Statement on Monetary Policy – May 2009 Domestic Economic Conditions

The sharp downturn in the international economy has flowed through to the domestic economy. In the December quarter, GDP declined by 0.5 per cent – the first quarterly fall since 2000 – to be 0.3 per cent higher over the year (Graph 28, Table 9). More recent economic indicators, including private-sector surveys and information from the Bank's liaison with businesses, suggest activity continued to decline in the early part of 2009, although at a significantly more gradual pace than in many other advanced countries.

The slowing in the domestic economy has been evident across most components of private-sector spending and in the labour market. Household consumption has been quite weak since the start of 2008 after having grown strongly over previous years, and dwelling investment declined in the second half of 2008, with a further decline expected in the first half of 2009. The pace of growth of business investment slowed in the second half of 2008 from the high rates seen in previous years, and indicators suggest that investment will contract through 2009. Export volumes have been broadly flat recently. As a result of the weaker economic environment, labour market conditions have deteriorated, with the unemployment rate increasing from its trough of around 4 per cent in early 2008 to 51/2 per cent in April 2009.

The slowing in the economy has been associated with a marked increase in uncertainty and a decline in confidence about the near-term prospects for the global and Australian economies. However, recently there have been signs that business confidence has improved from the low levels recorded earlier in the year (Graph 29). In addition, the sizeable falls in mortgage rates and the Government's fiscal initiatives are supporting household consumption, and there are some early signs pointing to growth in housing construction later this year. Reflecting these developments, the rate of contraction in the economy is expected to slow over coming months, although much will depend on an improvement in global conditions and sentiment.

Household sector

While conditions in the Australian household sector remain more favourable than in many other countries, there has nonetheless been a significant decline in wealth and unemployment has increased. Over 2008, household net worth declined by 8½ per cent, driven by large falls in equity prices (Graph 30). Not surprisingly, many households are taking a more conservative approach to their finances, although the stresses on households in a number of other countries have not been as evident in Australia. This reflects a number of factors, including that lending standards in Australia did not decline as much as in some other countries and that, after a large run-up in house prices in the years leading up to 2003, an adjustment in household behaviour has already been under way for some time (for further details, see the March 2009 Financial Stability Review).

In contrast to the decline in wealth, household income has grown strongly. Real household income (after interest payments) increased by more than 9 per cent over the year to the December quarter, reflecting robust growth in labour income last year and payments of around $8 billion that were part of the Government's fiscal stimulus package announced in October 2008. In addition, the decline in mortgage rates from September has provided a significant boost to many households' budgets, with the overall reduction in household interest payments estimated at around 4½ per cent of income (Graph 30).

While households have used part of this increase in income to boost their saving and pay down debt – the December quarter data show the household saving ratio rose to 8.5 per cent, its highest level since the early 1990s – the increase has also supported spending in recent months. The volume of retail sales is estimated to have risen by 1 per cent in the March quarter, and after significant falls through much of 2008, the rate of decline in motor vehicle sales to households has slowed (Graph 31). Consistent with these data, consumer sentiment has risen from the low levels of late 2008 and is stronger than in many other economies, with Australian households remaining quite positive about the medium-term prospects for the economy. Looking ahead, the $12 billion in additional budget transfers to households (announced in early 2009 and being paid from March) is likely to continue to support household spending, although the deterioration in the labour market will work in the other direction.

After falling modestly in 2008, nationwide housing prices were little changed in early 2009, although there is some variation in the range of available measures that use different techniques to control for changes in the composition of property transactions (Table 10). House prices in the most expensive suburbs have fallen quite significantly over the past year while prices for apartments and houses in the lower-priced suburbs have been supported by increased first-home buyer activity, partly associated with the temporary increase in grants paid to first-home buyers (Graph 32). Across the capital cities, prices have fallen most in Perth, which had the largest run-up in dwelling prices in recent years.

The softening of the housing market and deterioration in the economy have contributed to subdued housing activity in the second half of 2008 and the early part of 2009. Dwelling investment declined by 1.2 per cent in the December quarter, reflecting contractions in both new dwelling construction and renovation activity. Building activity is likely to have weakened further in early 2009, given that commencements fell by around 10 per cent in each of the September and December quarters and the number of private residential building approvals declined by 3 per cent in the March quarter, to be around 20 per cent below its level in mid 2008. Approvals and commencements for medium-density dwellings have fallen more than for houses, with high-rise developments particularly affected.

Looking ahead, low mortgage interest rates and the increase in grants for first-home buyers have made home purchase more affordable, and this is expected to help support residential building construction in the second half of 2009 (Graph 33). There are positive signs in the forward-looking indicators and from the Bank's business liaison. Loan approvals for new construction and first-home buyer grants paid for new homes have risen in recent months (Graph 34). Consistent with these indicators, surveys of consumer sentiment report a relatively high proportion of households responding that it is a good time to purchase a dwelling. Further, after slowing in the second half of 2008, housing credit growth picked up modestly over the March quarter (Graph 35). This reflected a rise in new lending, largely to first-home buyers, that has more than offset an increase in repayments by households with existing debt.

Business sector

After several years of strong profits, tight capacity utilisation and a historically high level of investment relative to GDP, conditions in the business sector have deteriorated recently (Graph 36). Given the global recession and general rise in uncertainty and risk aversion, many businesses are experiencing difficult trading conditions and have delayed or reduced investment plans while scaling back hiring intentions. Consistent with the decline in the level of activity, the capacity constraints firms were facing over recent years appear to be easing rapidly, with the NAB survey's capacity utilisation measure falling to levels last seen in 2001.

The more difficult environment is reflected in a decline in business profits. After reaching a historically high share of GDP in mid 2008, profits (excluding the financial sector) fell by 4 per cent in the December quarter and are expected to fall further in 2009 (Graph 37). Over 2008, profits in the non-mining sector (excluding the financial sector) fell by 10 per cent while, in contrast, profits in the mining sector doubled, although they will decline significantly over 2009 due to the recent falls in commodity prices.

The indicators generally point to a decline in business investment in 2009 (Graph 38). Machinery and equipment imports have fallen sharply since late last year, and surveys of business investment intentions – including the NAB and ABS Capital Expenditure surveys – suggest a fall in machinery and equipment spending over the first half of 2009. Building construction also appears to have been weak, with concrete production data (a timely gauge of construction activity) declining by around 8 per cent in the March quarter. Further falls in construction appear likely, with the value of approvals for private non-residential buildings having declined by around 50 per cent since mid 2008; approvals for large-scale projects such as offices and warehouses have fallen especially sharply. In addition, a number of large mining firms have announced reductions to capital expenditure plans for 2009, although the high level of commencements of engineering projects in the second half of 2008 suggests this spending may remain firm in the near term.

Growth in business debt has slowed markedly in recent months. There is evidence that this partly reflects reduced demand for credit as firms scale back their investment plans and attempt to consolidate their balance sheets. Nonetheless, most firms entered the slowdown in reasonably strong financial shape, with lower gearing ratios than those prevailing ahead of the early 1990s recession (for further details, see the ‘Domestic Financial Markets’ chapter). Credit conditions have also tightened for many borrowers as credit risk has risen and lenders have tightened lending terms and conditions, with the impact most pronounced for borrowers in the property development industry. This change in conditions is evident in the Bank's liaison with businesses and in surveys, although the ACCI-Westpac survey and Sensis survey of small and medium enterprises suggest that access to finance is a less important concern than issues such as costs and a lack of demand.

Activity has declined in commercial property markets over the past year, with a decline in prices, lower turnover and a sharp fall in building approvals for offices and warehouses. Office vacancy rates have increased from recent historically low levels, although they remain lower than the average rates seen over the past two decades (Graph 39). Nationwide office capital values are estimated to have fallen by 18 per cent over the year to the March quarter, although low sales volumes make this difficult to accurately measure. The deterioration in office market conditions has been pronounced in the Perth and Brisbane markets, where high demand for office space associated with the mining sector was most concentrated.

Farm sector

Farm production is expected to have increased by around 10 per cent in 2008/09, reflecting the reasonably strong 2008 cereal harvest. The outlook for the 2009 cereal crop is mixed, with substantial rainfall required in coming months to improve soil moisture levels. Inflows into the Murray-Darling river system were at a record low between January and March, suggesting that water availability for irrigated crops is likely to remain constrained.

External sector

Export volumes are estimated to have been broadly flat in the March quarter after small falls in the second half of 2008. Australia's total export volumes to date have not been affected as much as in other countries by the global slowdown (Table 11). In large part this reflects differences in the composition of Australia's exports. In particular, while manufactured exports have fallen sharply both from Australia and abroad – reflecting the significant decline in global spending on durables such as machinery, motor vehicles and other transport equipment – manufactured goods account for only around 20 per cent of the value of Australia's total merchandise exports, compared with over 90 per cent for countries such as Japan, Korea and China. In contrast, resource and rural exports account for around 80 per cent of Australia's merchandise export values (around 65 per cent of total exports, including services), which is significantly larger than for most of Australia's trading partners, and these exports have held up better over recent quarters.

More generally, the weakening in global demand conditions has had a much more pronounced effect on resource commodity prices than on Australia's export volumes (for further details, see ‘Box B: Recent Developments in Australia's Resource Exports’). The softening in commodity markets in the second half of 2008 was associated with a large depreciation of the exchange rate, although this has been partly reversed over the past few months (Graph 40). The lower exchange rate has moderated the decline in demand for Australia's other exports, including tourism and education exports. Rural exports have also picked up in recent quarters, as the large 2008 wheat crop has been shipped.

Import volumes have declined by considerably more than export volumes, and by around as much as the falls seen in other advanced economies. Following a 7 per cent decline in the December quarter, import volumes are estimated to have fallen by a further 7 per cent in the March quarter (Graph 41). This decline reflects the weakness in domestic demand in late 2008 and early 2009, as well as the earlier depreciation of the Australian dollar. The decline has been broad-based across the categories, but – as in other countries – has been larger for imports of capital goods and transport equipment. The trade account is estimated to have remained in surplus in the March quarter, at around 1½ per cent of GDP; the full flow-on of the declines in contract prices for coal and iron ore in 2009/10 is yet to be seen in export values (Graph 42).

Labour market

The slowing in economic activity has also been reflected in a deterioration in conditions in the labour market, with the unemployment rate rising and employment contracting since its peak in late 2008. The unemployment rate stood at 5.4 per cent in April, up from around 4 per cent in early 2008 (Graph 43). While labour market conditions have varied somewhat, all states have seen their unemployment rates trending up.

The contraction in employment has been driven by the full-time component, which has been trending down since August last year (Graph 44). This pattern is consistent with previous downturns in the labour market. Full-time employment has contracted by over 1 per cent since mid 2008, while part-time employment has continued to trend upward. In part this reflects the shift of full-time workers to part-time, as employers attempt to rein in labour costs while avoiding lay-offs. In recent months, there has been a significant increase in the number of full-time workers temporarily working shorter hours. While this latter group represents only a small share of the labour force, in previous cycles significant movements in this series have tended to lead movements in the unemployment rate (Graph 45).

The participation rate has remained around its historical high, despite the recent weakening of the labour market. Previous downturns in the labour market have generally been characterised by declining participation, as discouraged workers exit the labour force when employment prospects diminish. The absence of any fall to date may reflect lags, as was the case in the early 1990s downturn. In addition, older workers may be delaying retirement due to the significant losses in wealth arising from falling asset values.

Forward-looking indicators of labour demand suggest that conditions will deteriorate further in coming quarters. Aggregate job advertisements, as reported by the ANZ Bank, have shown a sharp fall in 2009 for both newspaper and internet advertisements (Graph 46). In addition, measures of hiring intentions in business surveys have fallen to their lowest levels since the early 1990s. The Bank's liaison with firms also points to a broad-based softening in hiring intentions over recent months, with reports of reduced hours, hiring freezes and labour shedding becoming more common.