Statement on Monetary Policy – May 2008 Economic Outlook

The international economy

The Bank's forecasts for the domestic economy are based on the assumption that growth in Australia's major trading partners slows to a little below 4 per cent in 2008 and 2009, down from 5¼ per cent in 2007. This outlook is largely unchanged from that presented in the February Statement. It is also broadly in line with the IMF forecasts published in early April, which contained a significant downward revision. Growth in the G7 economies is expected to be well below trend in both 2008 and 2009, reflecting a slowing in all the major economies and a mild recession in the United States (Graph 78). In the emerging economies, growth is expected to slow from the rapid rates of recent years, but to remain strong, supported by continued solid growth in domestic demand.

With nearly 65 per cent of Australian exports going to Asia and commodities representing around 60 per cent of total exports, the outlook for Asia and for commodity markets will be key determinants of how developments in the global economy affect the Australian economy. So far, there is only limited evidence of a slowing in the Asian economies, and commodity markets have tended to strengthen over recent months. Nevertheless, the slowing in developed economies and the difficulties in global financial markets will continue to have some dampening effect on Australian growth.

The large rises in prices for coal and iron ore in the 2008/09 contract year are expected to result in an increase of around 20 per cent in the terms of trade over the next few months (Graph 79). These increases will bring the run-up in the terms of trade over the past five years to around 65 per cent. Although the prospect of further tightening in commodity markets cannot be ruled out, the Bank's forecasts assume a medium-term easing in the terms of trade, reflecting the slowing in global growth in 2008 and the expected response of demand and supply to the current high commodity price levels over time.

Domestic activity

The forecasts for activity and inflation in Australia are based on the technical assumption that the cash rate and the exchange rate will remain at their current levels.

The outlook reflects the interaction of a number of opposing forces. On the one hand, the global slowdown and the significant tightening in financial conditions are clearly contractionary for the economy. Variable lending rates to households and businesses have risen by nearly 50 basis points since the time of the February Statement and by nearly 150 basis points since mid 2007. There has been some additional contractionary effect from tighter lending standards and reduced access to capital markets. These financial factors have been reflected in the observed fall in the rate of growth of borrowing by households and businesses. They have also contributed to the falls in measures of consumer and business sentiment and to the slowing in the domestic economy that is apparent in information from the Bank's liaison program and a number of the indicators of domestic spending, including retail sales.

On the other hand, the recent large price increases for coal, iron ore and other commodities are likely to boost national income by up to 3 per cent and can be expected to support domestic growth through a number of channels. The surge in export prices will boost the earnings of mining companies and the revenues of federal and state governments (especially corporate income tax revenues and royalty-type payments). Although foreign-ownership of the minerals sector is significant, a sizeable fraction of after-tax profits will accrue to domestic shareholders and to the extent that this lifts dividends or share prices, it will support household wealth and spending over time. Indeed, share prices in the resources sector have risen by around 16 per cent since the time of the previous Statement, in contrast to the non-resources sector where share prices have fallen by around 8 per cent over this period. To the extent that the recent boost to commodity prices results in expectations of higher average prices in the medium term, it could be also expected to provide a significant boost to investment over the medium term, with the attendant multiplier effects in terms of higher demand for labour and for goods and services from firms in both the resource-rich and other states.

The net effect of these forces is quite uncertain. The Bank's current assessment is that the near-term outlook for domestic demand is for moderate growth. Growth in non-farm GDP is forecast to slow from the rate of 4 per cent seen over the year to the December quarter 2007 to around 1¾ per cent over 2008, before rising somewhat to 2½ per cent over 2009 and 2¾ per cent over 2010 (Table 13). With farm sector output expected to recover over the next year or so, total GDP growth is forecast to be slightly stronger over this period. Excluding production in the mining and farm sectors, where outcomes are predominantly driven by changes in supply, output growth over the forecast period is expected to slow to around 1½ per cent over 2008 before rising to around 2¼ per cent. Given the recent and projected strong growth in the capital stock, these rates of output growth imply a significant easing in capacity pressures in the economy.

Much of the forecast slowing in 2008 is attributable to an expected slowing in household spending. Measures of consumer sentiment have fallen significantly in the wake of the tightening in financial conditions and the weakness in financial markets, and the growth of retail sales has slowed noticeably in early 2008. The recent increases in petrol prices will also weigh on consumption growth in the near term. While growth in consumption is expected to remain well below its earlier strong pace, impending tax cuts and the stimulus flowing from higher commodity prices should lend support to household spending, with a firming expected later in the forecast period. Dwelling investment is expected to contract over the coming year in response to higher interest rates, but is then expected to recover gradually, supported by the strong demand for housing as reflected in rising rents.

While the further rise in commodity prices is expected to sustain growth in mining investment over coming years, investment in the non-mining sector is forecast to slow as the current large pipeline of work yet to be done is gradually completed. The slowdown is expected to be most pronounced in building construction, where the tightening of financial conditions appears to be weighing on plans for new development; some weakness in this sector should free up resources for mining investment, allowing total business investment to remain at a high level as a share of GDP. Public demand growth is assumed to moderate somewhat from the relatively strong pace of recent years, reflecting slower growth in spending by both the Commonwealth and state governments. In the near term, export growth is expected to be constrained by supply disruptions to resource exports and the fall in rural production from the drought. In addition, the strength of the Australian dollar and the slowing in the growth of some of Australia's major trading partners are expected to slow exports of services and manufactures. However, resource exports are expected to pick up gradually over the forecast period, as new production comes on line.

The forecast slowing in GDP growth implies an easing of growth in labour demand from the considerable strength seen in recent years. Reflecting this, annual growth in employment is forecast to slow and the unemployment rate to increase somewhat, having fallen over the past several years.


The inflation forecasts have been revised to reflect both the stronger than expected consumer price inflation outcome in the March quarter and the softer outlook for the economy. The high rate of underlying inflation in the March quarter indicates that the demand pressures that have been evident for some time are continuing to have a significant effect on pricing in the economy and are allowing increases in input costs to be passed through into final prices. A reduction in inflation over time will require a significant slowing in domestic demand. As discussed above, there is now evidence that demand growth has slowed, but it will take time for this to have a substantial impact on inflation.

In the short term, the higher starting point for underlying inflation means that inflation over 2008 is forecast to be somewhat higher than previously expected. Underlying inflation is expected to be around 4 per cent over the year to the December quarter 2008 (Table 13). Headline CPI inflation over the same period is expected to be higher, at 4½ per cent, largely reflecting the sharp increase in oil prices so far this year. Further out, inflation is forecast to fall gradually, although year-ended inflation is expected to remain outside the target band for the next two years or so. The point forecast is for CPI and underlying inflation to be around 2¾ per cent by the end of the forecast period in December 2010. This reflects the expected slowing in demand growth and a gradual easing in capacity pressures, which are expected to reduce the pricing power of businesses. Wage pressures are also likely to ease in due course, as the rate of unemployment is forecast to increase, in line with the slower growth in activity and employment.

Risks to these forecasts can be identified in both directions. A further deterioration in the outlook for global growth would be the main source of downside risk to the forecasts for domestic activity. In particular, if the weakness in the major developed economies were to lead to a large moderation in growth in China and India, it is likely that the outlook for the Australian economy and commodity markets would deteriorate significantly. This could be expected to lead to lower growth of domestic incomes, spending and activity, and hence some further moderation in inflation over time. In addition, there is some risk that the current dislocations in capital markets could worsen and result in a more significant reduction in credit availability to households and businesses.

There are also upside risks to the domestic growth and inflation forecasts. It is possible that the recent weakness in consumer sentiment and domestic spending will prove to be mostly temporary, especially in light of the large boost to national income arising from the terms of trade. If demand were to be stronger than expected, the forecast moderation in the inflation rate would probably not eventuate. In addition, the persistence of inflation at relatively high rates for some time could result in inflation expectations becoming entrenched at higher than acceptable levels, which could feed back into wage- and price-setting behaviour.