Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 3 February 2009
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)
David Emanuel (Secretary), Anthony Dickman (Deputy Secretary)
International Economic Conditions
Board members noted that indicators of spending and business activity that had become available in recent weeks had weakened sharply in both developed and emerging economies. The global slowdown was highly synchronised, suggesting a common economic shock. The collapse of Lehman Brothers, with the ensuing financial turmoil, had been associated with a sharp fall in confidence and spending. The IMF had recently again revised down its forecasts for the world economy. The G7 economies were now forecast to contract by 2 per cent in 2009, with the rest of the world forecast to grow well below trend; if realised, the forecast for world growth of 0.5 per cent in 2009 would be the weakest year since World War II. The largest forecast revisions on this occasion had been for some of the smaller Asian economies, which to date had shown relatively good growth.
Members observed that world inflation was falling noticeably. Lower headline CPI readings in many countries had been driven by falls in oil prices, but core measures of inflation, which excluded food and energy, were also falling.
Turning to developments in individual economies, members noted that the 1 per cent fall in US GDP in the December quarter had been the result of weakness in private spending. Confidence overall was weak and the adverse dynamics of the housing cycle were still unfolding; housing activity and prices had continued to fall in recent months. The US labour market had weakened sharply late in 2008.
Japanese industrial production had fallen by 20 per cent over the December quarter. A similar decline had been recorded for export volumes. It was likely that a significant fall in GDP would be reported in due course.
GDP in China grew by 6.8 per cent over the course of 2008. Members were informed that the staff estimate of the quarterly growth profile indicated a sharp slowing from the high rates of previous years. Industrial production and export volumes had fallen sharply towards the end of the year. There had been a similar pattern of large falls in industrial production and exports in the smaller Asian economies, no doubt partly reflecting the integrated supply chain in Asia.
The euro area was experiencing significant economic weakness. Industrial and consumer sentiment fell sharply in the December quarter. In the United Kingdom, GDP fell by 1½ per cent in the December quarter, following a fall in the previous quarter. The near-term outlook was for further weakness, in part resulting from the severe problems in the financial services sector, which accounted for a higher-than-average share of the UK economy.
Members observed that oil prices had fallen markedly in the December quarter, but had stabilised somewhat in recent weeks. Movements in other commodity prices, including prices for base metals and rural commodities, had shown a broadly similar pattern in the past few months. Members regarded this as a possible indicator that global economic activity had not continued to deteriorate at the same pace as in the December quarter.
Domestic Economic Conditions
The discussion on the domestic economy commenced with an assessment of conditions in Australia relative to other industrial economies. Overall, members' assessment was that the deterioration in Australian economic activity to date had not been as marked as in other economies.
Over the year to the September quarter, real domestic demand had grown by a relatively strong 4 per cent, while GDP had grown by around 2 per cent. Demand had, until then, been sustained by very strong growth in real gross domestic income, which had been boosted by the strong rise in the terms of trade. The more recent collapse of commodity prices meant that this effect was now working in reverse. More generally, members noted that while the path of domestic economic activity had changed abruptly after September, it had not so far weakened to the same extent as overseas. Based on the currently available indicators, it was likely that GDP would be broadly flat in the December quarter, a relatively good result in comparison with other developed economies.
The run of regular data releases reviewed by the Board covered the business, household and housing sectors, the labour market, and prices and wages.
In the business sector, indicators from a range of business surveys suggested that investment spending was likely to slow markedly in the current financial year after the strong outcomes of recent years. Members were briefed that plans for future investment appeared to have been scaled back sharply in the December quarter. Business surveys suggested a fall to well below average levels. Data on approvals for non-residential building fell in the December quarter.
Turning to other indicators, members noted that there had been a large fall in business confidence, as measured by the NAB survey, in October and November. This took confidence to a level below that seen in the early 1990s. However, the survey's measure of business conditions had fallen by a lesser extent, and capacity utilisation had eased only gradually over the past year, from a record level to about average.
Growth in business credit had slowed sharply from the very high rates of a year ago. In fact, business credit outstanding had fallen in the month of December, though this appeared to have been affected by special factors. The slowing in credit probably reflected a combination of tighter lending standards and businesses seeking to reduce debt. According to the ACCI-Westpac survey of manufacturers, businesses in this sector had found it increasingly difficult to obtain finance over the past year or so.
Turning to the household sector, growth in real disposable incomes had been strong last year, boosted by lower fuel prices, falls in interest rates and the fiscal transfers to households in the December quarter. However, there had been significant falls in net worth, arising mainly from falls in equity prices, and households had become more conservative in their financial decisions. Growth in debt had been slower than growth in incomes, so the debt-to-income ratio had been declining.
Retail sales had risen modestly in November. Liaison with retailers conducted by the staff indicated that sales had picked up noticeably in December, but it seemed that they had weakened again in January. Consumer sentiment, after having fallen sharply around September and October, had picked up a little in recent months.
In the housing sector, members noted that construction activity remained weak, with building approvals having fallen further in November. However, early reports were that housing loan approvals had picked up sharply in December, consistent with increased interest in display homes, which followed the recent changes to the First Home Owner Grant scheme and lower interest rates. Yet the figures for housing credit indicated a slowing trend. This suggested that households had not as yet scaled back their loan repayments after recent falls in interest rates, preferring instead to pay off debt faster.
In the established housing market, house prices fell by about 3 per cent on average across Australia over 2008. This was very modest compared with the falls in some other countries. The declines were widespread across the capital cities over the past year, though Adelaide was an exception. In the larger capital cities the recent falls in house prices were most pronounced at the top end of the market.
Conditions in the labour market were softening. While employment growth remained positive during 2008, it had slowed and trend growth was now only a little above zero. The forward indicators of job vacancies and employment intentions from business surveys indicated that further deterioration was in prospect. Thus far, however, the unemployment rate had risen only gradually from its low of 4 per cent.
Members were briefed on the December quarter CPI and the outlook for growth and inflation. The CPI fell in the quarter, reducing the year-ended rate to 3.7 per cent. Most of the fall was attributable to lower petrol prices, but underlying inflation also moderated, to a little over 4 per cent. The slowing in the underlying inflation rate was driven by prices of non-tradable items such as housing, rents and domestic travel. Tradables prices had been expected to pick up following the depreciation of the exchange rate, but price discounting of motor vehicles and other goods had offset this effect.
There had not been any new data on wages over the past two months, with wages growth currently stable at around 4 per cent.
Members were informed that the staff forecast was for domestic output growth to be significantly lower than previously expected. This was due to the weaker global economy and a pronounced fall in the terms of trade. Working in the other direction were the effects of the recent cuts in interest rates, which had flowed through to lending rates faster in Australia than in other countries. The forecast also incorporated the effect of an assumed fiscal expansion.
The weaker growth profile would place greater downward pressure on inflation, which was now forecast to decline towards 2 per cent by the middle of 2011, compared with 2½ per cent previously. In the near term, the CPI inflation rate was expected to fall rapidly, owing to a fall in petrol prices in the March quarter, if current prices were sustained.
At this point in the meeting, the Secretary to the Treasury briefed the other members of the Board on the outline of the Government's Nation Building and Jobs package, which would be announced later that day. Members discussed various elements of the package.
Members noted that the extreme volatility of global financial markets during October and November had abated recently. There had been a noticeable improvement in conditions in credit markets following the introduction of various remedial policy measures by a range of countries. Nonetheless, sentiment remained fragile.
Looking at policy interest rates, there had been significant rate reductions in both developed and emerging economies over the past few months, including in most parts of Asia and Latin America. The US Federal Reserve had reduced the federal funds rate to close to zero, which meant the cumulative reduction since the onset of the financial crisis in the second half of 2007 was more than 500 basis points. With the federal funds rate at its current level, the Fed had announced a range of measures described as ‘credit easing’, which focused on the composition of its balance sheet assets and provision of support to credit markets.
In other economies, the European Central Bank lowered its policy rate by 75 basis points in December and by a further 50 basis points in January, to 2 per cent. The Bank of Japan had lowered its policy rate closer to zero and had introduced several measures to assist corporate financing. The Bank of England had reduced its bank rate by 150 basis points and had announced an intention to purchase financial assets directly. The Swiss National Bank, having cut rates to ½ per cent, was now contemplating additional stimulus measures. And the Reserve Bank of New Zealand had cut rates by 300 basis points, in two steps, to 3.5 per cent.
Members observed that in many countries the central bank rate reductions had flowed through to lending rates only to a limited extent, in particular for housing. They noted that the transmission of monetary policy changes to lending rates had been much more effective in Australia. This reflected the high share of variable rate lending in Australia and the fact that domestic financial institutions had passed on most of the recent declines in funding costs to both new and existing loans (though the pass-through to business lending rates in Australia had been slower and less complete). Members noted that US housing loan rates had declined somewhat since the announcement by the Fed that it would purchase mortgage agency paper.
In government bond markets, yields had fallen to post-War lows in many countries. Some European countries, however, had experienced a sharp widening of spreads relative to German government bonds.
There had been a large volume of government-guaranteed bank bond issuance around the world in the past few months. Australian banks had been very active, and had benefitted from strong demand for their bonds. The banks were now well ahead of their funding plans and had been able to run down short-term debt to some extent. Spreads had tended to narrow.
US corporate bond spreads had declined from their peaks late last year, but remained high. A similar pattern had occurred for emerging market spreads.
Turning to global share markets, members noted that equity prices had been fluctuating around a flat trend over December and January. Share prices were at low levels: in US and European markets they were back to levels of 2003 and 1997 respectively, while the Japanese market was back to its early 1980s level.
In foreign exchange markets, the US dollar had depreciated since early December, but was still well above its recent lows. In other notable developments, the pound sterling had depreciated significantly and was now at parity with the euro, and the Chinese renminbi had moved broadly in line with the US dollar in the past six months.
The Australian dollar had traded in a wide range over the past two months. There had been little net change on a trade-weighted basis over that period, with significant appreciation against the pound and the New Zealand dollar and significant depreciation against the yen and Swiss franc. Volatility in the exchange rate was lower than in late 2008, but still relatively high. Over the past year, the Australian dollar had depreciated by over 20 per cent. Members noted that this would help to lessen the effect on the economy of the global economic slowdown.
Interest rates in the Australian money market had fallen considerably over the past two months as markets had increasingly priced in future easing of monetary policy. Conditions in money markets had improved.
The 10-year Australian government bond yield had fallen to around 4 per cent, a level last recorded in the 1950s, in line with global trends. Increased issuance of government-guaranteed bank bonds had attracted some demand away from bonds issued by the States, and there had been a widening in spreads between yields on semi-government bonds and Commonwealth Government securities. However, the level of yields on semis had nonetheless fallen to low levels.
Members were further briefed on the pass-through of policy changes to lending rates in Australia. Most of the December cash rate reduction had been passed on, and on this occasion the reduction had flowed on to personal and small business rates also. Members noted that lending rates were now below average. A further reduction in the cash rate following this meeting, assuming it was passed on to borrowers, would push many lending rates to their lowest levels since the 1960s.
Financial companies had raised a large amount of equity, particularly in the December quarter, at discounts that were relatively modest by world standards.
In reviewing developments in business debt, members noted that foreign banks in Australia accounted for about a quarter of business credit, and that their loans were fairly evenly spread across the sectors of the economy. The foreign bank sector accounted for a negligible amount of housing lending in Australia. Discussions with foreign banks did not as yet reveal widespread withdrawal from the Australian market. This would need to be kept under review.
Members noted that market expectations were for an easing in the official cash rate of 100 basis points at this meeting, with the trough in the cash rate now expected to be around 2 per cent later in the year.
Considerations for Monetary Policy
The recommendation to the Board was for a reduction in the cash rate of 100 basis points to 3.25 per cent.
The primary backdrop to members' policy discussion this month was the marked deterioration in world economic conditions late in 2008. Members had noted at previous meetings that there had been an abrupt change to the outlook for global economic activity after September, following Lehman's collapse and the resultant strains in financial markets and declines in asset values. This had caused a collapse of household and business confidence and a very sharp fall in global demand. The dependence of Asian economies on manufactured exports meant that they had been severely affected. Domestic demand in Asia had also weakened sharply. This included the Chinese economy, which, though still growing, had slowed markedly. These effects were becoming evident in the economic data that had recently been released. The weakness had in turn been reflected in a further significant downward revision to the IMF's forecasts for growth in both developed and emerging economies in 2009, which was now expected to be the weakest in six decades.
Members noted that measures taken in developed economies to stabilise their financial systems had contributed to an improvement in the functioning of credit markets over the past few months. There had also been greater steadiness in commodity markets since November. The better functioning of markets plus the very significant monetary and fiscal stimulus that was being put in place in all regions would assist in promoting global recovery over time. Nonetheless, the near-term outlook was very weak.
Economic conditions in Australia were being affected by these global events, though, to date, the Australian economy had been more resilient than other industrial economies. Importantly, Australia's financial system remained in a relatively strong condition. Among other things, this had allowed the significant monetary policy easing starting in September to flow through to large reductions in many lending rates. Nonetheless, the headwinds from the global economy were very strong and would continue to have a significant negative effect on the domestic economy in the near term.
Members noted that the package of fiscal measures to be announced by the Government later that day would result in a significant boost to demand during 2009. Even so, given the contractionary forces coming from abroad and the clear evidence that inflation was on a downward trend again, members judged that another substantial easing of monetary policy at this time was appropriate. They supported the recommendation for a cut of 100 basis points.
Members agreed that, together with earlier rate cuts, this would amount to a very significant easing of monetary policy. This had occurred relatively early in the business cycle and lending rates in many cases would soon be at generational lows.
Together with the fiscal measures, this meant that a very significant macroeconomic stimulus had been applied to the domestic economy. This stimulus would take time to be effective and could be expected to have only a modest effect on the near-term outlook in Australia. Given the speed at which the global contraction had occurred, short-term prospects were thus still for weakness in demand and output. Nonetheless, the substantial measures taken would help to cushion the economy from the contractionary forces coming from abroad and, over time, work to establish conditions conducive to stronger demand later in the year. Assessments of those medium-term prospects, as well as the course of the short-term data, would be important to future policy decisions.
The Board decided to lower the cash rate by 100 basis points to 3.25 per cent, effective 4 February.