Statement on Monetary Policy – August 2008 Introduction

Inflation in Australia has remained high in the recent period against a background of tight capacity and earlier strong growth in demand. In these circumstances, the Board has been seeking to restrain demand in order to reduce inflation over time.

Recent indications are that a significant moderation in domestic demand is now occurring. In addition to the effects of tighter financial conditions, other factors including a slowing in global growth, declining asset markets and higher fuel costs are acting to restrain domestic spending and activity. At the same time, high global commodity prices are adding to Australia's terms of trade, and this is providing a significant countervailing influence. Prospects for growth of the Australian economy and for inflation will continue to depend on the net effects flowing from these opposing forces.

The slowdown in global growth has, to date, been most evident in the major advanced economies, but there are some recent signs that emerging economies are also being affected. In the United States, growth continues to be dampened by a sharp downturn in the housing sector, though the economy overall expanded modestly in the first half of 2008. Conditions in both Japan and the euro area have weakened noticeably since the start of the year. The Chinese economy to date has continued to grow rapidly, though the pace has eased somewhat since last year. While China's domestic spending has maintained a strong pace of growth, its exports to the major economies have slowed. Growth in other emerging economies has generally remained strong, though there have been signs of moderation in some cases. Official and private sector observers generally expect global growth to be well below the pace of recent years in both 2008 and 2009.

Despite the indications of weaker demand in a number of economies, inflation remains a significant concern. Higher food and energy prices have contributed to a pick-up in consumer price inflation rates around the world over the past year, but in a number of emerging economies broader inflationary forces appear to have emerged. Reflecting these developments, monetary policy has been tightened recently in a number of these economies. In addition, the ECB increased its policy interest rate in July, and market expectations in the United States have also shifted towards tightening.

Global credit market concerns have again come to the fore in recent months. In the United States, the federal mortgage agencies have come under severe stress, a number of relatively small banks have failed, and significant asset write-downs in the financial sector have continued. Loan delinquency rates in the United States have been rising, including on prime mortgages. More broadly, credit expansion has slowed noticeably in a number of the major economies. The focus now is on the interaction between the financial sector and the wider economy. That is, as growth slows in a number of regions of the world economy, loan losses are likely to increase, which could further weaken financial institutions, hampering the provision of credit and potentially amplifying the economic slowdown.

Partly reflecting these concerns, global equity markets have recorded large falls over the past three months, with financial stocks the most heavily affected. Notwithstanding increases in provisions by some Australian banks, the local banking system remains in much stronger condition than its international counterparts. Markets did not exhibit much tendency to draw these distinctions, however, and share prices of Australian banks also declined.

Notwithstanding these developments, money market conditions have tended to stabilise or even improve a little recently, both internationally and domestically. Bond issuance by domestic borrowers has been strong, and there has been some activity in the RMBS market.

Overall, market developments have continued to result in some tightening in domestic financial conditions in recent months. Banks have experienced increases in their funding costs, and in July they raised their variable mortgage rates by a further 15 basis points. This has brought the total increase in mortgage rates since the middle of last year to a little over 150 basis points, of which 100 basis points was in response to increases in the cash rate. Other developments, including higher risk spreads in corporate bond markets, falling equity prices and tougher lending standards, have added to the tightening in domestic financial conditions.

Global commodity prices have remained high over recent months, though they have generally come off their peaks. Most notably, oil prices have retraced some of their earlier upward movement to be trading recently around US$120 a barrel, down from a peak of US$146 in early July. Base metals prices have also fallen recently, as have prices for wheat and wool. At the same time, sharply higher contract prices for coal and iron ore have now come into effect. In net terms, Australia's terms of trade are estimated to have risen by a further 20 per cent since the start of the year, and by a cumulative 65 per cent over the past five years. The income gains from this source continue to represent a significant stimulus to the economy.

The Australian economy has, until fairly recently, been in an extended period of strong growth in demand and activity, marked by increasing pressures on available productive capacity. National accounts data indicate that the economy grew strongly through 2007, and indicators of capacity utilisation and labour scarcity in the early part of this year were generally close to cyclical peaks. It is against this background, in combination with rising global commodity prices, that inflation in Australia has increased. The March quarter national accounts indicated some slowing in the overall pace of growth, though domestic spending in the quarter was still estimated to be quite strong.

Other more timely information confirms that a significant moderation in spending and activity is now underway. This has been most noticeable to date in the household sector. Retail sales volumes declined further in the June quarter following the small fall recorded in the March quarter, and consumer sentiment has fallen markedly in recent months. Rising fuel costs are likely to have contributed to the moderation in consumer spending, though an offsetting factor in the second half of the year will be the tax cuts that came into effect on 1 July. In the housing sector, forward indicators point to declines in construction activity in the near term. Conditions in the established housing market have also softened, with house prices falling slightly in the June quarter. Consistent with a softer market, auction clearance rates in Sydney and Melbourne have been well below last year's levels, though they do not appear to have fallen further in the latest couple of months. The combination of falls in housing and equity prices means that household net wealth has declined in the first half of this year.

Indicators of business conditions have also declined over recent months. Surveys suggest that trading conditions in the June quarter returned to around average levels, down from the very strong levels that prevailed around the start of the year. Measures of capacity utilisation have started to fall, though they remain high. The latest indications of investment intentions are still relatively strong, though some scaling back of existing plans should probably be expected given recent declines in confidence and softer household demand. In the farm sector, the outlook is highly uncertain. Significant rainfall will be needed in the next couple of months if there is to be a substantial recovery in production from the drought-affected levels of the past two years.

At this stage, the general moderation in domestic conditions has been less evident in labour market indicators. Nonetheless, there are some early signs that demand for labour has begun to ease. While unemployment remains low, the pace of employment growth has slowed over recent months and there has been some softening in indicators of job vacancies and hiring intentions.

Tighter financial conditions and softening domestic demand have been associated with a sharp slowing in credit expansion to both households and businesses. Housing loan approvals have fallen significantly over the past few months, consistent with the weaker conditions prevailing in the established housing market, and overall growth in household credit has now slowed to a pace broadly in line with the growth in incomes. The most recent increase in mortgage lending rates can be expected to have some additional dampening effect. In the business sector, the overall growth of debt, from intermediated and non-intermediated sources, has slowed sharply in the first half of this year. While this has partly reflected a falling away in corporate merger activity, it also appears consistent with some scaling back in investment growth.

It is too early yet for these recent trends to have had a noticeable restraining effect on Australia's inflation rate. The June quarter CPI increase was unexpectedly high at 1.5 per cent in the quarter, for a year-ended rate of 4.5 per cent. This result needs to be interpreted with some caution, as it was boosted by a one-time correction to the financial services component. But even allowing for that, both the CPI and underlying measures suggest that inflation has remained high. Adjusting for this effect, underlying measures were a little over 1 per cent in the quarter, about the same as the March quarter result, and around 4 per cent over the year. A further strong increase in petrol prices added to the quarterly CPI, but this was offset by falls in other volatile prices, notably for fruit and vegetables. Price pressures remained strong in the non-tradables sector, where the largest contributions to the June quarter increase came from rents, house purchase and health-care costs. Producer price data also suggest that upstream price increases have remained firm, reflecting both increases in raw materials prices over the past year and higher output prices across a range of industries. To date, however, the rate of growth in aggregate wages has remained fairly stable, despite the increase in CPI inflation and generally tight labour market conditions.

In its recent policy deliberations, the Board has focused on both the risk that inflation may remain uncomfortably high, and on the accumulating evidence of a slowing in domestic demand and activity. Given the earlier background of strong growth in domestic spending and increasing pressure on productive capacity, the Board has for some time been seeking to restrain demand, and this has required a period of quite restrictive monetary policy. The evidence to date is that a significant moderation in demand is now occurring, and it is looking more likely that demand will remain subdued, and economic growth will be fairly slow, in the period ahead.

While inflation is likely to remain high in the short term, the Board judged at its August meeting that demand was slowing to an extent that could be expected to bring about a significant reduction in inflation over time. On this basis the Board decided that the existing monetary policy setting was appropriate for the time being. On the assumption that the subdued demand conditions are likely to continue, scope to move to a less restrictive monetary policy stance in the period ahead is increasing. The Board will continue to monitor developments and make adjustments as required in order to promote sustainable growth consistent with the medium-term inflation target of 2–3 per cent.