Statement on Monetary Policy – November 2006 Introduction

The recent period has seen continued growth in demand and output in Australia as the expansion now moves into its sixteenth year. Labour market conditions have remained tight, and underlying inflationary pressures are higher than they were a year ago. These developments have taken place against the backdrop of strong international growth and high commodity prices.

Most expectations are that the world economy will continue to grow at an above-average pace in the year ahead, albeit not quite as strongly as in 2006. While growth in the United States has moderated recently, strong economic conditions are generally prevailing in other parts of the world. Growth in the Chinese economy has remained above 10 per cent and there has been a significant improvement in conditions in the euro area since the beginning of the year. The expansion in Japan is continuing, and strong growth rates are being seen in a range of emerging economies in Asia and elsewhere. Overall the global expansion appears broadly based, and observers generally expect it to remain robust in the face of the moderate slowing now underway in the United States.

The strong global growth over a number of years has added to demand for commodities and contributed to significant upward pressure on a wide range of resources prices. While world oil prices have declined from their peaks over recent months, other resources prices have remained high, with base metals prices on average around 60 per cent higher than at the beginning of the year. These levels of commodity prices are continuing to have a significant expansionary effect on the Australian economy, having boosted Australia's terms of trade by more than 30 per cent over the past three years. The impact of higher commodity prices over this period has only partly been moderated by the rise in the exchange rate of the Australian dollar.

With this background of global expansion, the world's major central banks are at varying stages in the process of lifting their policy interest rates back to more normal levels. In the United States, short-term interest rates are now around historical averages. The European Central Bank and, more particularly, the Bank of Japan, started this process later than the US, and are generally expected to continue on their path of raising interest rates gradually over the period ahead. World equity markets have continued to strengthen in recent months, reflecting a general view that the global business environment is likely to remain favourable, even with higher short-term interest rates. The Australian equity market has been a little stronger than those in other countries, partly as a result of renewed strength in commodity prices. The market has also been boosted by a number of company-specific events including merger and acquisition announcements.

As has been the case for some time, growth of the Australian economy over the past year has been led by domestic spending, which has continued to be boosted by the effect of the rising terms of trade. Business investment again expanded at a double-digit pace over the year to the June quarter, with mining investment particularly strong. In combination with moderate growth in household spending, this has meant that the overall growth in domestic demand has remained relatively strong, albeit below the exceptional pace of a few years ago. A significant part of the additional demand has continued to be met by imports (and, in the latest quarter, by a run-down in inventories) resulting in somewhat lower recorded growth in total output, estimated at around 2 per cent over the past year.

The overall strength in domestic spending has been broadly reflected in the demand for finance, which has seen total credit growing rapidly over the past year at a rate of 14 per cent. There are some signs that this may now be starting to moderate. Housing loan approvals have declined in recent months, after a period of strength around mid year. Growth in credit outstanding to the household sector eased a little in the September quarter, though it remains quite strong at an average rate of around 1 per cent per month, which is about the same pace as in the March quarter. Demand for credit in the business sector also remains high, despite some recent moderation, with the amount outstanding increasing by 16 per cent over the past year.

Australia's economic expansion has now reached a mature stage in which previously unused productive resources have been substantially re-employed. In these circumstances, it is not surprising that the economy's growth rate in recent years has tended to be a little lower than was typical earlier in the expansion. Even so, employment has been increasing at a rate well above trend over the past year and the unemployment rate has reached 30-year lows. The strong demand for labour has also been evident from liaison reports and other indicators such as the high level of job vacancies and the high proportion of firms in surveys reporting difficulty obtaining suitable labour.

On its face, this combination suggests that there may have been some underlying slowdown in productivity, either of a cyclical or structural nature, though its extent is difficult to explain. What does seem clear, however, from several sources of information, is that the economy is operating with very limited spare capacity. In addition to the evidence of strong labour market conditions and shortages of suitable labour, business surveys and liaison reports continue to indicate that capacity utilisation in the non-farm economy is at cyclically high levels.

The combination of strong global conditions, rising commodity prices and tight capacity domestically has contributed to a pick-up in inflationary pressures since the start of the year. Producer price indices showed further strong increases in prices at all stages of production in the September quarter, with pressures evident across most industries. Measures of aggregate wages, though not accelerating further, have continued to grow at a pace that is higher than the average of recent years. Reports of significant increases in non-wage labour costs have continued over recent months.

Measures of consumer price inflation reflect these pressures. The CPI rose by 0.9 per cent in the September quarter and by 3.9 per cent over the year. The annual CPI figure continues to be influenced by the sharp rise in banana prices and by increases in petrol prices earlier in the year (though the latter have now started to fall). Estimates of underlying inflation, which abstract from these and other temporary influences, have in recent quarters been running at an annualised pace of about 3 per cent, compared with 2½ per cent at the end of last year. This outcome has been associated with increases in a range of measures of inflation expectations.

In its policy deliberations in recent months the Board took careful note of the effects of the drought, which will lower the supply of rural produce, reduce farm incomes and may temporarily affect some food prices. At this point, these developments appear unlikely to affect significantly the medium-term inflation outlook. The Board also took into account that the earlier interest rate increases this year could be expected to have some dampening effect on borrowing and spending in due course. Nevertheless, the Board's assessment, given the evidence of stronger inflation pressures since the start of this year, was that a somewhat more restrictive stance of monetary policy would be required in order to achieve average inflation outcomes of between 2 and 3 per cent over time. Hence it decided to raise the cash rate to 6.25 per cent at the November meeting. The decision was widely anticipated and caused little reaction in financial markets.

Looking ahead, and taking into account the likely effects of the changes to monetary policy this year, the Bank's assessment is that domestic demand can be expected to record moderate growth over the next year or two, with continued expansion in consumer spending, a noticeable easing in investment growth and a gradual pick-up in housing construction. Exports should pick up as capacity expansions in the resources sector come on stream, and will contribute more to overall growth than in recent years. These forces are expected to produce a gradual return to trend growth for the non-farm economy, associated with the easing of some capacity constraints. In the short term, GDP growth will be significantly affected by the drought, as the farm sector is unable to supply its normal level of production. Farm output could fall by around 20 per cent, which would directly reduce GDP growth in the year ahead by around half a percentage point, with some additional indirect effects flowing on to other parts of the economy.

There will be some significant fluctuations over the next eighteen months in the headline inflation rate. In particular the unwinding of earlier increases in petrol and banana prices will see the annual headline rate declining sharply over the next year, before rising again by the first half of 2008. The drought may add to some food prices in the short term, though the experience of previous drought episodes suggests that the net effect on the CPI should be fairly small. In setting monetary policy, the Board will continue to abstract from these short-term fluctuations, just as it did when temporary factors were adding to headline inflation.

Recent information suggests little reason to change the Bank's earlier assessment that in the near term, underlying inflation will continue to run at about 3 per cent. Longer term, prospects for some moderation in underlying inflation have been improved by the policy actions taken this year. The Board will continue, over the months ahead, to assess whether these actions will prove sufficient to achieve the objective of 2–3 per cent inflation over time.