Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 4 March 2008
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), Ken Henry AC (Secretary to the Treasury), John Akehurst, Jillian Broadbent AO, Roger Corbett AM, Graham Kraehe AO, Donald McGauchie AO
Members granted leave of absence to Warwick McKibbin in terms of section 18A of the Reserve Bank Act 1959.
Guy Debelle (Assistant Governor, Financial Markets), Malcolm Edey (Assistant Governor, Economic), Philip Lowe (Assistant Governor, Financial Stability)
David Emanuel (Secretary), Anthony Dickman (Deputy Secretary)
The minutes of the meeting held on 5 February 2008 were signed.
International Economic Conditions
The Board's discussion on the world economy commenced with a briefing on the outlook for growth in the economies of Australia's trading partners. The staff forecasts, which had been published in the February Statement on Monetary Policy, were for a noticeable slowing in trading partner growth in 2008, reflecting a sharp fall in growth among the G7 economies and ongoing strength in the Asian economies. Trading partner growth was then forecast to rise slightly in 2009.
Turning to the United States, where there had been little new information on the real economy in the past few weeks, members noted that indicators of housing construction continued to fall sharply in January. The low level of activity had led to a fall in the stock of unsold new houses, despite the low level of current sales. In an indication of the likely feedback effects on incomes and spending from the weak housing market, year-ended growth in retail sales fell below 3 per cent in January and there were signs that business investment had also slowed. However, growth in the US economy was benefiting from higher exports, which were being stimulated by the low exchange rate.
Japan had recorded strong growth in the December quarter 2007, but this was likely to reflect data volatility, as business and consumer sentiment had fallen in recent months and retail spending had softened. Housing construction activity had experienced a significant downturn since mid 2007, triggered by the introduction of tighter safety requirements for buildings.
Growth in the euro area had slowed over the course of 2007, to a rate just over 2 per cent, which was around trend.
Members observed that, in contrast, recent GDP data for the smaller east Asian economies had been strong, with the year-ended pace of growth of 6 per cent at the upper end of the range of recent years.
Turning to an assessment of inflation in the Asian region as a whole, the latest data showed inflation in China of over 7 per cent, mostly because of rising food prices. Members noted that the recent pick-up in consumer price inflation had not been confined to China; inflation in other east Asian economies was now around 4 per cent. Monetary policy settings throughout the region remained expansionary, with interest rates becoming negative in real terms as inflation had drifted higher.
Commodity prices had risen strongly in the past few months. The Tapis crude oil price, which was the most relevant benchmark for Australia, had eased around the end of 2007 but since then had increased to over US$100 per barrel. Members felt that while various supply-side explanations had contributed to the short-term movements, the main underlying factor was a continuation of strong demand, as a result of the high rates of growth in particular parts of the world economy.
Domestic Economic Conditions
Before reviewing developments in the domestic economy, members noted that the national accounts for the December quarter were to be released the next day. They were briefed on the Bank's assessment that the data published so far on the main expenditure and income components suggested growth in GDP could be around ½ per cent in the quarter and around 3½ per cent over the year, assuming no revisions. Domestic demand was expected to have increased by over 5 per cent through the year. Data released during the meeting, showing that net external trade had subtracted significantly from growth in the December quarter, along with strong growth in public demand, were not regarded as having a material net effect on the forecast for output growth in the quarter.
Members then turned to their review of recent developments in the domestic economy and considered the information provided by the run of regular data releases, covering household consumption, the housing, business and external sectors, and the labour market and wages.
Retail sales had increased rapidly over the course of 2007. The data for January, which were released during the meeting, indicated that sales were flat in the month, though they had grown strongly over the past year. Strong growth in household disposable income, which was around 8 per cent in real terms over the year to the September quarter, had underpinned growth in consumption. Industry sources suggested that conditions in the retail sector had been mixed during February. Members noted that consumer sentiment had fallen in recent months and was now below average, though sentiment had not always been a reliable indicator of short-term movements in consumption.
Discussion then turned to developments in the housing sector. Housing construction was seen as providing a source of future growth in activity, as the current level of commencements was running well below estimates of underlying requirements, based on population growth and household formation, and vacancy rates were at record lows. Although the sharp fall in building approvals in December had unwound the previously apparent growth in approvals, members recognised that this might have reflected data volatility. They were informed that the Bank's liaison with builders indicated that conditions were not as weak as suggested by the December building approvals figures.
In the secondary housing market, house prices had increased relatively strongly on a nationwide basis over the course of 2007. However, growth in house prices in Perth had ceased, after prices had reached a high level, and house prices in some outer suburbs of Sydney continued to be weak. In the main auction markets of Sydney and Melbourne, which reflect sales activity at the upper end of the market, conditions had softened in February. Auction clearance rates had fallen noticeably in both cities, and were now a little below average in Sydney and about average in Melbourne, having been close to peak levels in that city in mid 2007.
Demand for housing finance was now easing somewhat, with the monthly rate of growth of housing credit having fallen from around 1 per cent in mid 2007 to around 0.8 per cent, on average, in the past several months. This was at the lower end of the range over the past decade. Loan approvals as a share of credit outstanding had also fallen since mid 2007.
In the business sector, members observed that the NAB survey for the month of January showed a divergence between business conditions and business confidence. The business conditions index, which reflected activity and sales, had remained well above average levels, though it had flattened out, while business confidence fell sharply and was now below average. The latter was a more subjective indicator, and the latest movement most likely reflected global financial problems and tighter financial conditions domestically. The Sensis survey of small and medium businesses continued to show that these businesses were more concerned about finding quality staff than a lack of work or sales.
Businesses planned to increase investment in the year ahead, according to the latest capital expenditure survey, and business credit growth had risen steadily over the past 12 months, to about 24 per cent per annum. Part of this increase reflected the process of reintermediation as capital market funding for businesses had dried up for all but the largest companies. But total provision of credit to the business sector had nevertheless accelerated.
Turning to the external sector, members were informed that import volumes were estimated to have increased strongly in the December quarter and over the course of 2007. The increases were associated with the rapid growth in domestic demand, as well as owing something to the higher exchange rate.
The Board examined trends in commodity prices, which were picking up again after a flat period in the middle of last year, and would again contribute significantly to growth in domestic incomes. They would also be a source of cost pressure for some businesses in Australia.
New contract iron ore prices for 2008, which in January had been expected to rise by around 40 per cent, were now likely to rise by at least 65 per cent, based on a recent Japanese settlement with a Brazilian producer. A similar pattern was emerging in the market for coal, where the current spot price was more than double the 2007 contract price. Part of the pressure on coal prices had come from Chinese demand, as China had recently switched to being a net importer of coal. Negotiations over the 2008 coal contract prices were yet to be completed. Base metals prices had also strengthened in the past few months, though they were some way below the peak reached in the first half of 2007. Prices of rural commodities had risen very rapidly recently; wheat prices had doubled over the past year.
Overall, sharply higher prices for the key exports of iron ore and coal would underpin the terms of trade, which were now expected to increase by 10–15 per cent around mid year, noticeably higher than the forecast presented in the February Statement on Monetary Policy. Thereafter they were expected to fall somewhat as global demand eased and the supply of a range of commodities picked up.
In their discussion of the labour market and wages, members observed that the tightness of the labour market was consistent with the strength of the economy. Employment had increased again, and the unemployment rate had fallen, in January.
After adjusting the wage price index for the timing of the 2006 minimum wage decision, wages growth on this measure had been steady at just over 4 per cent for the past three years. Other wage measures, including ordinary-time earnings and the national accounts measure of average earnings, were showing higher rates of increase, though preliminary indications were that the national accounts measure would moderate in the December quarter. Members considered it possible that there had been some upward drift in wages that had not been captured in the wage price index, though the variation in other wage measures did not allow a definitive conclusion. A concern was that higher inflationary expectations might influence future wage outcomes.
The revised inflation forecast prepared for the meeting was lower than that presented at the previous meeting, as it incorporated the effect of the cash rate increase in February and the higher exchange rate since then. CPI inflation was expected to be a little above 4 per cent in the short term. In the central forecast, both underlying and headline inflation were expected to be slightly below 3 per cent by mid 2010. The inflation forecast was premised on demand growth slowing sufficiently to reduce capacity pressures in the economy. Members recognised that these forecasts were subject to a high degree of uncertainty and that there were significant risks on both the upside and downside.
The Board's discussion of developments in financial markets commenced with share markets. Members noted that while global share markets had been more settled for most of the past month, following the sharp falls in January, a degree of weakness and volatility had re-emerged in the past few days and sentiment remained fragile. Prices of financial stocks had continued to fall in all share markets and there had been further announcements of write-downs, which appeared to have spread beyond exposure to the sub-prime sector. There were also ongoing concerns about the financial condition of the specialist bond insurers.
Turning to money markets, members noted that tensions in the US and European markets had recently re-emerged after a few months of relative calm. In the United States, market pricing anticipated a reduction in policy rates at the Federal Reserve's March meeting, and further reductions beyond that.
The European Central Bank had maintained its current policy setting at its recent meeting. Despite officials emphasising their concerns about inflation, the market expected a cut in the policy rate in the euro area in the coming month. Interest rates in Japan were unchanged. Elsewhere, further rate cuts were expected in the UK, and also in Canada, where a significant easing had been priced in by the market, given the linkages between the Canadian and US economies. The policy rate had been lifted in Sweden, though further increases were not expected.
In their discussion on exchange rates, members noted that the US dollar had fallen sharply against the yen and the euro, after a period of a few months in which the dollar appeared to have stabilised. The dollar had reached a new low against the euro and on a trade-weighted basis. The euro had continued to rise in foreign exchange markets and was now at a record high in real effective terms. The falls in the US dollar had been accompanied by increases in the renminbi exchange rate, though these had not been large enough to forestall a fall in the Chinese effective exchange rate. Members observed that the recently higher inflation rate in China implied there had been some appreciation of China's real exchange rate.
The Australian dollar had moved higher over the past month, supported by high interest differentials, strong economic data and increases in commodity prices. In trade-weighted terms, the exchange rate had increased by 4 per cent over the month and by 10 per cent over the past year. The increase against the US dollar over the year had been close to 20 per cent.
Spreads in the Australian money market had widened significantly over the past month. The spread between three-month bank paper and the expected policy rate was now above the peaks since last August. The Bank had increased exchange settlement balances in the past few weeks, but by a smaller amount than at the time of the rises in spreads in September and December, as the stresses in the overnight market had not been as evident as in the earlier episodes. Current market pricing indicated that a rise in the cash rate at this meeting, and a further tightening by mid year, was expected.
Members then discussed recent trends in bank funding. Access to funding had been readily available, and banks’ offshore issuance in the first two months of the year had been very large. Issuance had been in several major markets, particularly the US private placement market. There had been a large amount of domestic issuance as well. Spreads had widened further relative to swap rates, which had themselves risen.
As a result of the substantial increases in banks’ funding costs, members observed that lending rates across the spectrum of loan products had risen by more than the increases in the cash rate since mid 2007. The funding pressures had already been passed on to business lending rates, which were mostly linked to bank bill rates. It was likely that banks would pass on recent increases in funding costs to prime housing loan rates in the period ahead.
The latest available data showed that margin calls had picked up sharply in January, which had led to a large fall in margin debt outstanding. This had contributed to a fall in personal lending in January.
Considerations for Monetary Policy
The recommendation to the Board was for an increase in the cash rate of 25 basis points to 7.25 per cent.
Members viewed the standard macroeconomic considerations as continuing to suggest the need for further tightening. Growth in the world economy was likely to be below trend this year and next, but at the same time very strong rises in key commodity prices would lift the terms of trade noticeably, thereby providing an additional boost to domestic incomes. If anything, commodity prices looked stronger than previously. Labour market conditions had remained strong early in 2008 and reports of high capacity usage and shortages of suitable labour persisted. In the near term, inflation was likely to rise further in year‑ended terms from its already-high level. It would then probably moderate during 2009, in response to the forecast slowing in demand. There was some evidence, albeit tentative, that a slowing in private demand was starting to emerge, but its extent remained uncertain. Overall, the economy still faced a period in which inflation could be uncomfortably high. Members were mindful as well of the risk that further increases in inflationary expectations could influence future wage and price outcomes, which could complicate the task of reducing inflation. Hence, the question remained whether the current stance of monetary policy was sufficiently restrictive to bring inflation back towards 2–3 per cent over a reasonable period.
In judging the appropriate extent of further tightening, members also recognised that developments in financial markets in recent months, both overseas and in Australia, had increased funding costs for intermediaries by more than the effects of past and expected future policy changes. Prior to the meeting, 90-day market yields on private paper had reached around 8 per cent, up by about 150 basis points since the middle of 2007. Rates for borrowers from intermediaries were likely to rise by more than any increase in the cash rate, reflecting these higher funding costs. Members also noted the possibility of non-price tightening of credit terms, which, if it occurred, would add to the restraint imposed by higher interest rates.
On balance, members concluded that a further 25 basis point rise in the cash rate was necessary to restrain demand, in order to reduce inflation over time. As a result of this decision and earlier policy adjustments, and rises in borrowing costs that were occurring independently of changes in monetary policy, members saw the overall tightening in financial conditions since the middle of 2007 as substantial. They judged that the higher setting of the cash rate would leave adequate flexibility to respond as necessary over the months ahead to new information about prospects for economic activity and inflation.
The Board decided to raise the cash rate by 25 basis points to 7.25 per cent, effective 5 March.