Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Sydney – 6 September 2022

Members present

Philip Lowe (Governor and Chair), Mark Barnaba AM, Wendy Craik AM, Ian Harper AO, Carolyn Hewson AO, Steven Kennedy PSM, Carol Schwartz AO, Alison Watkins AM

Members had granted leave of absence to Michele Bullock (Deputy Governor), in accordance with section 18A of the Reserve Bank Act 1959.

Others present

Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Andrea Brischetto (Head, Financial Stability Department)

Anthony Dickman (Secretary), David Jacobs (Deputy Secretary)

Marion Kohler (Head, Economic Analysis Department), Penelope Smith (Head, International Department), Carl Schwartz (Acting Head, Domestic Markets Department)

International economic developments

Members commenced their discussion by noting that global inflation was high and well above central banks’ targets in many economies. High inflation was impinging on households’ real incomes and sentiment, and the rapid increase in interest rates would further weigh on aggregate household disposable income. Fuel prices had declined recently and the latest data showed headline inflation had stopped rising in most economies, with the exception of Europe. However, underlying inflation remained high, so it was too early to conclude that this represented a change in trend. Upstream price pressures had continued to moderate, and supplier delivery times had edged closer to levels last seen prior to the pandemic. Shipping rates had also fallen over recent months. On the other hand, services inflation was still rising and wages growth in some economies was faster than would be compatible with inflation returning to targets.

Members observed that analysts had again downgraded the outlook for global growth, reflecting the deteriorating outlook in Europe and for interest-rate sensitive sectors in a number of economies. While some forward-looking business surveys had turned down in the past month or so, recent data in many economies pointed to ongoing expansion. Domestic final demand in advanced economies had remained firm in the June quarter, supported by an increase in consumption of services. Strong growth in nominal labour incomes and, in some advanced economies, further declines in saving rates were cushioning the effect of higher inflation on households’ spending. Labour markets remained strong, with job vacancies exceeding the number of unemployed in many cases. While business hiring intentions were slightly below their peaks, they remained at a very high level.

Energy availability had become a critical issue in Europe. Members noted that reduced gas supplies from Russia had coincided with a severe drought and other disruptions to production that had reduced the availability of hydro and nuclear power. European gas prices had surpassed their March peaks as Russian supplies to Europe had fallen 80 per cent below 2021 levels. The price of wholesale electricity was at record highs across the continent and was expected to remain at very high levels for the foreseeable future. Household and business energy costs were expected to surge later in the year as recent increases in wholesale gas prices are passed on to retail bills. Gas consumption had fallen significantly and authorities had committed to restrict consumption to 15 per cent below normal levels through winter.

The Chinese economy was recovering from recent lockdowns, but was facing significant headwinds, especially in the real estate sector. Policy remained accommodative and fiscal support had increased recently, with infrastructure investment expected to be a key driver of growth this year. Industrial production had increased moderately in July, although there had been some disruptions in a couple of provinces stemming from drought and associated electricity shortages. Members observed that the Chinese real estate sector remained very weak, despite some recent policy support. New housing sales had declined in July to be back around their lows during recent lockdowns. Liaison contacts had reported that market confidence had been affected by concerns about the solvency of developers. The weak outcomes for residential construction were exacerbating the outlook for steel production, which had already been constrained by government production caps. Iron ore prices had declined towards the bottom of their range over the past two years.

Members noted that high coal and gas prices were supporting Australia’s terms of trade at record levels. In contrast to other energy commodities, crude oil prices were well below their peaks following Russia’s invasion of Ukraine. This decline reflected concerns about the global outlook and improved supply. Even so, the price of crude oil remained about 20 per cent above the level at the beginning of 2022. Limited spare capacity and gas-to-oil substitution in Europe and elsewhere were likely to support crude oil prices in the period ahead. Base metals and food commodity prices had been fairly steady over the preceding month, but had declined from the peaks reached after Russia’s invasion of Ukraine.

Domestic economic developments

Turning to the domestic economy, members observed that timely indicators pointed to inflation remaining high and broadly based in the September quarter. Some retailers expected to apply further large increases in their prices in coming quarters, in part reflecting the pass-through of earlier rises in input costs. By contrast, petrol prices had declined in August and were expected to subtract from headline inflation in the September quarter. The expiration of the fuel excise cut would boost headline inflation in the December quarter. Consistent with the decline in petrol prices, short-term measures of inflation expectations had declined modestly. Longer term inflation expectations generally remained within the inflation target range. Members noted that, from October, the Australian Bureau of Statistics would commence publishing a monthly CPI indicator, which would provide a timelier read on price pressures – though it could take some time for reliable trends to be discernible.

Household spending appeared to have held up in the September quarter to date. Strong labour market conditions and income growth were providing an important counterbalance for household budgets that faced increased pressure from rising prices and higher interest rates. Although payments data had softened a little of late, retail sales had increased strongly in July and most retailers in the Bank’s liaison program had indicated that consumption behaviour was changing only slowly in response to cost-of-living pressures. Spending overseas by Australian residents had also grown strongly over prior months, which – although it would not add to domestic demand – was consistent with the ongoing rebalancing towards pre-pandemic patterns of spending. Members noted that domestic activity would benefit from increased numbers of foreign tourists and students, which are recorded as services exports.

Declines in housing prices had broadened out to most capital cities and regional areas, alongside weaker housing sales activity, rising interest rates and the expectation of further interest rate increases. By contrast, rental markets were tight. Vacancy rates in Sydney and Melbourne had declined from the high levels seen since the start of the year and were likely to decline further as international student numbers increased. Vacancy rates in other capital cities remained around historical lows.

Members noted that the June quarter National Accounts would be released the day after the meeting. GDP was expected to have grown strongly in the quarter, with growth in domestic final demand led by household consumption. Residential construction work done was expected to have declined in the June quarter, reflecting wetter-than-average weather conditions along the east coast of Australia, as well as ongoing shortages of materials and labour. Exports had grown strongly in the quarter, underpinned by resources exports, following several soft outcomes.

The outlook for business investment remained positive. The June quarter ABS Capital Expenditure Survey, conducted in July and August, indicated that non-mining firms expected to increase investment in the 2022/23 financial year, driven by investment in machinery and equipment. Capacity utilisation remained high across industries, with non-mining capacity utilisation at its highest level in over three decades.

The demand for labour remained robust, judging by the timely information from job ads and liaison. Most firms in the liaison program expected to increase headcount, but some had expressed concern about their ability to do so because of poor labour availability and strong competition from other firms. Measured employment had declined in July; however, looking through the monthly volatility, the labour market remained very strong. The employment-to-population ratio and participation rate were around record highs, and measures of spare capacity were at their lowest levels in decades. The unemployment rate had declined further to 3.4 per cent in July. Members noted recent announcements that staffing levels in visa processing would be increased to clear backlogs in this area. Immigration of skilled workers, students and working holidaymakers could all be anticipated to increase in the period ahead, which would add to labour supply as well as aggregate demand.

Wages growth was picking up as expected. A range of timely measures, including from liaison, business surveys and measures based on retail banking data, indicated that this pick-up had continued over prior months. In the June quarter, the Wage Price Index had increased by 0.7 per cent in the quarter and 2.6 per cent in year-ended terms. The pick-up in growth had been stronger in the private sector than in the public sector, where wages growth had remained more subdued. Wages growth had been strongest in the construction industry, consistent with information from liaison about labour costs and availability in that industry.

International financial markets

Members commenced their discussion of international financial markets by noting that central banks in most advanced economies had been increasing policy rates at a rapid pace to address high inflation and mitigate the risk that above-target inflation becomes embedded in wage- and price-setting behaviour. During the preceding month, the Bank of England, the Norges Bank and the Reserve Bank of New Zealand had raised their policy rates by 50 basis points, and the Bank of Korea had increased its policy rate by 25 basis points.

Central banks in most advanced economies had continued to signal that further policy rate increases are likely. Communication from the Federal Reserve and the European Central Bank emphasised that inflation is likely to be more persistent than earlier expected and that policy rates will need to remain higher for longer in order to bring inflation back to target. At the same time, these central banks acknowledged the adverse effect such outcomes would have on economic activity.

Government bond yields had risen over the preceding month, reflecting upward revisions to the policy rate paths implied by market pricing as well as increases in inflation expectations for the near term. Members noted that longer term inflation expectations had also increased, but remained within the 2 to 3 per cent range in most advanced economies. Sovereign yield curves in a number of advanced economies – including Canada, the United Kingdom and the United States – were flat or downward sloping, indicating market concerns about the possibility of recessions in these economies. Members observed that the Australian yield curve remained upward sloping.

Private sector financing conditions had become tighter than earlier in the year. Equity prices had fallen noticeably and corporate bond spreads were higher as market participants’ expectations for policy rates had trended higher. The US dollar had appreciated further, consistent with another increase in short-term US Government bond yields relative to other economies.

The Australian dollar had depreciated against the US dollar over the year to date, but had appreciated on a trade-weighted basis over the same period. The RBA Index of Commodity Prices was around its levels at the beginning of the year, despite the decline in the price of iron ore.

The People’s Bank of China had eased monetary policy further amid signs of increased weakness in the Chinese economy, particularly in the property sector; authorities had also announced lending support to help complete unfinished apartment projects. The further easing of policy rates had been associated with downward pressure on the renminbi, which had depreciated further from its recent lows against the US dollar as the interest rate differential between US and Chinese government bonds had widened.

Domestic financial markets

Members noted that, in the domestic market, yields had increased over the preceding month in line with global developments. Members observed that market pricing implied the cash rate was expected to be increased by a further 50 basis points in September, and to be around 3¼ per cent by the end of the year. The end-year pricing was a little above the median forecast of market economists. Banks’ overall funding costs had increased significantly in recent months, as much of their wholesale funding is ultimately linked to money market rates. Retail deposit rates had also increased, but by a smaller amount.

As was the case in previous months, housing lenders had passed on the full amount of the increase in the cash rate in August to their standard variable rates. Members noted that, as the previous increases in the cash rate flowed through, mortgage interest payments were expected to increase to around 4½ per cent of household disposable income over the coming months, and to almost 5 per cent by the end of the year. These estimates assumed that maturing fixed rate loans would be replaced with variable rate loans. Overall interest payments on housing loans were expected to respond more gradually to changes in interest rates than in the past because of the higher fixed-rate share of credit (almost 35 per cent of housing credit at present, compared with 20 per cent prior to the onset of the pandemic). Net payments into offset and redraw accounts had remained strong up to July, in line with flows in 2021, despite the rise in interest payments.

Members observed that credit growth had remained strong overall. Demand for business credit had been supported in recent months by strong economic conditions and the lagged effects of a high level of mergers and acquisitions activity. In addition, bank credit had been favourably priced relative to the issuance of corporate bonds, and businesses had drawn down existing credit facilities to manage liquidity challenges arising from supply chain disruptions and cost increases. By contrast, housing credit growth had moderated in recent months, and the decline in housing loan commitments from their high level at the start of the year was expected to result in a further slowing in housing credit growth in the period ahead.

Review of the bond purchase program

Members reviewed the operation and effectiveness of the bond purchase program (BPP) introduced in November 2020 as part of the second package of monetary policy measures implemented by the Bank in response to the effects of the COVID-19 pandemic. The discussion was based on a staff review commissioned by the Board.

Members observed that the BPP, together with the other monetary policy measures put in place during the pandemic, had contributed to the strong recovery of the Australian economy, with unemployment having declined to its lowest rate in almost 50 years.

The BPP involved purchasing government bonds in order to lower yields at the 5–10 year part of the yield curve. The program was introduced to complement the price-based, three-year yield target introduced in March 2020 and the Term Funding Facility, along with the longstanding overnight cash rate target, which forms the anchor point for the risk-free interest rate term structure. Together, the policy measures had lowered the whole structure of interest rates in Australia and supported confidence in the economy. However, members noted that it is difficult to identify the exact effect of the BPP on the economy, because it was implemented as part of a broader package of policy measures that reinforced one another. Moreover, a key benefit of the policy package was to provide insurance against the significant downside risks the economy was facing during the pandemic – a benefit that is inherently very difficult to quantify, especially given that downside risks were avoided.

Members noted that the BPP had affected the public sector balance sheet in several ways. There is expected to be a financial cost to the Bank because the purchased bonds pay a fixed return, while the interest paid on the Exchange Settlement (ES) balances created to finance the bonds varies with monetary policy settings and so rises as monetary policy is tightened. The ultimate cost will be known only once the last of the purchased bonds matures in 2033. Members noted that it is important to assess this potential cost in the context of the wider benefits to the economy that have flowed from the BPP as part of the package of monetary policy measures. There are also expected to be a number of benefits to the public sector balance sheet. The reduction in yields lowered the cost of government debt issuance, while stronger economic activity than otherwise increased tax revenues and reduced government support payments. These benefits to government finances are material, although they are difficult to quantify. Members observed that the Bank would record an accounting loss in 2021/22 because the increase in bond yields (consistent with the higher expected path of the ES rate) had caused the market value of the purchased bonds to fall. At the same time, the overall Commonwealth financial position would incorporate some offsetting accounting gains, given issued bonds represent a liability on the general government balance sheet.

In light of the experience, members judged it appropriate to consider use of a BPP again only in extreme circumstances, when the usual monetary policy tool – the cash rate target – has been employed to the full extent possible. Compared with a yield target, a BPP provides more flexibility to respond to evolving economic circumstances, although it could entail larger financial costs. In considering any future use of a BPP, members noted that it would need to be evaluated against other policy options at the time, taking into account the costs of the BPP under a full range of scenarios.

Members agreed to the publication of the review of the BPP. A review of the Bank’s approach to forward guidance is under way and will be published later in the year.

Considerations for monetary policy

In considering the policy decision, members noted that inflation in Australia was at its highest level in several decades and was expected to increase further over the months ahead. Global factors continued to explain much of the increase in inflation. However, domestic factors were also playing a role, with widespread upward pressure on prices from strong demand, a tight labour market and capacity constraints in some sectors of the economy.

Members noted that inflation was expected to peak later this year and then decline back towards the 2 to 3 per cent target range. The expected moderation in inflation reflected the ongoing resolution of global supply-side problems, recent declines in some commodity prices and the impact of rising interest rates. Medium-term inflation expectations remained well anchored, and it was seen as important that this remain the case. The Bank’s central forecast was for CPI inflation to be around 7¾ per cent over 2022, a little above 4 per cent over 2023 and around 3 per cent over 2024.

The Australian economy was continuing to grow solidly. Consumer spending had so far been resilient to higher interest rates, and national income had been boosted by a record level of the terms of trade. At the same time, the increases in interest rates had seen an easing of conditions in the established housing market alongside a softening in household demand for credit.

The labour market had remained tight and continued to indicate that the economy was having difficulty meeting the level of aggregate demand. Many firms were finding it challenging to hire workers. The unemployment rate had declined further in July to 3.4 per cent, the lowest rate in almost 50 years, and the continued high level of job vacancies suggested a further decline was in prospect over the months ahead. Members noted that many Australians are benefitting from the greater opportunities for work provided by the tighter labour market, notably young people, women and longer term unemployed people. Beyond the near term, some increase in unemployment was expected as economic growth slows owing to the effects of higher interest rates, although members noted that changes in labour market conditions tended to lag some other indicators of economic activity.

Wages growth had picked up from the low rates of prior years and there were some pockets where labour costs were increasing briskly. However, members noted that the rate of base wages growth so far had not reached levels that would be inconsistent with achieving the inflation target on a sustained basis. Nevertheless, given the tight labour market and the upstream price pressures, the Board would continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.

Members noted that an important source of uncertainty continued to be the behaviour of household spending. Higher inflation and higher interest rates were putting pressure on household budgets. Consumer confidence had also fallen and housing prices were declining in most cities and regions after the earlier large increases. Working in the other direction, people were finding jobs, gaining more hours of work and receiving higher wages. Many households had built up large financial buffers and the saving rate remained higher than before the pandemic. While the high levels of payments into offset and redraw accounts suggested that some households remained in a favourable financial position, members acknowledged that other households were finding conditions difficult in the face of higher interest rates and higher inflation. The Board would be paying close attention to how these various factors balanced out as it assessed the appropriate setting of monetary policy.

The outlook for global economic growth had deteriorated and posed a key uncertainty. Central banks in several large advanced economies had expressed further resolve in tightening monetary policy to prevent high inflation from becoming entrenched, and this was likely to entail a period of significantly lower growth. High inflation was also placing pressure on real incomes, most significantly in Europe, related to the worsening effects on energy markets following Russia’s invasion of Ukraine. In addition, COVID-19 containment measures and other policy challenges continued to weigh on the outlook for growth in China. Some slowing in the global economy would be important to returning inflation to central banks’ targets, but the potential for a sharp slowing continued to present a downside risk to the outlook.

Members judged that a further increase in interest rates would help bring inflation back to target and create a more sustainable balance of demand and supply in the Australian economy. They discussed the arguments around raising interest rates by either 25 basis points or 50 basis points. Members emphasised that price stability is a prerequisite for a strong economy and a sustained period of full employment. They acknowledged that monetary policy operates with a lag and that interest rates had been increased quite quickly and were getting closer to normal settings. Given the importance of returning inflation to target, the potential damage to the economy from persistent high inflation and the still relatively low level of the cash rate, the Board decided to increase the cash rate by a further 50 basis points.

The Board expects to increase interest rates further over the months ahead, but it is not on a pre-set path given the uncertainties surrounding the outlook for inflation and growth. The full effects of higher interest rates were yet to be felt in mortgage payments, and the broader effects on activity and inflation would take some time to be apparent. The Board was resolute in the need to ensure inflation returned to target, but mindful that the path to achieve this needed to account for the risks to growth and employment. The Board is seeking to return inflation to target while keeping the economy on an even keel. The path to achieving this balance remains a narrow one and clouded in uncertainty.

The size and timing of future interest rate increases will continue to be guided by the incoming data and the Board’s assessment of the outlook for inflation and the labour market, including the risks to the outlook. All else equal, members saw the case for a slower pace of increase in interest rates as becoming stronger as the level of the cash rate rises. The Board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time.

The decision

The Board decided to increase the cash rate target by 50 basis points to 2.35 per cent. It also increased the interest rate on Exchange Settlement balances by 50 basis points to 2.25 per cent.