Statement on Monetary Policy – August 2008 Economic Outlook

The international economy

The domestic forecasts are based on the expectation that growth in Australia's major trading partners will be around 4¼ per cent in 2008 and then slow to 3¾ per cent in 2009, down from 5¼ per cent on average in 2006 and 2007. A modest recovery in global growth is then projected for 2010. Growth in the developed economies is expected to be well below trend in both 2008 and 2009, with slowing activity in Europe, Japan and New Zealand and continuing weak growth in the United States (Graph 74). Growth in the emerging economies of Asia is also forecast to slow further from the very rapid rates of recent years, due to weakening external demand, and a slowing in domestic demand growth reflecting both the effect of higher commodity prices on real incomes and some tightening in monetary policy.

The forecasts for growth in 2008 are in line with those of the IMF and many external forecasters, and are a little higher than those presented in the May Statement: this revision reflects the generally stronger-than-expected growth outcomes recorded in the March quarter. The forecast for trading partner growth in 2009 has been revised downwards somewhat and is below the IMF and Consensus forecasts. This assessment reflects both an expectation of softer growth in Asia and a general view that the problems in global financial markets are proving to be deeper and more persistent, and will weigh on global growth outcomes for longer, than had generally been expected earlier.

Australia's terms of trade are expected to have increased by around 20 per cent over the year to the September quarter but are then forecast to gradually decline (Graph 75). However, with coal and iron ore spot markets tightening somewhat since the time of the May Statement, the expected easing in the terms of trade over the forecast period has been scaled back slightly.

Domestic activity

The forecasts for the domestic economy are based on the technical assumption that the cash rate will remain at its current level of 7.25 per cent through to the end of the forecast period (December quarter 2010). The forecasts also incorporate the effect of the tightening in credit markets since mid 2007. Variable lending rates to households and businesses have now risen by around 60 basis points more than the cash rate over this period. There has been some additional contractionary effect from tighter lending standards and reduced access to capital markets, as well as from the decline in equity markets. The forecasts also assume that the exchange rate remains around its current level, which is broadly unchanged in trade-weighted terms from the level at the time of the May Statement.

The outlook for the domestic economy continues to reflect the interaction of several opposing forces. The significant tightening in financial conditions and the global slowdown have continued to weigh on domestic financial markets. Since May there have been additional increases in bank variable lending rates (around 15 basis points in the case of households) and prices on the Australian share market have declined by around 15 per cent. Developments in financial markets over the past year have clearly begun to weigh on the domestic economy, as indicated by the sharp slowing in credit growth and broader slowing in a number of indicators.

At the same time, the global boom in commodity prices is having different effects on sectors depending on whether they are users or producers of energy and other commodities. Households and oil-intensive sectors such as transport and agriculture are facing higher fuel prices, prompting reduced household spending and cost cutting by businesses. While the mining sector is also facing escalating input costs, this is far outweighed by the higher prices for coal, iron ore and other commodities that mining firms are receiving. Overall, the rise in global commodity prices and the terms of trade can be expected to support growth, although the stimulatory effects will take some time to feed through to the broader economy. In the near term, the surge in export prices is raising domestic incomes by around 4 per cent, boosting corporate profits and government revenues. While foreign ownership of the minerals sector is significant, domestic shareholders have also benefited. Higher commodity prices should also boost investment spending by resources companies, although capacity pressures are expected to constrain the ability of the sector to increase investment significantly in the near term.

One other factor that is affecting economic performance in the near term is the early June explosion at the Apache gas plant in Western Australia. The high level of capacity utilisation in the economy increases vulnerability to such short-term supply disruptions. At this stage, staff estimates indicate that the disruption may result in a temporary reduction in national GDP of around ¼ percentage points spread over the June and September quarters, with the mining and manufacturing sectors most affected.

The staff's assessment is that the net effect of these forces is a softening in the outlook for the domestic economy since the time of the May Statement. The modest lowering of the forecasts also reflects information from the Bank's liaison program and some of the indicators of domestic activity, including retail sales, credit growth, building approvals, and measures of consumer sentiment and business conditions. Although the March quarter national accounts suggested growth in late 2007 and early 2008 was stronger than expected, the more timely information implies that spending may now be slowing noticeably. This is likely to be reflected in a weak GDP growth outcome for the June quarter.

The staff is now expecting that growth in non-farm GDP will slow from the year-ended rate of 3.6 per cent estimated for the March quarter 2008 to 1½ per cent over the year to the December quarter 2008, before gradually picking up to 2¾ per cent over 2010. With farm sector output expected to recover from the drought over the next year or so, total GDP growth is forecast to be slightly stronger over this period. Given the strong growth in the capital stock, these rates of output growth imply a significant easing in capacity pressures in the economy.

The slowing in growth is likely to be concentrated in household spending. Retail sales declined in real terms over the first half of 2008 and measures of consumer sentiment and the Bank's liaison suggest that subdued spending is likely in the near term despite the recent tax cuts. Overall household consumption is expected to grow only modestly over the second half of 2008 in response to the tightening of financial conditions, the high level of petrol prices and falling household wealth, before gradually picking up later in the forecast period. Housing investment is expected to contract over the next year reflecting developments in the cost and availability of finance and the subdued state of the housing market, but further out should be supported by strong immigration and rising rents. While the high level of commodity prices is expected to contribute to further growth in mining investment, investment in the non-mining sector is forecast to be relatively weak given the slowing economy and the tightening of financial conditions; commercial property development is expected to be particularly adversely affected. Public demand growth is expected to be moderate as a result of some fiscal consolidation by the Commonwealth and state governments, although state budgets indicate that public trading enterprises will increase their investment spending over 2008/09. Resource exports are expected to grow strongly over the forecast period, while growth of non-commodity exports is forecast to be moderate due to the high level of the Australian dollar and the slowing in the growth of our major trading partners.

The forecast slowing in GDP growth implies that labour demand will continue to ease, following a period of considerable strength in recent years. Annual employment growth is forecast to average ¾ per cent over the next year, before picking up gradually. With the rate of employment growth expected to remain below that of the working-age population, the unemployment rate is expected to rise.


The forecasts do not yet incorporate any effects, notably on inflation, from the Government's proposed Carbon Pollution Reduction Scheme (CPRS). Based on the Government's consultation paper released in July 2008, the introduction of the proposed measures would be expected to boost CPI inflation near the end of the forecast period. However, the precise details of the CPRS are yet to be determined, particularly the starting date, the starting price of carbon and its likely trajectory over time. The Bank will incorporate estimates of initial and ongoing effects into its forecasts as further details are released.

The forecasts for inflation have been revised upwards in the near term, but are broadly unchanged towards the end of the forecast period. The upward revision in the near term mostly reflects the slightly higher-than-expected outcome for both CPI and underlying inflation in the June quarter. In addition, petrol prices have been higher than expected at the time of the May Statement and inflation expectations appear to have risen somewhat.

It is expected that the annual rate of CPI inflation will rise further in the September quarter, in part due to the effect of higher petrol prices over the year. Underlying inflation is expected to be around 4½ per cent over the year to the December quarter and then to decline gradually to 2¾ per cent by the end of 2010 (Table 17). CPI inflation is expected to be higher in the short run, at around 5 per cent in the December quarter, reflecting the effects of higher petrol prices and the recent correction to estimates of financial services inflation, before declining thereafter. Excluding financial services and the effect of the child care tax rebate, underlying inflation would peak at 4¼ per cent while CPI inflation would peak at 4¾ per cent.

The current forecast profile implies that year-ended inflation will remain outside the target range until mid 2010. This extended period of high inflation is a reflection of the extent of price pressures evident in recent quarters, which in turn are the result of the high level of resource utilisation in the economy over recent years as well as increases in input costs resulting from global factors (Graph 76). However, demand pressures in the economy now appear to be easing and the forecasts project a significant period of slower growth, which will result in a moderation of capacity pressures. As this occurs, the pricing power of businesses is likely to fall. With the unemployment rate forecast to rise in line with slowing domestic activity and employment, growth in labour costs is likely to moderate. In addition, with global growth expected to slow, the forecasts assume no significant additional inflationary impulse from international factors, with oil prices assumed to remain around current levels.

There are risks to these forecasts in both directions. The June quarter inflation data provided some indication that inflation pressures may no longer be rising, but evidence of this was quite tentative. If the recent easing in demand is not as long-lasting as the forecasts envisage or if the stimulus to domestic activity from the terms of trade causes demand to be stronger than expected, the easing in inflation may be more modest than forecast. This could leave inflation expectations entrenched at unacceptably high levels, and feed back into the setting of wages and prices.

However, any further deterioration in the outlook for global growth would represent a significant downside risk to the domestic activity profile, particularly if it led to a marked slowing in growth in China and India. This could lead to a significant deterioration in the outlook for the Australian economy and commodity markets, which could lead to further moderation in inflation over time as growth of domestic incomes and spending eased and oil prices fell. In addition, the ongoing turmoil in capital markets could exacerbate the slowing in domestic growth by further reducing the availability of credit to households and businesses.