Statement on Monetary Policy – November 2007 Domestic Economic Conditions

The data released since the last Statement suggest that the economy has continued to grow strongly. Real GDP was estimated to have risen by 0.9 per cent in the June quarter, to be 4.3 per cent higher over the year, with the non-farm economy growing by 5.2 per cent over the year – the strongest outcome since the December quarter 1998 (Graph 38, Table 7). There were substantial increases in investment in the quarter. More timely indicators for the September quarter suggest that activity has remained firm. Retail sales and export volumes have risen solidly, consumer confidence remains high, employment has continued to grow and business surveys report stronger-than-average conditions.

However, the farm sector continues to be affected by drought, and has been subtracting from overall GDP growth. Weather conditions have deteriorated significantly over recent months, with hot and dry conditions persisting over much of the country and inflows to the Murray-Darling river system exceptionally low. This has prompted significant downward revisions to forecasts of the 2007 wheat crop and other rural production.

The recent difficulties in global credit markets do not seem to be having any significant direct effects on demand and activity in Australia. Australia's financial system appears to have fared better than those in many other countries. The impact on borrowing costs faced by households has generally been quite limited, although it has been more significant for some businesses. In addition, the Bank's liaison has suggested only a modest tightening in the availability of credit. While there has been some moderation in the pace of borrowing for housing, this is likely to at least partly reflect other factors, such as the August increase in the cash rate. Overall, the outlook for the domestic economy remains strong, partly reflecting the large increase in the terms of trade in the current commodity cycle.

Household sector

Strong growth in household income and wealth has supported a pick-up in consumer spending in recent quarters while also allowing a modest increase in the household saving rate. Real household disposable income grew by 0.7 per cent in the June quarter, to be 6.3 per cent higher over the year (Graph 39). The strong labour market, together with the income tax cuts in July, is likely to have supported continued strong growth in disposable income in the September quarter.

Household balance sheets are also generally in good shape. Household net worth is high relative to household income, having risen strongly over the past couple of years as growth in assets has exceeded that in liabilities. Strong asset growth has been underpinned by buoyant equity markets and rising house prices in recent quarters. While there has been some increase in loan arrears and other indicators of financial stress, they remain at low levels (for further details, see the September 2007 Financial Stability Review).

Household consumption grew by 3.9 per cent over the year to the June quarter, and more timely data suggest consumption continued to grow strongly in the September quarter. Real retail sales increased by nearly 2 per cent in the September quarter, to be around 5 per cent higher over the year (Graph 40). Motor vehicle sales to households remained at a relatively high level up to October, while the Westpac-Melbourne Institute consumer sentiment index continues to be well above its long-run average. Consistent with this, the Bank's liaison indicates continued broad-based strength in spending across retailers.


Residential building activity has been broadly stable over the past couple of years after declining from the cyclical peak earlier in the decade. Current levels of building approvals and commencements suggest that activity in the sector is likely to remain flat in the short term although, looking further ahead, residential construction activity is expected to pick up as the number of dwellings being built is currently well below estimates of underlying demand (Graph 41). Recently updated estimates based on data from the 2006 Census suggest that underlying demand due to demographic factors is around 180,000 dwellings per year, whereas only around 150,000 new dwellings were commenced over the past year. The weakness in new housing construction has been most pronounced in New South Wales, which has recorded its lowest annual number of private dwelling commencements since 1987. The recently announced cuts in development levies may boost building activity in NSW, although this may take some time to feed through.

The shortfall in housing construction can be seen in the rental market, where the vacancy rate remains around its historical lows (Graph 42).Anexceptionally tight rental market has contributed to rapid growth in rents across all capital cities, with the CPI measure of rents increasing by 1.6 per cent in the September quarter, to be 5.8  per cent higher over the year. Data from the state Real Estate Institutes indicate that rents for newly negotiated agreements continue to grow more strongly than the average increase measured by the CPI.

House prices have generally continued to grow at a solid pace in the September quarter, with ABS data indicating that capital city prices rose by 3.5 per cent in the quarter, to be around 10 per cent higher over the year (Table 8). Other measures of house prices, which use different techniques to control for changes in the composition of houses sold, show a similar picture (Graph 43). In the September quarter, house prices grew in all capital cities, with particularly strong increases in Melbourne and Adelaide.

In Melbourne and Sydney, price increases have been most pronounced in the more expensive suburbs. Median prices in Melbourne's most expensive suburbs have risen by 30 per cent over the year to the September quarter, while those in the least expensive suburbs were up by around 3 per cent. In Sydney, prices in the most expensive suburbs have risen by around 10 per cent over the past year, while those in the least expensive suburbs appear to have levelled out after several years of declines. These patterns have been consistent with strength in the Sydney and Melbourne auction markets, which tend to reflect developments in the upper end of the housing market where auctions are more prevalent (Graph 44). The most recent data for Sydney and Melbourne suggest that auction clearance rates have remained high, though they are a little below their August peaks.

Business sector

Business conditions in the non-farm sector continue to be favourable. Private-sector surveys suggest that aggregate conditions eased only slightly in the September quarter and remain well above average levels. As has been the case for several years, conditions in the manufacturing sector have been somewhat weaker than for the rest of the economy, but are also above-average levels (Graph 45). Firms continue to report high levels of capacity utilisation, though there are signs of capacity constraints easing in some sectors, possibly reflecting the benefits of several years of strong investment.

Total private-sector profits have continued to grow at a solid rate, with the national accounts measure increasing by around 8½ per cent over the year to the June quarter (abstracting from the reclassification of Telstra from the public to the private sector). As a result, the profit share has remained close to its 30-year high, at 31 per cent of GDP (Graph 46). However, there has been a shift in the drivers of profit growth. Profits have picked up in the non-mining sector, while financial corporations have continued to post strong growth. Profit growth has slowed in the mining industry reflecting the levelling out in commodity prices, higher input costs and the appreciation of the exchange rate. Farm profitability has fallen significantly as a result of the severe drought conditions. While equity analysts' expectations for non-mining, non-financial sector profit growth have been revised down in recent months, business surveys generally suggest that firms' own expectations of profitability remain around long-run average levels. Despite the recent problems in credit markets, and the resultant higher external funding costs, the high level of total corporate profitability continues to provide firms with a solid base of internal funds and businesses appear well placed to finance their investment decisions.

In the June quarter, new business investment increased by 4.6 per cent, to be around 10 per cent higher over the year (abstracting from the reclassification of Telstra). The recent growth in business investment has been driven by increased spending on non-residential construction, particularly in resource-related industries, although spending on infrastructure more generally has also been strong. Forward-looking indicators of private business investment suggest further solid growth. The pipeline of non-residential construction work yet to be done remains very high while the capital expenditure (Capex) survey's third estimate of firms' spending plans for 2007/08 points to further growth in machinery and equipment investment. Conditions remain particularly tight in office property markets, which should support non-residential construction (for further details see ‘Box B: Recent Developments in the Office Property Market’).

More broadly, the high rate of investment over recent years has added significantly to the productive capacity of the economy. Measures that include investment by both the private and public sectors suggest that the investment/GDP ratio has risen to its highest level in nearly two decades. The capital stock is growing rapidly after an extended period in the 1990s when its growth was quite weak.

Australian Government Budget

The Australian Government announced that the budget recorded an underlying cash surplus of $17.2 billion in 2006/07, or 1.6 per cent of GDP, which was $3.6 billion higher than projected in May (Graph 47). Taxation revenue was boosted by higher-than-expected corporate profits and contributions to, and earnings of, superannuation funds. On the outlays side, expenditure on unemployment and other social benefits was lower than expected. Updated economic forecasts and budget estimates were released in the Mid-Year Economic and Fiscal Outlook (MYEFO) and the Pre-Election Economic and Fiscal Outlook (PEFO) in October. The estimates incorporate the net effects of budget parameter variations and policy commitments undertaken up to that time. The expected underlying cash surplus for 2007/08 was revised up by $3.7 billion, to $14.4 billion, or 1.3 per cent of GDP, largely due to stronger taxation revenues. In subsequent years, the surplus is projected to remain broadly stable.

Farm sector

After an encouraging start to the year, conditions in the rural sector have deteriorated significantly, with most regions receiving below-average rainfall over the past few months. Based on information from the Australian Bureau of Agricultural and Resource Economics (ABARE) and other rural agencies, farm output is expected to rise by around 5 per cent in 2007/08, which would be a much more muted recovery in the farm sector than had been expected at the time of the previous Statement (Table 9).

With little rainfall over the winter-spring growing period, yield forecasts for the 2007 winter crop have been revised down significantly over the past two months. ABARE estimates are for a wheat crop of around 12 million tonnes, down from estimates of around 22½ million tonnes in June, with below-average crops in all the major producing states, particularly in New South Wales (Graph 48). The outlook for non-cereal crops has also been downgraded. After a period of herd rebuilding earlier in the year, livestock slaughter rates in south-eastern Australia have recently picked up, reflecting dry conditions and increases in feed prices. With cattle and sheep numbers well down on levels of a few years ago, meat and wool production is likely to be subdued for some time.

While the deterioration in the farm outlook primarily reflects below-average rainfall over recent months, it is also a function of the persistence of the dry conditions over several years. There was an unusually short gap between the severe drought in 2002 and that in 2006, which has been compounded by the weakness of the rebound in inflows to the major river systems, making the present period exceptional by historical standards. Over the previous 100 years, severe droughts were generally followed by a year of rainfall sufficient to see a significant rebound in the inflows to the major rivers. However, in 2003 the recovery of inflows to the Murray Darling river system was much weaker than following the two previous droughts, a pattern which has been repeated so far in 2007. Taken together, this has resulted in the lowest level of inflows in any six-year period since data were first collected in 1891 (Graph 49).

External sector

Export volumes are estimated to have risen by 2 per cent in the September quarter, to be around 5 per cent higher over the year. Non-rural export volumes rose by around 8½ per cent over the year, the fastest pace of growth since the turn of the decade, while rural exports have fallen by around 15 per cent due to the drought (Graph 50).

Resource export volumes have continued to grow solidly, rising by an estimated 2 per cent in the September quarter to be roughly 8 per cent higher over the year. Iron ore export volumes rose by around 8 per cent in the September quarter, to be up by 22 per cent since mid 2005 with further strong growth likely over the coming year or two as significant additional supply comes online (Graph 51). For example, Rio Tinto's Yandicoogina mine expansion has recently commenced production and BHP has started work on its Rapid Growth 3 project. Exports of oil and LNG fell in the September quarter but this follows particularly strong growth in 2006/07, when a number of large projects commenced production. After increasing solidly in the June quarter, coal exports fell modestly in the September quarter. Infrastructure bottlenecks, such as those associated with construction activity at the Dalrymple Bay Coal Terminal and insufficient rail rolling stock, continue to hinder export growth in the coal industry. Overall, resource export volumes are expected to grow strongly in the period ahead as a number of new projects and capacity upgrades at ports are completed.

Manufactured export volumes have continued to expand strongly over the past year. Services export volumes have also grown solidly over the past 18 months, underpinned by increases in education services exports.

Import volumes grew by around 2 per cent in the September quarter, and by 13 per cent over the year, consistent with the strength of domestic demand and the higher exchange rate. All major components of imports have grown strongly over the year, particularly capital imports.

The current account deficit widened to 6.0 per cent of GDP in the June quarter, with the trade deficit increasing slightly while the net income deficit was broadly steady. At 4.5 per cent of GDP, the net income deficit remains large relative to history, reflecting both high net equity payments due to the strong profitability of foreign-owned enterprises operating in Australia, and high net interest payments due to the rising stock of net debt.

As is discussed in the chapter on ‘International and Foreign Exchange Markets’, the nominal exchange rate has appreciated significantly over the past few months. As a result, the real trade weighted exchange rate has appreciated to be around 30 per cent above its post-float average, its highest level in three decades (Graph 52). The appreciation of the exchange rate over recent years has coincided with a substantial increase in Australia's terms of trade, which are nearly 45 per cent above their post-float average. The increase in the terms of trade represents a sizeable boost to national income, adding around 11/2 percentage points per annum to the growth of Australia's gross domestic income over the past four years.

Labour market

Conditions in the labour market have remained strong, with employment rising by 0.5 per cent over the three months to October, to be 2.7 per cent higher over the year. Growth over the year has been concentrated in full-time employment.

The participation rate has remained around record highs in October, at 65.0 per cent, and the unemployment rate is close to multi-decade lows, at 4.3 per cent. While the strong labour market performance has been shared across all states and territories, it has been particularly evident in Western Australia, Queensland and the Northern Territory, which have benefited most directly from the commodity price boom (Graph 53, Table 10).

Looking ahead, a number of indicators suggest that strong labour market conditions are set to continue. The ABS measure of job vacancies increased by 2.9 per cent in the three months to August and, as a share of the labour force, vacancies are at a multi-decade high of 1.6 per cent (Graph 54). The strength of labour demand is also evident in employment surveys and the Bank's liaison with firms, which continue to report strong employment intentions and labour shortages.