Statement on Monetary Policy – February 2010 Introduction

The global economy continues to recover following the sharp contraction in output in late 2008 and early 2009. The recovery is most advanced in Asia, although almost all economies are now growing again, albeit weakly in some cases. International trade is also continuing to recover and a degree of stability has returned to financial markets.

This is a much better environment than was feared likely in the early part of last year and forecasts for global growth have been revised up accordingly. The world economy is now widely expected to grow by around 4 per cent in each of the next couple of years. This is around the average pace of growth over the past decade or so, although it would represent only a relatively mild recovery from what has been a severe global downturn. The recovery in the advanced economies is likely to remain subdued for some time, with these economies continuing to operate with considerable excess capacity. In contrast, relatively strong growth is expected in the Asian region.

Although the outlook for the world economy as a whole has improved, significant uncertainties remain. One question is the durability of the recent growth in the major advanced economies. In many of these economies, current growth rates are being boosted by the dynamics of the inventory cycle and temporary fiscal measures. This is to be expected at this stage, but for a sustained recovery to take hold, a substantially stronger pick-up in private demand than has been evident to date will be required. Many of these countries also face very significant fiscal challenges that will need to be addressed over time and have banking systems that are still experiencing credit losses from the weak economic conditions.

In Asia, the issues are somewhat different. The Chinese economy has expanded very strongly and a number of other countries have been favourably affected as a result. Industrial production and international trade have rebounded, with the economies in the region operating with much less spare capacity than is the case for the advanced economies. Reflecting this, unemployment rates have started to fall and inflation pressures are emerging, with some countries taking steps to reduce the degree of policy stimulus that is in place.

There has also been a general improvement in sentiment in financial markets, although there continue to be occasional bouts of heightened risk aversion. Over the past couple of months these have tended to be associated with concerns about fiscal sustainability and the creditworthiness of some governments, rather than concerns about the creditworthiness of financial institutions as was the case in 2008 and much of 2009. As a result, spreads on government debt in some countries have increased significantly, although for most countries government bond yields remain at low levels. More broadly, credit market conditions have continued to improve gradually, with central bank support facilities being wound back further and issuance of government-guaranteed bank debt declining. Stock markets are also up significantly from their lows of last year, although most have moved broadly sideways over recent months. Despite the various signs of increasing normalisation, bank credit growth remains very weak or negative in almost all advanced economies. Many banks have a limited appetite for new lending, and many borrowers are still seeking to reduce their debt levels.

In Australia, economic conditions were better than expected in 2009. After contracting in the final quarter of 2008, the economy expanded through 2009 at a reasonable pace, particularly in light of developments in the global economy. Activity has been supported by the stimulatory settings of monetary and fiscal policy, Australia's strong trade links with Asia, a relatively high rate of population growth and a sound financial system.

Recent labour market outcomes, in particular, have been positive. Employment grew strongly over the final months of 2009 and average hours worked also increased after having fallen earlier in the year. Given these developments and a pick-up in hiring intentions by firms, it now looks likely that the unemployment rate has peaked at around 5¾ per cent, a much better outcome than thought likely early last year.

The stronger employment data have helped lift consumer confidence which, together with a recovery in household wealth, has supported consumer spending, despite the fading of the effects of the earlier cash payments to households. Notwithstanding this resilience, many households are still taking a more cautious approach to their spending than was the case a few years ago, with the household saving rate having risen.

Housing construction is also now providing a boost to domestic demand, with a significant pick-up in home-building under way. The recovery is mostly in the detached housing sector, with financing for the construction of apartments remaining tight. Aggregate measures of house prices also increased strongly over 2009, although prices at the bottom end of the market appear to have stopped rising recently, with the demand from first-home buyers declining after the scaling back of the additional government grants. Household credit outstanding continues to grow at a solid pace, although loan approvals have declined a little over recent months.

Business investment in Australia, particularly in the resources sector, is at a very high level, although many businesses remain cautious about increasing their capital spending despite confidence having improved significantly. One area of particular weakness is non-residential building, with private-sector building approvals remaining at quite low levels. An important offset to the weakness has been a large increase in public-sector infrastructure spending, especially in the education sector. In terms of business financing, total credit outstanding has continued to fall, reflecting both demand and supply factors. On the demand side, many businesses are using equity raisings and retained earnings to reduce their debt levels while, on the supply side, lending conditions for the commercial property sector remain very tight.

Inflation in Australia has moderated over the past year or so, in line with the Bank's expectations. In underlying terms, year-ended inflation is running at around 3¼ per cent, down from just over 4½ per cent in September 2008. This moderation reflects the significant easing of wage growth in the private sector, weaker domestic demand pressures, and more recently the substantial appreciation of the exchange rate. As these factors continue to work their way through, a further gradual moderation in the year-ended rate of underlying inflation is expected. In contrast, the rate of increase in the Consumer Price Index has picked up recently, to around 2 per cent, as temporary factors which were previously holding it down have abated.

Globally, many commodity prices have risen significantly since the middle of last year. Iron ore and coal prices, in particular, are up strongly as a result of renewed strength in demand from Asia. The prices of many rural commodities have also risen after earlier declines. This lift in commodity prices has resulted in an improvement in the outlook for Australia's terms of trade, which are now expected to rise over the next year, after falling in 2008/09.

The central forecast is for the economy to grow at around 3¼–3½ per cent in both 2010 and 2011. Private demand is likely to strengthen through 2010, with growth in the early part of the year being supported by strong public demand. The improvement in the global economy and the increase in commodity prices are expected to support continuing high levels of investment in the resources sector, and dwelling investment is expected to grow strongly. While overall growth in the economy is forecast to be reasonably strong, the appreciation of the Australian dollar that has taken place as the outlook for the resources sector has improved will restrain activity in a number of industries that are exposed to international competition.

Underlying inflation is expected to continue moderating in year-ended terms to reach a low of a little under 2½ per cent in the second half of 2010, before rising a little thereafter. Inflation expectations remain contained and the effects of the significant slowing in wage growth seen last year and the appreciation of the exchange rate have yet to fully work their way through. Notwithstanding this, these current forecasts represent a modest upward revision to those in the November Statement, with recent data suggesting that the economy starts the current upswing in activity with somewhat less spare capacity than earlier thought likely. Year-ended CPI inflation is expected to pick up over the next couple of quarters, as the temporary factors that have held it down drop out of the calculations. By late 2010, CPI and underlying inflation are expected to be running at similar rates and consistent with the medium-term target.

With the risk of a serious economic contraction in Australia having passed, the Board decided in October last year that it was prudent to lessen the degree of monetary stimulus that was put in place when the outlook appeared much weaker. Given this assessment, the cash rate was raised by 25 basis points at each of the October, November and December meetings to 3.75 per cent. Banks increased interest rates on loans by more than this, with most loan rates increasing by close to a percentage point over this period. While interest rates on loans remain below average, these increases have materially reduced the amount of monetary stimulus to the economy.

At its February meeting, the Board decided to keep the cash rate unchanged. With inflation moderating as expected, interest rates no longer at exceptionally low levels, and relatively little information available as to the impact of the recent increases, the Board judged it appropriate to hold the cash rate steady for the time being. Looking forward, if economic conditions gradually strengthen as expected, it is likely that monetary policy will need to be adjusted further over time to ensure that inflation remains consistent with the target over the medium term.