Statement on Monetary Policy – February 2009 Introduction

Recent data point to a marked deterioration in world economic conditions in late 2008. Output contracted significantly in the December quarter in the major advanced economies as well as in a number of emerging market economies, and there were unusually sharp falls in international trade and industrial production. The Chinese economy, though still growing, also slowed significantly.

The main factor behind this highly synchronised deterioration in global activity seems to have been the shock to confidence that followed the Lehman Brothers collapse in mid September. The loss of confidence was reflected in sharply declining equity and commodity prices, in survey-based measures of business and consumer sentiment around the world, and in a widespread downturn in private spending. These effects are likely to have been amplified by a cyclical slowdown in China, as well as by tighter conditions in global credit markets, including in relation to trade finance.

The weakening in spending and activity has been accompanied by a significant easing in world inflation. Prices of a range of commodities fell substantially during the December quarter, though they tended to stabilise late in the quarter and in the early part of 2009. Declines in oil prices have helped to bring down CPI inflation rates in most countries, and prices of internationally traded manufactured goods appear to have softened in response to weaker demand conditions.

While the global financial system remains under considerable strain, there have been some signs of an improvement in financial conditions recently. The extreme volatility that affected all markets in October and November following the Lehman's collapse has abated in the past two months. There have also been some signs of improvement in the functioning of credit markets in response to the substantial assistance measures taken by authorities in a number of the major economies. These measures have included injections of capital into financial institutions, the provision of government guarantees and various actions taken by central banks to improve market liquidity. While spreads in money markets remain high, yields have fallen to historically low levels in many countries. Debt issuance at longer terms has picked up, dominated by bonds issued by banks using government guarantees. There has been strong investor interest in these issues, with the spreads to sovereign debt tending to narrow and most offerings being well subscribed. These developments are helping to alleviate uncertainties about the availability of term funding in the world banking system. Australian banks have been among the more significant issuers of guaranteed bonds, with about two-thirds of that issuance being in offshore markets.

As well as measures designed to assist the financial sector, authorities around the world have taken substantial monetary and fiscal policy actions to stimulate their economies. Interest rates have been cut to very low levels in most countries and significant fiscal initiatives have either been announced or are in preparation, including a major package in the United States. These measures will help to improve the prospects for global recovery over time. Nonetheless, the short-term outlook has clearly weakened over the past few months and official and private-sector forecasts of world growth in 2009 have been revised significantly lower. At this stage it appears likely that global conditions will remain very weak for at least the first half of 2009, though there may be some pick-up later in the year as the expansionary policy measures take hold.

The combination of a severe global downturn and a sharp decline in commodity prices clearly represents a very difficult environment for the Australian economy. Nonetheless, a number of factors are helping to insulate the Australian economy from events abroad. Monetary and fiscal policies are providing substantial stimulus to demand and activity. The Australian financial system remains in better shape than many of its international counterparts, and as a result the monetary transmission process has been working more effectively here than elsewhere. Since the start of the current monetary easing cycle in September, substantial cuts in interest rates have been passed on to household and business borrowers. In contrast, the effect of reductions in policy rates on lending rates in many other countries has been much more limited. Another factor working to dampen the impact of global events on Australia has been the adjustment of the exchange rate, which depreciated by around 20 per cent in trade-weighted terms over the past year. Reflecting these ameliorating factors, the impact of the global crisis on Australia has to date been less than in other advanced economies.

National accounts data up to the September quarter suggest that demand and activity in Australia had been moderating broadly as expected before the recent sharp deterioration in the global economy occurred. GDP had expanded by 1.9 per cent over the year, while domestic demand, though moderating somewhat, was still growing at a relatively high rate of 4 per cent. The moderation up to that point was mainly the result of a slowing in consumer spending, with business and public spending continuing to expand quite strongly. More recent information indicates that the deterioration in global conditions in the December quarter has affected the Australian economy, particularly in the business sector, though in some respects conditions have improved recently in the household sector.

Australian business surveys report a sharp deterioration in confidence in the October/November period, as was occurring around the world. In some cases this has been partially reversed in December and January. The overall deterioration in sentiment has been accompanied by significant reductions in investment intentions. A number of major businesses have announced cutbacks in planned investment, particularly in the mining and construction sectors, and this is confirmed more broadly in business liaison, in non-residential building approvals, and in a range of private-sector surveys. Conditions in the mining sector are being affected by the fall in commodity prices since mid 2008, and there were sharp cutbacks in production in the December quarter in response to weaker external demand. Difficulty in obtaining credit has been a problem for some businesses, particularly in the construction sector, and this appears to have become more widespread in the aftermath of the Lehman's collapse.

In the household sector, disposable incomes are being boosted by the combination of fiscal payments, lower petrol prices and, for indebted households, lower interest rates. After showing little net growth for some months, retail sales picked up significantly through the December quarter. Consumer confidence also improved somewhat over this period, though it remains quite low. The interest rate cut and fiscal measures announced in early February will be adding further to household incomes in the March and June quarters this year.

Short-term indicators of housing construction suggest that activity weakened late last year, and there were modest declines in aggregate house prices. Nonetheless, prospects for the year ahead should be supported by the significant declines in interest rates that have occurred, along with the increase in the first home owners' grant announced in October. A recent pick-up in housing loan approvals and in reported display home traffic suggests that these factors are now starting to add to housing demand.

The labour market has been reasonably resilient to date, with the unemployment rate remaining close to generational lows. Nonetheless, labour market conditions have begun to soften in response to the general slowing in demand and activity. Employment growth slowed in the December quarter and the unemployment rate has been edging up. With job vacancies and hiring intentions falling and short-term economic prospects subdued, more significant rises in unemployment are likely in the period ahead.

Inflation in Australia has been relatively high in the recent period but, as expected, December quarter data indicate that it has begun to moderate. The CPI declined by 0.3 per cent in the quarter, reducing the year-ended rate from 5 per cent to 3.7 per cent. This sharp reversal in the CPI mainly reflected the impact of falling petrol prices in the quarter. Nonetheless, a range of measures confirm that some moderation in inflation is also occurring in underlying terms. Generally, underlying measures showed a quarterly rate of inflation of around ¾ per cent in the December quarter, after four consecutive quarters when it had been at 1 per cent or more.

There are a number of signs that prospects for a further moderation in inflation have improved. Falls in petrol prices are likely to reduce the CPI again in the March quarter, and falling global commodity prices should assist in containing input costs more generally. Earlier pressures on productive capacity are now easing. While the depreciation of the exchange rate represents a countervailing influence, the effect on final consumer prices from that source has to date been relatively muted. This appears to reflect both some softening in global traded goods prices and softer domestic demand conditions. In the non-traded sector there are also some signs of an easing in price pressures, particularly in relation to housing costs. Consistent with these influences, indicators of inflation expectations have generally moderated recently.

In summary, the international situation has deteriorated markedly over the past few months, and this is making for a much more difficult environment for growth of the Australian economy. In these circumstances, Australia's inflation rate is likely to continue to decline.

The Board has responded to these developments with a series of unusually large reductions in the cash rate at its recent meetings. This has brought the monetary policy setting to a position that is providing significant stimulus to the economy, with the cash rate now well below its previous cyclical lows. Substantial pass-through of these reductions to most borrowers over recent months has also seen variable lending rates fall significantly. In the period ahead, the economy will receive a large fiscal stimulus, with the Australian Government announcing further discretionary measures in early February in addition to those announced late last year. While the international situation is likely to remain difficult for some time, the combination of expansionary monetary and fiscal policies now in place will help to cushion the Australian economy from the contractionary forces coming from abroad.