Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 6 November 2007
GR Stevens (Chairman), R Battellino, KR Henry AC, JH Akehurst, JR Broadbent AO, RC Corbett AM, GJ Kraehe AO, DG McGauchie AO, WJ McKibbin
GL Debelle, ML Edey
DH Emanuel (Secretary), AL Dickman (Deputy Secretary)
The minutes of the meeting held on 2 October 2007 were approved.
Members were briefed on the latest inflation outcomes. The September quarter CPI had increased by 0.9 per cent in underlying terms, maintaining the relatively fast pace of the previous quarter. These increases had lifted underlying inflation to 3 per cent in year-ended terms.
The CPI had increased by 0.7 per cent in the quarter. The difference between this figure and the underlying rate was in the treatment of the childcare rebate reducing the CPI, with the net effect of other volatile factors roughly neutral in the quarter. The annual increase in the CPI was 1.9 per cent. As well as the effects of the childcare rebate in the latest quarter, this increase was held down by falls in petrol and banana prices over the past year. The year-ended increase in the CPI was expected to exceed 3 per cent by early next year as these passed out of the calculation.
The increase in the non-tradable items in the CPI, which was driven mainly by services prices, had been close to 4 per cent over the year to the September quarter, while year-ended inflation of tradables, which was driven mainly by goods prices, was well below 1 per cent. Some disinflation in tradable goods prices was expected as a result of the latest appreciation of the exchange rate, but the effect was likely to be mild. Non-tradables inflation was expected to strengthen further.
The staff forecast for underlying inflation, in the absence of any monetary policy tightening, was for it to rise to around 3¼ per cent in the next couple of quarters, after which it would gradually ease to just above 3 per cent by the end of 2008 and into 2009. The forecast for CPI inflation was for it to rise relatively sharply in the next two quarters, to around 3½ per cent, and then settle at a rate also just above 3 per cent by the second half of 2008. The forecast for an easing of inflation in a year's time was predicated on a softening in the growth of domestic and global demand and a dampening effect on prices from the appreciation of the exchange rate. Wages growth was expected to rise a little over the forecast period.
Domestic Economic Conditions
Members noted the recent changes to fiscal policy projections. At the time of the Australian Government's May budget, the surplus had been forecast to be around 1 per cent of GDP in 2007/08 and to rise gradually in subsequent years. Since May, parameter variations had suggested an increase in the surplus to around 2½ per cent of GDP over the period covered by the forward estimates. New expenditure and revenue measures announced since the budget and in the early part of the election campaign had since reduced the projected surplus to around 1 per cent of GDP. This meant that fiscal policy was roughly neutral in its overall effect on growth as conventionally measured, the recent initiatives having offset the ‘automatic fiscal stabilisers’.
Discussion then turned to the regular economic data releases.
Business conditions in the September quarter, according to the NAB survey, were higher than a year earlier and around the highest levels on record.
Credit growth had resumed its upward trend in the past few months due to the impact of business borrowing, which was now rising at 26 per cent on a six-month-ended annualised basis. The rate of growth of household borrowing, on the other hand, was at the low end of the range seen over the past decade.
Retail sales had increased by 8 per cent in nominal terms over the past year, up from the 6–7 per cent rate seen over the previous year or so. Retail sales had increased strongly in real terms in the September quarter. In a further sign of strength for consumer spending in the second half of the year, motor vehicle sales had continued to increase in the past few months, to be around 10 per cent higher than average levels in 2006.
Housing loan approvals and credit growth had both fallen since mid year, following a pick-up in the first half of the year. This may have been due to an easing in the demand for finance following the increase in interest rates in August, but the unwinding of the sharp superannuation-related increase in credit growth in June made it difficult to discern recent trends.
House prices had increased more strongly in the September quarter. The rises were broadly based, with particular strength over the past year in Melbourne, Brisbane and Adelaide. Auction clearance rates had remained at high levels in both Sydney and Melbourne in both September and October.
Housing construction had continued the weakness seen in recent years. The current level of commencements was below the underlying demand for dwellings, suggesting that there was an emerging build-up of excess demand. In due course, this could be expected to generate an upswing in housing construction, which would add to the growth in overall economic activity.
Conditions in the rural sector were weak. Estimates of wheat production in 2007/08 had been progressively revised down given the paucity of follow-up rainfall during winter, and the latest estimate was for only a modest increase on the level of production in the drought year of 2006/07. The recent rainfall in some cropping areas would have little effect on the wheat harvest, but could benefit summer crops. Members noted that two consecutive years of wheat production at such low levels had not been seen since the mid 1940s. Inflows into the Murray-Darling Basin, measured on the basis of two-year cumulative inflows, were the lowest on record. Farm output was now forecast to increase by only 4 per cent in 2007/08, following the 25 per cent fall in the previous year.
The run of positive labour market indicators had continued in September. Employment had increased at an above-average pace over the past year and the unemployment rate had declined. In confirmation that the labour market remained tight, business surveys indicated that the availability of suitable labour was the main factor constraining output, and this had become more important over the past year or so.
International Economic Conditions
Discussion of the world economy noted that since July there had been a downward revision of ½ percentage point to the forecast for global growth in 2008. Nonetheless, the forecast of 4¾ per cent was still well above the average of the past three decades. The composition of growth was skewed to the emerging economies, which were expected to grow at an above-average pace. In contrast, the G7 countries were expected to grow at a below-average rate for the second consecutive year.
The US economy had slowed since 2006, though the latest national accounts data had showed unexpectedly strong GDP growth in the September quarter; year-ended growth was moderate at 2½ per cent. Excluding the effect of the downturn in residential investment, GDP increased by 3 ½ per cent over the year to the September quarter. Activity in the housing sector remained weak, with leading indicators of activity and the stock of new houses falling further in recent months. There was little sign of a levelling out in the ratio of the stock of unsold houses to sales of houses. Despite the sharp downturn in the housing sector, other parts of the economy had been resilient and employment had recorded a strong rise in October.
Data on industrial production indicated that the pace of growth in the euro area had slowed over the past year. Indicators of consumer and business sentiment in the euro area had softened. Overall growth was expected to be moderate in the period ahead.
Growth in the Chinese economy had strengthened over the past year, which had provided a positive stimulus to other economies in east Asia. Year-ended GDP growth in Singapore and Korea had increased in recent quarters, and growth in industrial production in the east Asian region as a whole had increased steadily since the beginning of the year.
There had been further increases in commodity prices in the past few months. The price of a barrel of WTI crude oil was now well over US$90. While part of the latest increase reflected the depreciation of the US dollar, the oil price had also risen in SDR terms. Ongoing strong global demand for coal and iron ore, important bulk commodity exports from Australia, suggested substantial increases in contract prices were likely in 2008.
There had been large fluctuations in sentiment in financial markets during the past month, but on balance it had improved, helped by the policy easing by the US Federal Reserve.
The reduction in the fed funds rate of 25 basis points in late October had been fully anticipated by the market. The Fed's statement accompanying the policy easing indicated that the downside risks to growth were balanced by the upside risks to inflation. The market nonetheless continued to expect further cuts to the fed funds rate.
There had been no change in monetary policy in the other major economies, though Sweden had lifted interest rates. Monetary policy was being tightened in many emerging economies. In China, the required reserves ratio had been lifted further, as the People's Bank of China attempted to offset the increase in domestic liquidity arising from the accumulation of foreign reserves.
In capital markets, LIBOR spreads had come down for both the US dollar and euro, particularly for the one-month maturity. Spreads at the three-month maturity had also fallen but not to the same extent. Announcement of significant write-downs by some large investment banks had caused nervousness in markets. More write-downs were expected in the fourth quarter.
The improvement in sentiment had been more pronounced in Australia. Three-month bank bill and LIBOR spreads had fallen substantially from the peak levels reached at the height of the credit market disruptions. They were still above the lows prevailing in the past few years, though it was unlikely that market pricing would return to those low levels in the near term, as risk was now being priced more realistically.
Government bond yields in the major countries had fluctuated in quite a wide range over the past month, ending the month around the low end of the range. The spread between US and German yields had narrowed significantly.
The spread between Australian and US bond yields had risen considerably over the past few months, reaching over 190 basis points, the highest for some time. This suggested that markets perceived a significant difference in the outlook for the two economies.
Corporate spreads in the United States had been relatively flat over the past month, remaining around the levels prevailing after the start of the credit crisis. Notably, prime borrowers had faced lower funding costs in recent months because yields on Treasury instruments had fallen by more than spreads had risen.
Share prices globally had recorded reasonable gains in the past month, but gains in the larger markets were held back by weakness of financial stocks. Share prices in emerging markets had been particularly strong, notably in India, despite regulatory attempts to slow inflows of foreign capital, and in Indonesia. Chinese share prices had continued to rise very sharply.
In Australia, the performance of the financial sector, in particular the banks, stood in sharp contrast to that in the United States. Australian banks had reported strong growth in earnings in the half-year to September. No write-downs in asset values related to US sub-prime loans and structured debt were reported, as exposure to these instruments was negligible. The Australian share market had outperformed its international peers because of the strength of the resources sector and comparatively better performance of financial stocks. While there had been little change overall over the past month, the Australian market was about 18 per cent higher over the year to date, with resource stocks increasing by about 50 per cent over that period.
Margin lending in Australia fell in the September quarter. Margin calls had increased, but they were still low as gearing was quite conservative. These developments did not suggest investors were having any problems in meeting their obligations and, in any event, market indices had subsequently risen.
In foreign exchange markets, the main development over the past month was the further depreciation of the US dollar, which had reached record low levels in nominal and real trade-weighted terms, falling by about 12 per cent over the past year.
The renmimbi had also appreciated by about 5 per cent against the US dollar over the year, but in trade-weighted terms the effect of this appreciation had been approximately offset by the depreciation of the US dollar against other currencies. Attempts by the Chinese authorities to stem the rate of exchange rate appreciation against the US dollar had seen foreign exchange reserves rise to US$1.4 trillion.
The Australian dollar had appreciated further in October, but trading had remained volatile. The exchange rate had reached a new high both against the US dollar and in trade-weighted terms. Over the past year, the Australian dollar had increased by more than 10 per cent in effective terms and was higher against all currencies in the basket apart from the Canadian dollar. Members noted that movements in the Australian dollar had recently been highly correlated with general market sentiment towards risk.
Conditions in domestic credit markets had improved noticeably in October. As an indication of this, bond issuance had picked up, though mostly by financial institutions. Bond spreads had increased since the onset of the credit market disruption, and were about 20 basis points higher for top-rated borrowers. Issuance of residential-mortgage-backed securities had also increased recently, though the size of issues had fallen and spreads had widened. Bond issuance by corporates had been minor, perhaps indicating that these borrowers were looking to their bankers for funding, which would be consistent with the sharp growth in intermediated business credit in recent months.
Since the August cash rate increase, it was estimated that banks' funding costs had risen by an additional 15 basis points. This had been passed on to many business borrowing rates and most low-doc and non-conforming housing loan rates, but not to rates on standard variable mortgages.
Demand for exchange settlement funds at the Reserve Bank had declined as credit market conditions had improved, though it was still somewhat higher than the average level of recent years. The Bank was supplying enough to meet that demand, so as to keep the cash rate at the target.
In relation to Australian monetary policy, markets had moved immediately following the release of the CPI to fully price in a tightening at this meeting.
Considerations for Monetary Policy
The recommendation to the Board was for an increase in the cash rate of 25 basis points to 6.75 per cent.
In considering the recommendation, Board members agreed that on domestic economic grounds, the case for a further tightening of monetary policy was clear. Key data on demand and activity and prices all pointed to the likelihood of stronger medium-term inflationary pressures. According to the latest national accounts, all components of demand, apart from housing investment, were increasing strongly and economic activity had expanded at a pace well above average over the year to June. Available data suggested these trends had continued more recently. The labour market had tightened further and underlying inflation had risen to around 3 per cent.
Members noted that on a year-ended basis, inflation was expected to increase further in the near term. The staff's inflation forecast showed CPI and underlying inflation rising to above 3 per cent by mid next year, and there was a risk of inflation remaining above the target for an extended period. In discussing this outlook, members noted that strong investment was adding to productive capacity and the appreciation of the exchange rate was likely to have a dampening effect on prices. Nonetheless, if the recent pace of demand growth were sustained, there would be further pressure on the economy's productive capacity and the labour market, intensifying inflationary pressures over the medium term.
Members took note that parts of the world economy had become weaker in recent months and forecasts for the United States and other major industrial economies had been lowered, partly reflecting the likely effects of the tightening of capital market conditions since August. However, world growth was still expected to be above average in 2008, due to the growing importance of China and other emerging economies. Ongoing rapid growth in China, in particular, was stimulating the Australian economy, with the higher levels of commodity prices and the terms of trade lifting domestic incomes and underpinning strong growth in spending.
As in previous months, credit market developments in Australia and overseas were an important element in the Board's deliberations. Members noted that, although confidence in international credit markets remained fragile, market conditions had generally been more settled recently, with risk spreads narrowing from their peaks of a couple of months earlier. The disruptions from the tightening in credit conditions in the United States and other major economies were expected to play out over a protracted period and the extent to which they would moderate economic growth was uncertain. But the tightening of credit conditions in Australia had not been as pronounced as elsewhere and, in any event, local conditions had improved in recent weeks. Although interest costs in wholesale markets were still a little higher than a few months earlier, sound borrowers were still able to obtain finance readily.
In weighing all the information available on domestic and overseas economic conditions and developments in financial markets, members judged that, on balance, a further increase in the cash rate was needed to contain inflation to 2–3 per cent in the medium term.
The Board decided that the cash rate should be increased by 25 basis points to 6.75 per cent, effective the following day.