Statement on Monetary Policy – May 2007 Introduction

The Australian economy has performed strongly in the recent period, with favourable outcomes being recorded on several fronts. Output growth has picked up and this has been accompanied by continued strength in incomes and falling unemployment. At the same time, despite high levels of capacity utilisation and tight labour market conditions, there has been some moderation in underlying inflation.

These developments have taken place against a background of continued strength in the global economy. Most expectations are that growth of the world economy this year will again be above average, though a little below last year's pace. The US economy is now in a period of more moderate growth, with activity being dampened by a downturn in the housing sector. There remain uncertainties over the US outlook, particularly relating to developments in the sub-prime mortgage market, but the indications to date are that the spillover from the housing downturn has been limited. In other parts of the world, conditions have generally remained strong. China's rapid growth has continued, with the pace increasing further in the March quarter. The euro area is now recording its fastest growth for some time and the Japanese expansion is proceeding at a good pace, though growth in other parts of east Asia seems to have eased recently.

The global expansion has provided continued support to international commodity prices. Oil prices have firmed over recent months, though they are below the peaks reached in the middle of last year. Contract prices for Australia's bulk commodity exports have remained at very high levels after their sharp increases in the past two years, and base metals prices have risen further. How long the strength in commodity prices might persist is unknown. At some point, increased supply from major commodity producers can be expected to limit price increases, but forecasts of any such dampening effect have generally been pushed further into the future as prices have continued to rise. Reflecting the increases in resources prices, Australia's terms of trade have risen over the past four years by around 40 per cent. This is providing a substantial boost to incomes, spending and activity.

Financial markets around the world have been fairly buoyant in recent months. Although there was a bout of nervousness in late February and early March, markets have regained confidence since then. The major equity markets have recorded further net price gains since the start of the year, following on from their strong performances in 2006. Emerging-market risk spreads, which were also affected by the earlier nervousness, have fallen back to around the low levels prevailing at the start of the year. The Australian share market has reflected these recent international developments although, as was the case in 2006, it has posted larger overall price gains than in most of the other major markets. In foreign exchange markets, the US dollar has depreciated against the major currencies other than the yen, mainly reflecting softer prospects for growth in the US compared with other parts of the world. The Australian dollar has appreciated by around 5 per cent on a trade-weighted basis since the time of the last Statement, reflecting stronger domestic economic data and rising commodity prices.

Recent data on economic activity in Australia have provided a more consistent picture of an economy where output and employment have been strengthening since around the middle of last year. Non-farm GDP is estimated to have grown by 3½ per cent over the year to the December quarter 2006, a result which has gone some way towards resolving the apparent conflict between relatively weak output and stronger employment growth reported earlier last year. Information pertaining to the most recent period, including business surveys, labour market data, and indicators of private spending, suggests that a good deal of momentum has been carried forward into 2007.

The farm sector continues to be severely affected by the drought. At this stage the fall in farm output appears likely to reduce overall GDP growth in the current financial year by around ¾ percentage point. A return to more normal seasonal conditions in 2007/08 would see a significant recovery in farm output, but there remains a risk that this does not occur.

Growth continues to be driven mainly by domestic demand. Consumer spending growth picked up during the second half of last year, and the indications are that this firmer pace has continued in early 2007, supported by growth in employment and real wages, rising household wealth and a high level of consumer confidence. Other components of private spending have contributed more modestly to growth, with housing construction relatively flat and business investment growth moderating from the double-digit pace of the previous few years. The level of private business investment nonetheless remains high, and is resulting in strong growth in the capital stock. Growth of public sector spending has picked up over the past year to an above-average pace, led by investment. The net effect of these somewhat disparate movements has been that the growth of domestic demand in total was a little above trend over the past year, though well down from the clearly unsustainable pace seen earlier in the decade.

Last year's increases in interest rates have brought housing loan rates to a level that is a little above their medium-term average, and this has had a dampening effect on the demand for finance in the household sector. Household credit growth and housing loan approvals both moderated through the second half of last year, though this trend does not seem to have continued into 2007. At the same time, borrowing by the business sector has continued to expand rapidly. Business appetite for debt is being stimulated by favourable economic conditions and high levels of investment, though there is also a more general mood in the business sector in favour of greater leverage, as evidenced by the range of corporate takeover proposals now in train.

Australia's lengthy period of expansion has brought the economy in recent years to a position of high capacity utilisation and tight labour market conditions. Unemployment has declined to generational lows, and a range of business surveys and anecdotal reports indicate that labour scarcity has increased. The tight labour market has contributed to some pick-up in aggregate wages growth over the past couple of years. Wages at the end of 2006 were growing at a rate that was at the top end of the range seen over recent years, though they did not appear to be accelerating further. Given the overall momentum in domestic demand and the prospect of some pick-up in exports, it appears likely that growth of the non-farm economy will remain relatively strong in the period ahead. While ongoing increases in labour supply and high levels of business investment will be adding to productive capacity, this outlook implies that the economy will continue to operate at a position close to full employment of available resources.

Despite the general strength in demand and activity, the evidence from producer and consumer price indices is that inflation has moderated recently. Producer price indices in the March quarter recorded lower rates of increase at all stages of production than six months ago. In part this has been driven by some temporary factors including fluctuations in fuel and food prices along with recent declines in import prices, but there was also some moderation in core prices of domestically produced outputs. The underlying CPI inflation rate has also moderated. The Bank's estimates of underlying inflation were ½ per cent for the March quarter and 2¾ per cent over the past year, with the two latest quarterly increases noticeably below those in the two previous quarters. The headline year-ended CPI inflation rate eased more markedly, principally reflecting falls in fuel and food prices over recent quarters.

Since late last year, the Bank's assessment has been that inflation in underlying terms would decline gradually from the peak of around 3 per cent reached in the September quarter 2006. In recent months the decline appears to have been a little faster than originally expected, and it now seems likely that underlying inflation will be about 2½ per cent, or possibly a little lower, during 2007. Inflation as measured on a year-ended basis by the CPI will fall below 2 per cent over the next couple of quarters.

Longer term, it seems unlikely that inflation will continue to decline. All available data suggest high capacity utilisation, a tight labour market and strong demand growth. Based on these trends, inflation is forecast to return to the top half of the target during 2008.

In its policy deliberations in recent months, the Board has focused in particular on the evidence of greater strength in domestic demand and activity, on possible risks to the global economy, and on the recent domestic prices data. While uncertainties about the international situation remain, recent information has pointed to continued global expansion. A range of domestic data over recent months confirmed that demand and activity had strengthened towards the end of last year, and indicated that this strength had continued into 2007. However, the March quarter prices data, which became available for the Board's May meeting, suggested that inflation was running at a somewhat lower rate than previously expected.

In weighing up all this information, the Board considered that the broad forces at work – a strong world economy, strong demand growth and limited spare capacity – were still likely, if they persisted, to result in some upward pressure on inflation over time. But an appreciable tightening of policy had already been implemented during 2006, and the more benign recent inflation outcomes also lowered the starting point from which any future pick-up in inflation would occur. Hence the Board judged, at its May meeting, that maintaining the current mildly restrictive stance of policy would leave adequate time to respond as needed to the possibility of higher medium-term inflation. The Board will continue to monitor developments and make such adjustments to the policy setting as may be required in order to promote sustainable growth of the economy consistent with the inflation target.