Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 2 September 2008
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), Ken Henry AC (Secretary to the Treasury), John Akehurst, Jillian Broadbent AO, Roger Corbett AO, Donald McGauchie AO, Warwick McKibbin
Members granted leave of absence to Graham Kraehe AO in terms of section 18A of the Reserve Bank Act 1959.
Guy Debelle (Assistant Governor, Financial Markets), Tony Richards (Head of Economic Analysis Department)
David Emanuel (Secretary), Anthony Dickman (Deputy Secretary)
International Economic Conditions
The Board's discussion of the world economy commenced with an examination of conditions in the United States. GDP growth in the June quarter had been revised up to 0.8 per cent from the initial estimate of 0.5 per cent, with growth over the year now estimated at a little above 2 per cent. Growth had been boosted by exports, following the substantial depreciation of the US dollar. Although the tax cuts earlier in the year had supported consumption and allowed a rise in the saving ratio in the June quarter, the recent monthly data indicated falls in consumption in real terms in June and July. The housing sector had subtracted sizeably from growth over the past year. However, there was some evidence of a slowing in the rate of decline in house prices, house sales and housing starts, which suggested that the subtraction from growth from residential investment spending would ease.
Conditions in the US labour market painted a somewhat weaker picture of growth than the GDP data. Employment had fallen each month so far this year and the unemployment rate had risen significantly.
The run-up in oil prices around mid year had resulted in a sharp increase in the CPI in the United States in June and July, but the more recent falls in oil prices were expected to lead to a fall in CPI inflation. Similar trends were being seen in many other economies.
GDP data for the other major economies in the June quarter painted a consistent picture of slowing growth.
In the euro area, GDP had fallen, as the three largest economies had contracted. Confidence among consumers and businesses had fallen significantly over the past year, reflecting the effects of rapidly rising energy prices and negative news from the finance sector. There had been a similar pattern of slowing GDP in the United Kingdom, with essentially no growth in the June quarter.
The Japanese economy had contracted by about ½ per cent in the June quarter, with a broad-based slowing in growth to 1 per cent over the year.
In China, there had been a slight slowing in GDP growth to around 10 per cent on a year-ended basis. Although growth in industrial production and exports had fallen, reflecting softer demand in China's major trading partners, the retail sales data suggested there had been a pick-up in real spending since the start of the year.
GDP growth in India slowed in the June quarter, though growth over the year had remained robust at about 8 per cent.
In east Asia, weaker exports and slowing domestic demand resulted in a moderation in growth in the June quarter. The moderation had occurred in most of the economies of the region, where monetary policy was now being tightened in response to rising inflation.
Overall, members assessed growth in the major developed economies to be soft, while conditions in the larger emerging economies were slowing a little, but were still solid. They noted the staff estimate of growth in Australia's trading partners in the June quarter of around ½ per cent, and about 4 per cent over the year. External forecasts for growth of the world economy in 2009 were being revised down closer to the staff forecast published in the August Statement on Monetary Policy, which was for growth of 3¾ per cent for Australia's trading partners.
World oil prices had eased further over the past month, from a peak of around US$150 per barrel to a little below US$120 per barrel for Tapis crude, the relevant benchmark for Australian petrol prices. Members noted that the depreciation of the Australian dollar meant the full effect of lower US dollar crude oil prices was not being felt by Australian households.
Members discussed recent trends in spot commodity prices. The weakening world economy was weighing on commodity prices, with spot prices for coal and iron ore below the peaks reached in July. However, current spot prices for thermal coal were still well above the latest contract prices. Although refined metals and rural prices had fallen from the levels of a few months ago, rural prices in particular were significantly higher than the average of the past few years.
Prices and Wages
There had not been much new data on prices over the past month. Petrol prices had fallen significantly following the decline in the oil price, but the average of petrol prices in the September quarter to date still implied a small contribution to the September quarter CPI, assuming petrol prices remained at their current levels during the month of September.
Data on wages had been mixed. The wage price index had shown a relatively large 1.2 per cent increase in the June quarter, but this had followed a small increase in the March quarter and the year-ended rate of growth of 4.2 per cent was in the range of the past few years. Members observed that there had been a significant divergence in wage growth within sectors and states, and that measures capturing bonuses were running ahead of measures of base pay. Private-sector wages growth had drifted up to 4.3 per cent over the year to the June quarter, with this being offset by a fall in the growth of public-sector wages to about 3.8 per cent.
Other measures of wage growth from the average weekly earnings survey had not shown any evidence of upward drift, though these series had been highly volatile. Broadly, wage growth at present was seen as being at the upper end of the range in the inflation-targeting period.
Domestic Economic Conditions
Members considered the information provided by the run of regular monthly data releases, covering household consumption, the housing sector, the labour market and the business and external sectors.
There were no updated figures on retail spending from those discussed at the previous meeting, which had shown weakness over the year to June. Liaison with retailers conducted by the Bank's staff suggested that activity in the retail sector was somewhat stronger on average in July and August. However, there was considerable variation among types of retailers and retail spending overall remained subdued. Another monthly indicator of consumption was motor vehicle sales. These figures had clearly slowed since the start of the year and the recent weakness did not appear to be purely due to the changes in the luxury car tax. Consumer sentiment had increased modestly in August, after earlier steep falls to well below average levels.
In the housing sector, data on building approvals for July, which were released during the meeting, indicated no change in the current downward trend in housing activity. Information on house prices suggested that average nationwide prices had fallen over the three months to July. Other indicators of activity in the secondary housing market had remained subdued.
Housing loan approvals continued to slow in July and housing credit expansion was now running at about 0.5 per cent a month. A broader measure of household credit also showed subdued growth, at an annualised pace of 5 per cent.
Turning to the labour market, members observed that, despite year-ended growth of employment of 2.4 per cent, the run of monthly data suggested a weakening trend. The unemployment rate, at 4.3 per cent in July, was now a little above the low point seen earlier in the year. Newspaper job advertisements had been falling for several months and internet vacancies had also begun to ease, though the labour market was still tight given the high level of vacancies.
On the business sector, members observed that the NAB survey suggested that overall business conditions had now fallen from peak levels to below average. The more subjective measure of business confidence remained well below average. Capacity utilisation had eased, but was still at a high level.
Growth in lending to businesses remained weak. In recent months total business debt had been rising at an annualised rate of about 5 per cent, which was a significant slowing from the experience of the previous few years. Members observed that the pick-up in borrowing from banks in the latter part of 2007 was partly a result of financial reintermediation owing to the credit crisis, but was also boosted by new lending to fund mergers and acquisitions deals that had been announced earlier in 2007. Growth in lending to large businesses from foreign-owned banks had slowed by more than lending by domestically owned banks.
A large rise in export receipts in the June quarter, which mainly reflected higher prices for key commodity exports, had led to a modest trade surplus in that quarter. Some further increase in export prices was expected in the September quarter as the recent price increases were fully passed through. As a result of the developments in the trade balance, the current account deficit narrowed significantly in the June quarter.
Profits of non-financial companies had increased strongly in the June quarter, especially in the mining sector. Preliminary estimates suggested that business investment had risen solidly in the June quarter. The latest capital expenditure survey indicated that investment intentions among businesses for 2008/09 had risen strongly, in mining as well as other sectors, to be well ahead of similar estimates made a year earlier. These intentions suggested a very large rise in nominal spending on investment in the current financial year, though the results of this survey were usually associated with a high degree of uncertainty. Taken at face value, there would be a further increase in the already-high share of investment in GDP, which was difficult to reconcile with confidence measures from other business surveys. One possibility was that many business surveys underweighted the importance of the mining sector in the overall economy at present, but it was also possible that investment intentions might be scaled back over the course of the year.
With the national accounts for the June quarter to be released the next day, discussion on the domestic economy concluded with members being briefed about the partial data released in the few days prior to the meeting and during the meeting. These data pointed to a modest rise in GDP in the quarter.
A major development in financial markets over the past month was the appreciation of the US dollar from its recent historic low levels, which had been reached after several years of depreciation against the other major currencies. There was no simple explanation for the reversal in the US dollar exchange rate, though US economic data had been more positive than those in other G7 countries and, with expectation of policy tightening in the United States and easing elsewhere, interest differentials were shifting in favour of the US dollar.
Taking a longer-run perspective on exchange rate movements, members observed that the US dollar remained at low levels; although it had risen by about 5 per cent over the past month, it was still lower against the currencies of most of the United States' trading partners over the past 12 months.
Members noted that Asian currencies were generally lower over the past month and the authorities in some countries had intervened further to support their exchange rates. The Korean won, in particular, had experienced a sharp depreciation in an environment of uncertainty about the outlook for the Korean economy. The renminbi had moved little against the US dollar in net terms over the past month, but had appreciated against the yen and euro and most other currencies, including those in the Asian region.
A significant development in the Australian financial market had been the continued depreciation of the Australian dollar from the peak in mid July. The fall of 7 per cent in trade-weighted terms in August was one of the largest monthly movements in recent years. The exchange rate had depreciated against all the currencies in the trade-weighted basket, though the depreciation against the euro and other European currencies had been relatively small. The depreciation had been driven by both changing market perceptions about relative interest differentials and the recent broad-based decline in commodity prices. Despite the recent movements, the Australian dollar was still a little higher in trade-weighted terms over the past year.
Share prices in the United States and Europe had not changed much over the past month, but equity markets were significantly lower in Asia, particularly China. In the United States, growth of corporate earnings over the year to the June quarter, excluding the financial sector, had been reasonable, though earnings of firms in the consumer discretionary sector had been weak, in line with the softening in US consumption spending.
In Australia, listed companies outside the financial sector had also recorded solid profit results for the first half of 2008 compared with the same period in 2007; a large fall in the profits of the broadly defined financials category meant that the profit result for the market as a whole over that period was only modest. Financials had been the worst performers in the Australian equity market over the past year, particularly complex leveraged structures holding infrastructure assets.
Members noted that credit concerns had remained elevated over the past month. The concerns had been manifested in credit default swap indexes remaining high, particularly for US bonds, prompted by continued uncertainty over the financial condition of the US mortgage agencies, Fannie Mae and Freddie Mac, and some large US investment banks, whose credit default swap premia had risen sharply in the past few months.
Issuance of mortgage-backed securities in the United States had virtually dried up, which had exacerbated the credit difficulties confronting the housing market; the only issuance of note at present was by the mortgage agencies.
Members noted that the increased credit concerns in bond markets had not been seen in movements in money market spreads for the US dollar and the euro; although these were largely unchanged in August, they remained relatively high. Corporate spreads had widened over the past month, including for highly rated bonds.
In reviewing market expectations for policy rates, members observed that there had been little change in the three major economies. The US Fed was still expected to tighten a little, while no change was expected in the euro area and Japan. However, expectations had moved towards lower rates in the next few months in Canada and the United Kingdom, and also in New Zealand.
In Australia, there had been a marked change in policy expectations over the past few months. Currently, the market expected a cut at this meeting and a couple more by the end of the year. The changing expectations had seen the 90-day bank bill yield decline by about 60 basis points over the past month. The spread between bank bill rates and the expected cash rate had declined, reflecting an easing in money market tensions. Bond yields had also declined over the past month.
Members noted that bond issuance by the major Australian banks had continued at a reasonable pace in August, including several issues offshore. A large amount of bonds was due to mature around the world in the next few months, which would lead to a considerable rise in global issuance and could put pressure on the costs faced by banks. In recent months, domestic bond pricing spreads at issuance had remained relatively high, but with the benchmarks for pricing having fallen, the cost of new issuance had been somewhat lower. There had been minimal issuance of residential mortgage-backed securities.
The banks had been bidding keenly for term funding. Deposit rates had been raised over the past year and banks had been offering particularly high rates on ‘specials’ in the past month. Despite this, the reduction in short- and longer-term funding costs had allowed banks to lower fixed lending rates on several products.
Considerations for Monetary Policy
The recommendation to the Board was for a reduction in the cash rate of 25 basis points to 7.0 per cent.
In considering this recommendation, members discussed the possible effects of the opposing forces confronting the domestic economy. The tightening in financial conditions, owing to increases in the cash rate and rises in the cost of funds in financial markets, together with higher oil prices, had worked to dampen demand and economic activity. Household sector spending was weak, with wealth having fallen and higher interest rates and tighter credit standards impinging on spending decisions. Business conditions had noticeably softened since the middle of the year and confidence and credit growth to both households and businesses was now quite modest. Indicators of capacity utilisation, while still high, had declined and there had also been some signs of an easing in labour market conditions.
But investment spending had been strong and surveys of investment intentions indicated it would rise further in the year ahead. Overall, the picture seemed to be one of weak consumption and strong investment, but with aggregate growth of demand slowing. Members noted also that there was still considerable stimulus to domestic activity coming from the external sector. The run-up in commodity prices had increased Australia's terms of trade, adding substantially to national income and capacity to spend. Looking ahead, however, the world economy was slowing and it was therefore unlikely that the external stimulus to Australia would be as strong in the year ahead.
In weighing these various factors, members concluded that the slowdown in demand the Board had been seeking was unfolding. A necessary precondition for a decline in inflation back towards the target was therefore in place, even though evidence for that decline would not be seen in the figures for some time. This outlook was predicated on continued restraint in wage demands, helped by some softening in labour market conditions.
Given that assessment, and that financial conditions had been quite tight – and had tightened a little further recently – the question then became at what point it would be prudent to move to a less restrictive setting of monetary policy. There were risks in easing too soon, since the evidence for the expected fall in inflation was still some time away. Moreover, as inflation needed to fall a significant way to be consistent with the target, policy could need to be on the restrictive side of normal for some time ahead.
However, there were also risks in waiting too long to have some easing of policy from a quite restrictive setting. In that event, demand could weaken more sharply than necessary. This would deliver a faster reduction in inflation, but at greater short-term economic cost.
Policy had to balance these risks. After considering all the evidence, the Board came to the view this balance was best achieved by reducing the cash rate at this meeting.
The Board decided to lower the cash rate by 25 basis points to 7.0 per cent, effective 3 September.