Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 5 February 2008
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), John Akehurst, Jillian Broadbent AO, Roger Corbett AM, Graham Kraehe AO, Donald McGauchie AO, Warwick McKibbin
David Gruen attended in place of Ken Henry AC (Secretary to the Treasury) in terms of section 22 of the Reserve Bank Act 1959.
Guy Debelle (Assistant Governor, Financial Markets), Malcolm Edey (Assistant Governor, Economic)
David Emanuel (Secretary), Anthony Dickman (Deputy Secretary)
The minutes of the meeting held on 4 December 2007 were signed.
Board members were briefed on the CPI data for the December quarter 2007. The quarterly outcome was relatively high at 0.9 per cent, which had lifted the year-ended inflation rate to 3 per cent. There had now been three consecutive high quarterly readings, with the year-ended rate likely to rise further as the price falls associated with falling fruit prices around the beginning of 2007 dropped out of the calculation. In underlying terms, taking an average of the trimmed mean and weighted median measures, year-ended inflation had increased to 3.6 per cent after a period where it had been stable at around 3 per cent.
Members took particular note that the increase in prices over the past two years had been broadly based. This was supported by the fact that, over that period, around 70 per cent of items in the CPI by weight had increased at an annual rate of more than 2.5 per cent. Prices of non-tradable items in the CPI had increased by 4½ per cent over the year to the December quarter, continuing the increase seen since mid 2007. Price rises of tradable items, which had generally been held down by international competition in goods markets and a period of exchange rate appreciation earlier in the decade, had picked up gradually over the past two years. Members discussed anecdotal reports of rising cost pressures in China, which might add to inflation in internationally traded goods. They concluded, however, that there was no evidence thus far that Chinese export prices, measured in renminbi, were rising.
International Economic Conditions
The discussion then moved to the world economy, starting with the United States.
Members were briefed that US GDP data for the December quarter 2007 indicated growth of only 0.2 per cent in the quarter and 2.5 per cent over the year. Excluding housing construction, year-ended growth was 3½ per cent, which suggested that, in 2007, other parts of the economy had remained resilient. Export growth, in particular, had been strong, helped by the depreciation of the US dollar.
The US housing downturn had continued in recent months. Indicators of activity, namely permits to build and housing starts, had fallen further and were approaching the low levels seen in the 1990/91 recession. Although the stock of new unsold homes was falling, sales were falling more rapidly, which implied that the ratio of stocks to sales was still rising. House prices had continued to fall, with the Case-Shiller index of repeat sales in 20 major cities now 9 per cent below the peak in 2006.
Members concluded that last year's divergence in economic conditions between housing and other parts of the economy was unusual, and it was likely that the weakness in the housing sector would spread to other sectors as growth in incomes and spending declined. Indicators of business confidence and labour market conditions had recently signalled weakness.
Members then noted that recent data in a number of other developed economies had also softened, though developing countries were continuing to do well.
In Japan, indicators of sentiment had declined, particularly for consumers and the small business sector. Elsewhere in Asia, growth in China exceeded 11 per cent over 2007 and there was only modest evidence of a slowdown in external trading activity. India had also continued to record high rates of GDP growth during 2007. In Korea, GDP growth had picked up to be more than 5 per cent over the course of 2007, which was around the highest rate seen over recent years. In those economies where recent GDP data were not yet available, industrial production had held up towards the end of 2007.
Growth in industrial production in the euro area had continued at a solid pace in the final months of 2007, though indicators of sentiment had declined significantly, notably among consumers.
Members examined the IMF's forecast of growth in world GDP in 2008, which had been reduced to 4.1 per cent, following growth of around 5 per cent in both 2006 and 2007. This outlook incorporated significant weakness in the G7 economies, while growth in the developing world was expected to remain relatively strong. The IMF regarded the risks to its latest forecasts as predominantly on the downside. Members noted that the Bank staff forecasts envisaged outcomes for the US and global economies in 2008 that were weaker than forecast by the IMF.
Domestic Economic Conditions
Members considered the national accounts for the September quarter 2007, which had been released the day following the previous Board meeting. GDP had increased by 1 per cent in the September quarter, in line with the forecast provided to the Board at the time, and by 4.3 per cent over the year, which incorporated net downward revisions to previous quarters. Various inconsistencies in the economic data that had been apparent a year or two earlier had faded away. The data from a range of sources were now providing a picture of strong growth in output and employment, with high levels of capacity utilisation.
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 business conditions, the household and business sectors, housing, credit growth, external trade, and the labour market and wages.
A measure of business conditions from the NAB survey indicated that conditions had remained strong in the December quarter 2007, in line with the preceding few observations.
Retail sales increased rapidly in November, and the December figures, which were released during the meeting, were again strong. Year-ended growth had drifted higher though most of 2007 and reached 8½ per cent by December. Sales growth in volume terms was strong for the second consecutive quarter, to be 5.7 per cent higher over the year, the highest rate since 2004. Strength in sales appeared to be concentrated among large retailers, whose sales were rising rapidly. It was noted, however, that consumer sentiment had fallen sharply in January.
There was extensive discussion of recent developments in household incomes and spending. Although the data were only to the September quarter 2007, they showed that consumption growth of around 4 per cent over the year had been supported by growth in real household disposable income of around 8 per cent, which was close to the peaks of this series. Adjusting real household disposable income for interest payments lowered the year-ended growth rate only slightly, despite higher debt levels and rises in interest rates over that period.
House prices increased further towards the end of 2007, with 3 per cent growth nationwide in the December quarter taking the increase for the year to 12 per cent. Solid growth in the quarter was recorded in all cities except Perth. House prices had reached a plateau in Perth following several years of very rapid growth. The increase in house prices in Sydney of 8 per cent over 2007 had been concentrated in the upper end of the market, with prices at the lower end of the market remaining flat.
In discussing the housing market, members noted that building approvals, after having been relatively flat at a level below estimates of underlying demand, had shown tentative signs of a pick-up in the months up to November. However, a large, broad-based fall in December had made the trend in these data difficult to read. It was possible that the decline in December was a response to tighter financial conditions, but it was too early to draw firm conclusions.
In contrast, the situation with business investment was very clear. Investment had increased by 10 per cent over the year to the September quarter, in a continuation of the strong growth recorded over the past five years. Mining investment was the fastest-growing sector. With investment having reached a high level measured as a share of GDP, substantial additions to the capital stock were in prospect, which would in time help to boost the economy's productive potential.
This strong investment had driven up demand for funds by the business sector. Business credit was growing at 24 per cent, the fastest rate in two decades. Part of the rapid pace of growth was, however, the result of a greater reliance on intermediated finance on the part of borrowers who were having difficulty accessing funds directly in capital markets following the credit crisis. Household credit growth was around 12 per cent over 2007, which was at the lower end of the range in the past decade. There were signs that the household sector was slowing its demand for finance in the face of higher interest rates. Overall, however, total credit growth had picked up towards the end of 2007.
Turning to the external sector, members observed that although base metals prices peaked early in 2007 and had declined by around 30 per cent since then, other commodity prices were still rising. Wheat prices, in particular, had increased very rapidly in the second half of 2007. As a consequence of the decline in base metals prices, the terms of trade had fallen somewhat in recent quarters. Members were informed that, with rises in new contract prices for coal and iron ore expected to be significant, the terms of trade were forecast to rise again in the first half of 2008. Thereafter, they were expected to drift lower, reflecting the effect of the expected slowing in world GDP growth.
The discussion of the labour market concluded that the market remained tight. Employment rose by 2½ per cent over the course of 2007, and the unemployment rate remained at 30-year lows. Job vacancies in the December quarter, measured as a share of the labour force, were at the highest level in 30 years. Despite the tight conditions in the labour market, the wage price index (WPI) had maintained a steady growth rate of around 4 per cent per annum. Another measure – average earnings per employee from the national accounts – suggested that there had been a noticeable pick-up in wage growth, though this indicator was subject to significant volatility.
The outlook for GDP and inflation prepared for the meeting incorporated a slowdown in non-farm GDP growth to 2¾ per cent by the end of 2008, with growth rising to 3 per cent during the following year. GDP growth was expected to be a little higher than that, reflecting the improved conditions assumed for the farm sector during 2008. The staff forecast for underlying inflation, in the absence of any monetary policy tightening, was for it to rise to around 3¾ per cent early in 2008 before gradually declining in response to the forecast slowing in both the world economy and Australia. It was still expected to be above 3 per cent by mid 2010. Year-ended CPI inflation was forecast to rise more sharply in the March quarter 2008, to around 4 per cent, owing to the passing out of the very low figure recorded a year earlier. After that, year-ended CPI inflation was expected to settle broadly into the same trajectory as underlying inflation. There were clearly identifiable risks on both sides of the forecasts for growth and inflation.
The Board's discussion of recent developments in financial markets focused on the continuing turbulence and negative sentiment since the previous meeting, characterised by large falls in global share prices, further write-downs by financial institutions and growing pessimism about prospects for the US and world economies. The falls in share prices had been broad based in terms of both the sectors and countries affected.
The latest data on the US mortgage market, which related to the September quarter 2007, showed a further large rise in delinquencies on sub-prime loans, to over 16 per cent, as well as a smaller rise in delinquencies on prime loans. A large number of interest-rate resets on sub-prime loans from the 2006 vintage were scheduled to come through this year, although the reduction in US official interest rates had lessened the impact on these borrowers.
To date, financial institutions had written off over US$120 billion in losses associated with the sub‑prime crisis. Much of this was by several of the largest US investment banks, whose capital had been replenished by capital injections from sovereign wealth funds in Asia and the Middle East. There were still concerns in the market about the capital position of ‘monolines’ and the attendant risk of ratings downgrades.
The Federal Reserve had reduced the federal funds rate by 150 basis points, to 3 per cent, since early December. This included a 75 basis point cut in an inter-meeting move in late January. The futures market was pricing in a fed funds rate of 2–2¼ per cent by mid year.
The European Central Bank had not adjusted rates and neither had the Bank of Japan. However, the Bank of Canada had lowered rates by 50 basis points, and markets expected further reductions. The Bank of England was also expected to cut rates at its meeting later in the week.
There had been a tightening of monetary policy in some emerging market economies, notably China, where the People's Bank of China had continued to tighten a range of policy instruments to combat high inflation.
In money markets, members noted that spreads between short-term rates and expected policy interest rates had risen sharply as the year-end approached, but eased just before the end of December, after a co-ordinated announcement by central banks of various measures to ensure the adequate provision of liquidity. These spreads had since fallen back further, but remained well above the levels prevailing prior to the onset of the credit crisis in August.
A similar pattern in short-term interest rates had been seen in Australia. The Bank had significantly increased exchange settlement balances towards the end of the year. Although some of this had since been reversed, balances remained above the levels prior to the credit crisis. Members were briefed on the marked change to the composition of the Bank's balance sheet in recent months, driven by a decline in government deposits and the switch in market operations from foreign exchange swaps to domestic repurchase agreements.
The continuing decline in US long-term bond yields had not been matched by the falls in yields in other bond markets. Bond yields in Australia were largely unchanged in the past few months, which meant that the spread to the US market was now at 10-year highs.
Spreads on US corporate paper had widened but, given the fall in government bond yields, the level of corporate yields was flat to down on investment-grade paper or better.
Turning to exchange rates, members' discussion noted that currency markets had been volatile in the past few months. The yen had appreciated and the euro had reached multi-year highs against the US dollar. However, the US dollar had appreciated against some other currencies over the past two months, which implied that the effective exchange rate was little changed, albeit around historical lows. The pace of appreciation of the renminbi had increased significantly in the final quarter of 2007, which was part of the policy response by the People's Bank to restrain inflation in China.
The Australian dollar had also traded in a relatively wide range in the recent period and closely tracked the changing sentiment in global financial markets. Average intraday volatility in January had been the highest in over a decade. Measured on the trade-weighted index, the Australian dollar was 2 per cent higher over the past two months and around 9 per cent higher over the past year.
The Australian share market had fallen since the start of 2008, following a strong performance in 2007. At one time it had been as much as 24 per cent below the recent domestic peak, but strong rises recently had almost halved the losses. Intraday volatility had been particularly high in the past month; large price movements in both directions had prompted a noticeable increase in margin calls, though leverage had been steady. Share price indices for the commercial banks in Australia had declined by a smaller amount than their peers in the United States since early 2007, but the falls in share prices of Australian investment banks had been of similar magnitudes to those of US investment banks.
Looking at developments in capital markets, members observed that corporate and asset-backed bond issuance remained extremely low in recent months. However, banks had continued to raise funds by issuing bonds both offshore and onshore. The cost of raising funds in capital markets had increased significantly compared with costs prevailing up to mid 2007. This had lifted banks' overall cost of funds.
Members noted that, while banks' costs had risen, they had been able to continue to expand their balance sheets. The major banks had stepped up their lending to offset reduced lending by intemediaries relying on securitisation for funding and by international investment banks. To date, they had been able to accommodate the increased loan demand by corporates that were facing limited access to capital markets. Members discussed the possibility that funding and capital constraints on banks might, at some point, result in their restricting lending growth.
The increases in funding costs led banks to increase margins on business loans in December and housing loans in January. Business lending rates had continued to rise during the past month or so in response to increases in bank bill yields.
Members noted that, following release of the December quarter CPI, pricing in the money market had attached a high probability to a monetary policy 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 7 per cent.
In debating this recommendation, members agreed that a key issue was that inflation had increased, and was running at a higher pace than had been expected prior to the release of the December quarter CPI. On a year-ended basis, CPI inflation would rise further in the March quarter. Members took note of the staff forecast that inflation was likely to moderate somewhat during 2009 but that, in the absence of policy action, it was still likely to exceed the top of the target by mid 2010. In addition, indicators of demand had remained strong through the second half of 2007, capacity utilisation remained high and shortages of suitable labour persisted. Recent trends in world commodity markets suggested that Australia's terms of trade were likely to rise further, providing an additional boost to incomes in Australia.
Members were strongly of the view that a significant slowing in demand from the pace observed through 2007 would be required for inflation to return to the target. Two important factors would work in that direction: significantly weaker global growth and the effect of rises in borrowing costs that had already occurred. The global situation was still evolving, and it was too soon to see the full effects of previous increases in interest rates, though household borrowing had slowed to some extent.
While noting the uncertainties surrounding forecasts, members judged that, on the basis of currently available information, the main risk was that demand would still prove to be too strong to allow a decline in inflation over a reasonable time period. Indicators of inflation expectations were also tending to rise, which could increase the cost of reducing inflation over time. They therefore concluded that the outlook for inflation required an immediate response from monetary policy. The debate focused on whether the change in the cash rate should be 25 or 50 basis points.
The discussion noted that a good case could be made for the larger move, on the grounds that the inflation outlook had deteriorated and the risk of inflation expectations becoming dislodged had increased. Thus there was a case for the Board to send a stronger signal of its intention to act as necessary to reduce inflation. Further, on some measures, the level of the cash rate in real terms arguably was noticeably below what might be expected given the economy's circumstances. On this basis, a significant further rise in the cash rate could be necessary.
Members noted that an argument in favour of a rise of only 25 basis points was that the level of rates faced by borrowers had already risen somewhat over the summer, independently of policy action. A rise of 25 basis points now would produce a total rise over nine months of about 100 basis points for business borrowers and around 90 basis points for housing borrowers. This was a significant increase over such a period and much of the effect of it was still to be seen. Additional tightening could be implemented at the March and/or subsequent meetings as judged necessary. Reinforcing this, global credit and equity markets, which the Board considered carefully, had also been unsettled over recent weeks, and the working out of the financial difficulties of the major international financial institutions had some way to run. To date, the effects of this on Australia had been confined to a significant slowing in the pace at which non-bank corporates and intermediaries could raise funds directly, with the major banks largely making up the difference. But some wider dampening effects could occur over the period ahead, which were difficult to factor into economic forecasts.
The Board judged that the case for the 25 basis point rise was, at this time, the more persuasive. However, the judgement was finely balanced and the Board would continue to review whether policy was sufficiently restrictive to return inflation to the 2–3 per cent target within a reasonable period.
The Board decided to raise the cash rate by 25 basis points to 7.0 per cent, effective 6 February.