Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Sydney – 5 February 2019

Members Present

Philip Lowe (Governor and Chair), Guy Debelle (Deputy Governor), Mark Barnaba AM, Wendy Craik AM, Philip Gaetjens, Ian Harper, Allan Moss AO, Carol Schwartz AM, Catherine Tanna

Others Present

Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Alexandra Heath (Head, Economic Analysis Department), Penny Smith (Deputy Head, Financial Stability Department)

Anthony Dickman (Secretary), Andrea Brischetto (Deputy Secretary)

International Economic Conditions

Members commenced their discussion of the global economy by noting that growth in Australia's major trading partners had been above trend, despite moderating in the second half of 2018. Growth in major trading partners was forecast to be around trend in 2019 and 2020. However, the downside risks to the global outlook had increased in the preceding few months. Members noted that it was difficult to predict the effectiveness of recent policy measures in China and how the authorities would balance their objectives of supporting growth and containing financial risks. Trade tensions and signs of slowing domestic demand had also increased the risks to the outlook for China. More broadly, trade tensions remained a material risk to the global growth outlook.

US exports to China and Chinese exports to the United States had fallen sharply in late 2018 as a result of earlier tariff increases. There had been ongoing speculation that the United States might impose tariffs on automotive imports, which would affect imports from Germany and Japan. Some economies, particularly in the east Asian region, had been affected by the trade tensions because they provide inputs to Chinese exports as part of global supply chains. A number of economies had also faced a moderation in export growth because Chinese domestic demand had slowed. However, members noted that there had also been reports of firms accelerating existing plans to shift production from China to other low-cost producers in the east Asian region.

Labour markets had tightened further in most advanced economies and wages growth had increased. Core inflation had picked up to be close to target in some advanced economies, but remained low in others. Headline inflation had declined towards the end of 2018 because oil prices had fallen by almost 30 per cent from their peak in October.

GDP growth in the United States had remained strong over 2018. Fiscal stimulus and strong employment growth had supported consumption growth. The labour market had continued to tighten in early 2019 and wages growth had picked up. However, the outlook for investment had softened. Some measures of business and consumer confidence had fallen sharply in January. However, members noted that it was difficult to determine whether this reflected uncertainty associated with volatility in financial markets or a genuine deterioration in the circumstances facing businesses and consumers.

GDP growth in Japan was expected to recover after the sharp slowing in the September quarter, which had mainly reflected disruptions from natural disasters. Growth in consumption had been supported by a strong labour market and a pick-up in wages growth. Members noted that consumption would receive a short-term boost as consumers brought forward spending ahead of an increase in the consumption tax in October. Recent data suggested that business conditions in Japan had also remained positive. By contrast, growth in output in the euro area had slowed over 2018, reflecting a combination of weaker external demand, especially from China, and some localised factors that could have persistent effects, particularly if they were not resolved quickly. Investment intentions and surveyed business conditions had fallen recently in the euro area.

GDP growth in China had slowed in 2018, as had been expected given the earlier tightening in financial conditions. However, there were signs that underlying momentum in the Chinese economy had slowed by more than suggested by the GDP data. The authorities had responded with further targeted policy measures. Many of these measures were aimed at encouraging spending on infrastructure, which had led to a lift in growth in public infrastructure investment and an upgrade to the outlook for steel demand. In India, crude steel production had remained high in 2018, despite an easing in GDP growth overall.

The improved outlook for steel demand and stockpiling ahead of the Chinese New Year had supported prices for iron ore at the end of 2018, and earlier increases in oil prices had boosted liquefied natural gas (LNG) prices. As a result, Australia's terms of trade were expected to have increased in the December quarter. Iron ore prices had increased further in 2019, following the collapse of a tailings dam at an iron ore mine in Brazil and the subsequent closure of a number of other similar mines. Members observed that iron ore prices could remain high for some time, but prices were still expected to decline over the medium term. Looking ahead, the effect of higher iron ore prices on the terms of trade was expected to be offset by the effect of lower prices for LNG, as the decline in oil prices since October gradually feeds through.

Domestic Economic Conditions

The September quarter national accounts had been released the day after the December meeting. Members noted that growth in real GDP of 0.3 per cent in the quarter and 2.8 per cent over the year had been noticeably below expectations. There had also been downward revisions to GDP growth in previous quarters, which had subtracted around ¼ percentage point from the year-ended growth rate. Taking account of this and other information, the Bank had revised down its forecast for growth in the Australian economy by around ¼ percentage point for both 2019 and 2020. This primarily reflected a modest downgrading of the outlook for household consumption and residential construction. The outlook had also become more uncertain over the preceding few months.

Growth in GDP was expected to be around 3 per cent over 2019, supported by accommodative monetary policy and ongoing strength in public spending and business investment. Further gradual tightening in the labour market was expected to support growth in household income and consequently growth in household consumption. GDP growth was expected to moderate to 2¾ per cent over 2020 because LNG output was expected to reach targeted levels of production and would therefore no longer materially add to growth. Dwelling investment was also expected to decline more sharply than previously expected, consistent with the decline in residential building approvals and the fall in housing prices.

Growth in consumption had slowed to 2½ per cent over the year to the September quarter. Revisions to previously published data made it difficult to assess the underlying momentum of consumption over the preceding year. On balance, the slower reported growth in consumption, together with subdued growth in retail sales in the December quarter and the likely effect of lower housing prices and reduced housing market activity on consumption, warranted a downward revision to the outlook for consumption. As a result, year-ended growth in consumption was expected to pick up only a little over the forecast period. Members noted that uncertainty about the recent momentum of consumption and factors affecting households' future consumption decisions remained a key risk for the domestic economic outlook.

Dwelling investment was likely to have been close to its peak in the second half of 2018. Although there was still a large pipeline of residential work to be done and few signs that projects already under way were being cancelled, it had become more difficult for new apartment projects to obtain finance, and building approvals were the lowest they had been for five years. As a result, dwelling investment was expected to remain at a high level in the near term, but then to decline faster than previously expected. Members noted the uncertainty about the extent and speed of the downturn in the dwelling investment cycle.

Non-mining investment had been flat in the September quarter. Non-residential construction had declined, but the pipeline of work yet to be done had remained relatively high, suggesting that non-residential construction would recover in coming quarters. Investment in machinery & equipment and computer software had grown solidly in the September quarter. A reasonably positive outlook for investment was supported by continued growth in corporate profits and accommodative financial conditions for larger firms, although conditions for smaller firms had been more constrained. While information from liaison implied that the economy had reasonable momentum around the turn of the year, surveyed business conditions had declined to around their long-run average. A large pipeline of projects was expected to support growth in public investment over the following year.

Mining investment had fallen in the September quarter. Liaison had suggested that very little additional spending was needed to bring the remaining LNG projects on line. Mining investment was expected to increase over the forecast period as mining firms invest to maintain production; this outlook was supported by mining firms' profitability having remained strong. Members noted that the declines in mining investment that had weighed on growth for the previous six years were close to an end, and instead mining investment was expected to make a small contribution to output growth in the forecast period. Recent trade data suggested that supply disruptions had continued to affect resource exports in the December quarter.

Farm output had fallen by 8 per cent over the year to the September quarter, subtracting around ¼ percentage point from year-ended GDP growth. Members noted that the outlook for the farm sector continued to depend on the timing and magnitude of rainfall; drier-than-average conditions in key farming areas were expected to continue in the near term. Recent trade data suggested that rural exports had fallen in the December quarter, and the Australian Bureau of Agricultural and Resource Economics and Sciences had revised down its forecast for farm production in 2018/19.

Members noted the continued improvement in conditions in the labour market and that the labour market data had been stronger than other data on economic activity. Employment had continued to grow faster than the working-age population in the December quarter, with most of this growth in full-time employment. Forward-looking indicators had been consistent with above-average employment growth over the first half of 2019. The unemployment rate had declined to 5 per cent, which was the lowest rate since 2011 and lower than had been expected a year earlier. Labour market conditions had been particularly strong in New South Wales and Victoria, where unemployment rates had fallen to be between 4 and 4½ per cent. The national unemployment rate was expected to edge a little lower to around 4¾ per cent over the following few years. Tightening labour market conditions were expected to put upward pressure on wages, although to date wages growth in Australia and elsewhere had been slower to pick up than in previous expansions.

Turning to the latest data on inflation, members noted that inflation had remained low in the December quarter, with both headline and underlying inflation a little under ½ per cent in the quarter and around 1¾ per cent over the year. Headline inflation had been lower than forecast, largely because fuel prices had been lower than expected in the quarter. Domestic cost pressures had been relatively subdued, partly because wages growth had remained low. More recently, utilities prices had increased only modestly, after substantial increases in previous years, and inflation in the prices of other administered services had declined noticeably as a result of government pricing decisions.

Strong competition in the retail sector had continued to dampen inflation, although deflationary pressures in the retail sector appeared to have eased somewhat in the December quarter. This could have reflected some pass-through of the modest depreciation of the Australian dollar over 2018. The drought had also contributed to higher retail inflation for food, particularly meat.

Inflation in rents had remained subdued and data on newly advertised rents suggested there was little prospect of a pick-up in the near term. Rent inflation had started to trend lower in Sydney, where the rental vacancy rate had risen and was expected to rise further in the near term as more supply becomes available. Rents in Perth had fallen further, although the pace of deflation had eased. Inflation in the cost of new housing construction had trended lower, despite the high level of dwelling investment.

Members noted that the inflation outcome for the December quarter had been fairly close to expectations. However, the forecast pick-up in underlying inflation was now expected to occur a little later than previously expected, mainly as a result of the lower forecast for growth in GDP and downside risks to utilities and administered price inflation in the near term. Underlying inflation was expected to increase to 2 per cent by the end of 2019 (previously by mid 2019) and to reach 2¼ per cent by the end of 2020. Headline inflation was expected to fall to 1¼ per cent in mid 2019 as a result of the fall in fuel prices since the December quarter, on the assumption the lower oil price is sustained.

Members spent some time considering a paper on the implications of recent developments in housing markets for the economic outlook. After rising by almost 50 per cent over the five years to September 2017, national housing prices had fallen by around 8 per cent to be back around mid-2016 levels. Members noted the significantly different developments in housing prices across the country. Housing prices had fallen by 12 per cent in Sydney and by 9 per cent in Melbourne from their peaks in 2017. There had also been significant falls in housing prices in Perth and Darwin over recent years. By contrast, housing prices in Hobart and Canberra had increased over 2018, while housing prices in Adelaide, Brisbane and many regional centres had been flat. Members noted that the cumulative falls in housing prices in Sydney and Melbourne were relatively large by historical standards, and that it was unusual for housing prices to fall significantly in an environment of low mortgage interest rates and a declining unemployment rate.

Members noted that some of the dynamics in housing prices could be explained by the fact that the supply of housing does not respond quickly to changes in demand. In particular, the run-up in housing prices had occurred during a period when housing supply had not picked up sufficiently to match higher demand from more rapid population growth. Over time, higher housing prices had eventually led to a sizeable increase in supply, but this had taken longer than in previous cycles. Another factor weighing on prices was a noticeable decline in demand from foreign buyers in recent years, which had also been apparent in housing markets in some other economies.

Rental vacancy rates are one key indicator of the balance of supply and demand in the housing market. In most states, rental vacancies had been around or somewhat below average at the end of 2018, suggesting supply and demand for housing had been roughly balanced. In Melbourne, despite the fall in prices and large increase in supply, the vacancy rate had declined. By contrast, rental vacancies in Sydney had been increasing and advertised rents had fallen.

Members also noted that housing credit growth had declined further in preceding months and that there had been a notable drop in loan approvals by the major banks. Growth in lending to investors had slowed sharply since mid 2017 to be close to zero, while growth in lending to owner-occupiers had moderated to around 5½ per cent in six-month-ended annualised terms.

The slower growth in lending for housing over the preceding year appeared to reflect weaker demand. Nevertheless, credit conditions for some borrowers had remained tighter than they had been for some time following the strengthening of lending policies and practices over recent years. Liaison with mortgage brokers suggested that the increased public scrutiny associated with the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry may have led some individual loan assessors at banks to apply stricter criteria than specified in official lending requirements. However, banks reported that while loan assessors had been referring more approvals to credit officers, final loan approval rates had remained high. Moreover, lenders had continued to compete for borrowers of high credit quality by offering new loans at lower interest rates than those offered on existing loans.

From a longer-run perspective, members assessed that, following such large increases in housing prices, the effect of the recent price falls on overall economic activity was expected to be relatively small. However, members observed that if prices were to fall much further, consumption could be weaker than forecast, which would result in lower GDP growth, higher unemployment and lower inflation than forecast. From a financial stability perspective, tighter lending standards, an improving labour market and low interest rates were all likely to support households' capacity to service their debt. Few households were in negative equity positions despite the falls in housing prices, implying that banks' losses would be limited even if household financial stress were to become more widespread.

Financial Markets

Turning to other financial market developments, members observed that while housing credit growth had declined, business credit growth had strengthened over 2018, with contributions from the foreign banks and the major banks. However, this growth had been driven by increased lending to large businesses.

Members observed that conditions had tightened somewhat in a number of Australian financial markets, in line with global developments. Spreads of bank bond yields to Australian government bonds had widened a little, reflecting a global rise in risk premiums. Nevertheless, yields on bank bonds were little changed around the level of the preceding few years, given the decline in Australian government bond yields. Australian equity prices had declined in the December quarter along with global equity markets, but had recovered in January to be back around their October levels. Members noted that share prices of Australian banks had risen on the morning of the meeting, following the release of the final report of the royal commission and the Government's response the preceding afternoon.

Money market interest rates had remained higher than a year earlier, contributing to a small increase in banks' funding costs over the period since then. In response, most lenders had increased their standard variable mortgage interest rates a little since mid 2018. However, the effect of rising standard variable rates had been partly offset by borrowers refinancing at lower rates, given the strong competition for low-risk borrowers. Members noted that, overall, mortgage interest rates remained relatively low.

Turning to global financial markets, members observed that financial conditions had tightened somewhat in recent months in most advanced economies, with increased volatility and a general rise in equity and credit risk premiums. Nevertheless, there had been a partial retracement of the tightening in recent weeks and financial conditions remained accommodative.

At its January meeting, the US Federal Open Market Committee (FOMC) had left the federal funds rate unchanged and removed its forward guidance for further interest rate increases. The FOMC had emphasised that it would be patient in making any future adjustments to the federal funds rate, and that future monetary policy decisions would be more closely guided by the incoming data because interest rates were closer to estimates of neutral. The FOMC had also indicated that it would be open to slowing the pace of its planned balance sheet reduction if warranted by economic or market developments. Financial market pricing had shifted to imply that the next move in the federal funds rate was expected to be down, although this was not expected to occur until at least late 2020. Elsewhere, the European Central Bank and the Bank of Japan were expected to maintain their stimulatory policy settings for an extended period.

Members noted that government bond yields had declined across the major global markets over the preceding two months, reflecting the downward shift in expectations for future policy rates, along with a fall in compensation for future inflation following falls in oil prices. These changes had also reflected increased concerns about downside risks to the outlook for global growth. Australian government bond yields had declined broadly in line with global developments, with long-term government bond yields in Australia remaining around 50 basis points below those in the United States.

There had been a modest depreciation of the US dollar in nominal trade-weighted terms since late 2018, reflecting the more noticeable shift in the outlook for monetary policy in the United States than in other major economies. Members noted that the depreciation had been more pronounced against the Japanese yen, which had appreciated to around its highest level in two years on a trade-weighted basis. The Chinese renminbi had also appreciated modestly over the preceding month, reflecting the depreciation of the US dollar as well as signs of some progress on US–China trade negotiations.

The Australian dollar had depreciated a little further in nominal trade-weighted terms over the preceding two months, largely reflecting the appreciation of the yen and renminbi. However, overall, the Australian dollar had remained within the range observed over the preceding few years. Members observed that there had been two broadly offsetting influences on the Australian dollar exchange rate over the preceding year: the increase in commodity prices and the terms of trade had been supporting the Australian dollar over this period, while the relative decline in Australian government bond yields had been working in the opposite direction.

In global capital markets, corporate bond spreads had risen in recent months and bond issuance had eased, particularly for lower-rated borrowers. There had been some retracement of the increase in corporate borrowing costs in early 2019. Similarly, global equity markets had declined sharply in late 2018, before recovering somewhat since. The widening in credit spreads and decline in equity prices had reflected lower expectations for corporate earnings growth, as well as a rise in the risk premium demanded by investors. However, members observed that overall borrowing costs for corporations had remained low as a result of low government bond yields, and the corrections in these markets had followed an extended period of elevated valuations, particularly in the United States.

In China, the authorities had implemented further targeted measures to support lending to private firms, particularly small-sized enterprises, in the context of slowing economic growth. These firms' access to finance had been tightened over the course of 2018 as a result of earlier measures by the authorities to reduce risks in the financial system by restricting the availability of ‘shadow finance’. Since the latter part of 2018, the authorities had been encouraging banks to increase their lending to these types of firms, although members noted that larger banks were less accustomed to lending to this sector.

Members noted that conditions in other emerging markets had stabilised in recent months, following a tightening in conditions during 2018. Currencies had appreciated, equity prices had risen, bond spreads had narrowed and capital outflows had moderated across a number of emerging market economies. These developments had reflected policy adjustments in some countries, lower policy rate expectations in the United States and the associated depreciation of the US dollar, and, for oil-importing countries, the decline in oil prices. However, members noted that there remained a risk that financial conditions in emerging markets could tighten further. Concerns about trade tensions and a slowdown in growth, particularly in China, remained particularly important for emerging markets in Asia.

Financial market pricing implied that the Australian cash rate was expected to remain unchanged for a considerable period, with some expectation of a decrease by late 2019.

Considerations for Monetary Policy

In considering the stance of monetary policy, members observed that the global economy had continued to grow at an above-trend pace in 2018, although growth had moderated in some economies in the second half of the year. In particular, growth in China had slowed further and the authorities had continued to ease policy in a targeted way to support growth, while continuing to pay close attention to risks in the financial sector. Labour markets in the advanced economies had continued to tighten and wages growth had picked up. Core inflation had picked up in a number of economies, including the United States. Globally, lower oil prices had led to a decline in headline inflation.

Growth in Australia's major trading partners was expected to be around trend over the following year or so, but the downside risks had increased. Slowing growth in China and ongoing trade tensions had led to lower growth in global trade. Forecasters had lowered their outlook for global growth and market participants no longer expected a further tightening of monetary policy in the United States. Government bond yields had also declined in most countries, including Australia. More broadly, however, financial conditions had tightened somewhat in most major advanced economies, but remained accommodative. The terms of trade had remained above their trough in early 2016 and the Australian dollar had remained within its narrow range of recent times.

Domestically, growth in output had been weaker than expected in the September quarter. Nevertheless, growth was expected to be a little above trend over the forecast period. The outlook for business investment and spending on public infrastructure was positive. Growth in consumption was expected to be supported by a pick-up in growth in household disposable income, although recent data had prompted a downward revision to the consumption outlook. The outlook for consumption continued to be one of the key uncertainties for the forecasts for the domestic economy, given the environment of declining housing prices, low growth in household income and high debt levels.

Following a significant increase in construction activity and a large run-up in housing prices, housing markets were going through a period of adjustment. Housing prices in Sydney and Melbourne had declined further and the outlook for dwelling investment had been revised lower. In Sydney, rental vacancy rates had been increasing and rent inflation remained low across the country. Credit conditions had tightened for some borrowers and the demand for credit in the housing market, particularly by investors, had slowed noticeably as the dynamics of the housing market had changed. But housing lending rates had remained low and there was strong competition for borrowers of high credit quality.

The labour market had tightened further over 2018 and there had been some pick-up in wages growth. The unemployment rate had declined by ½ percentage point to 5 per cent, its lowest level in over seven years, and employment growth had been above average. The Bank's forecast was for the unemployment rate to decline a little further over the following few years. The vacancy rate was high and there were reports of skills shortages in some areas. Wages growth was expected to pick up gradually over the following year or so.

Inflation had remained low and stable in both headline and underlying terms over 2018. Underlying inflation was expected to pick up gradually over the forecast period, although headline inflation was expected to decline in the near term because of lower petrol prices.

Members noted that the sustained low level of interest rates over recent years had been supporting economic activity and had allowed for gradual progress to be made in reducing the unemployment rate and returning inflation towards the midpoint of the target. While the labour market had continued to strengthen over the preceding year, less progress had been made on inflation. Taking account of the available information on current economic and financial conditions, as well as the revised forecasts, members assessed that the current stance of monetary policy should continue to allow for further gradual progress on both unemployment and inflation to be made. However, members noted that there were significant uncertainties around the forecasts, with scenarios where an increase in the cash rate would be appropriate at some point and other scenarios where a decrease in the cash rate would be appropriate. Moreover, the probabilities around these scenarios were now more evenly balanced than they had been over the preceding year, when an eventual increase in the cash rate had appeared more likely.

Members would continue to assess the outlook carefully. However, given that further progress in reducing unemployment and lifting inflation was a reasonable expectation, members agreed that there was not a strong case for a near-term adjustment in monetary policy. Rather, they assessed that it would be appropriate to hold the cash rate steady and for the Bank to be a source of stability and confidence while further progress unfolds. Members judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

The Decision

The Board decided to leave the cash rate unchanged at 1.5 per cent.