Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Hybrid – 4 October 2022

Members participating

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

Members had granted leave of absence to Carol Schwartz AO, in accordance with section 18A of the Reserve Bank Act 1959.

Others participating

Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Bradley Jones (Assistant Governor, Financial Stability)

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

Jonathan Kearns (Head, Domestic Markets Department), Marion Kohler (Head, Economic Analysis Department), Penelope Smith (Head, International Department)

International economic developments

Members commenced their discussion of international economic developments by observing that inflation remained high. Headline inflation had declined in some economies as oil prices had fallen, but core inflation was yet to show any signs of easing in most advanced economies. The UK and other European governments had announced sizeable assistance packages to alleviate the effects of stress in energy markets and support their economies, especially households. While these assistance packages had lowered the expected near-term peaks in headline inflation stemming from higher energy costs, the scale of the UK fiscal stimulus was expected to add to inflationary pressures over the medium term.

European gas and thermal coal prices had fallen significantly over the prior month owing to the commitment to implement energy rationing and the imposition of a windfall tax on non-gas energy generation, including from coal. Nevertheless, prices remained many times higher than a few years earlier and there was considerable anxiety about how the energy situation would evolve over the European winter. Non-energy commodity prices were well below the peaks reached immediately following Russia’s invasion of Ukraine, in part because the outlook for global growth had weakened.

Members noted that, in a number of other advanced economies, monthly headline inflation had lately declined from recent peak rates, mainly reflecting lower petrol prices. Goods price inflation had also eased from high levels, as demand rebalanced from goods back to services and as input price pressures moderated. Members observed that global supply chains were also improving; shipping costs and supplier delivery times had fallen and further declines could be envisaged, given that they were still well above pre-pandemic levels. This improvement was likely to have reflected supply chain realignments, reduced backlogs and an easing in global demand for goods.

Notwithstanding the easing in measures of headline inflation, core inflation remained high and was increasingly being driven by higher prices for services. Higher services inflation was a response to strong domestic demand and growth in labour costs running above rates that would be consistent with inflation returning to central banks’ targets. Labour markets remained tight, with very high vacancy rates and unemployment rates back to or a little below their pre-pandemic lows.

Recent indicators continued to point to a further moderate softening in aggregate demand in advanced economies. Household consumption was growing modestly, with some switch back to spending on services and away from goods. Businesses’ hiring and investment intentions remained at or above pre-pandemic levels. The recent cost-of-living policies announced by governments in Europe would help support economic activity and reduce some of the downside risks. The housing sector in a number of countries remained an area of weakness, reflecting rising interest rates.

Members observed that the Chinese economy continued to face significant headwinds as it grappled with its weak real estate market as well as periodic bouts of rising COVID-19 case numbers and associated lockdowns. In response to mounting concerns about developers pausing or abandoning development projects, the Chinese authorities had put in place a number of measures to support the completion of projects. However, given the sharp decline in starts, housing construction was expected to fall further for some time. COVID-19 containment restrictions had been imposed on more parts of the country in September, although the effect on the movement of goods had been more modest than following the Shanghai lockdown earlier in the year. China’s zero-COVID policy seemed likely to continue until at least the five-yearly party congress on 16 October, and possibly beyond then.

Domestic economic developments

Turning to the domestic economy, members noted that information over the preceding month showed little change in overall economic conditions from the assessment in early September. According to the newly released monthly Consumer Price Index (CPI) indicator, inflation had remained high in the first two months of the September quarter and was in line with the Bank’s expectations. The national accounts had confirmed that the domestic economy had grown strongly in the June quarter, driven by household consumption and exports. More timely information suggested that household spending growth had held up well in the September quarter, supported by continuing strong conditions in the labour market.

Members observed that household spending had increased solidly in the September quarter, supported by the ongoing recovery in consumption of services and the return to a more usual level of household saving. Firms generally were optimistic about the longer term outlook for demand and this was reflected in investment intentions remaining at or above average levels. However, shortages of materials and labour were expected to remain a challenge in a number of areas of the economy, including residential and infrastructure investment projects.

The current high level of energy-related commodity prices had boosted Australia’s national income. Members noted that the combination of record-high terms of trade, strong demand and high inflation had meant that nominal income growth had been very strong in the June quarter and nominal GDP was growing around its fastest pace over the inflation-targeting period.

Members observed that the monthly CPI indicator had confirmed the Bank’s expectation that inflation had picked up further in July and August, and that it was broadly based. Overall, headline inflation was expected to be around 7¾ per cent and underlying inflation around 6 per cent over 2022. Although some of the supply-side factors that had contributed to inflation over the preceding year were expected to ease in coming quarters, items such as utilities prices and rents were likely to pick up further and add to inflationary pressures for some time. The very limited supply of properties available for rent, as reflected in low and declining vacancy rates, was supporting large increases in advertised rents and this was starting to flow through to the stock of rents as recorded in the CPI.

The labour market remained very tight. The employment-to-population ratio and the participation rate were both around record highs, and measures of spare capacity in the labour market were near their lowest levels in decades. Labour demand remained strong, with job advertisements and vacancies at very high levels in August and into September. Members noted, however, that conversion of this strong demand into additional employment had been relatively modest of late, suggesting that limited spare capacity remained in the labour market. Consistent with this, firms in the Bank’s liaison program and in business surveys generally reported that finding suitable labour remained their most significant challenge. Growth in labour costs looked to have picked up somewhat, with the liaison measure of private-sector wages growth increasing a little further in the September quarter. Information from liaison and business surveys pointed to a further increase in wages growth in coming quarters. A number of state governments had also recently offered larger wage increases than had previously been agreed.

International financial markets

Members observed that financial markets had been volatile over the preceding month as uncertainty about the global economic outlook increased. This reflected persistent inflationary pressures in most advanced economies, and an expectation by financial markets that central banks would raise policy interest rates by more and for longer than previously anticipated. Developments affecting financial stability in the United Kingdom had also contributed to the volatility in financial markets.

Central banks around the world had continued the rapid and synchronised tightening of monetary policy. Members noted that the speed and extent of monetary policy tightening had been faster than any episode in recent decades, and market pricing implied that the level of policy rates in most major economies was expected to be a little below, but still comparable with, the peaks reached in the mid-2000s. Over the prior month, market participants had raised their expectations for further policy rate increases in response to higher-than-expected inflation and communication by some central banks that monetary policy settings would need to be restrictive to return inflation to their targets. These developments were contributing to growing concerns around the risk of recession in a number of economies.

Long-term government bond yields had increased noticeably over the preceding month and had become increasingly volatile, reflecting uncertainty about the outlook for growth and inflation and limited liquidity in some markets. In the United Kingdom, sovereign bond yields had increased sharply in response to the government’s announcement of further substantial fiscal stimulus. The increase in yields had been further amplified by the selling of long-dated government bonds and other assets by UK pension funds to cover margin calls. To restore market functioning and reduce risks from contagion to credit conditions for UK households and businesses, the Bank of England had undertaken temporary bond purchases. Members noted that UK sovereign bond yields had retraced some of their previous increase following the Bank of England’s actions.

Private sector financing conditions had continued to tighten in most advanced economies. Equity prices had fallen further over the preceding month and corporate bond yields and credit spreads had risen.

The US dollar had appreciated against most currencies since the start of the year, most notably against the Japanese yen and the UK pound. Members noted that the Japanese Ministry of Finance had intervened to slow the depreciation of the yen, while the People’s Bank of China had implemented measures to lean against the pace of depreciation of the renminbi. The Australian dollar had depreciated further against the US dollar, but had appreciated slightly over 2022 on a trade-weighted basis. Members noted that the trade-weighted exchange rate typically has a greater bearing on imported inflation than bilateral rates.

In China, financial conditions had become more accommodative, supported by earlier fiscal and monetary policy easing and more recent targeted efforts to bolster the property sector. Members noted that financial stress among Chinese property developers had broadened to some smaller state-owned developers over preceding months. Chinese equity prices had declined further over September, reflecting concerns about growth prospects in China. In many other emerging markets, central banks had further tightened policy amid high inflation.

Domestic financial markets

Members noted that Australian financial markets had followed global trends but with more moderate moves, as evidenced in Australian Government bond yields, equity prices and market expectations for the cash rate. This was consistent with inflationary pressures generally being seen to be weaker in Australia, with wages growth lower than in many advanced economies. Expectations for the cash rate, as revealed by market pricing, had increased over the preceding month, but to a lesser extent than in other countries. At the time of the October meeting, market pricing implied that financial market participants applied around a 75 per cent likelihood of a 50 basis point increase in the cash rate and a 25 per cent likelihood of a 25 basis point increase; the cash rate was expected to be around 3.4 per cent by the end of 2022 and peak slightly above 4¼ per cent in mid-2023. Market economists expected the peak in the cash rate to be a little lower than this.

Housing mortgage payments had risen and were set to rise further in the period ahead as a result of the increase in home loan interest rates that had already been announced. Given the increases in the cash rate prior to the October meeting, required housing mortgage payments as a share of household income were expected to increase to around levels last seen in 2010. This included the effect of fixed interest rate loans rolling off over time. Payments into offset and redraw accounts were still high, but somewhat lower over 2022 than in 2021. Housing loan commitments had declined for both owner-occupiers and investors, demonstrating the effect of higher interest rates on housing lending.

Financial stability

Members discussed the Bank’s regular half-yearly assessment of financial stability risks.

Financial stability risks had increased over preceding months. Global financial conditions had continued to tighten as persistently high inflation had prompted the rapid and synchronised increase in policy rates in advanced economies. Growth in housing prices had slowed or reversed in many economies. Alongside a sharp downgrade in forecasts for global economic growth over recent months, financial asset prices had declined and volatility had increased significantly. Geopolitical tensions had continued to destabilise energy markets, particularly in Europe, where the macroeconomic and financial stability outlook had deteriorated sharply. A turn in the global credit cycle was therefore apparent, although from a starting point where loan arrears were at very low levels and large global banks were well capitalised.

Financial stability risks had continued to increase in China and in some emerging market economies where longstanding domestic vulnerabilities were being exacerbated by the more difficult environment for external financing. Foreign investors had reduced their exposure to China’s bond markets over the year; members noted it was too early to tell if foreign portfolio outflows from China were largely a cyclical response to domestic and external factors, or whether they marked the beginning of a longer term reassessment of the risks associated with deploying capital in China.

Turning to the outlook for domestic financial stability, members noted that households, firms and banks in Australia had entered what was likely to be a more challenging economic environment in a strong financial position overall. Many Australian households and businesses had established substantial savings buffers during the pandemic, and policy support had contributed to a strong recovery in labour market outcomes and private incomes. This, along with forbearance for some borrowers, had resulted in low levels of loan arrears.

However, members noted that resilience across private sector balance sheets was not evenly distributed, and housing and financial asset prices had declined in 2022. While many variable-rate borrowers were well ahead on their mortgage payments, pressures on some household budgets and business cash flows were rising in response to higher interest rates and higher inflation. Members noted that variable-rate borrowers with low incomes, small liquidity buffers and high debt were most vulnerable to mortgage payment difficulties, although the share of borrowers in such a position was low. Many fixed-rate borrowers were also set to face large increases in their minimum payments when their fixed-rate terms expire. Members recognised, however, that lenders had assessed borrowers’ ability to service their mortgages at interest rates above those prevailing at the time those mortgages originated.

Members discussed the reduction in loan-to-valuation ratios since the onset of the pandemic. Most borrowers had accumulated large amounts of equity in their homes, reflecting the large increase in housing prices over prior years and the small share of high loan-to-valuation ratio lending in recent times. These developments had reduced risks to the financial system flowing from borrowers encountering difficulties in their debt-servicing capacity.

Members noted that, in aggregate, the effects of rising interest rates and inflation were more likely to be evident in a slowdown in consumption growth over the period ahead, rather than a large spike in banks’ non-performing loans. However, this outlook did not account for the potential for a large increase in unemployment, which would be problematic.

Members noted that, following a period of forbearance during the pandemic, the number of business insolvencies in Australia had picked up of late, including in sectors where cost pressures were acute or where balance sheets had been severely affected by pandemic-related restrictions. However, the recent increase in the number of business insolvencies had occurred from very low levels, similar to the pattern observed in other countries.

Banks in Australia remained very well capitalised with high levels of liquidity. Large capital buffers meant banks were well positioned in the event non-performing loans picked up from their current very low levels. Non-bank lending for housing had been particularly strong. Members noted that, while non-bank lending comprised a small share of system-wide credit and there had been little evidence of a decline in lending standards, it was important that lending standards remained prudent.

Finally, members discussed the Bank’s ongoing involvement in work streams addressing the financial stability risks associated with cybercrime and climate change. The recent cyber-attack on Optus underscored the importance of organisations having effective cyber resilience and recovery plans. In conjunction with other agencies comprising the Council of Financial Regulators, the Bank had participated in several exercises aimed at assessing the preparedness of financial institutions to navigate significant cyber-related disruptions. The Bank also continued to progress work on the economic and financial stability implications of climate change and associated policies, including the modelling of physical and transition risks and scenario analysis. In addition, the Bank continued to engage in international forums on the development of consistent standards for ‘green finance’ and the reporting of climate-related disclosures, which was relevant to its ongoing analysis of the cost and availability of finance in Australia.

Considerations for monetary policy

In considering the policy decision, members noted that inflation in Australia was too high, as was the case in most countries. Global factors explained much of the high inflation, but strong domestic demand relative to the ability of the economy to meet that demand was also playing a role.

A further increase in inflation was expected over the months ahead. Inflation was then expected to decline towards the 2–3 per cent range, reflecting the ongoing resolution of global supply-side problems, recent declines in some commodity prices and the effect of rising interest rates. Medium-term inflation expectations remained well anchored and members emphasised the importance of this remaining 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. Members noted that a full set of updated forecasts will be published in November following the release of the September quarter CPI.

Members discussed the continued solid growth of the Australian economy and noted that national income was being boosted by a record level of the terms of trade. The labour market was very tight and many firms were having difficulty hiring workers. The unemployment rate in August was 3.5 per cent, around the lowest rate in almost 50 years. Job vacancies and job advertisements were both at very high levels, suggesting a further decline in the unemployment rate over the months ahead. Beyond that, some increase in the unemployment rate was expected as economic growth slows.

Wages growth had continued to pick up from the low rates of recent years, although it remained lower than in other advanced economies, where inflation was also higher. Many firms were seeking to raise their headcount, and the increased difficulty finding workers meant that this strong labour demand was likely to result in a further lift in wages growth in coming months. The Board will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.

Members agreed that a further increase in the cash rate was necessary to achieve a more sustainable balance of demand and supply in the Australian economy. Price stability is a prerequisite for a strong economy and a sustained period of full employment. Given this, the Board’s priority is to return inflation to the 2–3 per cent range over time while keeping the economy on an even keel. Members saw the path to achieving this balance as a narrow one clouded in uncertainty.

Members carefully considered two options for the size of the increase in the cash rate: continuing with the 50 basis point increases of the preceding four meetings; or announcing a smaller 25 basis point increase.

The arguments for continuing with an increase of 50 basis points stemmed from the inflationary environment and risks to inflation expectations. Inflation was high, broadly based and expected to increase further. Inflationary pressures had earlier proven more persistent than expected and there were upside risks to inflation from the labour market, rents and energy costs. While wages growth had increased more rapidly in other economies where labour supply had been more adversely affected by the pandemic, Australia could yet have the same experience given the tightness of the labour market.

If the Board were to reduce the size of the rate increase, it would be the first to do so among advanced economies. This might in turn prompt an unhelpful reaction in inflation expectations and financial markets, if the community came to question the Board’s resolve to reduce inflation. Ultimately, if upside risks to inflation were to materialise, or the credibility of the path to reduce inflation came into question, it would be costly to re-establish low inflation.

In this context, members also noted that the cash rate was not at an especially high level. Consumption had so far proven resilient to the increase in interest rates, supported by strong labour market conditions and the large financial buffers that many households had built up during the pandemic.

The arguments for a 25 basis point increase rested on the risks to global and domestic growth, and the potential for inflation to subside quickly. The cash rate had risen by a significant amount in a short period of time. While consumption had so far held up, monetary policy operated with a lag and there was a risk that household spending might adjust by more than expected. Higher interest rates, alongside higher inflation, were putting pressure on household budgets and consumer confidence had fallen. The full effects of higher interest rates were yet to be felt in mortgage payments and the increases in the cash rate were close to the interest rate buffer applied when many current borrowers took out their loans. The tightening of monetary policy was having a clear effect in the housing market, where prices had declined after earlier large increases, and the demand for housing loans had also fallen. Previous episodes of lower housing prices and turnover had seen a large effect on consumer spending, in part through the wealth channel of transmission.

With regard to inflationary pressures, members noted that wages growth had not reached levels that would be inconsistent with the inflation target. Moreover, some further rise in wages growth would not necessarily be cause for concern, given the flexible and medium-term nature of the inflation target, so long as inflation expectations remained well anchored. Institutional features of the Australian labour market also made a sharp rise in wages less likely than in other economies, which would help smooth the cycle in wages growth until some of the tightness of the labour market lessened.

External inflationary pressures might ease quickly given that the global outlook had deteriorated. Commodity prices had generally declined and supply chain pressures had begun to ease. Increases in policy rates in advanced economies were likely to entail a period of significantly lower output growth, which would be important for reducing global inflationary pressures.

Finally, members noted that, in an uncertain environment, there was an argument to slow the adjustment of policy for a time to assess the effects of the significant increases in interest rates to date and the evolving economic outlook. Drawing out policy adjustments would also help to keep public attention focused for a longer period on the Board’s resolve to return inflation to target. While some other central banks had been increasing policy by larger increments, policymaking bodies in these central banks met less frequently than the Reserve Bank Board.

Members acknowledged that the arguments were finely balanced. They concluded, though, that the case to increase the cash rate by 25 basis points at the present meeting was the stronger one. A smaller increase than that agreed at preceding meetings was warranted given that the cash rate had been increased substantially in a short period of time and the full effect of that increase lay ahead. Members also recognised the benefits of a smaller increase while the incoming data on both the global and domestic economy were assessed. At the same time, the Board agreed on the importance of returning inflation to target and the need to establish a more sustainable balance of demand and supply in the Australian economy. This was likely to require further increases in interest rates over the period ahead.

The Board will continue to monitor the global economy, household spending and wage- and price-setting behaviour closely. The size and timing of future interest rate increases will continue to be determined by the incoming data and the Board’s assessment of the outlook for inflation and the labour market. The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that outcome.

The decision

The Board decided to increase the cash rate target by 25 basis points to 2.60 per cent. It also increased the interest rate on Exchange Settlement balances by 25 basis points to 2.50 per cent.