Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 1 June 2010
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, Graham Kraehe AO, Warwick McKibbin
David Gruen (Executive Director, Macroeconomic Group, Treasury) attended in place of Ken Henry AC (Secretary to the Treasury) in terms of section 22 of the Reserve Bank Act 1959.
Members granted leave of absence to Donald McGauchie AO in terms of section 18A of the Reserve Bank Act 1959.
Guy Debelle (Assistant Governor, Financial Markets), Philip Lowe (Assistant Governor, Economic), Tony Richards (Head, Economic Analysis Department), Anthony Dickman (Acting Secretary)
Developments in the euro area had dominated events in financial markets in the past month. Sentiment had deteriorated sharply in the period following the previous Board meeting as concerns about the fiscal position of Greece, Spain and Portugal intensified. The poor sentiment led to a marked scaling back of trading in bonds issued by European sovereigns outside Germany. Members were briefed on details of the European support package developed by the European Union, the European Central Bank and the IMF. Since then yields had fallen somewhat, though trading conditions had generally remained poor with low liquidity.
Members noted that yields had also declined in most major bond markets around the globe. Australian bond yields had been part of this trend. Members noted that the recent Australian Government Budget showed that debt levels were expected to peak at a significantly lower level than previously projected.
Funding pressures in global money markets had increased, but to a much lesser extent than in 2008. They mainly related to US dollar markets, owing to the need for European banks to fund large US dollar asset holdings. The major central banks had announced a re-establishment of temporary US dollar swap lines with the Federal Reserve but the take-up thus far had been limited, given that the rate central banks were charging for use of the facility was currently above the market rate facing most institutions.
In Australia, while the spread between bank bill yields and the expected cash rate had widened somewhat in the past few weeks, the market had continued to function well, albeit with slightly increased volatility.
Credit spreads on emerging market and corporate bonds had increased around the globe. However, members noted that, despite the increased spreads, actual borrowing costs had fallen in some cases, given the falls in benchmark yields.
Corporate bond issuance in May had been minimal in both the United States and the euro area as a result of the dislocation in markets. The Australian banks did not need to access term debt markets for several months as they were ahead on their funding needs for the year, but there were indications that there remained good underlying demand for Australian bank debt in overseas markets.
Global share markets had been volatile and share prices had fallen significantly over the past month. In addition to the developments in Europe, two factors had adversely affected investor sentiment: the large intra-day fall on the US share market on 6 May, whose cause in part appeared to relate to the activities of model-based high-frequency trading platforms; and the unexpected announcement by the German financial regulator of a ban on ‘naked’ short-selling of a range of financial instruments.
Foreign exchange markets had also seen the effect of investors' reduced willingness to take on risk. Volatility in exchange rates had increased significantly. The euro had depreciated further against the US dollar in May, but from a longer-run perspective was not at a particularly low level in trade-weighted terms. The US dollar had appreciated against most currencies during May, with the exception of the yen. The renminbi had remained fixed to the US dollar at the rate set almost two years earlier; the broad appreciation of the US dollar over the past month implied that the renminbi had appreciated in nominal trade-weighted terms.
There had been several large moves in the Australian dollar exchange rate over the past month. Partly, this reflected the fact that many traders had taken ‘long’ positions in the Australian dollar against other currencies, in terms of their benchmark exposures, and the exchange rate fell as a consequence of these positions being unwound. Members were informed that the depreciation of the exchange rate generally had been orderly, with a satisfactory level of liquidity in the market. The exchange rate had depreciated by about 7 per cent on a trade-weighted basis over the past month; volatility had been high but was below the peak level in October 2008. Taking a longer perspective, the Australian dollar remained well above its post-float average, both against the US dollar and in trade-weighted terms.
Turning to monetary policy settings, members observed that the expected commencement of policy tightening in the major economies had now been pushed out into next year, with the exception of Canada. In Australia, market pricing at the time of the meeting indicated that no change in the cash rate was expected. Members noted that the increase in the cash rate at the previous meeting had been passed through to lending interest rates in full, and that lending rates to both households and businesses were now around their average levels of the past decade.
International Economic Conditions
Members commenced their discussion of developments in the international economy by observing that the recent turmoil in financial markets had prompted a number of European governments to announce a significant tightening of fiscal policy. A few months earlier, it had appeared that those economies with poor fiscal positions might be able to wait until economic recovery was more firmly entrenched before undertaking significant fiscal consolidation. However, the escalation of market uncertainties meant that the downside risks from waiting to announce tighter fiscal policy had increased. The fiscal measures announced had included pay freezes or pay cuts for public-sector employees, increases in the retirement age and increases in value-added tax rates.
Members discussed the fiscal challenges facing Europe. Sizeable budget deficits were expected to persist for a number of years in some countries. This was in part a reflection of the large structural deficits that had built up over the years, with breaches of the deficit limit of the European Union's Stability and Growth Pact having not been unusual, even when economic conditions had been relatively benign. Debt to GDP ratios were projected to continue to increase significantly in many countries, raising concerns about fiscal sustainability.
Members noted that the fiscal challenges faced by many governments, not only in Europe, would be accentuated by the changes in demographic patterns that were occurring in most countries, notably ageing populations and rising dependency ratios.
Growth in much of Europe had been soft, though economic conditions were somewhat brighter in Germany, with industrial production growing again and construction spending picking up. Members noted that growth in much of the rest of the world had been quite strong, especially in Asia. In China, retail sales, investment, exports and credit had all risen further in April, with investment particularly strong in the first four months of the year. In the housing market, growth in house prices had remained strong up to April, but there were indications of a slowing in turnover in May, suggesting that the policy measures taken earlier were having some effect on conditions.
Elsewhere in Asia, growth had continued to surprise on the upside, with domestic demand in the region growing solidly over the past year. A number of east Asian economies had registered double-digit GDP growth rates over the year to the March quarter, and data for exports and industrial production in April suggested that growth was continuing in the current quarter. India had recorded strong GDP growth in the March quarter and there had been an upward revision to the earlier and surprisingly weak figure for the December quarter. With Asia accounting for more than half of Japan's total exports, strength in domestic demand in the region was benefiting the Japanese economy, which had registered strong growth in the March quarter.
Economic conditions had also continued to improve in the United States. Employment was now growing again, after contracting through 2008 and 2009, and labour market participation had picked up. While higher participation would slow the prospective fall in the unemployment rate, growth in employment would help to support consumption growth. Business investment was rising and capital goods orders had increased strongly over the past year.
Overall, in contrast to the turbulence in financial markets, the recent data on global economic activity had generally been positive and suggested that the global economy was expanding at a relatively firm pace over the first part of 2010. It was too early to tell what effect the current turbulence in financial markets would have on the global recovery. It was likely that weaker activity in Europe would have some flow-on effects to the rest of the world through the traditional trade channels, though the more important consideration would be the extent to which the problems in Europe had a sustained effect on global attitudes to risk. Offsetting these effects, members observed that the uncertainty surrounding developments in Europe might mean that the process of withdrawing policy stimulus in other parts of the world, including in Asia, would be delayed.
The developments in financial markets and in Europe and concerns about a potential slowing in construction activity in China had resulted in falls in commodity prices over the past month. There had been significant declines in the prices for oil, iron ore and base metals. Nevertheless, spot prices for Australia's bulk commodities were still above those in the June quarter 2010 export contracts.
Domestic Economic Conditions
Domestically, members observed that conditions had been mixed. There had been a high level of activity in the construction sector from the fiscal stimulus, but retail spending had been relatively subdued and there were some signs of slowing in the housing market. The national accounts for the March quarter were due for release the day after the meeting. The staff expected the data to show modest growth in GDP for the quarter, with conditions varying across sectors of the economy.
In the household sector, surveys showed that sentiment had declined in May, though it remained above its long-run average level. Developments in household spending had been mixed. ABS data on retail trade, including figures that were released during the meeting, showed solid growth in spending in March and April, but spending was only modestly higher than a year earlier, when it had been boosted by government transfer payments. Liaison with retailers suggested fairly weak trading conditions more recently, with many retailers noting that significant discounting was occurring. In contrast, purchases of motor vehicles by the household sector had been strong this year.
Members noted some signs that the earlier buoyancy in the housing market was easing. Most notably, auction clearance rates in May had been lower than the very high levels of earlier months. Growth in housing credit had slowed in April, after a decline in loan approvals over the prior six months.
Business investment was estimated to have fallen in the March quarter, with this largely reflecting the earlier pull-forward of spending on plant and equipment as a result of tax incentives. The ABS capital expenditure survey continued to point to strong growth in spending on buildings and structures in 2010/11, especially in the mining sector, implying continued strong growth in the capital stock over the next year or so.
Most business surveys continued to point to above-average levels of business confidence and conditions. Construction activity was being supported by the strong growth in public spending, especially for building in the education sector. Construction in the office and commercial sectors remained weak, but there were signs of some pick-up in the apartment sector. Liaison suggested that financing conditions for firms in the construction sector were improving, though they remained tight. More broadly, business loan approvals also appeared to be rising, though business credit had declined in April after having been broadly unchanged over the preceding three months.
The Australian Government estimated that its budget deficit would narrow significantly in 2010/11 and return to a small surplus in 2012/13, three years earlier than projected a year ago. Policy changes announced in the Budget were, in net terms, broadly neutral for the cumulative budget position over the next four years. The projected narrowing of the deficit primarily reflected the effects of the improving economy (including the higher level of the terms of trade) and the scheduled winding down of stimulus measures announced in late 2008 and early 2009.
The labour market had continued to perform solidly, with a further increase in employment in April. With population growth remaining high, the unemployment rate had been broadly steady over the past few months, after declining around the turn of the year. Surveys of firms' hiring intentions remained solid, and some skills shortages had emerged in the mining and construction sectors.
The main piece of news on wages and prices over the past month was the wage price index, which suggested that wage growth in the private sector had picked up in the first quarter of 2010 from the low rates of the preceding three quarters. In the public sector, wage growth remained quite firm and above the average of the past decade. Measures of inflation expectations were generally at, or a little above, the average of the past decade or so.
Considerations for Monetary Policy
In considering the setting of monetary policy, members noted that the situation in Europe had deteriorated significantly over the previous month. Market confidence had been severely eroded, and some governments were now in the very difficult position of having to tighten fiscal policy at a time when growth remained weak. Notwithstanding the actions that had been taken by European policymakers and the IMF, the situation remained uncertain. The difficulties in Europe would inevitably weigh somewhat on prospects for global growth. However, in areas such as Asia where growth had recently been strong, it had become more likely that the withdrawal of policy stimulus would be delayed as a result of the developments in Europe.
While the international environment facing the Australian economy had become more uncertain, members noted that the medium-term outlook remained positive. The prices of Australia's main commodity exports were still elevated, despite recent falls, and the high level of the terms of trade would add to domestic incomes and demand. Most indicators suggested that the economy was continuing to expand and employment growth had been solid. Conditions, however, clearly differed across sectors and aggregate spending was still being supported by public demand. While recent data for prices and wages suggested that the disinflationary forces in the economy were not quite as strong as previously expected, global events could also have implications for the inflation outlook in the medium term. Members noted that the CPI data for the June quarter, which would be released in late July, would provide information on the extent of inflationary pressures in the economy.
As a result of actions at previous meetings, policy had moved from the very expansionary settings reached in early 2009 to the point where interest rates paid by borrowers were now around their average levels of the past decade or so. Members judged that these previous actions afforded policy the flexibility to await information on how the recent market uncertainty might affect the global economy, as well as news about the outlook for inflation. For the near term, therefore, members judged that it was appropriate to leave the cash rate unchanged.
The Board decided to leave the cash rate unchanged at 4.5 per cent.