Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 5 August 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, Graham Kraehe AO, Donald McGauchie AO, Warwick McKibbin
Guy Debelle (Assistant Governor, Financial Markets), Malcolm Edey (Assistant Governor, Economic), Tony Richards (Head of Economic Analysis Department)
David Emanuel (Secretary), Anthony Dickman (Deputy Secretary)
Board members were briefed on the CPI data for the June quarter 2008. The high quarterly outcome of 1.5 per cent had lifted the year-ended inflation rate to 4.5 per cent. A significant contribution to the CPI had come from the financial services component, which accounted for around 8 per cent of the CPI; this component had risen by more than 10 per cent over the year to the June quarter and had increased by 4 per cent in the quarter itself. The high quarterly increase incorporated a significant one-time correction for previous underestimates. Members noted that this component of the cost of living was very difficult to measure. But even abstracting from this, inflation had still been high over the past year, with a range of measures of underlying inflation currently around 4 per cent.
Members noted that prices of tradable items in the CPI, which had been held down by competition in world goods markets and a period of exchange rate appreciation earlier in the decade, had risen over the past year. Prices of non-tradable items, which were mainly services, had increased strongly over the past year; the largest contributions in the June quarter had come from increases in rents, house purchase and health-related costs. Using an internationally comparable definition of core inflation simply excluding food, energy and financial services, the pick-up in Australia's inflation rate was less pronounced than the CPI suggested, but still indicated stronger inflation pressure in Australia than in other developed countries.
International Economic Conditions
The Board's discussion of the world economy examined conditions in the major economies, which were generally seen as weak.
In the United States, consumption and exports had underpinned growth in GDP in the June quarter, but a key question was the extent to which consumption spending would continue to increase once the effects of the recent fiscal stimulus faded. Employment had fallen for the seventh consecutive month in July and the unemployment rate had risen by a little over 1 percentage point from its trough, but the deterioration in labour market conditions thus far had not been as severe as in the 2001–2002 slowdown. However, housing activity, which had been a major source of weakness, had fallen by the same extent, and to about the same low point, as in past cyclical downturns, and house prices were still falling. Stocks of unsold new houses were now being run down, but there was still a large overhang, which suggested that building activity was likely to remain low for a while longer.
Growth had slowed a little in China, to about 10 per cent over the year to the June quarter. Domestic demand had remained strong, but growth of exports, particularly to the large developed economies, had slowed sharply over the past year.
Conditions in Japan were deteriorating. Measures of business sentiment among large firms, as measured by the Tankan survey, had declined from high levels to about average, while sentiment indices for small businesses and consumers were close to earlier cyclical lows.
In the euro area, the latest indicators of industrial production and consumer and business sentiment pointed to slowing growth. The UK economy had slowed significantly in the first half of 2008, with GDP growth declining to around 1½ per cent over the year to the June quarter. The housing sector was an area of particular weakness at present and business sentiment had also deteriorated.
Domestic Economic Conditions
Members considered the information provided by the regular monthly data releases, covering household consumption, the housing and business sectors, the labour market, and trade and commodity prices.
They observed that consumption spending had weakened considerably in 2008, with retail sales being essentially flat in value terms over the first half of the year. In volume terms, retail spending had fallen in this period, with both large and small retailers exhibiting weaker trends in sales. Liaison with retailers conducted by the staff had confirmed that June had been a very weak month, but suggested that sales in July had not been as weak. Consumer sentiment had fallen further in July.
Turning to the housing sector, members noted that the fall in building approvals since late 2007 implied that the current rate at which the housing stock was being expanded was noticeably below the long-term growth in underlying demand. Conditions in the secondary housing market had nevertheless softened, with nationwide house prices flat in the first half of the year, following a strong rise over the course of 2007. Auction clearance rates in Sydney and Melbourne had remained well below last year's high rates over the past month, and the number of properties offered for sale had begun to fall. Current levels of these indicators were consistent with house prices showing little change at present. Earlier movements in equity markets and house prices suggested that household net worth had declined by almost 5 per cent over the first half of 2008.
Growth in household credit continued to slow in June. The fall in monthly growth of household credit from about 1 per cent late in 2007 to 0.6 per cent now implied annual growth of around 7 per cent, which was similar to the growth of household income.
In the business sector, surveys suggested that overall business conditions had eased from peak levels to about average over the past year, but the more subjective measure of business confidence had fallen well below average. Growth in total business borrowing had slowed sharply in the past few months.
Members noted that, despite a rise in employment in June, there were some early signs of easing in labour market conditions. Although year-ended employment growth was steady at a bit above 2 per cent and the unemployment rate had been little changed in June, newspaper job advertisements measured by the ANZ Bank had declined sharply in the past few months. Broader measures that included job advertisements on the internet were also softening, and employment intentions from a range of business surveys suggested employment growth would moderate in the period ahead.
Members noted that no data on aggregate wages developments had been released over the past month.
On international trade and commodity prices, members observed that high prices for key commodities had led to a sharp turnaround in the trade balance from a large deficit to a small surplus in recent months. The increase in export values had largely reflected the higher prices, as export volumes had been little changed.
Many commodity prices had eased somewhat over the past month. Nonetheless, coal and iron ore spot prices were still 30–40 per cent above the most recently established contract prices. The Tapis crude oil price had peaked at over US$150 per barrel in mid July, but more recently had been trading around US$130 per barrel.
Compared with some earlier cyclical growth slowdowns, measures of confidence and household spending looked weaker, but the slowdown in the labour market and survey-based measures of business conditions had, so far at least, been relatively mild by past standards. The staff forecast for growth had been revised down slightly, while that for inflation was slightly higher in the near term but still saw inflation starting to fall back towards the target during 2009 and 2010.
Members noted that credit concerns had resurfaced in global financial markets over the past month and that financial conditions generally had deteriorated. Despite better-than-expected second-quarter earnings figures and significant new capital raisings, there had been large write-downs by several major financial institutions and some rating downgrades.
Credit default swap premia had widened during the month, notably early in July in response to concerns over the financial condition of Fannie Mae and Freddie Mac, whose share prices had declined very sharply in July, after having fallen significantly in August 2007 at the start of the credit crisis. Members were briefed on the current financial condition of the agencies and the US policy response, including the government commitment to inject equity capital if needed.
Members noted that the increased credit concerns had not been reflected in money market spreads for the US dollar and the euro, which had not changed much in July. In Australia, money market spreads had narrowed in the most recent period.
Global share markets had been volatile over the past month, with equity prices down a little after the large decline in June.
In Australia, the share prices of financial stocks had fallen significantly over the past month, particularly following the announcements of large provisions by NAB and the ANZ Bank. The magnitude of the fall in the ASX 200 since its peak in November – 28 per cent – was quite substantial by historical standards. Members noted that, notwithstanding the increased provisions made by some Australian banks, underlying profits for the major banks were still likely to be strong for the latest half-year period. Members noted that the banks had increased standard variable housing loan rates by 15 basis points in the past month.
In considering developments in capital markets, members observed that the pace of bond issuance by Australian banks had slowed a little in the past few months, but was still solid and the banks remained well ahead on their funding needs. There had been further issuance of bonds in the domestic residential mortgage-backed securities market; although volumes had been low, spreads appeared to have stabilised somewhat.
Members observed that major foreign exchange markets had remained relatively calm over the past month. In Asia, the authorities in some countries had intervened to support their exchange rates. The renminbi had continued to appreciate gradually and had risen considerably against the currencies of several of China's Asian trading partners over the past year.
The Australian dollar reached new highs in mid July, both against the US dollar and measured on a trade-weighted basis. However, it had since depreciated to end about 3 per cent lower over the month, as many global commodity prices eased and markets revised down their expectations for Australian interest rates. Market expectations about monetary policy in Australia had changed significantly in the past month, reflecting the accumulating evidence of slower demand in the economy. The market had now fully priced in a cut in the cash rate by October, with a further cut by February.
Overseas, markets still expected the US Fed to tighten over the year ahead, though expectations of a near-term tightening had dissipated. Markets expected no further change by the European Central Bank following its tightening in July; Japanese monetary policy was also expected to remain on hold. Further easing was expected in New Zealand following the rate cut in July.
Yields on government bonds in the major markets had been volatile in the past month, reflecting the competing concerns of rising inflationary risks and the effects of the renewed credit disruption. Over the month, the spread between US bond yields and those in Australia had narrowed from its highs.
Considerations for Monetary Policy
The recommendation to the Board was to leave the cash rate unchanged at 7.25 per cent.
In evaluating the recommendation, members noted that there had clearly been a significant change in trend in household demand over the preceding few months. Tight financial conditions, high petrol prices and declining asset values were all contributing factors, though petrol prices had recently declined somewhat and tax cuts had taken effect. A range of business surveys suggested that conditions across most sectors had also moderated, though the slowing seemed milder than in the case of household activity. The national accounts for the June quarter, to be published in early September, were likely to show that growth of GDP had been low, and the staff forecasts suggested that a weak outcome in the September quarter was also possible. There were some early signs of slowing in the labour market. In addition, while global economic growth in the first half of the year had been reasonable in aggregate, over the past month there had been signs of weaker conditions in more of the major economies. Moreover, the effects of the global credit market disruption had intensified again recently, and this had led to a further tightening of financial conditions domestically over the past few weeks.
Members continued to see considerable uncertainty about the outlook for demand and inflation, as the economy remained subject to powerful forces pulling in opposite directions. Tighter financial conditions were causing the economy to slow but, on the other hand, the rise in the terms of trade would continue to add substantially to national income and capacity to spend. On balance, it was now looking more likely that demand would remain on a slower track, and economic growth would be fairly slow, over the period ahead.
The staff forecast for growth of the Australian economy over the year ahead had been lowered slightly and remained below consensus. It was likely that the headline rate of inflation would rise further in the immediate future, but the softer demand outlook meant that inflation was still forecast to decline during 2009 and to be consistent with the target during 2010. Clear evidence of that decline beginning, however, was unlikely to be seen for a while yet.
In assessing the implications for monetary policy of the latest information on the economy and the revised forecasts for growth and inflation, members focused on two key considerations.
First, a lengthy period of inflation above the target was occurring, with attendant risk that this would begin to affect wage setting, though there was no evidence of this in aggregate wages data to date. If that occurred, the cost of reducing inflation later would be greater. Policy had to take account of this risk, particularly given both the recent high CPI reading and those in prospect in the near term. This argued for maintaining the current stance of policy.
Second, members were conscious that financial conditions were clearly quite tight, and effectively getting tighter as a result of ongoing pressure on lenders' cost of funds in the market. Given there had been a significant change in borrowing behaviour, confidence was weaker, asset prices had declined and slower overall growth was in prospect, tighter financial conditions were not warranted. Indeed, less restrictive conditions could soon be called for, otherwise the risk of a deeper and more persistent slowing in the economy would increase. On these considerations, a case could be made for an early reduction in the cash rate.
Weighing up all these considerations, members judged that the current stance of policy was appropriate for the time being. Nonetheless, given the slower trend in demand, scope to move towards a less restrictive setting of monetary policy was judged to be increasing.
The Board decided to leave the cash rate unchanged at 7.25 per cent.