Statement on Monetary Policy – November 2006 Domestic Economic Conditions

The data released over the past three months suggest that economic activity has expanded at a solid pace. Employment has grown strongly and business surveys suggest reasonably buoyant trading conditions. The latest quarterly GDP data, which are for the June quarter, were somewhat weaker (Table 5); the first estimates suggested that GDP increased by 0.3 per cent in the quarter and by 1.9 per cent over the year (though more recent annual GDP data suggest the possibility of some upward revision to these initial estimates). The June quarter accounts showed moderate growth in household spending, some slowing from the earlier rapid growth of business spending, and a modest pick-up in exports. Although domestic final demand expanded by a solid 3.8 per cent over the year, the June quarter output data were noticeably lower than had been expected, and the weakness can only partly be explained by factors such as a surprisingly large rundown in inventories.

The recorded slowdown in output growth has coincided with continuing firm conditions in the labour market. As a consequence, estimated productivity growth – given by the difference between the rates of growth of output and employment – has been low. While several factors have been advanced to explain the slowdown – as outlined below – at this stage none seems adequate to fully account for its apparent magnitude.

The recent flow of data continues to suggest that the economy is operating at close to full capacity. Available indicators of household consumption point to an increase in spending in the September quarter, backed by further strength in the labour market. Looking ahead, consumption growth is expected to remain moderate while the pace of business investment continues to ease. Growth in exports is expected to pick up due to the substantial increase in capacity in the resources sector and firm growth in the world economy. However, the outlook for the rural sector has deteriorated due to the exceptionally dry conditions.

Household sector

Household spending has continued to expand in recent months. Real household consumption increased by 1.5 per cent in the first half of the year, up from 1.1 per cent in the second half of 2005. More recently, spending has been supported by the strong labour market and the tax cuts that took effect in July 2006. In the September quarter, the volume of retail sales increased by 0.4 per cent, to be 3.2 per cent higher over the year (Graph 20), and the Bank's liaison with retailers indicates that recent spending growth has been fairly broad-based. Motor vehicle sales to households have also been higher than earlier in the year. The Westpac-Melbourne Institute measure of consumer sentiment was modestly above its long-run average in October, although the index is significantly lower than the levels seen in the past several years.

Household debt increased by 3.9 per cent in the June quarter, and the ratio of interest payments to disposable income rose to 11.4 per cent (Graph 21), although debt has increased at a more moderate pace in the most recent months. The solid growth in household debt in recent years appears to reflect not just households' confidence in their current and future financial circumstances, but also easier access to debt. During this time, the value of equities, superannuation holdings and deposits has increased strongly, and households' net financial wealth – the difference between financial assets and liabilities – is now close to its historical high relative to disposable income.


Although recent liaison suggests that the increases in interest rates this year have slowed the pace of recovery in the dwelling construction sector, most available data suggest that activity has been running above the troughs seen around the end of 2005. After declining by around 10 per cent over the two years to the March quarter 2006, dwelling investment increased by 3.7 per cent in the June quarter, with higher spending on both new construction and alterations & additions. Forward-looking indicators suggest a gradual pick-up in construction over the next year. In the September quarter, the number of house building approvals was 7 per cent higher than at the end of 2005, while approvals for medium-density dwellings increased by 8 per cent over the same period (Graph 22).

Conditions in residential rental markets remain tight, with the nationwide rental vacancy rate around its lowest level since the 1980s (Graph 23). According to the state real estate institutes, vacancy rates have remained lowest in Adelaide and Perth and have fallen significantly in Sydney and Melbourne over the past year. Consistent with movements in vacancy rates, rents for houses and units have increased in most capital cities. The low vacancy rate should lend support to dwelling construction over the medium term.

House prices picked up in the first half of 2006, but appear to have stabilised more recently. The APM mix-adjusted measure of house prices was broadly flat in the September quarter, and 7 per cent higher over the year (Graph 24, Table 6). Price indices constructed by Residex using a repeat-sales methodology suggest similar developments. Much of the recent growth in prices has been recorded in Perth, where house prices rose by around 30 per cent over the year, although prices also increased moderately in most other state capitals. Apartment prices were broadly flat over the year to the September quarter, with soft conditions in the larger markets of Melbourne and Sydney offset by growth in other capitals. Over recent months, auction clearance rates in Sydney and Melbourne have been lower than earlier in the year, possibly reflecting the increases in the cash rate in May and August.

Business sector

Business conditions in the non-farm economy are favourable overall, though differences are evident across sectors. Output in the services sector has grown at a robust pace over the past year, with particular strength in industries supplying business services, while output in the goods sector has grown more slowly. Overall, private-sector surveys indicate that business conditions in the September quarter were a little above their long-run average level (Graph 25). In addition, according to the NAB survey, capacity utilisation tightened further in the September quarter, and stands at its highest level in the 17-year history of the series. In the manufacturing sector, which has a relatively high trade exposure, conditions remain weaker than in the rest of the economy, but were reported to have improved recently.

High levels of capacity utilisation and corporate profitability continue to prompt higher rates of business investment, although the pace of growth is moderating from the earlier rapid rates. In the June quarter, year-ended growth in business investment slowed to 12 per cent, reflecting developments in both machinery & equipment and non-residential construction. In the past financial year, investment growth was concentrated in resource-related industries, with mining investment increasing by over 50 per cent (Graph 26); non-mining investment grew by around 9 per cent in the same period.

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 bolstered in the June quarter by a pick-up in commencements of engineering projects (Graph 27). However, labour and equipment shortages and rising construction costs could slow the progress of some projects. With regard to machinery & equipment investment, the June quarter capital expenditure (Capex) survey suggests that in 2006/07 firms intend to moderate the pace of growth, while the latest Rabobank survey indicates that investment intentions for farm equipment (which are not covered in the Capex survey) have fallen.

Total private-sector profits have continued to grow at a solid rate, with the national accounts measure increasing by 7.6 per cent over the year to the June quarter, and the profit share at a record high of over 30 per cent of GDP (Graph 28). While this was significantly below the recorded growth rate in profits of listed companies, this is partly explained by differences in coverage, with the profits of listed companies including offshore profits and overweighted towards the mining sector. Both the national accounts and share market data suggest that profit growth has been strongest in the mining sector, although this now appears to be moderating somewhat. Outside of the mining and financial industries, the national accounts measure of profits fell slightly over the year to the June quarter, as businesses' margins contracted due to rising material and labour costs. Nonetheless, business surveys indicate profit expectations remain around or above long-run average levels.

Labour market

Employment outcomes have been strong in 2006. Employment is estimated to have grown by 0.2 per cent over the three months to October and by 2.5 per cent over the year. The unemployment rate was estimated at 4.6 per cent in October, down from 5.2 per cent a year earlier, while the participation rate was 64.7 per cent. Employment growth has been broad-based across all sectors except the household services sector, with the goods sector and the business services sectors making strong contributions to year-ended employment growth.

Businesses are reporting firm hiring intentions and significant difficulty in finding suitable labour. ABS data show that the nationwide job vacancy rate is around its highest level since the mid 1970s, which is the last time the unemployment rate was also at similar levels (Graph 29). Liaison indicates that while labour shortages remain most pronounced among skilled workers in the non-residential construction, resource and business services sectors, shortages are widespread across most industries and skill levels.

Recent strong labour demand has coincided with a trend increase in participation. Examining the participation of different age groups, much of this is explained by those aged 55–64 years (Graph 30). Both male and female participation in this age group has been rising sharply in recent years, likely reflecting in part a greater awareness by workers of the need to save for retirement. For younger cohorts, gradual declines in male participation have generally been offset by increases in female participation, leading to approximate stability in the total participation rates for those age groups. The exception is those aged 45–54 years, where female participation has increased especially strongly during the past two decades.

Regional economic developments

At the state level, activity has remained strongest in the resource-rich states. Final demand in Queensland and Western Australia expanded rapidly in the June quarter, to be around 10 per cent higher over the year, driven in large part by resource-related investment. In contrast, final demand growth in the other states has generally slowed. However, it is likely that divergences in the growth rates of output are smaller than those in final demand. In particular, part of the surge in spending in the resource-rich states will have been met by imports from either foreign countries (e.g. imported investment goods) or other states (e.g. financial services and manufactured goods from the south-eastern states). The state accounts for Queensland, the only full set of accounts yet available, confirm this, indicating that growth in gross state output over the year to June 2006 was significantly below that of state final demand. ABS data on 2005/06 gross state product for all states were scheduled to be released the day after this document was finalised. However, preliminary estimates for state product from state budgets released around mid year suggested that divergences in output growth in 2005/06 were no larger than has been typical in the past (Graph 31), nor larger than in other countries and regions.

Other indicators provide a broadly consistent picture of differences in state activity. The NAB survey indicator on business conditions in the non-farm sector showed that, while conditions in Western Australia and Queensland in the September quarter were stronger than those in other states, conditions in all states were above their long-run averages and the dispersion across states was lower than usual (Graph 32). The strength of the labour market is also evident across all mainland states, with current unemployment rates generally close to the national average (Table 7).


As noted above, recent data showing real GDP growing below trend are somewhat difficult to reconcile with strong employment growth, and imply that labour productivity growth has been low, at 0.6 per cent per annum over the two years to 2005/06 (Graph 33). However, periods of weak productivity growth are not unusual by past standards. Over the past two decades, there have been a number of episodes at roughly five-year intervals where labour productivity has remained broadly flat for around one to two years at a time.

The reasons for the current slowdown in estimated productivity are difficult to determine. Much of the apparent weakness has been concentrated in the mining sector, where labour productivity is estimated to have declined by around 12 per cent per annum in the past two years, lowering overall productivity growth by around ¼ percentage point per year. Three developments in the mining sector appear to have played a significant role in this outcome. First, production of oil and gold – which accounts for around one-third of mining industry value added – has declined significantly as some existing fields have been exhausted, with no commensurate reduction in total industry employment. Second, efforts to boost capacity in the mining sector may have disrupted normal operations, particularly for coal and iron ore producers. Third, with significant construction of new mining capacity occurring, some employees may be recorded as being in the mining sector rather than in the construction sector, thereby depressing measured productivity in mining. However, with a large number of mining projects coming on line this year, including the Enfield oil project, mining output and productivity growth are expected to rise in the coming quarters, although the increases in production would have to be very large to offset the apparent decline in mining productivity seen in recent years.

More broadly, recent developments may be consistent with the pattern of adjustment that would be expected when capacity constraints are encountered. Demand in some sectors has been especially strong over a number of years, reflecting the growth of the domestic and international economies. If firms cannot bring new factories or mines immediately on line when capacity constraints become binding, they may decide to hire more labour to work their existing production processes more intensively. This would lead to strong employment growth, but also a fall in the growth rate of average labour productivity because only relatively modest additional output can be produced by hiring more labour without additional capital. In the longer term, however, as new capacity comes on stream, output and labour productivity would be expected to pick up. However, while this may explain some aspects of recent experience, it would require a very large impact of the new workers on the productivity of those already employed in order to generate the weak productivity growth recorded over recent years.

Other possible reasons for the productivity slowdown have also been advanced. In liaison some firms have attributed the slowdown to higher rates of labour market turnover, with new entrants initially less efficient than the staff they replace and training costs of new staff increasing. However, a recent survey by the ABS suggests that the rate of labour market turnover is not appreciably higher now than it has been in the past.

Another possible explanation is that the slowdown in measured aggregate productivity growth might be the result of sectoral shifts in the economy. It is possible to shed some light on this by separating the change in aggregate productivity into the movement implied by productivity growth in each industry and the effect implied by shifts in employment between industries with high and low productivity. Two caveats with this type of decomposition are that productivity data by industry are notoriously noisy over relatively short periods, and that the characterisation of high or low-productivity industries masks significant differences within industries. Subject to these issues, the results of such analysis using the most recently available annual data indicate that shifts in employment between industries (for example, between the ‘market’ and ‘non-market’ sectors) cannot explain the weak overall average performance (Table 8). Indeed, employment shifts alone would have actually boosted average productivity by around 1/2 percentage point per annum, with the effect concentrated in the shift toward employment in the mining sector, which traditionally has had a high average level of labour productivity due to its high level of capital intensity. Instead, the weak aggregate productivity outcome of the past two years apparently reflects low productivity growth within a number of industries in both the market and non-market sectors, including the mining and utilities industries in particular.

Alternatively, the low recorded pace of productivity growth may reflect unavoidable measurement errors, with recent GDP growth underestimated and/or employment growth overestimated. Leads and lags in the output and employment data can also affect the measured rate of productivity growth depending on the period selected. Overall, it is likely that no single explanation fully accounts for the magnitude of the recorded productivity slowdown and that a combination of factors is at work. Developments in coming quarters may be informative in resolving these issues.