Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 7 February 2017
Philip Lowe (Governor and Chair), Guy Debelle (Deputy Governor), John Akehurst, Kathryn Fagg, John Fraser (Secretary to the Treasury), Ian Harper, Allan Moss AO, Heather Ridout AO, Catherine Tanna
Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Alexandra Heath (Head, Economic Analysis Department)
Anthony Dickman (Secretary), Andrea Brischetto (Deputy Secretary)
International Economic Conditions
Members commenced their discussion by noting that the data on activity and inflation in the global economy had been more positive over recent months. There had been a broad-based pick-up in surveyed conditions in manufacturing across economies as well as in growth in industrial production and merchandise trade. GDP growth in Australia's major trading partners had increased a little over recent quarters and forecasts for 2017 and 2018 had been revised a little higher, partly because of expectations of expansionary fiscal policy in the United States. However, trading partner growth was still expected to ease slightly towards the end of the forecast period, reflecting a projected slowing in growth in China in the medium term.
Members observed that inflation in the advanced economies had continued to increase recently, mainly as a result of higher oil prices. Some measures of inflation expectations had also risen in late 2016. These developments and a decline in spare capacity were expected to flow through to higher core inflation in the advanced economies over time. Inflation rates were still below central banks' targets in most countries.
In China, economic growth had picked up in mid 2016, supported by accommodative financial conditions and fiscal stimulus, which had helped the authorities to achieve the annual GDP growth target. These outcomes had led to more confidence that Chinese growth would remain resilient in 2017. A range of policy measures had contributed to an increase in residential investment. There had been growth in residential property investment across a range of Chinese cities in the second half of 2016, which had led to a pick-up in demand for construction materials and growth in industrial sector output. Total social financing had increased at almost double the pace of GDP over 2016. This had supported the economy in the near term, but implied a further rise in China's debt-to-income ratio, which heightened the risks to Chinese growth in the medium term. Members noted that developments in China continued to be one of the main sources of uncertainty for the Australian economy.
Growth in the United States had increased in the second half of 2016. Further improvements in labour market conditions and rising consumer confidence had supported growth in household consumption, but business investment had remained subdued. Inflationary pressures had increased and inflation was close to the Federal Reserve's goal. The new US administration's proposed fiscal policy was expected to provide additional support to economic activity in the United States. However, members noted that the new US administration might introduce more restrictive policies on trade and immigration, which would pose significant downside risks to the forecast for global growth.
Growth in Japan had picked up over 2016 to be above estimates of potential growth, supported by public consumption and further improvements in labour market conditions. However, nominal wage growth and domestic inflationary pressures had remained subdued.
Growth in east Asia (excluding China and Japan) had been little changed over the previous year or so, supported by accommodative monetary and fiscal policies throughout most of the region and a rise in external demand. Members noted that there had been a distinct pick-up in growth in industrial production in these economies in recent months. Growth in New Zealand and India had been relatively strong.
GDP growth in the euro area had been above estimates of potential growth and had been broadly based. While the euro area unemployment rate had declined to its lowest level since mid 2009, there was still spare capacity in many economies in the region.
Members observed that there had been a broad-based increase in global commodity prices since the previous meeting. The exception was the price of coking coal, which had fallen sharply from very high levels, as temporary disruptions to Australian supply had been resolved and the Chinese authorities had eased some of the restrictions on Chinese coal production. As a result of these commodity price developments, Australia's terms of trade had increased significantly and by more than had been expected. Although the rise in the terms of trade had been larger and lasted longer than expected, members noted that the stimulus for additional mining investment was likely to be limited and some of the higher income would accrue to foreign owners. The terms of trade were expected to decline over the forecast period, but to remain above their lows of early 2016. Nevertheless, the higher terms of trade represented a boost to national income, which provided some upside risks to the domestic forecasts.
Domestic Economic Conditions
Members started their discussion of the domestic economy by noting the outcome for GDP growth in the September quarter. The 0.5 per cent decline in real GDP in the quarter was considerably weaker than had been expected, reflecting some temporary factors, including disruptions to coal supply and bad weather. Slower growth in consumption had also been a factor. This weakness was not expected to have continued into the December quarter and the forecasts for quarterly GDP growth were little changed. GDP growth was expected to pick up to around 3 per cent in year-ended terms later in 2017, and to remain above estimates of potential growth over the rest of the forecast period.
Although export volumes had been unexpectedly weak in the September quarter because of supply disruptions, growth in resource exports had subsequently increased. Members noted that Australia had recorded a significant trade surplus in the December quarter. Over the forecast period, Australia's low-cost producers of iron ore were expected to increase output further and the ramp-up in liquefied natural gas production was expected to make a significant contribution to output growth. The drag on growth from falling mining investment was also expected to diminish.
Non-mining business investment had increased by around 5 per cent over the year to the September quarter. Growth in non-mining business investment had been strongest in New South Wales and Victoria over recent years, where economic conditions had been most favourable. While non-residential building construction was likely to remain subdued in coming quarters, the increase in approvals over the past year across a range of sectors suggested that non-residential building construction would contribute to GDP growth towards the latter part of the forecast period.
Household consumption growth had been subdued in the June and September quarters of 2016, consistent with subdued growth in household income. More recently, growth in retail sales volumes for the December quarter had increased, households' perceptions of their personal finances had remained around average and expectations of unemployment had been low relative to recent years. Subdued growth in household income was likely to constrain consumption growth over the forecast period.
Members noted that the forecasts for consumption growth were closely related to labour market developments and households' expectations about their income growth. Employment had risen modestly in the December quarter and all of the increase had been in the full-time component, reversing the pattern of the previous few quarters. Forward-looking indicators had been consistent with some pick-up in employment growth over the period ahead. The unemployment rate had increased slightly in late 2016 to 5.8 per cent and was expected to edge only slightly lower over the forecast period.
Ongoing spare capacity in the labour market had contributed to subdued wage pressures, although there were some indications that wage growth had reached a trough. Growth in wages and household income were expected to increase gradually. Members observed that any increase in uncertainty that households have about their future income growth could lead to lower consumption growth, particularly for those households servicing sizeable debts. In contrast, if households were to become more positive about their future employment, income or wealth, then consumption growth could be stronger than suggested by the forecast. Similarly, stronger actual income growth would also tend to lead to stronger consumption growth than forecast.
Private dwelling investment had declined unexpectedly in the September quarter, largely because poor weather had disrupted construction. However, dwelling investment had grown at an above-average rate over the previous year, supported by low interest rates and further increases in housing prices. The large amount of work in the pipeline was expected to support dwelling investment at high levels over the next year or so, although there was some risk of more cancellations than usual if conditions in apartment markets deteriorated.
The combination of increased supply and lower population growth had already depressed rents and apartment prices in Perth and, increasingly, Brisbane. In contrast, conditions in the established housing markets in Sydney and Melbourne had strengthened over the second half of 2016 and investor housing loan approvals had risen over recent months. Members noted that housing market activity in Melbourne and surrounding areas had been supported by strong population growth and improvements in transportation infrastructure.
Low wage growth and rent inflation had contributed to another low inflation outcome in December. Underlying and headline inflation had both been around 1½ per cent over 2016, in line with the forecasts presented in the November Statement on Monetary Policy. Petrol prices had risen in the quarter, after subtracting from inflation over much of the previous few years. Higher tobacco prices had made a significant contribution to headline inflation over the year, and were expected to continue to do so given the further increases in tobacco excise that are scheduled over the next four years.
There were signs that non-tradables inflation had stabilised over recent quarters, after declining for a number of years. Prices of tradable items (excluding volatile items) had declined in the December quarter and over the year. The earlier depreciation of the exchange rate was no longer estimated to be putting upward pressure on tradables prices. Heightened competitive pressures in some product markets from the entrance of new competitors had also contributed to low inflation. While the impact of these pressures was expected to wane over time, the point at which this might occur was uncertain.
There had been very little change to the forecast for inflation. Underlying inflation was expected to pick up gradually, largely because unit labour costs were expected to rise gradually and spare capacity in the economy was expected to diminish. However, members noted that the factors that had weighed on inflationary pressures could be more persistent than had been assumed. On the other hand, wage growth could rise more quickly than forecast if labour market conditions were to improve by more than expected, particularly if employees were to demand wage increases to compensate for the period of low wage growth over recent years. Members also noted that the recent pick-up in global inflationary pressures could flow through to domestic inflation by more than expected.
Members commenced their discussion by observing that the US election result had driven developments in financial markets over the past two months. Market adjustments had been orderly and most measures of market volatility had remained low.
Financial market participants had generally viewed the new US administration's policies on corporate taxes, infrastructure spending and deregulation as positive for US growth, contributing to a further rise in Treasury yields and US share prices. Bond yields and share prices had already been moving higher since mid 2016 in response to the improved outlook for global growth and inflation. More recently bond yields had declined somewhat.
There had been similar movements in bond yields and share prices across the major economies, with the exception of government bond yields in Japan, which had remained around 0 per cent, consistent with the policy of yield curve control being implemented by the Bank of Japan (BoJ). Also, in contrast to the other major economies, inflation in Japan had eased over the past year.
Members observed that most financial market measures of market volatility had remained low, despite measures of global policy uncertainty having risen to a high level. Meanwhile, the adjustments to financial market prices in emerging markets had been relatively contained, with the exception of large currency depreciations and increases in bond yields in Mexico, which is most exposed to any changes in US trade policy, and Turkey, reflecting domestic developments. Brazil and Russia had experienced exchange rate appreciations, largely reflecting higher commodity prices.
The Federal Open Market Committee (FOMC) had raised the federal funds rate by 25 basis points in December, and members of the FOMC had revised up their projections for the pace of future rate increases, citing positive labour market and inflation developments. Financial market participants' expectations were that the federal funds rate would be increased by more than previously thought, but a slower pace of increase was expected than indicated by the FOMC.
The BoJ had left monetary policy unchanged since instituting its yield curve control framework in September 2016 and asset purchases had continued at around the same pace. The European Central Bank had made some adjustments to its policy stance, which remained very stimulatory.
Members observed that euro area government bond spreads to German government bonds had increased, particularly in Italy and France, due to political developments.
In nominal trade-weighted terms, the US dollar exchange rate had been appreciating since mid 2016 in line with positive economic data; it rose significantly following the US election. However, over the prior two months it had been little changed. The Japanese yen had also been little changed in nominal trade-weighted terms since the December Board meeting, while the euro had been broadly steady since early 2016. The Chinese renminbi had appreciated against the US dollar during 2017, after depreciating over 2016, but had been relatively stable since mid 2016 in trade-weighted terms. Net private sector capital outflows had increased over the second half of 2016, prompting the Chinese authorities to take measures to limit outflows.
The Australian dollar had appreciated a little over the prior two months, supported by rising commodity prices.
Australian share prices had risen since the December Board meeting, in line with developments in international markets. In addition, higher commodity prices had supported increases in prices for resource stocks. Price-to-earnings ratios for Australian stocks had declined to be a little above their average since 2003.
Australian banks' bond issuance in 2016 had reached its highest level in a few years and had been at a longer-than-average tenor. Issuance had continued at a strong pace in 2017. The cost of new wholesale debt had risen, but was close to the cost of outstanding issuance for both short- and long-term debt. The composition of banks' funding had continued to shift towards domestic deposits and away from short-term debt ahead of the introduction in 2018 of the Net Stable Funding Ratio. Banks had used differences in deposit rates to encourage growth in longer-term deposits.
Over recent months there had been a small increase in variable housing lending rates for investors in housing, but little change in overall lending rates for owner-occupiers and in business lending rates. Over the prior year, the major banks had lowered lending rates by a little less than the decline in the cash rate.
Members noted that financial market pricing indicated that market participants expected the cash rate to remain unchanged at the February meeting.
Considerations for Monetary Policy
In considering the stance of monetary policy, members viewed the near-term prospects for global growth as being more positive, although recognised the risks from policy uncertainty in the medium term. Stronger growth had contributed to higher inflationary pressures, including higher commodity prices, which had implications for the future stance of monetary policy in the advanced economies in coming years. Long-term bond yields had moved higher in many advanced economies.
Domestically, the economy was continuing its transition following the end of the mining investment boom. The fall in GDP in the September quarter had reflected some temporary factors. Looking forward, resource exports were expected to make a significant contribution to growth over the forecast period and the drag on growth from falling mining investment was expected to wane. The depreciation of the exchange rate since 2013 had also assisted the economy in its transition following the mining investment boom. An appreciating exchange rate would complicate this adjustment. Consumption growth was expected to be stronger than the subdued outcomes in the middle of 2016, supported by low interest rates. However, the increase in consumption growth was expected to be limited given the forecast for subdued growth in household incomes. Non-mining business investment was also expected to gain some momentum. The outlook continued to be supported by the low level of interest rates.
Labour market outcomes had been mixed and, as a result, there was uncertainty about the momentum in the labour market. The unemployment rate had increased slightly at the end of 2016, but full-time employment growth had increased, having fallen throughout most of the year. The unemployment rate was forecast to edge lower, which implied that spare capacity would persist in the labour market for some time.
Conditions in housing markets varied considerably across the country. Housing prices and rents had been falling in Perth and there were signs that the significant increase in the supply of apartments had begun to affect prices and rents in Brisbane. In contrast, activity in the established housing market had picked up in Sydney and Melbourne in the second half of 2016, and investor credit growth had increased. Supervisory measures had strengthened lending standards and some lenders were taking a more cautious attitude to lending in certain segments.
Inflation outcomes for the December quarter were much as had been expected and there had been very little change to the forecast for inflation. Labour cost pressures were expected to build gradually from their current low levels as spare capacity in the labour market diminished and the effect of heightened competitive pressures on retail prices eased. Medium-term inflation expectations had remained well anchored and inflation was expected to increase gradually.
Taking account of all the information available, including the updated forecasts, an assessment of the risks affecting these forecasts and the level of the cash rate, the Board judged that holding the stance of policy unchanged would be consistent with sustainable growth in the economy and achieving the inflation target over time.
The Board decided to leave the cash rate unchanged at 1.5 per cent.