Statement on Monetary Policy – August 2009 Introduction

The global economy is stabilising after contracting sharply in the December and March quarters. Over recent months, the value of international trade and global industrial production have both recorded modest gains after earlier large declines, and the extreme risk aversion seen earlier in the year has receded somewhat. Reflecting this, forecasts for world growth are being revised up for the first time in more than a year.

The pick-up in economic conditions is most evident in China, where growth has been boosted by a large fiscal stimulus and increased bank lending. Elsewhere in Asia, output has retraced part of the earlier sharp falls, with a number of countries benefiting from the stronger growth in China, their own fiscal and monetary stimulus, and the absence of significant problems in their financial systems. There are fewer signs of recovery in the advanced economies, although the rate at which output is contracting has slowed noticeably. In the United States, in particular, there is tentative evidence that the economy is reaching a turning point, with the housing market showing signs of stabilisation.

This improvement in the global economy has been reflected in financial markets. Equity prices are up considerably from their lows in March when risk aversion was at its peak, and credit markets have continued to improve, with many spreads back to the levels prevailing before the failure of Lehman Brothers last year. There has also been a marked pick-up in equity and debt issuance, and banks are relying less on government guarantees to raise funding.

These are encouraging developments and they have lessened the downside risks to the world economy that were very real in late 2008 and early this year. Despite this improvement, significant headwinds remain. Credit conditions are still difficult in many countries and the effect of the global slowdown has yet to show up fully on many banks' balance sheets. More unexpected bad news in the financial sector could again have an unsettling effect on confidence. In addition, many countries face balance-sheet issues not only in the financial sector, but also in the public sector, with the ratio of public debt to GDP forecast to rise rapidly over the next few years, to reach historically high levels. Reducing public-sector debt to more sustainable levels is likely to weigh on growth in many of the advanced economies for some time. In contrast, prospects for growth in the Asian region, which is becoming increasingly important to Australia, look more positive.

Domestically, the economy continues to exhibit considerable resilience in the face of what has been a very difficult international environment. The December and March quarter GDP data, in conjunction with other information on the economy, suggest that output contracted only modestly around the turn of the year, compared with the very sharp contractions experienced in most other countries. More recently, the information that has become available suggests that demand and output have strengthened a little, with household consumption continuing to grow in the June quarter while investment has been weak.

A number of factors have contributed to this comparatively good performance of the Australian economy. One is the strong state of Australia's financial system. Another is the significant monetary stimulus arising from the 4¼ percentage point reduction in the cash rate since September last year, with the lower rates largely passed through to end-borrowers. A third factor has been the fiscal stimulus which, in particular, has provided a considerable lift to household disposable incomes over the past nine months. The depreciation of the exchange rate last year also provided a stimulus to domestic activity, although much of this has been unwound by the appreciation over recent months. Finally, the strong recovery in China, which has boosted commodity prices and demand for Australia's exports, has also been important. While most countries have recorded declines in export volumes of at least 10 per cent since September last year, Australia's exports are estimated to have recorded a small rise over this period.

Over the past few quarters, household consumption in Australia has been stronger than in a number of other countries, with disposable incomes boosted by government transfer and tax bonus payments. Households with a mortgage have also benefited from the large reduction in mortgage rates. Over the past few months, household wealth has also risen – boosted by higher housing and equity prices – unwinding a considerable part of the large decline that took place in 2008. Given these outcomes, consumer sentiment has recovered strongly from earlier declines, and concerns about unemployment, though still prominent, are lower than earlier in the year.

In the housing market, new construction looks to have again been weak in the June quarter, but the outlook for the second half of the year has improved. Lending approvals and information from liaison point to strong demand by first-home buyers since the start of the year, boosted by both low interest rates and the temporary increase in government grants. Housing prices in a broad range of markets have also shown renewed strength this year. Housing credit continues to be widely available, although there has been some tightening of lending standards. Unlike in many other countries, borrowing for housing continues to increase at a solid pace.

Business investment remains the main area of weakness in the economy, although the Bank's liaison and business surveys suggest that as conditions and confidence have improved, some firms are reconsidering earlier decisions to postpone or cancel investment plans. Private non-residential construction is likely to remain weak for some time, with many property developers experiencing difficult funding conditions. In contrast, recently there has been a pick-up in spending on some types of plant and equipment, partly in response to temporary tax incentives. There has also been a marked shift in the composition of business funding, with many larger firms replacing debt with equity to reduce their leverage. With lending standards having also been tightened, especially for commercial property, business credit outstanding has declined over the past six months, although total business funding has been rising at a reasonable pace.

Reflecting the slowdown in the economy over the past year, the labour market has softened, although the rate at which unemployment is increasing has slowed recently with the unemployment rate currently at 5¾ per cent, up from around 4 per cent in early 2008. Importantly, flexibility in the labour market has allowed many firms and their workers to modify working conditions as an alternative to layoffs. Partly as a result, aggregate employment has shown less weakness over the past year than total hours worked in the economy.

Recent data on prices continue to suggest that price pressures in the economy are abating gradually. Over the year to the June quarter, the CPI increased by 1.5 per cent, the lowest annual increase for a decade, while underlying inflation was around 3¾ per cent. This unusually large difference between CPI and underlying inflation reflects significant falls in the price of fuel and the ABS estimate of the price of deposit & loan facilities facing the household sector. Importantly, recent quarterly outcomes for underlying inflation have been below the rates recorded for most of the previous year, and a further reduction is expected over the period ahead. Upstream price pressures are moderating and there are signs that wage growth is slowing in an environment of weaker demand for labour. Measures of inflation expectations also remain relatively low.

Overall, recent economic conditions in Australia have been stronger than expected at the time of the previous Statement. The central forecast is now for the economy to record modest growth of around ½ per cent over 2009, with growth gradually firming through 2010. Investment is expected to decline further over the year ahead, although the level of investment relative to GDP is likely to remain high compared with that in most other advanced economies and the Australian experience of recent decades. Consumption over the second half of the year is also likely to be weaker than in the recent past, as the effects of the recent boost to household income from the government transfer payments fade. In contrast, stronger dwelling activity and increased public sector infrastructure spending are expected to provide support to demand. Inflation is still expected to decline gradually, although the expected trough, at around 2 per cent, is higher than anticipated at the time of the previous Statement.

In response to the rapid change in the global environment that took place following the financial events of last September, the Board reduced the cash rate by 4¼ percentage points in six steps between September and April. Consistent with the Board's forward-looking approach to monetary policy, this rapid and large easing of monetary policy was made in anticipation of a very weak domestic economy and a decline in inflation from elevated levels. At its meetings since April, the Board has held the cash rate constant at 3 per cent. Over much of this period, it judged that the inflation outlook provided some scope for a further reduction in the cash rate to below 3 per cent if that were needed. However, the recent stronger-than-expected economic data and the general improvement in sentiment both in Australia and abroad have reduced the likelihood that a further reduction will be required.

Given the rapidly evolving international financial and economic conditions, the outlook for the Australian economy continues to be subject to considerable uncertainty, although the risks are more balanced than they have been for some time. With confidence globally still fragile, it remains possible that the outlook could again weaken. On the other hand, with the cash rate at an unusually low level and the global economy stabilising, movement towards a more normal setting of monetary policy could be expected at some point if further signs of a durable recovery emerge. For the time being though, the Board's judgment is that the present accommodative setting of monetary policy is appropriate given the economy's circumstances. Over the period ahead, the Board will continue to monitor economic and financial conditions and how they affect prospects for a sustained recovery in the domestic economy, consistent with achieving the inflation target.