Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 2 August 2016
Glenn Stevens AC (Governor and Chair), Philip Lowe (Deputy Governor), John Akehurst, Kathryn Fagg, John Fraser (Secretary to the Treasury), Ian Harper, Allan Moss AO, Heather Ridout AO, Catherine Tanna
Guy Debelle (Assistant Governor, Financial Markets), Christopher Kent (Assistant Governor, Economic), Alexandra Heath (Head, Economic Analysis Department)
Anthony Dickman (Secretary), Andrea Brischetto (Deputy Secretary)
Domestic Economic Conditions
Members commenced their discussion of the domestic economy with a review of the consumer price index (CPI) for the June quarter. The CPI increased by 0.6 per cent (in seasonally adjusted terms), after falling a little in the March quarter, to be 1.0 per cent higher over the year. Measures of underlying inflation had picked up to ½ per cent in the June quarter, to be around 1½ per cent over the year. Increases in the prices of volatile items, namely fuel, fruit and vegetables, made some contribution to headline inflation in the quarter, but the increase in inflation was broadly based. Members noted that the latest inflation data had been in line with the forecasts in the May Statement on Monetary Policy.
The most recent data on prices and labour costs confirmed that domestic cost pressures had been subdued. This reflected a number of factors associated with low wage growth and pressures on costs and margins, which had resulted in the lowest year-ended rate of non-tradables inflation since the late 1990s. Heightened retail competition in recent years, including from new foreign entrants, had limited increases in goods prices. Rent inflation had remained at low levels and members observed that this was likely to persist for some time given the large pipeline of new construction. In contrast, growth in prices of administered items and the cost of constructing new dwellings had increased in the June quarter. Meanwhile, the prices of tradable items (excluding volatile items and tobacco) had declined in the June quarter and were little changed over the year. Although the depreciation of the exchange rate over the past few years had exerted upward pressure on import prices, this had been largely offset by subdued domestic costs.
Members noted that there was little change in the forecast for underlying inflation. The central forecast was still for inflation to remain around 1½ per cent over 2016 before increasing to between 1½ and 2½ per cent by the end of the forecast period. The substantial depreciation of the exchange rate over recent years was expected to exert some upward pressure on inflation for a time and inflation expectations were assumed to return to longer-run average levels. The forecast increase in underlying inflation also reflected the expectation that strengthening labour market conditions would lead to a gradual rise in growth in labour costs. In particular, members noted that growth in average earnings had been low given the spare capacity in the labour market. Moreover, growth in average earnings had been affected by lower wage outcomes in sectors related to the mining industry as a part of the process of adjusting to the lower terms of trade and the end of the mining investment boom. Both of these effects were expected to wane over the forecast period. Members noted that there continued to be considerable uncertainty about momentum in the domestic labour market and the extent to which domestic inflationary pressures would rise over the next few years.
The unemployment rate had remained at around 5¾ per cent over recent months. Following a very strong outcome over 2015, employment growth had moderated over the first half of 2016; growth had been concentrated in part-time employment, although full-time employment had increased noticeably in June. Forward-looking labour market indicators had been mixed but, on balance, pointed to employment growth consistent with the unemployment rate remaining around its current level over the coming months. Over the forecast period, though, the unemployment rate was expected to decline slightly to be closer to 5½ per cent, which suggested that there would be ongoing spare capacity in the labour market. Members noted that liquefied natural gas (LNG) production, which is less labour intensive than other industries, was likely to make a significant contribution to output growth in the coming years. This suggested that the past relationship between growth in GDP and employment might be less useful as a guide for forecasting labour market conditions over the coming few years.
Real GDP growth appeared to have moderated in the June quarter, following the stronger-than-expected outcome in the March quarter, when unusually favourable weather conditions had boosted resource export volumes. Members noted that there had been little change to the outlook for GDP growth, which was expected to be around 2½–3½ per cent over 2016 before rising to around 3–4 per cent by 2018 (above estimates of potential growth). This outlook reflected the effects of low interest rates and the depreciation of the exchange rate since early 2013, which were supporting the rebalancing of economic activity towards non-resource sectors of the economy.
Looking at the components of the forecast for output growth in more detail, members noted that household consumption growth was expected to remain close to its long-run average over the next couple of years. Surveys suggested that households' perceptions of their own finances had continued to be above average, despite relatively weak income growth, and that consumers' unemployment expectations had fallen in recent years. Members observed that household income growth was forecast to rise gradually to around its average rate, consistent with a gradual pick-up in wage and employment growth. These forecasts implied a further slight decline in the household saving ratio, but there was some uncertainty about whether households would respond to developments affecting their disposable incomes by adjusting consumption growth or altering their saving rates.
Dwelling investment was expected to increase further, having grown strongly in recent years, although the contribution to output growth was expected to diminish over the forecast period. Building approvals had declined over the preceding year, but remained at high levels and had exceeded the amount of work completed. As a result, the number of dwellings under construction had increased to very high levels. Further, members noted that the pipeline of residential construction work, which included work that had not yet commenced, had increased the risk of oversupply in parts of the country. The outlook for the balance of supply and demand in the housing market was important for the inflation outlook because housing costs make up a significant share of the CPI basket.
Turning to the established housing market, members noted that most indicators pointed to an easing in conditions since late 2015. Recent data indicated that housing prices appeared to have grown modestly in the June quarter and had declined a little in most capital cities in July. Data on housing price growth from CoreLogic, which had been discussed at previous meetings, indicated that housing prices had increased very strongly in several cities in April and May. However, new information had revealed that these growth rates were overstated because of changes to CoreLogic's methodology; data from other sources indicated that housing price growth had instead remained moderate in the June quarter. Other information showed that, while auction clearance rates had recently picked up a little in Sydney and Melbourne, the number of auctions was lower than in the preceding year and the average number of days that properties were on the market had increased. Housing credit growth had been little changed in recent months and remained below that of a year earlier. Rent inflation had declined to its lowest level since the mid 1990s and the rental vacancy rate had drifted higher to be close to its long-run average.
Net exports were expected to make a positive contribution to output growth over the forecast period, supported by the earlier exchange rate depreciation and ramp-up in LNG production. In contrast, mining investment was expected to fall further, although the effect of this on output growth was expected to diminish over the next year or so. While there had been some signs that non-mining business investment was rising in some parts of the economy, overall it was expected to remain subdued in the near term. The pipeline of non-residential construction had remained at a low level and non-residential building approvals had been little changed over recent years. Looking ahead, indicators of business investment intentions had continued to point to subdued non-mining business investment in the next year or so, although survey measures of business conditions and capacity utilisation had been noticeably above their long-run averages. Non-mining business investment was expected to pick up in the latter part of the forecast period as demand strengthened.
International Economic Conditions
Members observed that growth in Australia's major trading partners had been a little below average over the first half of 2016 and that the outlook for their growth overall was unchanged from that presented in May. Despite this, commodity prices had picked up since the beginning of the year, partly because of reductions in supply by some high-cost producers of commodities, including iron ore and coal. GDP growth in Australia's major trading partners was expected to be up to ½ percentage point below its average rate in each year of the forecast period. There had also been little change to the outlook for the terms of trade, which were expected to remain close to current levels over the forecast period, having declined by around 35 per cent since their peak in late 2011.
GDP growth in China had eased in the first half of 2016 and was expected to decline further. Growth in the Chinese industrial sector had declined considerably in recent years and subdued conditions in that sector had contributed to a decline in private investment growth. The Chinese Government had implemented additional policy measures to support demand, including increased public spending on infrastructure. Financial conditions had remained accommodative. Conditions in China's residential property market had eased a little recently, while growth in the services sector had been resilient.
The effect of the easing in growth in China had been evident in a number of east Asian economies and emerging economies in other regions with strong trade links to China. The outlook for the Chinese economy remained an important source of uncertainty for global growth and the demand for commodities. A substantial slowing in demand in the Chinese property market would pose risks for property developers and related industries, including the steel industry. There was also uncertainty related to how the Chinese authorities would respond to the difficult trade-off involved in supporting growth and avoiding financial disruption in the near term, while achieving more financial discipline and broader reforms over the longer term.
GDP growth in the major advanced economies had been around or above estimates of potential growth, supported by expansionary monetary policies and less-contractionary fiscal policies. Members noted, however, that potential growth was lower in most advanced economies than it had been prior to the global financial crisis. Combined with low inflation, this implied low growth in nominal incomes, which potentially created challenges for agents in the economy that had nominal obligations, such as debtors and pension funds, particularly if they had assumed that growth would continue at higher rates.
Labour market conditions in most advanced economies had continued to improve, although inflation remained below most central banks' targets. The labour market had been particularly tight in Japan and wages there had risen at an above-average, but still low, rate, although negotiations between unions and large employers had pointed to a moderation in wage growth over the coming year. Growth in economic activity in Japan was expected to remain around its current low rates, supported by the recently announced additional fiscal stimulus package. In the United States, the unemployment rate had fallen to around, or even below, estimates of its long-run equilibrium and there was some evidence of an increase in wage growth. Inflation had also increased in the United States since mid 2015 but, in year-ended terms, had remained a little below the Federal Reserve's inflation goal. While the unemployment rate had continued to decline in the euro area, considerable spare capacity remained and inflation had continued to be lower than the European Central Bank's target.
Members commenced their discussion of developments in financial markets by noting that markets had stabilised following the volatility surrounding the UK referendum in late June. Price movements during the past month had been driven by US economic data and expectations of further monetary policy stimulus in Japan and Europe.
In late July, the Bank of Japan announced further stimulatory policy measures and that a comprehensive review of policy would be undertaken ahead of its next meeting in September. As had been expected by market participants, the Federal Open Market Committee (FOMC) kept the US federal funds rate unchanged following its July meeting. Market expectations of the length of time before the FOMC would raise the federal funds rate again fell after the release of strong US employment data, but since then had risen in response to weaker-than-expected US GDP data. Members noted that another rate rise in the United States was not priced in by markets until late 2017. Market pricing indicated that the European Central Bank was expected to ease monetary policy at its meeting in September in response to concerns that the uncertainty following the UK referendum might weaken the economic outlook for the euro area. The Bank of England had indicated that it expected to ease policy at its meeting in coming days.
Sovereign bond yields declined to record lows in early July and subsequent movements were largely in response to the flow of US economic data and expectations of Japanese policy stimulus. Yields remained materially below levels at the start of the year, most notably in the United Kingdom. Japanese government bond yields increased by 10 basis points after the Bank of Japan announced its recent stimulus measures. Members observed that Australian government bond yields had moved broadly in line with global developments, to reach a historical low. The downward revision to Standard & Poor's outlook for Australia's sovereign credit rating had no impact. Issuance of Australian Government Securities had been well received in July.
The US dollar and euro were little changed in trade-weighted terms over the past month, while the Japanese yen had depreciated following expectations of further monetary policy stimulus, before appreciating once it was apparent that the stimulus was more limited than expected. The Australian dollar was also little changed. The Chinese renminbi depreciated by 22 per cent against the yen and by 7 per cent on a trade-weighted basis over the past year.
Members were briefed on recent developments in global funding markets, including foreign exchange swap markets. They noted that the cost of borrowing US dollars in exchange for euros and yen in short-term foreign exchange swap markets had increased over 2016 to date, as had spreads on short-term bank funding in US dollars. These developments appeared to have reflected increased demand from Japanese investors and banks, as well as impending reforms to US money market funds. The Bank of Japan's latest policy announcement included a facility to enhance access to US dollar swap lines, which reduced the cost of borrowing US dollars in exchange for yen. In Australia, the spread of 3-month bank bill rates to overnight indexed swap rates had declined relative to levels earlier in the year, but remained higher than during 2015.
Share price indices in the major markets had increased over the past month, with the US share market reaching a new high. The share prices of banks globally had underperformed owing to concerns that continued low interest rates would erode their profitability as well as ongoing concerns about the health of the Italian banking system. A number of open-ended UK commercial property funds had suspended redemptions as a result of liquidity pressures following the UK referendum. In Australia, share prices rose, including for resource companies as a result of higher commodity prices.
Australian banks' bond issuance was strong in July and in the year to date, while corporate bond issuance had remained subdued, particularly for resource companies. Members noted that bank deposit rates and lending rates had generally declined in line with the 25 basis point cash rate reduction in May, with the exception of term deposit rates and large business lending rates, which were little changed.
Pricing in domestic financial markets indicated a 75 per cent chance of a reduction in the cash rate at the present meeting.
Considerations for Monetary Policy
In considering the stance of monetary policy, members noted that GDP growth in Australia's major trading partners had remained slightly below average in the first half of 2016 and was expected to continue at around this pace in each year of the forecast period. This forecast was largely as had been expected three months earlier. Growth in China had continued to moderate, which was having noticeable effects on other economies with large trade exposures to China. Actions by the Chinese authorities were supporting the near-term growth outlook, but there was uncertainty about the underlying pace and composition of China's growth over the longer term. Growth in the advanced economies had been around or above potential and labour market conditions had continued to improve. Despite this, inflation had remained below most central banks' targets. Consequently, monetary policy had continued to be highly accommodative in most economies and there was a reasonable likelihood of further stimulus by a number of the major central banks.
Commodity prices overall had risen since the previous meeting and the Australian dollar exchange rate had appreciated a little since earlier in the year. Changes to expectations about central banks' policies continued to have an important influence on global exchange rate developments. The terms of trade for Australia were expected to be little changed over the forecast period, largely as had been previously forecast.
The latest CPI data for Australia had confirmed that inflation pressures were subdued, as had been expected when the previous forecasts were discussed in May. As such, the outlook for underlying inflation was little changed. Underlying inflation was expected to remain low for a time before picking up gradually as spare capacity in labour and many product markets diminished.
The outlook for Australian GDP growth and the unemployment rate had also been little changed since May. While GDP growth had been stronger than expected in the March quarter, reflecting unanticipated strength in resource export volumes, it was expected to have been more modest in the June quarter. Economic growth was expected to pick up to be above estimates of potential by mid 2017. Employment growth was expected to increase as a consequence and the unemployment rate was expected to fall marginally over the forecast period. Low interest rates and the depreciation of the Australian dollar since 2013 were expected to continue to support the necessary adjustments in the economy following the end of the mining investment boom, though an appreciating exchange rate could complicate this.
In coming to their policy decision, members noted that the recent CPI data had confirmed that inflation was likely to remain low for some time. They also observed that while prospects for growth were positive, there was room for stronger growth, which could be assisted by lower interest rates. At the same time, members noted that indicators for the established housing market in the first half of 2016 had pointed to an easing in conditions, including lower housing credit growth and an easing in housing price pressures. These developments were consistent with the tightening in lending standards towards the end of 2015 and decline in turnover in the housing market to low levels. This suggested that the risks associated with rising household sector leverage and rapid gains in housing prices had diminished.
Taking all these considerations into account, the Board, on balance, judged that prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy at this meeting.
The Board decided to lower the cash rate by 25 basis points to 1.5 per cent, effective 3 August.