Statement on Monetary Policy – August 2006 Domestic Economic Conditions

The pace of economic expansion in Australia appears to have picked up over the first half of 2006. Ongoing positive business conditions have in recent months been joined by renewed strength in recorded employment growth and some pick-up in household spending growth. Reports of capacity constraints and labour market tightness continue to feature in both survey data and feedback from liaison with firms.

The March quarter national accounts reported that growth in the Australian economy returned to a rate closer to long-run trends, after a period of somewhat slower growth (Table 6). Growth was also more balanced between domestic and external demand than had been the case for some time, with net exports not subtracting from GDP growth in the quarter. Business investment has been particularly strong in the resource-intensive states of Western Australia and Queensland, where activity continued to run faster than in the rest of the country. In addition, household consumption growth picked up in the quarter, to be more in line with the overall rate of economic expansion.

More recent data suggest that the economy has continued to grow at a firm pace. Available information on household consumption points to a solid increase in the June quarter, while forward indicators of housing activity suggest the downturn in dwelling construction is nearing its end. The established housing market has also shown signs of firmer conditions in recent months, with nationwide house prices rising in the June quarter. Business investment is expected to continue to grow, although a noticeable slowing from its earlier rapid pace of expansion seems likely. Looking through the considerable monthly volatility, a recovery in exports growth appears to be in train, supported by continued strong growth in the world economy and a large amount of new capacity that is starting to come on line in the resources sector.

Household sector

Household demand strengthened in the first half of the year, following a period of moderate growth in consumption spending and a corresponding increase in the household saving ratio in 2005. In the March quarter, household consumption rose by 0.9 per cent, to be 2.9 per cent higher over the year. Spending growth was broad-based across both goods and services, and outpaced household income growth in the quarter.

More recently, the volume of retail sales increased further, rising by 0.6 per cent in the June quarter and 3.6 per cent over the year (Graph 16). Across the mainland states, year-ended retail sales growth was still fastest in Western Australia and Queensland. Motor vehicle sales to households fell slightly in the June quarter and have been broadly unchanged over the past two years, following a period of strong growth before that. Consumer sentiment, as measured by the Westpac-Melbourne Institute index, rose in July and remains above average levels, after having eased in recent months in line with higher petrol prices and the increase in the cash rate in early May.

Even during the earlier period of more moderate consumption growth, household credit expanded at a solid pace, and it increased by around 13 per cent over the year to June. As a result, the debt-servicing ratio has been rising steadily, to stand a little below 11 per cent in the March quarter (Graph 17). Continued strength in the labour market, and the recent tax cuts and other fiscal measures announced in the Australian Government Budget, are expected to support growth in household income and consumption in the second half of this year. Despite the expected growth in disposable income, the household debt-servicing ratio is likely to rise further in the period ahead, since household debt has been growing at an even faster pace than income. Together with the recent increases in interest rates, this is likely to boost households' interest payments.



The downturn in housing construction activity since early 2004 continued into the early part of 2006. Dwelling investment fell by 2.5 per cent in the March quarter, with declines in both new dwellings and alterations & additions. The weakness in the quarter was concentrated in New South Wales and Victoria. However, there was a sharp rise in the number of dwellings commenced in the March quarter, reportedly as work began on a number of large medium-density projects in New South Wales that had been approved some time ago but then kept on hold by the developers. In addition, other forward indicators, such as local government building approvals, have risen a little over the past six months or so, suggesting that the current downturn may be nearing its end (Graph 18).

Feedback from liaison with builders has also pointed towards a modest recovery in demand for new housing since the start of the year; contracts to build are above their trough, which is expected to flow through to higher commencements in the second half of the year. The current downturn has been mild compared with previous dwelling investment cycles; investment has fallen by around 9 per cent nationwide from its peak in early 2004. The bulk of this occurred in New South Wales, where dwelling investment has fallen by 23 per cent and the process of recovery appears likely to be fairly slow.

Financing and prices

Housing finance has continued to strengthen in recent months, with the value of housing loan approvals increasing by 5.5 per cent over the three months to May (Graph 19). The growth in loan approvals since the trough in 2004 has been almost entirely attributable to owner-occupiers. As a result, the shares of investors and owner-occupiers in total approvals have now returned to levels last seen in early 2002; investors have recently accounted for around 35 per cent of approvals, compared with a peak of 45 per cent in late 2003. In line with their lower share of loan approvals, investors have accounted for less of the growth in the stock of housing credit than previously. Overall housing credit grew at an annualised rate of around 15 per cent over the six months to June, up from 11½ per cent over the previous six months.

Conditions in the established housing market picked up further over the first half of the year. The APM mix-adjusted measure of nationwide house prices rose by around 2 per cent in the June quarter, to be 5½ per cent higher over the year (Graph 20). House prices were estimated to have risen in all state capitals in the quarter except Melbourne, with the strongest growth continuing to be in Perth and Darwin; prices rose in Sydney in the quarter but were broadly flat over the year (Table 7). Apartment prices were also broadly flat over the year, partly because the relatively higher concentration of apartments located in Sydney and Melbourne has weighed on the nationwide measure relative to that for houses. Auction markets appear to have been little affected by the increase in interest rates in May, with clearance rates in Sydney and Melbourne broadly unchanged over recent months, at around their highest levels for two years.

Residential rental markets have continued to tighten, in line with a gradual absorption of earlier excess supply in the apartment market; this is likely to result in some recovery in rental yields towards more normal levels. Data from state real estate institutes suggest that rental vacancy rates have fallen steadily over the past couple of years. Consistent with this, tenancy authorities confirm that apartment rents are now increasing, even in inner-city areas, where oversupply had been most evident. Apartment rents rose by more than 5 per cent over the year to the June quarter in all capital cities.

Business sector

Overall business conditions remained positive during the first half of 2006, but this was more evident in the services sector than the goods sector, particularly manufacturing, where production fell in the March quarter. Business surveys for the June quarter were broadly consistent with a continuation of this pattern (Graph 21). The NAB survey indicated that non-farm business conditions remained well above average levels, and capacity utilisation high (Graph 22). Positive business conditions were also reported in the ACCI Survey of Investor Confidence and the St. George-ACCI survey in the June quarter, while the Sensis survey reported softer conditions for small and medium-sized firms. The major surveys continue to indicate more moderate conditions in the manufacturing sector. This has had the greatest effect on the manufacturing-intensive states of Victoria and South Australia where trading conditions are generally reported to be weaker than elsewhere.

Consistent with the business surveys, the Bank's liaison continues to suggest that capacity utilisation remains unusually high across a range of industries. However, constraints are said to have eased in the residential construction industry and in parts of manufacturing where demand has been subdued.

The outlook for rural production is less favourable than it was a few months ago. The latest ABARE forecasts suggest that the 2006/07 winter crop will fall by 11 per cent from last year's record crop, with a 9 per cent decrease in wheat production. Private-sector forecasters and state government departments are factoring in even lower production, owing to further deterioration in growing conditions since ABARE's forecasts were released, particularly in Western Australia, the largest wheat-growing region. Continued dry conditions in New South Wales have also reduced forecast crop levels; more than 90 per cent of the state is now drought-declared.

Total private-sector profits rose by 9.6 per cent over the year to the March quarter, with the profit share hovering at a record-high 30 per cent of GDP (Graph 23). Profits growth continues to be driven by the mining and finance sectors; excluding these two sectors, profits fell in each of the three quarters up to March, to be slightly below their decade average as a share of GDP. It appears that businesses' margins are being squeezed by rising material and labour costs. Nevertheless, forward indicators such as the NAB survey's actual and expected profitability series continue to point to reasonable optimism about near-term prospects for overall profits.

Business investment increased further in the March quarter, after a period of exceptionally fast growth in 2005, to be 19 per cent higher over the year. This strength was seen in both machinery & equipment and non-residential building investment, and was quite broad-based across industries. Business investment continued to be the major contributor to the very strong growth of demand in Queensland and Western Australia, with investment in these states increasing by more than 30 per cent over the year.

High levels of capacity utilisation and corporate profitability continue to provide a favourable backdrop for investment. The March quarter capital expenditure (Capex) survey's early reading of firms' investment plans for 2006/07 suggests modest growth in spending on machinery & equipment, from the current high levels. However, these long-range expectations are very preliminary and have historically been subject to large changes. Forward-looking indicators of non-residential construction suggest that activity will remain strong over coming quarters, with the pipeline of work yet to be done still at high levels despite a fall in the March quarter (Graph 24). However, ongoing labour and equipment shortages have reportedly been causing delays in some resource projects, and the viability of some planned projects has been reduced by rising construction costs. Together with the additional call on resources from public infrastructure projects, this could hamper further expansion in non-residential construction activity.

Government budgets

The Australian Government Budget for 2006/07, delivered in May, showed a substantial increase in the expected underlying surplus for 2005/06 in both cash and accrual terms. This largely resulted from significant upward revisions to the revenue estimates, particularly for individual employee and company taxation. While revenue growth is expected to remain strong in 2006/07, the budget surplus is projected to be lower than in the previous year, as a further round of personal income tax cuts and various other fiscal measures take effect (Table 8). The State Budgets for 2006/07, announced over May and June, are expected to move slightly into deficit in aggregate, reflecting expectations of slower growth in revenue and an increase in spending on capital projects and health. In addition to developments in the general government sector, state government trading enterprises are also expected to increase their investment spending significantly in the current year. However, it remains to be seen if the planned higher investment by the various levels of government can be fully implemented in an environment of capacity constraints and strong investment spending by the private sector.

Labour market

Employment growth was strong in the first half of 2006, following some weakness in the second half of 2005. Employment increased by 0.8 per cent in the June quarter and by 1.8 per cent over the year, with the growth broadly based across both the full-time and part-time components (Graph 25). The strength in the labour market has encouraged new entrants into the labour force, with the participation rate reaching a record level of 64.8 per cent in June. The unemployment rate recorded a 30-year low of 4.9 per cent in May and June, after remaining in the 5 to 5¼ per cent range for an extended period.

Labour market conditions remain favourable across all the states, although employment growth has been particularly strong in Western Australia and Queensland, reflecting the strength in mining and construction employment. Despite some divergence lately, there is by historical standards relatively little dispersion in unemployment rates across the mainland states, except for Western Australia, where it has been below the national rate for some time (Table 9).

Over the year to the June quarter, employment growth was strongest in the mining and electricity, gas & water industries, with the household services, business services and construction sectors also experiencing particularly strong growth. The largest decline was in the accommodation, cafes & restaurants industry, and employment also contracted in the rural sector. These outcomes were broadly in line with recent sectoral trends in output. Employment growth has been strongest amongst the more-skilled occupations, consistent with reports of high demand for skilled workers.

Survey-based indicators and vacancy data mostly suggest that demand for labour is still strong and that the labour market will remain tight. The ABS measure of job vacancies increased in the June quarter, to show a nationwide vacancy rate of 1.5 per cent, the highest level in over thirty years (Graph 26). Private-sector measures of vacancies also show robust annual growth in job vacancies. In contrast, the ACCI-Westpac measure of manufacturing firms' hiring intentions fell in the June quarter.

Continued strength in labour demand has led to ongoing labour shortages. Business surveys report that firms are experiencing difficulty finding suitable labour, and employers note that this remains a key factor constraining their output. Feedback from the Bank's liaison program indicates that labour shortages are broad-based across industries and skill levels. However, shortages are most pronounced for skilled workers in the non-residential construction and resources sectors, and in much of the business services sector.