experiencing growth outcomes that are far below average. Almost all industrial economies and much of Asia have seen output contract. China has experienced a very substantial slowdown in growth in the order of 5–6 percentage points over the past year or so and the Indian economy has also slowed sharply.
While the world economy had been slowing since late 2007, the recent period of extreme weakness followed the intensification of stresses in the global financial system around the collapse of Lehman Brothers in mid September. This turmoil contributed to a sudden further loss of confidence among households and businesses around the world, who quickly reduced spending, particularly for discretionary items including motor vehicles and capital goods (Graph 2). Firms responded by cutting production sharply, though in many countries they did not do so quickly enough to prevent some unplanned build-up in inventories. Many countries have experienced declines in international trade volumes and industrial production of around 20 per cent or more since late last year. Private-sector credit growth has also slowed sharply, but nevertheless remains slightly positive in most developed countries (Graph 3).
The slump in demand has resulted in a fall in measures of capacity utilisation to multi-decade lows in a range of developed economies (Graph 4). Combined with the current high degree of uncertainty and ongoing risk aversion, as well as falling profitability, this suggests that spending on business investment will remain weak for some time. The economic weakness is also resulting in reduced demand for labour, with the falls in employment that are now occurring likely to weigh on household spending over the next year or two.
Despite the recent weak GDP outcomes, there are some signs that the pace of decline in activity has begun to ease. Measures from business surveys, such as the various purchasing managers indices, have picked up for many countries, although they generally remain at levels consistent with further declines in output (Graph 5). In addition, data for exports and industrial production in some countries – most notably in China and elsewhere in east Asia – are showing some signs of improvement after the sharp falls in earlier months.
The latest GDP figures for the United States show that the economy shrank by 1.6 per cent in the March quarter, similar to the decline seen in the December quarter. After expanding modestly through much of 2008, business investment fell sharply for the second quarter in a row, while a rundown in inventories also subtracted from output. By contrast, household consumption rose slightly in the quarter, which was a marked turnaround from the large falls in the previous two quarters. While this stabilisation was encouraging, consumption fell again in the month of March and falling employment is likely to continue to weigh on consumer spending. Indeed, the magnitude of the recent economic weakness is starkly illustrated by the labour market, where non-farm payrolls fell by 1½ per cent in the first three months of the year and have fallen by 3¾ per cent since the end of 2007, the sharpest deterioration for many decades (Graph 6). This has seen the unemployment rate rise from 4½ per cent in mid 2007 to 8½ per cent in March.
Notwithstanding the weak labour market, a growing number of business indicators in the United States have shown recent signs of improvement. In April, both the manufacturing and non-manufacturing ISM indices, while still weak, were noticeably above their levels at the end of 2008. A range of measures of housing activity and prices have also shown signs of stabilisation or even picked up modestly in recent months, and the architecture billings index, a leading indicator of non-residential construction, rebounded solidly in February and March after falling sharply over the course of 2008. Further improvement in US credit and financial markets will, however, be necessary for the modest gains in these and other indicators to develop into a sustained recovery in investment and hiring by US firms. Progress in this direction, and recent initiatives by the US government and the Federal Reserve to promote recovery in the financial sector, are discussed further in the ‘International and Foreign Exchange Markets’ chapter.
While the United States has been at the centre of the global financial crisis, the sharpest downturn in activity among the major developed economies has been in Japan, where the economy contracted by 3 per cent in the December quarter and recent monthly data suggest that GDP fell sharply again in the March quarter (Graph 7). Industrial production, which accounts for a little more than 20 per cent of the Japanese economy, fell by an unprecedented 22 per cent in the March quarter, after declining by 11 per cent in the December quarter. In large part, this reflects extremely weak external demand, with merchandise export volumes falling by around 15 per cent in the December quarter and around 30 per cent in the March quarter. Household spending is also weak given falling employment, slowing wages growth and the depressed level of consumer confidence. Nevertheless, there have been some tentative signs of stabilisation in the economy with industrial production and exports both rising slightly in March, after falling for around nine months. Business surveys, such as the Shoko-Chukin survey of small and medium enterprises, also indicate that business conditions have recovered modestly in recent months, although they remain at very low levels.
One reason that Japan has been particularly hard-hit by the current global downturn is the relative importance to the Japanese economy of high-value manufacturing – particularly capital goods and consumer durables such as cars. Similarly, Germany is suffering a larger fall in exports, industrial production and aggregate output than most other European economies. More generally, although the deterioration in activity and demand in the developed economies is now evident across all sectors, conditions in the manufacturing sector continue to be particularly weak (as discussed in ‘Box A: Global Industrial Production’).
Recent activity indicators in the euro area suggest another large fall in GDP occurred in the March quarter, following the 1.6 per cent contraction in the December quarter. Industrial production in February was 7 per cent lower than in the December quarter, exports have fallen sharply, and the volume of retail sales fell further in the March quarter to be 3 per cent lower over the year. Residential building permits also fell by nearly 20 per cent over 2008, suggesting that further sizeable falls in dwelling investment are in prospect. Reflecting the weak economic conditions, the unemployment rate in the euro area rose from 7¼ per cent to nearly 9 per cent over the year to March, with unemployment in Spain rising particularly sharply. While the German unemployment rate has only risen slightly to date, there has been a large jump in the number of workers on reduced hours.
Conditions in the United Kingdom are also very weak. GDP fell by 1.9 per cent in the March quarter, after falling by 1.6 per cent in the December quarter, to be more than 4 per cent lower over the year. Despite some recovery in the month, measures of business and consumer sentiment remained very low in April. The claimant count measure of unemployment has risen by 2.1 percentage points over the past year.
The clearest signs of improvement in economic conditions are from China. While on a year-ended basis, Chinese growth slowed further in the March quarter to 6.1 per cent, RBA estimates suggest that the pace of quarterly growth picked up in the March quarter, and other indicators of activity generally tell a similar story (Graph 8). Exports appear to have levelled out after falling by roughly 25 per cent from October to February, while industrial production increased solidly in the March quarter, and particularly in the month of March, following falls in the second half of last year (Graph 9). The Chinese PMI surveys also suggest some improvement in the manufacturing sector in recent months, while infrastructure investment and credit have increased strongly since the end of 2008, supported by a range of fiscal initiatives and lending directives. The pick-up in investment spending has been particularly pronounced in the areas of transport infrastructure and residential construction. This has flowed through to demand for Australia’s resource exports and helped to support a more favourable export performance for Australia compared with many other countries. Growth of retail sales in China has eased but remained strong at around 2 per cent in the March quarter and 16 per cent over the year.
Elsewhere in east Asia, conditions have been weak, though there are also some signs that key activity indicators are beginning to stabilise. In the March quarter, real GDP was flat in Korea, after falling sharply in the December quarter, to be more than 4 per cent lower over the year. In contrast, output fell sharply again in Singapore, down by more than 5 per cent in the quarter to be 11½ per cent lower over the year. Across the region, industrial production grew modestly in February and March, following a run of precipitous monthly declines (Graph 10). Recent monthly exports data for a number of economies, including Korea, Taiwan and Hong Kong, have also shown some signs of improvement following large falls.
After appearing relatively immune to the slowing in growth occurring across the developed world for much of 2008, major Latin American economies including Brazil, Mexico and Chile all suffered large falls in output in the December quarter. Falls in industrial production continued in the early months of 2009 in several countries (though not in Brazil). Likewise in emerging Europe activity declined significantly in many economies in the December quarter, with industrial production falling further in early 2009.
Headline inflation has declined noticeably around the world in response to the weakness in global demand and lower commodity prices (Graph 11). In a number of countries, such as the United States, Japan and China, year-ended headline inflation is now negative largely due to the sharp decline in oil and food prices over the past year or so. However, core inflation has not fallen to the same degree and for most industrial countries remains relatively close to average rates seen over the past decade.
Policy responses and forecasts
Central banks around the world have responded to the deterioration in economic conditions with further cuts to their policy interest rates, as discussed in the ‘International and Foreign Exchange Markets’ chapter. A number – including the Federal Reserve and the Bank of England – have also moved to supplement ongoing measures to ease credit conditions with explicit large-scale purchases of government and private-sector debt.
Governments around the world have also enacted significant discretionary fiscal easings over recent months. In the United States the American Recovery and Reinvestment Act was passed in mid February, setting in train a discretionary stimulus in excess of 4 per cent of annual GDP to take effect over 2009 and 2010. Combined with the impact of the weakening economy on revenues and outlays, and the costs of various financial rescue packages, the Congressional Budget Office anticipates that the United States federal deficit for fiscal year 2009 will be around 13 per cent of GDP, more than double its previous record level since the late 1940s (Table 1). In the United Kingdom, budget projections are now for deficits of around 12 per cent of GDP for the next 2 years, with only gradual improvement thereafter.
A number of European countries have also introduced discretionary stimulus packages in recent months, and several Asian nations – most notably Japan and Korea – have announced further significant fiscal stimulus measures to supplement the sizeable discretionary easings from late last year. While the discretionary stimulus packages in European countries have generally been smaller than elsewhere this partly reflects the larger role for automatic stabilisers in these countries, which make government finances more naturally responsive to changes in economic conditions. Overall, fiscal balances around the world have moved to very large deficits, highlighting the extent of fiscal stimulus that is in place.
Notwithstanding these additional policy responses, IMF forecasts for growth in almost all large economies – China is an exception – have again been lowered significantly over the past three months. The IMF now expects world output (with countries weighted by GDP valued at purchasing power parities) to contract by 1.3 per cent in 2009, down from positive growth of 0.5 per cent forecast in late January (Table 2). Large falls in output are expected in all the major developed and many emerging or newly industrialised economies, while China and India are forecast to record growth well below trend. The IMF expects only a tepid recovery in global activity in 2010. The Bank’s forecasts, discussed further in the ‘Economic Outlook’ chapter, are slightly weaker for global growth in 2009 but similar for 2010.
Commodity price movements have been mixed in recent months, with prices for exchange-traded commodities (such as the base metals and crude oil) generally rising but spot prices for bulk resource commodities falling. Contract prices for coal have settled sharply lower, and although new iron ore contracts are yet to be settled, large falls in export prices are also expected. Overall, the April estimate for the RBA’s index of commodity prices is 31 per cent below the September 2008 peak (in SDR terms). Around two-thirds of the fall is due to the inclusion of preliminary estimates for the 2009/10 coal and iron ore contract prices, with a further fall of 8 per cent expected once the lower contract prices take full effect.
Base metals and oil prices have recently recovered some of the sharp falls in the second half of 2008, broadly similar to developments in equity and credit markets. Market commentary has attributed the recent increases to improved sentiment about economic prospects and concern by some investors about longer-term inflationary pressures, which has renewed interest in investing in commodities as an asset class. The RBA index of base metals prices has increased by 14 per cent since the time of the February Statement, to be about 20 per cent above its December 2008 low (Graph 12). The prices of copper, lead and zinc have all risen solidly since the previous Statement, although inventory levels are quite high. Prices also appear to have been supported by Chinese and Korean government stockpiling, and production cuts for some metals. Oil prices have risen by around 20 per cent since January, although there have been some divergences in developments between WTI and other benchmark prices.
Rural commodity prices are broadly unchanged since the previous Statement, with the RBA index of rural commodity prices about 2 per cent higher over the period. The prices of wool, sugar and canola have risen, offsetting falls in barley, beef & veal and wheat prices.
Benchmark coal contract prices for 2009/10 have been settled by a number of Australian companies at significant discounts to last year’s record prices (Graph 13). Thermal coal contract prices have fallen by 44 per cent. Contract prices for the different grades of metallurgical (coking) coal have settled around 60 per cent lower, with world steel production contracting by 24 per cent over the year to March. Contract negotiations are continuing for iron ore prices, but prices for iron ore are generally expected to fall by around 30–40 per cent, roughly in line with recent trends in spot prices. While the falls in contract prices are substantial, 2009/10 bulk contract prices are still likely to be high by historical standards, remaining around 25–35 per cent higher for thermal and coking coal than in 2007/08, with prices for iron ore also expected to be above 2007/08 prices.