Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Sydney – 6 June 2017

Members Present

Philip Lowe (Governor and Chair), Guy Debelle (Deputy Governor), John Akehurst, Kathryn Fagg, John Fraser (Secretary to the Treasury), Ian Harper, Allan Moss AO, Carol Schwartz AM, Catherine Tanna

Others Present

Michele Bullock (Assistant Governor, Financial System), Christopher Kent (Assistant Governor, Financial Markets), Alexandra Heath (Head, Economic Analysis Department), John Simon (Head, Economic Research Department)

Anthony Dickman (Secretary), Andrea Brischetto (Deputy Secretary)

International Economic Conditions

Members commenced their discussion of international economic developments by noting that global economic conditions had continued to improve in 2017, although headline inflation had eased a little in most economies and core inflation remained low.

Survey measures of business conditions in both the manufacturing and services sectors had improved since mid 2016 in a range of countries, and global consumer confidence had increased markedly to a high level. Members noted that global consumption growth had remained steady at a solid rate and had underpinned growth in the world economy over recent years.

The improvement in global economic conditions had been evident in stronger growth in both merchandise trade and industrial production. Data on new export orders suggested continued strong growth in exports in the near term. Members observed that there had been some signs that this strength was flowing through to business investment, particularly in Japan and the high-income economies in east Asia. Business investment had also picked up recently in the United States. Members also noted that a more broadly based strengthening in business investment would assist in generating a self-sustaining positive dynamic in the world economy.

In China, growth in private fixed asset investment had been slowing for some time from very high rates. This reflected structural factors, as growth rebalanced in line with the maturing of the Chinese economy, as well as cyclical factors more recently. Members noted that dwelling investment had picked up over the preceding year or so, partly in response to an easing in housing policies in 2015. The recovery in residential construction had continued despite the Chinese authorities having again tightened policy measures aimed at reducing speculative activity in a number of cities to contain rapid housing price growth.

Spending on property construction, as well as infrastructure investment, in China had supported the demand for steel and, in turn, Chinese imports of iron ore and coal. This strength in demand had been reflected in Chinese steel prices, but iron ore prices had declined, as expected, largely reflecting increases in supply. Coal prices had also declined recently, as supply disruptions associated with Cyclone Debbie had been resolved.

Globally, headline inflation had picked up over the preceding year, largely reflecting higher oil prices. However, members noted that this inflationary impulse had started to dissipate as oil prices had fallen since the start of the year. Core inflation had generally remained low.

Unemployment rates in many major advanced economies had been around or below levels that could be associated with a build-up in wage pressures. Wage growth had been increasing gradually in the United States and Japan, but an increase had not been as apparent in most European countries. Taking into account the low rate of productivity growth generally, growth in unit labour costs had been above average in the United States, Japan and Germany.

Domestic Economic Conditions

Members commenced their discussion of domestic economic conditions by noting that the March quarter national accounts, which were scheduled for release the day after the Board meeting, were likely to show that GDP growth had moderated following the strong December quarter outcome. Partial indicators had suggested that slower growth in consumption and falls in residential investment and resource exports were likely to be recorded in the accounts. However, nominal output growth was expected to have been supported by the strength in the terms of trade during the quarter.

Weak growth in retail sales in the March quarter had pointed to a slowing in consumption growth following strong growth in the December quarter. According to liaison and survey data, retail trading conditions had remained challenging, although they had appeared to have improved a little since the start of the year, and this assessment had been supported by the large rise in retail sales in April. Low household income growth and concerns about increased indebtedness had continued to pose downside risks to the outlook for consumption growth.

The labour market was an important factor in the outlook for household income growth. Employment growth had picked up over 2017 and forward-looking indicators of labour demand suggested that the recent pace of employment growth was likely to continue. However, growth had continued to be disproportionate, with part-time jobs and total hours worked having fallen in prior months. Members observed that, although the unemployment rate had fallen to 5.7 per cent in April, the number of employed people who would like to work more hours had not declined.

Members noted the divergence in labour market developments across the states, although the degree to which this was consistent with other indicators of economic conditions across the states varied. In particular, the steady growth in hours worked in Victoria, in line with the state's strong economic growth, was in contrast to the fall in hours worked over the previous year or so in New South Wales, which had also posted relatively strong economic growth. The pick-up in hours worked in Western Australia and, more recently, Queensland suggested that the drag from the adjustment to the downturn in mining investment in those states might be running or have run its course.

Members also discussed conditions in the youth labour market, which historically has been very sensitive to changes in labour market conditions more generally. In particular, members noted that the proportion of 15–19 year olds not in education, training or employment had been declining over recent years, while the proportion of 20–24 year olds not in education, training or employment had been increasing.

The wage price index had increased by 0.5 per cent in the March quarter, suggesting that aggregate wage growth had stabilised at low levels. Wage growth had remained particularly low in the mining sector. Liaison suggested that, while wage growth is likely to remain subdued for some time yet, there had been isolated reports of localised and skills-specific labour shortages feeding into higher wages.

Work done on residential construction had posted an unexpected fall in the March quarter. Members noted that this was partly explained by wet weather in some states during this period, suggesting some recovery could be expected in the June quarter. In contrast, there had been further falls in construction in Western Australia, which was consistent with the persistently weak conditions in that state's construction sector. The outstanding pipeline of work had remained high in most other states and was expected to support residential building activity over the forecast period. However, building approvals had fallen across most states since late 2016, particularly for higher-density dwellings, and the pipeline of work to be done was likely to decline over the forecast period.

Conditions in the established housing market had continued to vary across the country. Conditions remained strong in Sydney and Melbourne, although there had been some tentative signs of easing; housing price growth and auction clearance rates in both cities had declined. In contrast, housing market conditions had been weaker elsewhere for some time, particularly in Perth and in the Brisbane apartment market, where housing prices had been declining.

Housing credit growth overall had been relatively steady in recent months. Some slowing in the growth of credit to investors in housing had been apparent, which was consistent with the reduction in loan approvals to investors. This had been associated with the increases in interest rates on these loans and in interest-only loans more broadly. Members noted that it would take some time for the full effects of the latest prudential supervision measures introduced by the Australian Prudential Regulation Authority (APRA) to flow through to the housing lending data.

The ABS survey of capital expenditure suggested that mining investment had increased slightly in the March quarter, in contrast to the forecast by the Bank of a further decline at the time of the May Statement on Monetary Policy. In line with the Bank's forecasts, however, the capital expenditure survey continued to suggest further falls in investment in the mining sector over the coming year or so, but at a declining rate. Growth in non-mining investment was also expected to have increased in the March quarter, mainly due to an increase in non-residential construction.

The capital expenditure survey continued to imply subdued growth in non-mining investment for the next year or so. However, members noted that this survey covers only around half of non-mining investment and excludes investment in areas such as health and education, and in intangible assets, such as software, for which investment growth had been strongest in recent years. Furthermore, monthly building approvals for non-residential construction had picked up a little in recent months and reports from liaison had identified a range of commercial property projects that are under consideration for the year ahead. Members also noted that survey measures of business conditions had risen further, to be around their levels before the financial crisis. However, surveys suggested that conditions in the retail sector remained difficult, despite a recent improvement, consistent with reports of heightened competition in that sector.

The Australian Government Budget had reported little change to the expected cash deficits over the next few years and, as a result, had had little effect on the Bank's near-term outlook for the Australian economy. Some new large infrastructure projects had been announced as a part of the Budget, but most of that spending would occur after 2019.

Financial Markets

Members observed that financial markets had remained relatively quiet over prior months and political developments had continued to be a key focus of market participants over the preceding month. Financial conditions had generally remained very accommodative, with the exception of China, where the authorities had acted to reduce leverage in the financial system.

Long-term government bond yields in the United States had declined a little over the preceding month, to be at the lower end of the range experienced since the US election, as uncertainty remained about the near-term implementation of the administration's policy agenda. Long-term bond yields in other major markets had been little changed over the preceding month. In Australia, yields on long-term government bonds had declined a little over the preceding month and the spread to US Treasury bond yields had remained at low levels.

Members noted that estimates of the term premium in the United States had been at historically low levels for most of the preceding six years, including some negative estimates at times. The low level of the term premium implied that market participants were generally not concerned about the prospect of a sharp rise in either inflation or real interest rates, and/or that compensation for these risks was low for other reasons, including possibly the lack of suitable alternatives for a number of market participants to investing in long-term US government securities.

The major central banks had left policy settings and the nature of their policy guidance largely unchanged since the previous meeting. The minutes of the previous US Federal Open Market Committee meeting had highlighted that the Federal Reserve was likely to begin shrinking its balance sheet gradually later in 2017. The European Central Bank had earlier slowed its rate of asset purchases and was expected to reduce it further in 2018. The Bank of Japan was expected to continue with its asset purchase program.

In foreign exchange markets, the US dollar had been little changed on a trade-weighted basis over the preceding month and was around its level immediately before the US election. The euro had appreciated a little further since the previous meeting, in response to an easing of political risks following election outcomes and generally positive economic developments. The Australian dollar had depreciated a little over the preceding month on a trade-weighted basis, consistent with the decline in commodity prices.

After several years of depreciation in the renminbi against the US dollar and net private capital outflows from China, the exchange rate of the renminbi against the US dollar had stabilised since the end of 2016, although it had appreciated a little very recently. At the same time, net capital outflows had declined markedly as the authorities had increased their scrutiny over capital flows. Members noted that the People's Bank of China had recently adjusted the daily fixing mechanism for the exchange rate.

Members noted that global financing conditions had remained generally favourable, with corporate bond yields having declined in most major economies and emerging markets, as well as in Australia, over the preceding month.

In contrast to developments elsewhere, in China sovereign and corporate bond yields had risen further in response to measures aimed at reducing leverage in the financial system and improving the transparency of investment products. One consequence of these actions had been reduced demand for corporate bonds and hence issuance of these bonds had declined noticeably. Members observed that household credit growth in China had continued to rise.

Major share markets had been increasing over 2017 to date, but banks' share prices had generally declined over prior months. In the United States, these falls had reflected the market's changing expectations about implementation of the US administration's policy agenda and, in Japan, bank share prices had declined following lower-than-expected corporate earnings.

Australian share prices had declined over the preceding month, to return to around their levels at the end of 2016. The decline had been driven by a sizeable fall in bank share prices. Members noted that some part of this reflected the fall in bank share prices in global markets, but that there had also been a range of domestic factors contributing to the fall, including somewhat mixed bank profit results relative to expectations and the announcement of a major bank levy in the Australian Government Budget. In the days following Standard & Poor's announcement lowering the ratings of a number of smaller Australian financial institutions, equity prices of these institutions generally fell relative to those that had not been downgraded. Members noted that the magnitude of the major bank levy was not particularly large compared with typical market movements in bank funding costs. They also noted that there was likely to be some effect of the rating downgrade on the cost of wholesale funding for smaller financial institutions, but these institutions accessed less wholesale funding than the major banks. More broadly, bank funding costs were estimated to have declined a little further in recent months.

Financial market pricing continued to indicate an expectation that the cash rate would remain unchanged over the remainder of 2017.

Considerations for Monetary Policy

Members discussed how financial stability considerations bear on monetary policy decisions, reviewing both the academic literature and policy experience in a number of countries, including Sweden and the United States.

The Bank has responsibility for promoting financial stability within its flexible medium-term inflation targeting framework. Over recent times, with interest rates at low levels, the Board has set monetary policy to support the economy in its transition following the mining investment boom, while also paying close attention to trends in household borrowing and related financial stability considerations. Members discussed the effect of monetary policy decisions on financial stability and on future inflation, employment and output. They also discussed the role that prudential supervision can play in promoting financial stability. In view of this, members acknowledged the importance of a strong relationship between the Bank and other regulators, particularly APRA. They observed that the current positive culture of cooperation across the relevant agencies in Australia has been of considerable value to good policy outcomes in recent years and it is therefore important that it be maintained. The strong relationship among regulators is facilitated by the Council of Financial Regulators, which is the coordinating body for the main financial regulatory agencies to promote the stability of the Australian financial system, as well as contribute to the efficiency and effectiveness of financial regulation.

Turning to the immediate decision regarding the level of the cash rate, members noted that the broad-based pick-up in the world economy was continuing. Labour markets had tightened further in many countries and this was expected to lead to a pick-up in wages and prices over time. Headline inflation rates in most countries had moved higher over the past year, partly reflecting higher commodity prices. Nonetheless, core inflation had remained low.

Domestically, members' assessment was that the transition to lower levels of mining investment following the mining investment boom was almost complete. Surveyed business conditions had improved and business investment had picked up in those parts of the economy not directly affected by the decline in mining investment. Although year-ended GDP growth was expected to have slowed in the March quarter, reflecting the quarter-to-quarter variation in the figures, members noted that economic growth was still expected to increase gradually over the next couple of years to a little above 3 per cent per annum.

Members noted that, although employment growth had been stronger in recent months, growth in total hours worked had declined. Nevertheless, the various forward-looking indicators pointed to continued growth in employment over the period ahead and a gradual erosion of the spare capacity in the labour market. Wage growth had remained low and this was likely to remain the case for some time yet. However, wage growth and inflation were expected to increase gradually as the economy strengthened. Members observed that low growth in incomes, along with high levels of household debt, appeared to have been restraining growth in household consumption.

The economic outlook continued to be supported by the low level of interest rates. 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.

Conditions in the housing market had continued to vary considerably around the country. Housing prices had been rising briskly in some markets, although there had been some signs that price pressures were starting to ease. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. Growth in housing debt had outpaced the slow growth in household incomes. APRA's recent prudential supervision measures should help address the risks associated with high and rising levels of indebtedness. In response to those measures, increases in mortgage rates, particularly for investors and interest-only loans, had been announced, but were yet to have their full effect.

The Board continued to judge that developments in the labour and housing markets warranted careful monitoring. Taking into account all the available information, including that year-ended growth in output was expected to have slowed in the March quarter, the Board judged that holding the accommodative stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

The Decision

The Board decided to leave the cash rate unchanged at 1.5 per cent.