Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Brisbane – 5 September 2017

Members Present

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

Members granted leave of absence to Carol Schwartz AM in terms of section 18A of the Reserve Bank Act 1959.

Others Present

Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Ivan Roberts (Head of Asian Economies Research Unit, Economic Research Department)

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

Domestic Economic Conditions

Members commenced their discussion of the domestic economy by noting that labour market conditions had continued to improve, although spare capacity remains. Employment had risen further in July, the participation rate had edged higher and the unemployment rate had remained steady at 5.6 per cent. Full-time employment had risen strongly over the preceding year (even though it had declined in July) and had outpaced the growth in part-time employment over that period. Members noted that the improvement in the labour market since late 2016 had been broadly based across the states. Forward indicators suggested that the improvement in labour market conditions was likely to continue. Members discussed current influences on the participation rate, noting in particular the rise in participation by older female workers as they delayed their retirement.

While unemployment rates in Queensland and Western Australia had remained high relative to earlier periods, employment growth in those states had risen, suggesting that the labour market adjustment to the earlier decline in the terms of trade and falling mining investment was progressing. In the context of a broader discussion of economic developments in Queensland, members observed that economic conditions in the state had generally strengthened over recent quarters, reflecting continued growth in consumption and, increasingly, a pick-up in business investment and public demand. Strength in tourism and other service industries had supported growth in aggregate demand in Queensland. In contrast, population growth had been below average, reflecting lower net overseas and interstate migration.

Members discussed the broad trends in activity by industry across the eastern states over the preceding decade or so. The cycle in mining activity and commodity prices, the spillover to related industries and the sustained strength in construction had dominated developments in Queensland. Members noted the increasing contribution to growth from the education and training sectors, particularly in New South Wales and Victoria, which had been supported by demand from overseas. The trend decline in manufacturing was evident across all states on the eastern seaboard.

The wage price index data for the June quarter confirmed that wage growth had remained stable at a low rate. Other data showed that wage increases in new enterprise bargaining agreements had remained below the average of current agreements. Members noted that these data were consistent with the Bank's forecast for growth in wages to remain low for some time, before picking up gradually in response to the strengthening labour market. The pattern of growth in wages across industries had broadly mirrored the pattern of employment growth, with higher outcomes in the healthcare and education sectors and lower wage increases in the mining and retail sectors.

Members were briefed on developments in the housing market. For Australia as a whole, after population growth had outpaced growth in the number of dwellings for much of the decade from the mid 2000s, the converse had been true in recent years. Although dwelling investment remained at a high level, members noted that building approvals had stepped down and the pipeline of residential construction work appeared to have passed its peak. In Western Australia, dwelling investment had declined significantly, while in Queensland it had declined from very high levels and the stock of work in the pipeline was being worked down gradually. Although a further substantial increase in dwelling investment was not expected, the large amount of work remaining in the pipeline in New South Wales and Victoria suggested that dwelling investment was likely to stay at a high level in the subsequent couple of years. In the eastern capital cities, a considerable number of new apartments was scheduled to be completed in the period ahead.

In the established housing market, a number of indicators suggested that conditions had eased in Sydney, but to a lesser extent in Melbourne. Housing price growth had slowed over 2017 in Sydney, but had remained strong in Melbourne. A similar pattern was evident in auction clearance rates, which had declined by more in Sydney than in Melbourne. Auction volumes had also remained relatively low in Sydney. Rent increases had remained low in most cities and rents had continued to decline in Perth.

Members noted that the national accounts for the June quarter would be released the day after the meeting and that an increase in the quarterly growth rate of GDP was likely. Solid growth in retail sales suggested that household consumption growth was likely to have risen in the June quarter. However, retailers had discounted prices to achieve sales, which meant that growth in nominal retail sales had been more modest.

Non-mining business investment was expected to have increased in the June quarter, based on recent data. Forward-looking indicators such as capacity utilisation and investment intentions from business surveys suggested a further pick-up was in prospect, consistent with the Bank's forecast for growth in non-mining investment to strengthen gradually. Non-residential building approvals had picked up strongly over preceding months and non-mining investment intentions for 2017/18 reported in the ABS capital expenditure survey had been revised upwards. The data still pointed to modest growth at best, but the survey covers only around half of non-mining investment; growth in investment in the other parts of the non-mining sector, such as education and health, had been stronger.

Mining investment was expected to have declined in the June quarter and the capital expenditure survey pointed to a further, but moderate, fall in 2017/18 as expected. Members noted that strength in public investment was expected in the subsequent couple of years, driven by the program of current and planned infrastructure projects.

Members also noted that profits in the mining sector had remained high, in line with commodity prices, despite a decline in the June quarter, and that profits in the non-mining sector had strengthened over the year to the June quarter, following earlier weakness.

International Economic Conditions

Turning to global economic developments, members noted that conditions in the world economy had remained positive, although inflation pressures remained subdued.

Members noted that GDP growth in the three largest advanced economies had picked up in the June quarter, driven by faster growth in business investment and continued strong consumption growth. Accommodative policy settings had helped sustain growth above estimates of potential for several years. The outlook for business investment had improved for all three economies and the outlook for growth in consumption remained positive in light of continued improvements in labour markets. Unemployment rates in the United States and Japan remained below estimates of full employment. Although spare capacity remained in the euro area labour market, unemployment rates had fallen in most countries and GDP per capita had been growing. Nevertheless, growth in wages had not increased materially in any of the major economies and core inflation remained low. In recent months, core inflation had been declining in the United States and Japan. Headline inflation rates had also declined, largely because of the earlier decline in oil prices.

In China, GDP growth had been a little stronger than expected over the first half of 2017, supported by generally accommodative policy settings. Strong growth in infrastructure investment had continued in July, and further sharp increases in crude steel production and electricity generation had continued to support imports of coal and iron ore from Australia. In the rest of east Asia, a pick-up in export growth as global demand strengthened had underpinned stronger domestic demand.

Members discussed the influence of China on the global iron ore and steel markets more generally. They noted that China was by far the largest consumer and importer of iron ore globally. This reflected the fact that China, with the world's largest population, had reached a similar level of steel production per capita to that of industrialised economies. Iron ore prices had been supported at higher levels because of sustained strong demand for steel in China. However, prices were expected to fall in the period ahead because of the ongoing expansion of global iron ore supply following an extended period of strong investment. Members also noted that Chinese steel production per capita was likely to be close to its peak and that growth in Chinese steel production would not add much to global demand for iron ore in the future. Members observed that, in the longer run, there was potential for India to have a noticeable effect on commodity markets as investment in residential construction and transport infrastructure increased.

Members discussed the challenges facing the Chinese authorities as they balance their commitment to short-term growth targets with their efforts to address medium-term risks arising from high and rising levels of debt in the Chinese economy. Members also discussed the Chinese authorities' progress in implementing structural reforms announced in 2013 at the Third Plenum. There had been progress on a number of fronts, including a broadened value added tax, some deregulation of interest rates and the relaxation of the one-child policy. However, the authorities' goal of allowing the market to play a ‘decisive role’ in allocating resources was still some way from being realised. In particular, state-owned enterprise reform had been focused on strengthening these firms and increasing the oversight of their activities by the Chinese Communist Party, rather than reducing the influence of state-owned firms in the economy. Members noted that the outcome of the 19th Congress of the Chinese Communist Party in mid October would affect the pace and focus of further reforms, and influence how the authorities address the tension between achieving short-term growth aims and managing the build-up of risks to financial stability associated with rising debt levels.

Financial Markets

Members commenced their discussion of developments in financial markets by noting that there had been a muted response in markets to rising tensions on the Korean peninsula. Overall conditions in financial markets had remained very accommodative and volatility had remained low over the preceding month.

Long-term government bond yields in the major financial markets had generally declined over the preceding month. US Treasury bond yields had reached the lowest level since the US election, in part reflecting continued uncertainty about the implementation of the administration’s policy agenda and lower-than-expected inflation data. While the Federal Reserve was widely expected to commence its balance sheet reduction later in 2017, market pricing indicated that the federal funds rate was not expected to be increased until the second half of 2018. Members noted that yields on US government bills that mature in early October had increased, reflecting concerns that US legislators might not raise the US debt ceiling in time to meet funding requirements.

The yield on Australian 10-year government bonds had changed little over the preceding month. The spread of Australian 10-year government bonds to US Treasuries had widened over recent months, which was also the case for spreads to US Treasuries of a number of other sovereign bonds.

Major share markets had declined a little over the preceding month, in part reflecting rising geopolitical tension.

Major market corporate bond spreads to sovereign bonds were around their lowest levels since the onset of the global financial crisis and overall funding conditions for companies remained favourable.

In foreign exchange markets, the US dollar had depreciated a little further in trade-weighted terms over the preceding month to be lower than before the US election. However, it was still well above levels at the end of the period of expansion of the Federal Reserve's balance sheet in 2014. In trade-weighted terms, the Japanese yen and the euro had been little changed over August, with the latter having appreciated over preceding months to be around late-2014 levels. The Australian dollar was little changed over August, in both US dollar and trade-weighted terms. The appreciation of the Australian dollar over the course of 2017 had, in large part, reflected a broadly based depreciation of the US dollar.

In China, tighter enforcement of capital controls by the authorities had contributed to a reduction in capital outflows in 2017 and had been accompanied by an appreciation of the renminbi against the US dollar. Bond yields had also increased since the end of 2016 in line with some tightening in financial conditions. Members observed that financial market conditions in China nevertheless remained accommodative overall.

In Australia, growth in housing credit had remained steady during 2017; slower growth in lending to investors had been offset by stronger growth in lending to owner-occupiers. Members observed that, while growth in housing lending by the major banks had slowed over 2017, growth in housing lending by smaller lenders had increased. This partly reflected the response of the major banks to the measures introduced by the Australian Prudential Regulation Authority (APRA) earlier in the year in relation to interest-only lending, which makes up a larger share of lending by major banks than by other lenders. Members also noted that loan approvals for new dwellings had continued to increase over 2017.

Average lending rates were estimated to have increased slightly over 2017, reflecting higher interest rates for investors and borrowers with interest-only loans. Members noted that the average interest rate on new variable-rate loans was estimated to be around 30 basis points below that on outstanding loans.

Overall, major banks' funding costs were estimated to have declined gradually over 2017. Combined with the increase in average lending rates, the implied spread between the average outstanding lending and funding rates for banks was estimated to have edged higher over 2017. Also, spreads for Australian residential mortgage-backed securities had declined over the prior year and issuance had been strong relative to the average of the post-financial crisis period.

Profits reported by Australian listed companies in August had generally increased compared with a year earlier, although they had been somewhat below expectations. Share prices across the major sectors were higher than a year earlier, particularly for resource companies, reflecting higher commodity prices.

Financial market pricing had continued to indicate that the cash rate was expected to remain unchanged throughout 2017, with some expectation of an increase in the cash rate by mid 2018.

Considerations for Monetary Policy

In considering the stance of monetary policy, members noted that the data received over the prior month confirmed that global economic conditions had strengthened since 2016. Labour markets had continued to tighten and above-trend growth was expected in a number of advanced economies. Growth in wages and inflation had generally remained subdued and core inflation had eased a little. In China, continued strong growth in infrastructure investment had supported demand for commodities, although medium-term risks associated with high and rising debt levels remained.

Conditions in global financial markets had generally remained very accommodative; long-term bond yields in the major financial markets had declined and volatility had been low. No further monetary easing was expected in the major economies and the US Federal Reserve was expected to raise the federal funds rate further in the period ahead.

Members noted that the Australian economy had grown at a below-trend rate over 2016/17. The data on domestic activity received over the prior month had, on balance, been positive and consistent with a gradual pick-up in growth as forecast. Members noted that conditions had been conducive to a pick-up in non-mining investment for some time and the latest data on investment expectations pointed to this occurring, which was a welcome development. The decline in mining investment was diminishing and strength in public infrastructure investment was expected. Residential investment appeared to have passed its peak, but was expected to remain at a high level for some time.

Employment growth had been broadly based across the states, suggesting that the adjustment to the end of the mining investment boom was nearing completion. Solid growth in employment was expected to continue, which would support household incomes and thus spending in the period ahead. Members acknowledged the risks to this scenario from growth in housing debt having outpaced the slow growth in household incomes over the preceding few years. Growth in wages and inflation had remained low but stable. This was expected to remain the case for some time. Nevertheless, a gradual increase in growth in wages and inflation was expected as the spare capacity in the labour market was reduced and the economy continued to strengthen, supported by the low level of interest rates.

The appreciation of the Australian dollar over recent months, driven in part by a broad depreciation of the US dollar, was weighing on domestic growth and contributing to subdued inflationary pressure. A further appreciation of the Australian dollar would be expected to result in a slower pick-up in growth and inflation.

Members noted that conditions in established housing markets had continued to vary considerably. There had been clearer signs of an easing in conditions in the Sydney market but less so in Melbourne, where prices had continued to grow strongly. Borrowing for housing had continued to outpace growth in incomes, although the composition had shifted towards owner-occupiers, with higher interest rates for investors in housing reflecting the ongoing effects of APRA’s recent measures to strengthen lending standards in this area.

Taking into account all of the available information, and the need to balance the risks associated with high household debt in a low-inflation environment, the Board judged that holding the stance of monetary policy unchanged 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.