Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Hybrid – 7 November 2023

Members participating

Michele Bullock (Governor and Chair), Ian Harper AO, Carolyn Hewson AO, Steven Kennedy PSM, Iain Ross AO, Elana Rubin AM, Carol Schwartz AO, Alison Watkins AM

Others participating

Christopher Kent (Assistant Governor, Financial Markets), Marion Kohler (Acting Assistant Governor, Economic)

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

Penelope Smith (Head, International Department), Tom Rosewall (Acting Head, Economic Analysis Department), Carl Schwartz (Acting Head, Domestic Markets Department)

International economic developments

Members commenced their discussion of international economic developments by observing that high inflation remained the primary concern for central banks in advanced economies. Headline inflation had edged higher over recent months in several countries because of increases in fuel prices. Core inflation had declined in year-ended terms, but core services inflation generally remained high. Although inflation in the prices of services other than housing had likely passed its peak and demand in the services sector had started to ease, the overall disinflation process was viewed as likely to take some time.

The Israel-Hamas war had increased uncertainty about the global economic outlook. Members noted that the conflict could present an upside risk for global inflation if it were to lead to a disruption in energy supply from the region. Prices for liquified natural gas had already increased significantly following the shutdown of Israel’s Tamar gas field. Oil prices had been volatile since the beginning of the conflict but had not increased in a sustained way. Members also noted that the ongoing El NiƱo event presented an upside risk to global food price inflation.

Output growth had slowed in many advanced economies, in response to tighter monetary policy and cost-of-living pressures. But the slowing had been less than anticipated in some economies and labour markets remained tight; economic activity in the United States was particularly strong in the September quarter. Growth in G7 economies was expected to slow further in the coming year because of tighter financial conditions.

Members discussed the near-term outlook for Australia’s major trading partners. Output growth was expected to slow from 3½ per cent in 2023 to 3 per cent in 2024, well below the average growth rate in the decade prior to the pandemic. This outlook was largely unchanged from the August meeting. Members observed that the economic outlook in China remained uncertain. The economy there had continued to recover in the September quarter, driven by activity in the services sector, but the level of GDP remained below the trend expected by many observers prior to the pandemic. Government stimulus had provided support to growth this year, particularly through the financing of infrastructure investment. However, the property sector remained very weak, which was expected to weigh on Chinese growth in the year ahead. Members considered the risk that fragility in the property sector might have a more pronounced adverse effect on the Chinese economy as a whole.

Domestic economic conditions

Turning to the domestic economy, members observed that inflation had continued to decline in year-ended terms in the September quarter. However, underlying inflation was stronger than expected a few months earlier and, on a quarterly basis, had picked up slightly. When considered with other information, the assessment of the staff was that higher inflation reflected demand pressures in the economy being stronger than had been expected. Stronger-than-expected inflation was evident for a broad range of services, reflecting a high level of domestic demand and continued pressure from the costs of both labour and domestic non-labour inputs (including factors such as rents, electricity and insurance). Housing rent inflation over the prior six months had been running at around 10 per cent in annualised terms, reflecting low vacancy rates and strong growth in population and aggregate income. Meanwhile, goods price inflation had eased further in the September quarter – largely in line with expectations – because of an easing in supply chain pressures and raw materials prices.

Members observed that a range of indicators of activity over preceding months supported the conclusion that domestic demand pressures had been a little stronger than previously thought. Consequently, the outlook for output growth and inflation had been revised up over the forecast period, with the largest revisions being for the year ahead. Inflation was expected to decline at a more gradual pace than previously expected, because of the greater-than-expected persistence in services price inflation. As demand and cost pressures progressively ease, inflation was expected to decline to a little below 3 per cent by the end of 2025.

Output growth was expected to remain below trend over 2023 and 2024, and GDP per capita was expected to decline over 2023. Inflation and high interest rates continued to weigh on demand, particularly via their effect on people’s real incomes and, consequently, growth in household consumption. Even so, the outlook for output growth had been revised up in the near term compared with the previous forecasts. This partly reflected stronger-than-expected population growth, which had been revised higher over successive prior quarters, and more strength in private and public investment than had previously been expected.

Members observed that subdued growth in consumption had persisted into the second half of 2023, based on a range of timely indicators. However, recent retail sales data suggested that spending had held up better than had been expected a few months earlier. Real household disposable income was expected to decline over 2023, reflecting the combined effects of high inflation and the rise in interest rates and tax payable. As these effects begin to fade during 2024, household consumption growth was forecast to pick up. Furthermore, housing prices had increased over the preceding nine months (regaining their April 2022 peak) and this additional wealth was expected to provide some support to consumption (though possibly less than in the past given the low rates of housing turnover and credit growth).

Spending in the economy had been supported by the rebound in international student and tourist arrivals (whose spending is recorded as services exports in the national accounts). This was supporting demand for consumer-facing firms, partly offsetting the decline in spending by residents. A recovery in residential investment was also expected further out, supported by strong population growth, the continuing recovery in housing prices and shortening construction times.

The outlook for non-mining business investment remained favourable, given a high level of capacity utilisation, strong population growth and an easing in supply constraints. Both business investment and public demand had contributed to the resilience in demand in the first half of 2023, which was expected to continue. Investment was expected to be supported by the large pipeline of private and public projects, particularly in infrastructure construction and projects related to the transition to renewable energy sources.

Members noted that the labour market had been resilient in 2023, though there had been signs of gradual easing in a range of measures. Employment growth had slowed to around the rate of population growth, such that the employment-to-population ratio had remained around its multi-decade high. Hours worked had been a key margin of adjustment for firms. Average hours worked had declined over preceding months and most of the employment growth during that period had been in part-time work. As a result, the underemployment rate had picked up a little more than the unemployment rate; however, both remained very low, consistent with labour market conditions remaining tight. The stronger outlook for economic activity over the year ahead resulted in the forecast rise in the unemployment rate being more gradual than had previously been expected. The unemployment rate was anticipated to stabilise around 4¼ per cent from late 2024, with employment growing but at a more moderate pace.

Despite the ongoing tightness in the labour market, the outlook for wages growth had been revised a little lower in the near term based on the signal from timely indicators. Liaison with firms suggested that there had been a moderation in wages growth in some jobs and industries, such as business services and construction, where wages growth had been especially strong in the preceding year. However, growth in unit labour costs, which incorporated weak productivity outcomes over preceding years, remained very high. Members noted that the forecasts assumed that productivity growth would pick up, such that growth in unit labour costs eased to a rate consistent with the inflation target.

Members considered the annual review of the Bank’s forecasts. Headline inflation and the unemployment rate had been broadly in line with the forecasts a year earlier. On the other hand, underlying inflation had been higher than anticipated, reflecting the persistence of broad-based domestic cost pressures in an environment of still-robust levels of aggregate demand. Members discussed the relative importance of headline and underlying inflation for future inflation, noting that both measures contain relevant information.

Over the prior year, there had been offsetting misses within the outlook for GDP growth. Growth in consumption had turned out weaker than had been expected and capacity constraints had persisted in some industries, particularly construction. However, population growth had turned out substantially higher than had been assumed, as the return of students and international visitors had occurred faster than had been expected, which had added strongly to spending. Members noted that the upside surprise on population growth had added to both demand and supply; as a result, the net effects on inflation had been largely offsetting in aggregate but may have varied across sectors. Members also noted the staff’s response to the lessons learned from the previous year’s review, which included incorporating more signal from overseas developments, expanding the suite of alternative timely indicators and increasing the use of scenario analysis.

International financial markets

Central banks in advanced economies had left policy rates unchanged over the prior month. Most had communicated that policy rates were restrictive and that the full effect of cumulative policy tightening was still to be felt, given the lags with which policy affects the economy. Central banks had also continued to communicate that future decisions will depend on incoming data. While commentary from most central banks had focused on balancing upside risks to inflation with downside risks to output growth, inflation was still above central banks’ targets and most retained a monetary policy tightening bias.

Market participants’ expectations for the trajectory of policy rates had generally been little changed since the October meeting. The central expectation was that policy rates would be held at or near current levels until at least mid-2024, then gradually decline. Members noted that Australia was an exception.

Government bond yields in advanced economies had risen over preceding months. Most of the increase in longer term yields reflected higher real yields. While there had been a small increase in longer term market-implied inflation expectations, these remained consistent with inflation targets. Shorter term bond yields had generally been stable in the major advanced economies, reflecting expectations that policy rates would remain around current levels for an extended period. In Japan, yields had risen after the Bank of Japan adjusted its yield curve control policies.

Members discussed possible reasons why real longer term bond yields in advanced economies had risen. One explanation was that market participants had increased their estimates of neutral interest rates in light of the resilience of economic activity and the persistence of inflation. Estimates of term premia had also risen and uncertainty over the future path of inflation and interest rates was likely to have contributed to this. The increase in term premia had occurred alongside expectations of rising government debt levels – especially in the United States – and as central banks reduced their asset holdings. Higher term premia implied a tightening in financial conditions independent of monetary policy. Members noted that the economic significance of this tightening was somewhat lower in Australia, given that bond markets are less important for corporate finance in Australia than in the United States.

Conditions in private funding markets had tightened over preceding months. Corporate bond yields had increased together with the rise in government bond yields and a modest widening of credit spreads. Equity prices in the United States and Europe had declined, in part owing to higher interest rates. Levels of these asset prices suggested that investors did not anticipate significant declines in corporate profits or a large rise in corporate defaults, despite significant increases in policy rates to levels judged to be restrictive.

In China, property developers remained under extreme stress. They had very limited access to funding from capital markets and banks had been hesitant to extend loans as defaults had risen. Stress in the property sector had been contained thus far, but there were ongoing concerns about possible spillovers to other parts of China’s financial sector. Chinese authorities had taken measures to stabilise the property market, in addition to fiscal and monetary policy measures to support the recovery more broadly. The renminbi had stabilised around multi-decade lows.

The Australian dollar had appreciated a little on a trade-weighted basis and against the US dollar since the October meeting. This had been underpinned by increases in Australian government bond yields relative to other advanced economies and higher commodity prices.

Domestic financial markets

Members noted that financial conditions in Australia were restrictive. The average outstanding variable home loan rate had increased by around 330 basis points over the monetary tightening phase. This was less than the 400 basis point increase in the cash rate because of competition for customers among banks, although there were signs that this competition was easing at the margin. Housing loan commitments had increased in preceding months to be 9 per cent above the low point in February 2023. Nonetheless, housing loan commitments remained almost 30 per cent below their peak in January 2022, consistent with the effect of higher interest rates on maximum borrowing capacity.

Households’ required mortgage payments had increased further over the September quarter to around 10 per cent of household disposable income. While this remained a little above the previous estimated historical peak for mortgage payments, households’ overall debt-servicing costs were estimated to be lower than the previous peak as households had substantially reduced their stock of personal debt over the preceding 15 years. Required mortgage payments were expected to rise further as borrowers with fixed-rate loans roll off onto higher rates. Meanwhile, there was a rise in extra payments into offset and redraw accounts in the September quarter, and the share of borrowers drawing down these balances had remained stable over the course of the year.

Members observed that longer term government bond yields in Australia had risen, partly reflecting an increase in inflation expectations, and that domestic long-term yields had moved above those in the United States. Short-term bond yields had also increased, along with market expectations for the cash rate, which had risen following the minutes of the October meeting and the higher-than-expected inflation data. Market pricing was consistent with participants ascribing around a two-thirds probability to a 25 basis point increase in the cash rate in November, and some expectation of a further increase by mid-2024. The market economists monitored by the Bank were all expecting a 25 basis point increase in November, with a small minority expecting a further increase in December.

Considerations for monetary policy

In turning to the policy decision, members noted that underlying inflation had been more persistent over the prior few months than had previously been expected. High inflation was being underpinned by above-average price rises for a wide range of consumer goods and services. There was clear evidence – most notably for services price inflation, which was quite brisk – that this owed to domestically generated pressures associated with aggregate demand exceeding aggregate supply. This strength in demand was allowing firms to pass on higher costs for labour and non-labour inputs. Data released over prior months had also signalled that domestic demand had been more resilient than previously expected. This resilience in activity had occurred despite the increases in the cash rate over the prior 18 months progressively working their way through the economy. Members noted that the experience of other countries over prior months had been similar, and that international experience previously had been a useful guide to economic developments in Australia.

Members considered the revised central forecasts produced by Bank staff. They observed that the forecasts were for inflation to decline to the top of the target range only in late 2025, a bit later than had been envisaged in August. Members also noted that the unemployment rate was still expected to increase, but by less than thought in August.

Members considered the implications for monetary policy of developments in financial conditions. They noted that the cash rate remained below policy rates in many other countries, despite similar economic conditions, although various factors might account for this difference. The rise in longer term bond yields over preceding months had fewer implications for Australia than in some other countries, and the exchange rate was little changed on a trade-weighted basis. Members also noted that the staff’s broader estimates of required household debt repayments (as a share of disposable income) implied that the debt repayment burden was not as high as it had been 15 years earlier. More generally, members noted that fixed-rate borrowers were tending to roll onto (more expensive) variable-rate loans without a noticeable adverse effect on their ability to service their loans. At the same time, housing prices were continuing to rise and loan approvals had increased over prior months, both of which might indicate that financial conditions are not especially restrictive.

In light of these observations, members considered whether to raise the cash rate target by a further 25 basis points or to hold the cash rate steady.

The case to raise the cash rate target by a further 25 basis points centred on the risks arising from the outlook for inflation being stronger than it had been some months earlier. Members noted that underlying inflation in the September quarter had been higher than previously expected, inflationary pressures were evident across a broad range of consumer items, and inflation was most apparent in items for which inflation typically took longer to subside (such as services). Collectively, these observations implied that it would take some time for inflation to return to target.

Members also noted that the greater-than-expected resilience of domestic demand over preceding months had implications for the inflation outlook. In particular, the staff’s forecasts for a more modest slowing in output growth, and for the unemployment rate to be lower over the forecast profile than previously assumed, implied that overall demand would remain higher for a significant period. As a result, it would take longer to bring aggregate demand and supply into balance than previously expected. Members observed that the forecasts were predicated on there being an additional one to two increases in the cash rate over coming quarters and an assumption that productivity growth would recover over the year ahead. Moreover, members noted that lowering inflation from its current level would require growth in aggregate demand to remain subdued; this was unlike the disinflation achieved to date, which had occurred largely because of fading supply shocks. As a result, it was expected to take longer to return inflation to target than it had taken so far to reduce inflation from its peak.

Members also observed that, while longer term inflation expectations remained broadly anchored, there had been signs of a slight upward drift in some financial market measures of inflation expectations. If sustained, this would contribute to higher inflation. Furthermore, members noted growing signs of a mindset among businesses that any cost increases could be passed onto consumers. In this environment, members assessed that tightening monetary policy at this meeting would help to mitigate the risk of an unwelcome rise in inflation expectations. A scenario prepared by the staff illustrated that even a modest further increase in inflation expectations would make it significantly more challenging and costly to return inflation back to target within a reasonable timeframe.

Collectively, these observations underpinned the case to raise the cash rate target at this meeting to mitigate the risk that progress in returning inflation to target is further delayed.

The case to hold the cash rate constant at this meeting was premised on the argument that inflation was continuing to decline in year-ended terms, the economy was slowing, and the geopolitical and economic outlook was highly uncertain. In that environment, there was a case to wait for additional information before determining whether a further adjustment to the cash rate was required. Members noted that an escalation of tensions in the Middle East would be likely to dampen consumer confidence and global demand (though it could also lead to higher inflation expectations and the impact on economic activity in Australia was less clear). In addition, members observed that the surge in population growth in Australia over the prior year was making it more challenging to assess the underlying resilience of the economy. Given these uncertainties, and the acknowledgement that inflation expectations remained broadly anchored, there was a credible case that a somewhat slower return of inflation to target did not warrant a policy response at this meeting.

After weighing up these two options, members agreed that the case to raise the cash rate target at this meeting was the stronger one. Members noted that the risk of not achieving the Board’s inflation target by the end of 2025 had increased and that it was appropriate that monetary policy should be adjusted to mitigate this. They observed that delaying such an adjustment would create a risk that a larger monetary policy response might be required in coming months, especially if inflation pressures turned out to be stronger than expected. More generally, members noted that it was important to prevent inflation expectations from increasing significantly, given the costs of that eventuality. They agreed there was a risk of inflation expectations increasing if the Board left the cash rate target unchanged at this meeting, particularly given the Board’s repeated statements that it has a low tolerance for inflation returning to target after 2025. Members also noted that the staff’s inflation forecasts would be for higher inflation if they had not been predicated on one or two rate rises.

Members discussed the implications of this decision on household finances. While some households were benefiting from rising house prices, substantial savings buffers and higher interest income, others were experiencing a painful squeeze on their finances. Members noted that a larger-than-typical share of borrowers had been drawing down funds in their offset accounts – even while households in aggregate continued to build up balances in offset accounts – which was consistent with those households finding it harder to finance their expenditure from current incomes. At the same time, members observed that this share had not risen over prior months and that banks had not seen a significant rise in the incidence of households experiencing difficulties making their mortgage payments. Nonetheless, financial pressures on households would be exacerbated by inflation remaining higher for a longer period than forecast.

Members agreed that whether further tightening of monetary policy is required to ensure that inflation returns to target in a reasonable timeframe would depend on how the incoming data alter the economic outlook and the evolving assessment of risks. In making its decisions, the Board will continue to pay close attention to developments in the global economy, trends in domestic demand, and 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 4.35 per cent and to increase the interest rate on Exchange Settlement balances by 25 basis points to 4.25 per cent.