Statement on Monetary Policy – February 2009 Economic Outlook

The outlook for the international economy has weakened since the time of the November Statement. As a consequence the domestic growth forecasts have also been revised down, though the extent of the impact on domestic growth will be moderated by the easings that have occurred in monetary and fiscal policy and by the significant depreciation of the exchange rate. Consistent with the weaker outlook for domestic activity, the inflation forecasts have also been lowered. It is likely that underlying inflation has passed its peak in both quarterly and year-ended terms. Underlying inflation is expected to decline gradually from its current elevated level, to reach the lower end of the target band by the end of the forecast period.

As previously, the forecasts do not incorporate any effects, particularly on inflation, from the Government's Carbon Pollution Reduction Scheme (CPRS). While the precise emissions reduction target has not yet been decided, the proposed 5 per cent reduction in emissions from 2000 levels by 2020 would be expected to increase the CPI by around 1 per cent, with relatively small ongoing effects thereafter. For further details see ‘Box C: Climate Change Mitigation Policy and the Macroeconomy’.

The international economy

Recent data point to a marked deterioration in the near-term outlook for the world economy, with the earlier slowdown in some developed countries broadening and intensifying sharply in late 2008 to become a highly synchronised global recession. Indicators of activity such as industrial production and trade, while weak almost everywhere, have recently declined most sharply in a range of emerging economies, especially in east Asia. Accordingly, global growth in 2009 is expected to be the lowest in the period since World War II, notwithstanding the substantial monetary and fiscal stimulus now being brought to bear in many countries. The subsequent recovery in world growth is likely to be quite gradual, consistent with the typical profile in the aftermath of financial crises.

Reflecting this outlook, the Bank's domestic forecasts are based on the projection that, on an export-weighted basis, output in Australia's major trading partners will contract by around ¾ per cent in 2009, down from annual growth of around 5¼ per cent in 2006 and 2007. This forecast is lower than implied by the country forecasts in the World Economic Outlook update released by the IMF in late January, in part reflecting the continuing flow of soft data in the intervening period.

The forecasts include a further contraction in the developed economies in early 2009 following the sharp declines in the December quarter. A stabilisation is expected later in 2009, reflecting the significant monetary and fiscal stimulus in many countries, especially in the United States. Growth in China and India in 2009 is expected to be markedly below the rates recorded in recent years, while some of the other economies of east Asia are projected to record sharp contractions in year-average terms. Growth in both the major advanced countries and the rest of the world, weighted by Australia's export share with each country, is expected to be nearly 5 percentage points below trend in 2009 (Graph 88).

The developments in the world economy and the softening in commodity markets will be reflected in a significant decline in Australia's terms of trade (Graph 89). Export prices for base metals and rural commodities are significantly lower than in mid 2008, and US dollar-denominated prices in spot markets for coal and iron ore remain well below the current contract prices despite production cuts by producers in Australia and elsewhere. A large fall in the terms of trade is expected in the first half of 2009 as renegotiations of annual contract prices for coal and iron ore take effect. Overall, the terms of trade are forecast to decline by around 20 per cent between late 2008 and early 2010, implying a significant reduction in real domestic income.

Domestic activity

The forecasts for the domestic economy incorporate the planned significant fiscal expansion announced in late 2008 and early 2009. Taking the measures for 2008/09 and 2009/10 together, the discretionary policy actions sum to around $50 billion, equivalent to around 2 per cent of GDP a year. In addition, the forecasts reflect the 4 percentage point reduction in the cash rate since September 2008. The technical assumption is that the cash rate remains at 3.25 per cent, while the exchange rate is assumed to remain near its current level and the oil price assumption is based on pricing of near-term futures contracts. Sentiment in financial markets is assumed to remain fragile for some time.

The sharp contraction in the global economy in late 2008 suggests that the near-term growth outlook is materially weaker than projected in the November Statement. However, it is likely that the slowdown in Australia will be less severe than in many of our major trading partners. This partly reflects the stronger momentum in the Australian economy in the period leading into the global crisis. As in other countries, there has been a significant monetary and fiscal easing in Australia. But given the predominance of floating rate debt in Australia and that the Australian financial system is in stronger shape than elsewhere, the easing in monetary policy is resulting in a larger fall in borrowing rates and more effective transmission of monetary policy. In addition, the depreciation of the exchange rate over the past half-year will help to moderate the effect of the global slowdown on the import-competing and export sectors.

Growth in GDP is now expected to slow from 1.9 per cent over the year to the September quarter 2008 to around ¼ per cent over the year to mid 2009. The economy is expected to begin to pick up from late 2009, with quarterly growth gradually recovering to around trend rates by late 2010 (Table 14). This forecast implies a very significant easing in capacity pressures in the economy.

The projected weakness in real GDP coupled with the large fall in the terms of trade implies a sharp fall in real domestic income, which is forecast to contract by around 4 per cent over 2009. However, the significant foreign ownership of the mining sector means that part of this reduction will be borne by foreign shareholders (just as they shared the gains as export prices rose), so the fall in real income accruing to Australian residents will be somewhat smaller, though still substantial. Consistent with the large fall in income, real gross national expenditure is forecast to contract modestly through 2009, offset by a contribution to growth from net exports as a result of the depreciation of the exchange rate.

Growth in household consumption spending is expected to remain subdued over much of the forecast period, given an expected weakening in employment and the decline of around 10 per cent in net worth over the past year as a result of the sharp fall in the equity market and smaller fall in house prices. However, the significant fiscal stimulus to households will provide support to consumption over the first half of 2009 and growth in spending is subsequently expected to gradually return to more normal rates. In the near term, dwelling investment is likely to fall significantly, given recent trends in building approvals and dwelling commencements. The Bank's liaison with developers has also indicated a significant reduction in the availability of credit for new development, which may slow the recovery in the near term. However, the increase in the First Home Owner Grant and the significant falls in mortgage rates will limit the fall in dwelling investment and contribute to a recovery from late 2009.

Business investment, which has recently been at its highest level as a share of GDP since the early 1970s, is expected to fall through most of the forecast period albeit by less than would otherwise have occurred due to the Government's introduction of tax deductions on eligible investment. Falls in commodity prices and resource company share prices are expected to result in a substantial scaling-back of mining-related investment. Consistent with this, a number of major mining firms have recently announced significant cuts to their capital expenditure plans for 2009 and beyond. Given falls in approvals in recent months, non-residential building is also forecast to contract significantly, especially for large developments such as offices, where developers are having greater difficulty accessing finance.

Public demand is expected to make a significant contribution to growth over the forecast period, reflecting the measures announced in late 2008 and early 2009 by the Government. Measures announced include spending on schools, public & defence housing and transport infrastructure. The outlook for exports has deteriorated given the sharper-than-expected weakening in demand in Australia's major trading partners and the contraction in global trade in the December quarter. Exports are expected to be broadly flat over 2009. However, given the relatively low exchange rate and the build-up of production capacity by resource companies, non-rural exports are expected to grow rapidly towards the end of the forecast period as global growth begins to recover.

Although labour market conditions have held up reasonably well so far, the projected softness in domestic activity over 2009 is expected to lead to a further weakening in the demand for labour. Employment is forecast to fall over 2009, although growth is expected to resume as the economy gradually recovers. Despite the significant stimulus already provided by monetary and fiscal policy, the unemployment rate is forecast to increase materially over the next year or so.


The inflation forecasts incorporate the weaker outlook for global and domestic growth, significantly lower oil prices, and a modestly lower exchange rate than assumed at the time of the November Statement. The net effect has been a downward revision to the earlier inflation forecasts.

While year-ended underlying inflation is expected to remain above the Bank's medium-term target range in coming quarters, price pressures in the domestic economy should ease. This reflects the slowing in global and domestic activity, which will alleviate capacity pressures and reduce the pricing power of businesses (including the extent to which firms can pass on higher prices for imports). Wage growth is likely to slow in line with conditions in the labour market. The projected decline in inflation will also be aided by the significant decline in inflation expectations since mid 2008 and the falls in the prices of oil and many other commodities. However, the decline in overall inflation is likely to be a gradual process as price pressures in the non-tradables component have been significant and broad-based in recent years. In addition, tradables inflation is expected to pick up for at least the next year from the relatively low levels recorded in recent years, as the sharp rise in import prices due to the large depreciation of the exchange rate more than offsets an easing in world price pressures due to weakness in the global economy.

Overall, underlying inflation is forecast to decline gradually to around 2 per cent by mid 2011. Reflecting falls in petrol prices and some other special factors, including a fall in the measured cost of deposit & loan facilities, year-ended CPI inflation is expected to decline more quickly in coming quarters. CPI inflation could fall to below 2 per cent later in 2009, but is then expected to move broadly in line with underlying inflation.

These central forecasts reflect a judgment as to the net effect of a number of powerful forces – some contractionary and some stimulatory – on the Australian economy. Working on the downside is the extraordinary weakening of the global economy in late 2008, when the G7 economies experienced the largest quarterly fall in GDP for the period for which quarterly GDP data are available and trade and industrial production in east Asia contracted at an unprecedented rate. On the upside, there has been a major easing of monetary and fiscal policy in Australia and the exchange rate has depreciated significantly over the past six months. Given the extraordinary circumstances at present, the uncertainty surrounding the forecasts is significant.

The forecasts assume that the world economy continues to contract in the first half of 2009, but at a slower pace than seen in late 2008. However, given the ongoing stresses in financial markets and the rapidity of the deterioration in the global situation in late 2008, it is possible that the world economy could weaken by more than has been assumed. Even if this did not occur, it is possible that the effects on domestic confidence and activity of the global deterioration that has already occurred could be deeper or more persistent than has been factored into the outlook. In particular, a more rapid unwinding of the resources boom than has been assumed would have significant negative effects throughout the economy, resulting in softer growth in domestic incomes and spending. Furthermore, there is also a risk that developments in capital markets could result in larger-than-expected effects on the availability of credit, particularly to businesses, thereby exacerbating the slowing in investment and in domestic activity more broadly. If these risks materialise, there would be a quicker fall in inflation.

The principal upside risk that can be identified arises from the same simultaneity that characterised the sharp international downturn of the past several months, together with the speed and size of the policy responses being put in place around the world. Provided that policy-makers in key countries are able to stabilise financial systems to the point where growth in bank lending resumes, macroeconomic policy stimulus stands a good chance of restoring higher levels of confidence as well as providing a direct boost to demand. The rapidity with which production has responded to weaker demand could also mean that the inventory cycle will be relatively muted – that is, firms may have identified the slowing in demand at an earlier stage than in past cycles, so the unintended build-up in inventories may have been smaller. If so, when demand returns, production will pick up more quickly than in past cycles. In such a scenario, a synchronised upturn in the world economy would be a distinct possibility.