Statement on Monetary Policy – August 2007 International Economic Developments

The world economy has continued to expand strongly during the first half of 2007. Growth has been fairly broad-based across countries, with rapid growth in China and other emerging economies, and firm growth in Europe and Japan. The exception is the United States, where growth has been below trend for the past year. While forecasts for economic growth in the United States in 2007 have been lowered since earlier in the year, this has been more than offset by a stronger outlook for other major economies, and the IMF is forecasting that world GDP will grow at an above-trend pace of 5.2 per cent in 2007 and 2008 (Table 1). China and India, in particular, are expected to continue growing rapidly, accounting for two-fifths of projected global growth, measured on a purchasing power parity basis (for a discussion of alternative ways to calculate world GDP growth see ‘Box A: Measuring Global Growth’). As yet, there are no indications that the recent turmoil in financial markets is having a significant effect on expectations for global growth.

Headline inflation has picked up in the major developed economies and east Asia since late 2006 as a result of rising oil and food prices (Graph 1). Although ‘core’ measures of inflation have drifted lower, the combination of sustained strong global growth, high levels of capacity utilisation and tight labour markets have led to upside risks to the inflation outlook, and some central banks have expressed concern about the potential for rising food and oil prices to raise inflation expectations. During the past quarter, monetary policy has been tightened in the euro area, the United Kingdom, Canada, New Zealand and a number of east Asian economies.

Consistent with the strength of the world economy, global commodity prices have remained high over the past three months. Rural export prices have continued to increase, in line with the recent rises in world food prices. Base metals prices have been broadly unchanged, with the exception of a sharp fall in nickel prices from the extremely high levels they reached earlier this year. Continued strong world demand, particularly from China, has also underpinned a positive outlook for coal and iron ore prices, with many analysts now expecting contract prices to rise by around 15 per cent in 2008.

Major developed economies

Most major developed countries continued to grow at a firm pace during the first half of 2007. Japan and the large European economies recorded solid GDP growth in the March quarter. The exception to this pattern was the US, where growth has slowed due to ongoing weakness in the housing sector.

In the US, real GDP increased by 0.8 per cent in the June quarter to be 1.8 per cent higher over the year, down from year-ended rates of around 3 per cent in the previous couple of years (Graph 2). Residential investment fell by 2.4 per cent in the June quarter and is down by 19 per cent since its peak in December 2005. Construction activity seems likely to fall further given recent weakness in forward indicators, such as housing permits and starts, and the high level of unsold new homes (Graph 3). A further decline in the number of home sales also points to a weakening in housing demand, and mortgage rates have increased. Growth in house prices has continued to slow, with the Office of Federal Housing Enterprise Oversight (OFHEO) purchase-only measure suggesting that nationwide house prices grew by 0.6 per cent in the March quarter and by 3 per cent over the year, which was the slowest annual pace of growth in almost a decade. Other more recent data suggest that house prices continued to weaken in the June quarter. While mortgage repayment distress has been largely contained to the sub-prime market, conditions may deteriorate further as some loans are reset to higher interest rates over the coming year (for more details on recent developments in the US sub-prime market, see the ‘International and Foreign Exchange Markets’ chapter).

Despite the weakness in the housing market, household consumption has remained relatively resilient in the face of the housing downturn. While consumption growth slowed to 0.3 per cent in the June quarter, this followed a strong 0.9 per cent rise in the previous quarter. The slowing in the quarter partly reflected a rise in petrol prices of around 30 per cent. Over the year, growth was 2.9 per cent, supported by strong labour market conditions with firm growth in household incomes. Payrolls employment rose by 1.4 per cent over the year to July, and the unemployment rate remained low at 4.6 per cent.

Business investment rose solidly in the June quarter, to be 3.4 per cent higher over the year. Non-residential investment picked up strongly in the quarter, while equipment remained weak. The outlook for business investment is reasonably positive, with growth in core capital goods orders having firmed, high levels of capacity utilisation and surveys indicating stronger business conditions (Graph 4). Moreover, financing conditions have been generally favourable, with healthy corporate balance sheets and the cost of capital still relatively low despite the recent rise in corporate bond spreads (see the ‘International and Foreign Exchange Markets’ chapter for further details).

Headline consumer price inflation has picked up since late last year, to be 2.7 per cent over the year to June (Graph 5). This mainly reflects higher energy prices, although food prices have also risen strongly. Over the same period underlying inflation has eased, in line with the slowing in the pace of activity. In June, core CPI inflation (which excludes food and energy) was 2.2 per cent for the year, down from around 2¾ per cent late last year. Core inflation is generally expected to moderate further as growth in housing costs continues to slow, although there is some upside risk to this outlook from the high levels of resource utilisation and rising import prices.

The Japanese economy has continued to expand at a relatively strong rate. Real GDP increased by 0.8 per cent in the March quarter, to be 2.7 per cent higher over the year, with consumption and exports growing strongly. Consumption has been supported by high levels of consumer confidence and favourable labour market conditions. Employment has grown by 1.7 per cent over the past year, which is the fastest rate of increase since the early 1990s, and the unemployment rate has fallen to a nine-year low of 3.7 per cent (Graph 6). In addition, indicators of labour demand, such as the jobs-to-applicants ratio and Tankan survey measure of employment intentions, remain positive. Growth in business investment has been firm and conditions remain supportive of further expansion. Capacity utilisation rates are high, particularly for large manufacturers, balance sheets are in good shape and corporate sector borrowing has continued to expand. According to the June quarter Tankan survey, Japanese firms are positive about overall business conditions and expect solid growth in investment in the coming year.

Upstream price pressures have strengthened in recent months, with year-ended growth in corporate goods prices increasing to 2.3 per cent in June, led by a pick-up in import prices. At the retail level, however, CPI inflation has not shown a clear direction; the core measure (which excludes food and energy prices) has gradually picked up over the past couple of years but remains below zero (Graph 7).

In Europe, economic growth has eased since late 2006, although it remains firm. Euro area GDP increased by 0.7 per cent in the March quarter, to be 3.1 per cent higher over the year. Business investment has been a key driver of growth in the euro area and is running at its fastest year-ended pace since the late 1990s. The outlook is also favourable, with capacity utilisation at high levels, business sentiment positive, and profits at healthy levels. The positive conditions in the business sector have been supported by strong external demand, particularly from eastern Europe.

Household consumption continued to grow in the March quarter in most of the major euro area economies, with the exception of Germany where it was affected by an increase in taxes. Euro area retail sales have been soft in the June quarter, although there are some positive signs, with rising consumer sentiment and a further improvement in labour market conditions. The unemployment rate was 6.9 per cent in June, which is its lowest level in more than 15 years.

Headline inflation is in line with the ECB's target of below but close to 2 per cent (Graph 8). Core inflation (which excludes food, energy, alcohol and tobacco) has also levelled out recently after rising through 2006 and early 2007, to be 1.9 per cent over the year to June. The ECB raised its policy rate by 25 basis points to 4 per cent at its June meeting, and noted that the risks to inflation are to the upside, owing to high levels of capacity utilisation and tight labour markets.

Growth has also remained firm in the UK, with GDP rising by 0.8 per cent in the June quarter, to be 3.0 per cent higher than a year ago. While headline inflation has eased in recent months, this is due largely to falls in regulated electricity and gas prices. Core inflation (which excludes food, energy, alcohol and tobacco) has been trending up and at 2.0 per cent remains close to a decade high (Graph 8). The Bank of England increased its policy rate by 25 basis points at each of its May and July meetings, noting that capacity utilisation is high and that pricing surveys are pointing to increasing inflationary pressure.

Other major trading partners

Growth in Australia's other major trading partners has remained strong in 2007, with continued rapid growth in China and India and solid growth in the rest of east Asia.

Growth in China has accelerated, with Chinese GDP increasing by almost 12 per cent over the year to the June quarter (Graph 9). Recent policy initiatives intended to rebalance growth away from exports and investment and towards household consumption seem to have had limited effect so far. Despite a range of policy changes designed to slow their growth, exports were still nearly 30 per cent higher over the year to the June quarter. Similarly, fixed-asset investment growth has remained strong, regaining momentum after a policy-induced slowdown late last year, to be nearly 30 per cent higher over the same period. Although growth in retail sales has picked up, consumption is still growing more slowly than investment.

Corporate goods prices have continued to outpace consumer price inflation. Over the year to June, corporate goods prices increased by 5.4 per cent, partly driven by sharply higher agricultural and mining goods prices. Consumer price inflation has picked up, to be 4.4 per cent over the year to June, although excluding food, core consumer price inflation is estimated to have held steady at around 1¼ per cent. In response to very strong growth in activity and rising inflation, the People's Bank of China has continued to tighten policy, increasing its reserve requirement ratio and benchmark lending and deposit interest rates.

Elsewhere in east Asia (excluding Japan), GDP increased by 4.8 per cent over the year to the March quarter. Domestic demand growth moderated in the quarter, offset by a rebound in exports. After slowing through most of last year, growth in industrial production and exports has picked up a little recently, in line with stronger demand for capital goods (Graph 10). Labour market conditions remain favourable and are expected to continue to support solid growth in consumption in most of the region. Preliminary estimates of June quarter GDP for Korea and Singapore suggest strong growth in these economies. Inflationary pressures throughout the region remain contained. Headline inflation for east Asia excluding China and Japan has been around 2½ per cent since the end of 2006, while core inflation moderated to 21/4 per cent over the year to June.

The Indian economy continues to grow strongly, with real GDP increasing by 2.7 per cent in the March quarter, to be 9 per cent higher over the year. Growth in the quarter was led by activity in the services sector, although manufacturing production also picked up. Inflationary pressures have moderated, with wholesale price inflation slowing to below the Reserve Bank of India's 5 per cent target rate.

In New Zealand, GDP increased by 1.0 per cent in the March quarter and by 2.5 per cent over the year, driven by strong growth in domestic demand (Graph 11). The terms of trade have continued to rise due to a sharp increase in the prices of dairy products. Dairy products account for one-fifth of New Zealand's merchandise exports and have more than doubled in price in US dollar terms since August 2006 (in New Zealand dollar terms they have risen by around 70 per cent). Although year-ended consumer price inflation eased to 2.0 per cent in the June quarter, most measures of underlying inflation are running at a faster pace. The RBNZ tightened monetary policy at its July meeting, citing concerns about the recent pick-up in domestic demand and the rising terms of trade.

Commodity prices and the terms of trade

Australia's terms of trade are estimated to have been broadly flat in the June quarter, having risen by around 40 per cent over the past four years. The RBA index of commodity prices (ICP) has risen by 90 per cent (in SDR terms) over the same period. The large run-up in the terms of trade, however, now appears to be slowing; the RBA's index of commodity prices rose by 4.4 per cent over the year to July, which is the slowest rate of increase since late 2003 (Graph 12, Table 2). Nonetheless, with the favourable outlook for global demand, in particular the resource-intensive growth of developing Asia, Australia's terms of trade are likely to remain at historically high levels over the next few years. While there are signs of increasing global supply for some commodities in response to the run-up in prices seen in recent years, at this stage it seems unlikely to be sufficient to result in significantly lower commodity prices overall.

Rural commodity prices rose by 9 per cent over the three months to July, with increases across all of Australia's major exports. Wheat prices have risen by around 15 per cent, as northern hemisphere crop forecasts have been pared back, and wool prices have also risen strongly, to be almost 40 per cent higher than a year ago. The recent increases in rural export prices have been in line with rising food prices both in Australia and globally; the IMF Commodity Food Price Index rose by around 5 per cent over the three months to June, to be at its highest level since the mid 1990s (Graph 13).

The RBA index of base metals prices has fallen by nearly 10 per cent over the past three months, although it is still 4 per cent higher than at the beginning of the year. The recent fall in the base metals index reflects the sharp fall in nickel prices amidst signs of an easing in supply constraints and more moderate activity in the stainless steel industry (where nickel is a major input). While nickel prices have fallen by more than 30 per cent over the past three months, they are still more than double their price level at the start of 2006 (Graph 14). Abstracting from nickel, base metals prices rose modestly over recent months, as the markets for copper and lead continued to tighten, and current prices are near record levels. Looking forward, futures markets continue to point to a decline in most base metals prices over the next couple of years, although they are expected to remain at high levels.

Since the May Statement, the outlook for coal and iron ore prices has improved significantly and these commodities are now expected to provide a moderate boost to overall export prices in 2008. Coal markets have tightened considerably this year as China – the world's largest producer – has become a net importer, having historically been a net exporter of coal, and as supply constraints persist worldwide. Reflecting this, thermal coal prices on the spot market have risen sharply in 2007. Market analysts now expect hard coking coal contract prices to rise by around 15 per cent for the 2008/09 Japanese fiscal year, compared with an expectation three months ago that prices would decline by around 5 per cent (Graph 15). Demand for iron ore also remains strong, with Chinese imports continuing to increase at a rapid pace, driven by its buoyant steel industry and a shortage of low-cost iron ore in China. As a low-cost supplier of iron ore to China, Australia is well positioned to take advantage of this demand, and market analysts generally expect 2008/09 contract prices to also rise by around 15 per cent.

Oil prices have risen significantly since the start of the year to be currently trading close to record highs at US$75 per barrel. There has been solid growth in demand but little change in global production, given that OPEC has cut its production. Increased geopolitical tensions and indications of increased demand from financial market participants also appear to have contributed to higher oil prices. The price of West Texas Intermediate crude oil increased more sharply than for most other types of crude oil, such as Malaysian Tapis (which is the benchmark for Australian prices), as some special factors that had distorted the US oil market have been unwound (for more detail on oil prices see ‘Box B: Recent Developments in Oil Prices’).