Statement on Monetary Policy – August 2008 Domestic Economic Conditions

The Australian economy grew at a moderate pace in the March quarter, with real GDP estimated to have risen by 0.6 per cent, to be 3.6 per cent higher over the year (Graph 29, Table 7). The year-ended rate was boosted by an unusually high estimate of growth in the financial services sector. Output in this sector was estimated to have grown by 18½ per cent over 2007 and by 14½ per cent over the year to the March quarter, which appears at odds with other indicators of activity in the sector. Excluding the financial services sector, GDP is estimated to have increased by around 3.2 per cent over the year to the March quarter. Within the year, the quarterly pattern showed relatively strong growth in the first half, with growth slowing to an annualised rate of 2½ per cent over the six months to March. Domestic spending, however, continued to grow strongly, with real domestic final demand rising by 0.9 per cent in the March quarter and by 4.8 per cent over the year.

More timely indicators and the Bank's business liaison both suggest that growth in domestic demand has moderated further in recent months, and that GDP growth in the June quarter is likely to have been quite weak. Real retail trade and sales of motor vehicles both decreased in the June quarter, consumer and business sentiment have fallen, household and business borrowing have slowed significantly, and conditions in the housing market have softened. However, while there has been some moderation in recent months, conditions remain reasonably firm in the labour market. In addition, the resources sector and the broader economy are experiencing a considerable income boost from the substantial increases in bulk commodity contract prices that have recently been settled.

An explosion at Apache Energy's Varanus island facility in early June reduced Western Australian domestic gas production by around one-third. While household energy supplies have been unaffected, business users of energy generated from Apache's gas have faced sharply higher energy prices and, in particular cases, have experienced a reduced supply of energy, most notably in the manufacturing and mining sectors. The disruption to production has been mitigated to some extent by firms obtaining energy from alternative supplies, such as diesel, gas from the North-West Shelf and from some power stations being returned to service. Partial gas supply resumed in early August, and is expected to rise to around two-thirds of normal production by mid August, with full production by end 2008. Overall, the disruption is expected to result in a temporary reduction in national GDP growth of around ¼ percentage point, spread across the June and September quarters.

Household sector

Household consumption increased moderately in the March quarter, rising by 0.7 per cent to be 4.3 per cent higher over the year. The resilience in household spending was a little surprising given the tightening in financial conditions, rising petrol prices and falling consumer confidence, although it still represented a noticeable slowing from average quarterly growth of around 1¼ per cent during 2007. More timely data suggest that the pace of consumption growth slowed further in the June quarter. Real retail sales fell by 0.6 per cent in the quarter, while motor vehicle sales to households fell by 6 per cent in the three months to July (Graph 30). Measures of consumer sentiment have also declined further in recent months and are now around their lowest levels since the early 1990s. The Bank's liaison with retailers suggests the weakness in consumer spending has continued into the September quarter.

The slowing in the pace of household spending is consistent with slower growth in disposable incomes and recent falls in household net worth. After accounting for increases in inflation and interest payments, growth in real household disposable income slowed to 4.2 per cent over the year to the March quarter, down from 6.6 per cent over 2007. Growth in household purchasing power is likely to have slowed further since then reflecting higher mortgage rates, the increase in inflation, and an easing in the pace of employment growth (Graph 31). Household net worth declined in the first half of the year, reflecting a sharp fall in the share market and a small decline in house prices (Graph 32).

Households have also cut back on the growth of their borrowing in response to tight financial conditions. Household credit growth has slowed from an annualised rate of around 15 per cent in mid 2007 to an annualised rate of 7 per cent over the three months to June, which is the slowest pace of growth since the early 1990s. Housing loan approvals have fallen by around 25 per cent from their peak in mid 2007 (Graph 33). Nevertheless, while household indebtedness is around historical highs and the interest burden has risen in the past few quarters, the latest data to June suggest that only a relatively small proportion of households are in arrears on their loans: non-performing loans account for around 0.4 per cent of the value of housing loans on banks' domestic books.

Residential property markets have weakened across the country since the beginning of the year. Nationwide house prices fell slightly in the June quarter, after rising by around 13 per cent over 2007. According to the ABS measure, house prices fell by 0.3 per cent in the June quarter, although they were still around 8 per cent higher over the year (Table 8 and Graph 34). Other measures, which use different techniques to control for changes in the mix of houses sold, also show that house prices fell in the June quarter following modest growth in the March quarter, to be down slightly over the first half of the year. The softening in house prices was broad-based across the capital cities. Auction clearance rates, which are noisy but timely indicators of conditions in the established housing market, have stabilised in Sydney and Melbourne over the three months to early August, following a significant decline through the first half of the year.

Housing construction activity also remains relatively subdued. Over the year to the March quarter, investment in the construction of new dwellings fell slightly, while renovation activity was little changed. Forward-looking indicators point to continued weakness in construction activity. The number of building approvals fell by 3½ per cent in the June quarter, with falls in both houses and the medium-density sector (Graph 35). Information from liaison with builders also suggests that activity is expected to remain soft over coming quarters.

Business sector

Private-sector surveys indicate that business conditions weakened noticeably in the June quarter, falling below long-run average levels for the first time since 2001 (Graph 36). Business confidence fell in the June quarter, to be around 15 per cent below its average level and at its weakest level since the early 1990s. The NAB survey's measure of capacity utilisation has also fallen from the record levels reported in late 2007 and early 2008 although it remains high. Surveyed business conditions have fallen in all states since the start of the year. In the June quarter, business conditions were strongest in Western Australia and Tasmania and weakest in New South Wales and Queensland.

New business investment increased by 2 per cent in the March quarter, to be around 7 per cent higher over the year. The rise in the quarter was driven by a solid increase in non-residential construction activity, which in turn reflected strong growth in engineering construction. As a share of nominal GDP, new business investment remains around its highest level since the 1980s. Much of the recent growth in investment has been attributable to the significant increase in mining investment – especially mining-related engineering construction – as mining companies have sought to increase their capacity to meet the rising demand for resources. This has resulted in investment in the mining sector almost doubling as a share of nominal GDP since 2004. In contrast, investment in other industries has fallen modestly as a share of nominal GDP over the period (Graph 37).

Forward-looking indicators continue to suggest that the near-term outlook for business investment is positive, particularly in the mining sector. The most recent capital expenditure survey (taken in April and May) pointed to strong growth in firms' investment plans in 2008/09, though some scaling back of plans may have occurred since then. Much of the growth was expected to be resource-related, reflecting the large pipeline of work that has commenced but has not yet been completed. Project-level data also indicate that some large mining-related projects are due to commence in the next year or so. However, the outlook for the non-residential building sector has deteriorated, as the tightening of financial conditions has reduced the viability of commercial property projects.

Private-sector profit growth slowed to around 6½ per cent over the year to the March quarter, down from 11½ per cent over the previous year. Nonetheless, the profit share remained close to record levels, at 31.5 per cent of GDP. Looking ahead, the recent large increases in coal and iron ore contract prices will provide a substantial boost to mining profits while slower growth in domestic demand and continuing cost pressures, particularly high oil prices, may dampen growth in non-mining profits.

Growth in businesses' external funding has slowed since late last year, in response to the higher cost of debt, tighter lending standards and reduced access to capital markets (for further details see the ‘Domestic Financial Markets’ chapter). However, the balance sheet of the business sector as a whole remains in good health according to the standard metrics. Measures of corporate gearing have increased over recent quarters (especially market-based measures that have been affected by falls in the equity market). Net interest payments have also increased in recent years, in line with rising interest rates and earlier rapid growth in business credit, but remain at relatively low levels as a share of corporate profits.

Conditions in the office property market have been significantly affected by ongoing stress in global financial markets, with higher funding costs and general caution among lenders and investors weighing on prices and turnover in the first half of 2008. While there is considerable uncertainty around recent trends in capital values – with few market transactions to serve as a benchmark – estimates based on Jones Lang LaSalle data suggest national capital values have fallen by 5 per cent since the end of last year, following growth of almost 80 per cent over the previous three years (Graph 38). Office capital values may continue to be negatively affected by poor sentiment among lenders and investors, asset sales by some leveraged property trusts, and the expansion in office supply currently in the pipeline. Nonetheless, the fundamentals underpinning the office property market generally remain in reasonable shape; vacancy rates are close to historical lows, rents have continued to increase and employment has continued to grow.

Government budgets

The Australian Government Budget, tabled in May, showed a small increase in the expected general government surplus for 2007/08 relative to the mid-year estimates (Table 9). As with previous years, the upward revision was largely due to higher-than-expected revenue estimates, particularly for personal income tax and collections from superannuation funds. The surplus is expected to increase slightly in 2008/09, reflecting continued strength in personal income and company tax receipts and a moderation in the pace of spending growth. State budgets for 2008/09, handed down over May and June, forecast that the aggregate state general government balance will remain essentially unchanged in 2008/09. Continuing the pattern of recent years, state government trading enterprises plan to increase their capital expenditures significantly in the coming year.

Farm sector

Conditions in the rural sector have deteriorated a little since the summer, with a large number of agricultural regions experiencing below-average rainfall. As a result, estimates of the area planted with wheat and other winter crops have been revised down, although parts of the wheat belt received good rains in July, particularly in Western Australia. Flows into the Murray-Darling river system have remained very low, with inflows in June the lowest on record for that month, suggesting that conditions for irrigated crops are likely to remain difficult over the coming year. At this stage, 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 15 per cent in 2008/09 from the drought-affected level of 2007/08. However, these estimates assume a recovery in rainfall to seasonally normal levels in the months ahead. The forecast mainly reflects an increase in the wheat crop and other cereals, with livestock production likely to be subdued (Graph 39).

External sector

Export volumes are estimated to have increased in the June quarter, to be around 5 per cent higher over the year. Resource export volumes are estimated to have risen solidly in the June quarter. Coal exports recovered from the floods in Queensland that disrupted production earlier in the year, while the volume of iron ore exports also rose, boosted by the first shipments from Fortescue Metals' Pilbara project (Graph 40). In value terms, there was a much more pronounced increase in coal and iron ore exports in the June quarter as the substantial increases in contract prices that were recently settled took effect. In contrast, the disruption to Apache Energy's gas supplies in Western Australia has caused some difficulties for parts of the resources sector. Nevertheless, the medium-term outlook for resource export volumes remains positive. The completion of the North-West Shelf Project's fifth train will boost LNG exports in the second half of this year and, more generally, growth in resource export volumes is likely to be underpinned by infrastructure expansions.

Manufactured exports appear to have risen solidly in the June quarter, to be around 11 per cent higher over the year. Although service export volumes also rose solidly in the June quarter, the year-ended growth rate has slowed noticeably over the past 18 months. The moderation in the pace of service exports growth has been particularly concentrated in travel services – in line with the weakness in short-term visitor arrivals to Australia – possibly reflecting the contractionary impact of the higher exchange rate. By contrast, the number of short-term departures has grown rapidly over recent years with growth to most destinations, though departures to the Asian region have been particularly strong (Graph 41). The noticeable pick-up in Australians travelling abroad over recent years likely reflects the strength in domestic incomes as well as the higher Australian dollar that has reduced the cost of overseas travel.

Import volumes are estimated to have increased solidly in the June quarter, to be roughly 12 per cent higher over the year. The increase in the June quarter followed particularly strong growth in the March and December quarters and indicates some slowing in the pace of import growth, albeit not quite to the same extent as suggested by some indicators of domestic demand growth.

The current account deficit widened slightly to 6.9 per cent of GDP in the March quarter, but looks to have narrowed significantly in the June quarter due to the strong growth in export values (mostly reflecting the substantial increase in the terms of trade).

The real trade-weighted index has been little changed over the past three months, and is around 28 per cent above its post-float average (Graph 42). While the appreciation of the exchange rate in recent years has adversely affected some parts of the traded sector, the associated increase in Australia's terms of trade has benefited the economy as a whole. Once the increases in annual iron ore and coal contract prices take full effect, the level of the terms of trade is projected to be around 65 per cent higher than five years ago.

Labour market

There has been some easing in labour market conditions over the past few months, although unemployment remains low. Employment growth slowed in the three months to July, although it was still 2.3 per cent higher in trend year-ended terms. The national unemployment rate was 4.3 per cent in July, only modestly above the multi-decade low recorded earlier in the year (Graph 43). Unemployment is lowest in the resource-rich states of Queensland and Western Australia (Table 10).

Forward-looking indicators of labour demand provide some evidence of a softening in conditions. The vacancy rate implied by the job vacancies measure from the ABS survey of employers was broadly flat over the first half of the year, after an extended period when it rose steadily (Graph 44). Likewise, the ANZ and SEEK measures of job vacancies suggest a noticeable slowing of growth in the number of advertised vacancies. The various business surveys and information from the Bank's liaison program also generally report some easing in firms' hiring intentions, although they suggest that the demand for labour is still around the average of the past two decades.