Statement on Monetary Policy – November 2008 Introduction

World financial markets have come under severe stress in the period since the last Statement. Strains in credit markets escalated in early September, and the period since then has been marked by further large declines in equity prices and exceptional volatility across a range of markets. In response to these developments, a number of governments have announced measures to strengthen their financial systems, which should help to stabilise conditions over time.

The renewed turmoil was sparked by the failure or near-failure of a number of financial institutions in the United States and Europe. In the United States, the largest mortgage institutions were effectively nationalised in early September along with one of the world's major insurance companies. September also saw the demise of the large US investment banks, with one bank filing for bankruptcy, another being taken over and the remaining two announcing their conversion to commercial banks. Several large financial institutions in the United Kingdom and the euro area came under stress during this period and required government assistance. All of this is part of a major reshaping of the financial landscape, in which the business models of some of the most highly leveraged institutions have proven to be no longer viable.

These events saw an intensification of the credit tightening that was already beginning to take hold in a number of countries. While this had previously been mainly apparent in increased funding costs, which were typically passed on to borrowers in the form of higher lending rates, the renewed turmoil saw this develop into a serious tightening in credit availability. As confidence in the financial sector deteriorated, banks became more uncertain about their ability to sustain their funding, and this in turn made it more difficult for them to lend to sound borrowers in the non-financial sector. In some countries, this has been exacerbated by a lack of capital in the banking system, which has been difficult to replenish in the current environment.

The policy responses to these developments took several forms. Central banks around the world have further increased their provision of liquidity to the financial system. In addition, there have been widespread reductions in official interest rates, including a co-ordinated rate cut of 50 basis points by a number of major central banks in early October. In Australia, the RBA has announced rate cuts amounting to a total of 200 basis points at its September, October and November meetings. In addition the Australian Government announced a substantial fiscal stimulus in mid October, equivalent to a little less than 1 per cent of GDP, with the bulk of the effect to be delivered in the December quarter.

Governments around the world have also taken a number of direct measures to strengthen their financial systems. The US authorities have put in place a plan aimed at injecting capital and purchasing distressed assets from financial institutions, and have announced a number of measures to support other parts of the financial system including money market mutual funds, the commercial paper market and the foreign exchange swap market. Governments in Europe have announced substantial direct injections of capital into their banking systems. In addition, a number of governments around the world, including in Australia, have taken steps to increase protection for retail deposits and to offer guarantees to various types of wholesale lending. In the wake of these measures, there have been some signs of improvement in conditions in global credit markets, though sentiment remains fragile. Throughout this period, credit markets in Australia have generally continued to suffer less dislocation than has occurred in other countries.

Foreign exchange markets have been very volatile during the recent period, with evidence of deleveraging and flows associated with hedging activity contributing to sharp movements. In net terms, the yen has appreciated substantially against all currencies over the past three months, while the US dollar has appreciated against most currencies except the yen. Emerging market currencies have fallen sharply. The Australian dollar has been highly volatile and, in net terms, has depreciated by around 20 per cent on a trade-weighted basis since the time of the last Statement. The RBA has intervened at times to provide liquidity to the market during this period.

Recent international data have generally indicated that there was a further deterioration in economic conditions in the period leading into this latest financial turmoil. In the United States, GDP contracted slightly in the September quarter. US consumer spending has weakened significantly, reflecting several factors including falls in employment and household wealth and deteriorating consumer confidence, while the housing construction sector has remained a drag on the economy. Conditions in the euro area, the United Kingdom and Japan have also deteriorated in recent months. In addition there have been increasing signs of a slowing in China and other parts of the developing world. China's annual growth rate dropped back to a still-rapid 9 per cent in the September quarter, reflecting both weaker exports and earlier measures to restrain domestic demand. Production and exports have softened in a number of other countries in the Asian region over recent months.

These developments, coupled with the expected impacts of the recent financial turmoil, have prompted significant downward revisions to expectations of world economic growth by official and private-sector observers. As a result, global inflation is expected to decline more quickly than in earlier forecasts.

The deteriorating outlook for world growth has contributed to broad-based falls in world commodity prices over recent months. Oil has traded recently at around US$65 a barrel, down from a peak of over US$140 at mid year. Spot prices for steaming coal and iron ore have dropped sharply over the same period and are now well below current contract prices. Base metals prices are down by an average of more than 30 per cent since the start of the year, and rural commodity prices have also fallen. Based on these developments, it is clear that Australia's terms of trade have now peaked, and movements in the terms of trade are likely to subtract noticeably from national income growth over the year ahead, after several years when they had made large positive contributions.

Recent indicators of spending and activity in Australia, like those available internationally, mostly run up to the August–September period, and hence largely predate both the latest interest rate reductions and the most recent bout of financial turmoil. They suggest that the overall path of economic activity in Australia was close to what the Board had expected, with the needed moderation in demand occurring after an earlier period of rapid growth that had contributed to upward pressure on inflation.

The slowdown in domestic spending has been led by the household sector. Consumer spending declined slightly in real terms in the June quarter, and indications are that it picked up only modestly in the September quarter. Consumer sentiment has been adversely affected by a number of factors, including rising fuel costs in the period up to around mid year and, more recently, by the renewed financial turmoil. Spending on discretionary items has been particularly affected by these developments.

Households are now borrowing at a significantly slower pace than has been seen for some time. Some of this reflects a decline in equity-related margin loans outstanding, but there has also been a gradual slowing in housing-related borrowing. The established housing market has been subdued, with modest falls in house prices occurring in both the June and September quarters. Overall, the combination of declines in house prices and equity prices means that household wealth has fallen significantly since the end of last year, and this is likely to be contributing to the overall moderation in consumer spending.

Business investment continued to grow strongly in the period up to the June quarter, but survey-based indicators of business activity show that conditions overall have softened. Capacity utilisation is reported to have been declining since the early part of this year, though it remains fairly high. Surveys of business investment intentions are providing mixed signals but, on balance, it appears likely that there will be a significant scaling-back of earlier investment plans, in view of the deteriorating world outlook and increased financial uncertainties. A number of businesses have been reporting increased difficulty in obtaining credit. This has been most pronounced in the construction sector, but also appears to have become more common in other parts of the economy recently. As at September, however, business borrowing was still growing at an annual rate of around 8 per cent. While this has moderated significantly from last year's pace, it does not seem to have slowed further in the most recent few months for which data are available.

Consistent with the general moderation in demand and activity, labour market conditions have softened in recent months. Employment has grown at an annualised rate of a little over 1 per cent recently, down from rates of around 3 per cent earlier in the year. Unemployment remains low, but estimates of the number of job vacancies have been declining for several months.

September quarter prices data confirm that inflation has remained high. The CPI rose by 1.2 per cent in the quarter, and in year-ended terms inflation picked up to 5 per cent. Price increases were broadly based, with housing costs making a particularly strong contribution over the past year, reflecting rises in construction costs, rents and utilities prices. Measures of underlying inflation were close to the CPI outcome in the September quarter and a little below the CPI in year-ended terms, at just over 4½ per cent.

The rise in inflation over the past two to three years has been a consequence of a number of factors, including a period of very strong growth in domestic demand and limited spare productive capacity, higher growth in unit labour costs and rapidly rising raw materials costs. There are grounds for expecting at least some of these forces to abate in the period ahead. Growth of domestic demand has moderated significantly and aggregate capacity utilisation is now declining. Given the weakness in the global economy, prospects are that growth in domestic spending and activity will remain below trend for some time. In addition, while commodity price increases were adding to costs in the period up to the September quarter, it is increasingly clear that the global commodity price cycle has peaked. A slowing in global prices of manufactured goods also appears likely, though the recent depreciation of the Australian dollar represents a significant countervailing influence.

On balance it appears likely that underlying inflation is now reaching a peak in quarterly terms and that it will begin to decline over the next few quarters. Given recent falls in world oil prices and their expected flow-on to domestic fuel prices, CPI inflation can be expected to fall more quickly in the short term than underlying measures. Even so, a reduction of inflation to the target is still expected to take some time.

In summary, world financial market developments and economic prospects have moved rapidly in the period since the last Statement. At its recent meetings, the Board noted that domestic economic conditions had been evolving broadly as expected in the period immediately prior to the latest bout of financial turmoil. With the needed moderation in demand occurring, the Board judged at its September meeting that inflation was likely to decline gradually over time, and that this allowed scope to begin moving the cash rate towards a less restrictive setting.

The renewed financial turmoil which began in the second week of September materially altered the balance of risks and raised the prospect that global economic conditions could be significantly weaker than previously assumed. That, in turn, would mean weaker prospects for demand and output in Australia, and greater downward pressure on inflation over time. In view of this shift in the balance of risks, the Board judged at its October and November meetings that a significantly more rapid adjustment of the monetary policy setting was needed, and hence the Board decided to make unusually large reductions in the cash rate at those two meetings. In reviewing the stance of policy each month in the period ahead, the Board will be seeking to strike the appropriate balance between avoiding an unduly sharp weakening in demand and the need for inflation to fall back to the target over a reasonable period.