Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Adelaide – 1 May 2018
Philip Lowe (Governor and Chair), Guy Debelle (Deputy Governor), Mark Barnaba AM, Kathryn Fagg, John Fraser, Ian Harper, Allan Moss AO, Carol Schwartz AM, Catherine Tanna
Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Bradley Jones (Head, International Department), Adam Cagliarini (Representative, China)
Anthony Dickman (Secretary), Andrea Brischetto (Deputy Secretary)
Domestic Economic Conditions
Members commenced their discussion of the domestic economy by noting that the outlook for the economy had not changed materially over the preceding three months. Stronger growth was expected over the following couple of years, which would reduce spare capacity in the economy and lead to a further gradual decline in the unemployment rate. This, in turn, was expected to lead to a gradual pick-up in wages growth and inflation.
The inflation data for the March quarter had been in line with the Bank’s expectations. Inflation had been ½ per cent in the quarter and close to 2 per cent over the year in both headline and underlying terms. The largest increases in prices over the year had been for tobacco, following excise increases, and utilities, reflecting higher electricity prices. The prices of tradable goods and services, excluding volatile items, had been declining since late 2016, despite the relative stability in the exchange rate over the preceding few years. Members observed that this was likely to reflect ongoing strong competition in the retail sector. Non-tradables inflation had remained a little above 3 per cent in year-ended terms. While non-tradables inflation had picked up over the preceding year, it remained lower than its average over the first decade of the 21st century. Members observed that spare capacity in the labour market and associated low wages growth had continued to keep inflation low, particularly for market services, which have a relatively high domestic labour cost component.
Private non-mining business investment had grown very strongly over 2017, driven by non-residential construction. Members noted that businesses had continued to report positive conditions, with above-average levels reported in all states. Survey measures of capacity utilisation had also continued to rise. An increasing proportion of businesses had been reporting that constraints on output were coming from premises and plant limitations and availability of materials. Consistent with this, the NAB survey measure of expected capital expenditure had risen to above-average levels over the preceding year. The pipeline of non-residential construction work yet to be done had also increased, particularly for office buildings in Sydney and Melbourne, where tenant demand had been strong. Public infrastructure spending had also continued to support growth in economic activity.
Export volumes looked to have recovered somewhat in early 2018, after declining in the December quarter. Liquefied natural gas (LNG) exports appeared to have increased strongly as production ramped up in Western Australia, and coal export volumes had partially recovered from the supply disruptions in late 2017. Members noted that further growth in resource exports was expected as the remaining LNG projects were completed and additional production capacity came on line. However, the completion of construction on these projects would largely offset the boost to economic growth from this source.
The prices of Australia’s commodity exports, and thus the terms of trade, had been higher than expected a year earlier. However, prices were still expected to decline over the period ahead, as additional global supply of bulk commodities came on line. Members noted that the terms of trade were expected to remain high relative to the averages of prior decades, reflecting continued strong global demand for bulk commodities.
In the housing sector, dwelling investment was expected to remain at a high level over the period ahead, given the historically high pipeline of residential work yet to be done, particularly in New South Wales and Victoria. In established housing markets, housing prices had eased a little further in Sydney and Melbourne over preceding months, but had been little changed elsewhere.
Members considered estimates of the median level of housing prices across the capital cities, observing that the relative ordering of price levels broadly corresponded to the sizes of the populations across the cities. Members noted that housing prices in Sydney had tended to have the most pronounced cycles over recent times and that median housing prices in Perth were at a similar level to those in Brisbane, following the unwinding of the mining investment boom.
Household consumption had grown solidly over 2017, and recent data on retail and motor vehicle sales, as well as information from the Bank’s liaison, suggested that this momentum had continued in early 2018. Members noted that consumption had been relatively resilient to the slower growth in household income over recent years.
Turning to the labour market, members observed that employment growth had moderated in 2018 following very strong growth in 2017. The growth in employment in the first quarter of 2018 had been in part-time jobs, whereas increases in full-time jobs had driven overall employment growth over 2017. The unemployment rate had remained around 5½ per cent since mid 2017, as the growth in employment had been matched by a rise in the participation rate. Survey measures of job vacancies and hiring intentions, as well as information from the Bank’s liaison, pointed to above-average employment growth in the near term. Consistent with this, an increasing number of firms responding to the NAB business survey had been reporting availability of suitable labour as a constraint on output. Members observed that growth in the wage price index had not picked up as much or as quickly as its past correlation with the NAB business survey measure of availability of suitable labour would have implied. A similar divergence had also occurred in the corresponding data for the United States. Members discussed possible reasons for this divergence, including competitive pressures from globalisation and technological change.
Members noted that the momentum in domestic demand over the second half of 2017 had been stronger than expected three months earlier, reflecting upward revisions to household consumption growth in previous quarters and stronger-than-expected growth in non-mining investment in the December quarter. Beyond that, the Bank’s forecast for GDP growth was little changed. Growth was expected to increase to a little above 3 per cent from late 2018, supported by low interest rates and the upswing in the global economy.
The Bank continued to forecast a gradual pick-up in inflation over the following couple of years as spare capacity in the economy is absorbed and wages growth gradually picks up. Members noted, however, that spare capacity in the labour market would remain for some time. Headline CPI inflation was expected to be a little above 2 per cent in both 2018 and 2019. Underlying inflation was also expected to increase from close to 2 per cent currently to above 2 per cent by the end of the forecast period.
Members were briefed on developments in the South Australian economy. They noted that conditions in South Australia had improved over the preceding year, in line with the national trend. Growth had been broadly based across consumption, business investment and public demand. Employment growth over recent years had been concentrated in household services, as it had been in the rest of Australia. Wine and wheat exports are important contributors to the South Australian economy, with fruit, vegetables and meat also becoming increasingly important exports from the state. Members discussed the effect of the closure of the car-building industry in South Australia, noting that, in net terms, manufacturing employment had been relatively steady over recent years. Members recognised that the car plant closures had nevertheless been disruptive and difficult for many individuals and communities.
International Economic Conditions
Members commenced their discussion of international economic conditions by noting that conditions in the global economy overall had remained positive. Economic forecasters had gradually upgraded their outlook for the global economy over the preceding year. While global GDP growth was expected to ease a little over the following couple of years, growth was still expected to be at or above trend in most of Australia’s trading partners. This should add to inflationary pressures over time, particularly in the major advanced economies. The outlook for the global economy was little changed from the Bank’s previous forecast.
The global economic expansion of recent years had absorbed spare capacity, particularly in the major advanced economies, where unemployment rates had moved below estimates of full employment and wages growth had picked up modestly. Core inflation had been drifting up recently in some economies, but remained low.
Turning to the recent data, members noted that survey measures of global business conditions had remained at high levels despite easing a little recently, especially in the euro area, and global trade growth had been resilient. Members noted that GDP growth in east Asia (excluding China and Japan) looked to have picked up in early 2018. This was particularly the case in the high-income economies, where growth in consumption and investment had strengthened. Together with a range of other indicators, this suggested that the softer economic data for this region in late 2017 had been temporary.
In China, economic growth had eased a little around the turn of the year, but had been fairly steady in year-ended terms at around 7 per cent. Members noted that growth had been materially stronger in nominal terms, at 11 per cent over the year, which was helpful in the context of high levels of debt in the economy.
Members had a detailed discussion of the deepening economic linkages between the Chinese and Australian economies. They noted that bilateral trade had broadened in scope over the prior decade to encompass a wider range of goods and services. Although exports to China are still weighted towards bulk commodities, Australian exports of tourism and education services had increased notably in recent years. Members noted the strong global competition to supply the Chinese market and that Australia does not have the same natural comparative advantage in other exports as it has in some resources. Direct investment in Australia from China had also increased over the preceding 15 years, driven initially by investment in mining and energy, and more recently by a shift towards real estate, transport and infrastructure. Nevertheless, direct investment from China remains a small share of the total outstanding stock of foreign investment in Australia.
Members were also briefed on developments in the Chinese financial system. The evolution of the financial system since the late 1970s had played a key role in facilitating industrial and urban development in China. Members noted that, over the preceding decade, the role of credit in the Chinese economy had become more expansive, reflecting new forms of lending and borrowing activity and spurred on by regulatory arbitrage (particularly on the part of small banks). While credit growth had helped to sustain strong rates of economic growth, financial stability risks had also risen. In their discussion, members focused on the growing size, interconnectedness and opacity of the Chinese financial system. They noted that targeted policies recently implemented had been aimed at preventing a further rise in financial stability risks while minimising the impact on GDP growth. However, it was acknowledged that considerable uncertainty remains over the nature of the adjustment that could follow the decade-long credit boom in China. Members also discussed how the authorities might act to help reconfigure the financial system over the longer term to better support future drivers of growth in the Chinese economy. Key concerns of the Chinese authorities in this regard were levelling the playing field for small and medium corporate borrowers, expanding the provision of retirement services and continuing with a measured pace of capital account reform.
Members commenced their discussion of developments in financial markets by noting that global financial conditions had been little changed in April and, overall, remained accommodative for households and businesses. This followed a modest tightening in financial conditions in recent months, including an increase in the federal funds rate by the Federal Reserve at its March meeting. In addition to this, the cost to banks and corporations of borrowing US dollars over short terms had risen and credit spreads on corporate bonds were a little wider than the narrow levels reached earlier in 2018. Members noted that market participants had suggested the tightness in short-term funding markets reflected increased US Treasury bill issuance in the context of a higher US budget deficit as well as the effect of recent US tax measures. There was uncertainty about how long and to what extent these pressures in money markets would persist; some aspects were likely to be temporary, while others reflected structural changes in these markets.
Members noted that long-term government bond yields in the advanced economies, including Australia, had increased somewhat in April. The rise was particularly pronounced in 10-year bond yields in the United States, which had moved above 3 per cent for the first time in over four years. This reflected greater compensation for inflation risk amid recent increases in oil and some other commodity prices, as well as a rise in real yields. Government bond yields in the euro area had increased to a lesser extent than in other markets, consistent with generally weaker-than-expected economic outcomes in the region, following stronger economic outcomes in 2017.
Central bank policy settings in the major advanced economies were unchanged since the previous meeting. In China, the People’s Bank of China had lowered the reserve requirement ratio. Members noted that this would tend to increase liquidity and had been associated with a general decline in interest rates, which would help to offset the increased cost of finance associated with measures aimed at restricting the availability of credit provided by non-bank entities.
Global equity markets had been mixed over the preceding month, with changing sentiment around international trade policy developments contributing to higher volatility in share prices in the United States and China. Australian equity prices had increased slightly, underpinned by rises in resources and energy stocks following higher commodity prices; share prices of Australian financial institutions had fallen by around 7 per cent since the end of 2017.
Volatility in foreign exchange markets remained at low levels. The Australian dollar had been little changed on a trade-weighted basis over the preceding month, but had depreciated by around 5 per cent since the end of 2017 in an environment of lower bulk commodity prices and a declining yield differential between Australia and the United States. The Australian dollar exchange rate had remained in a narrow range over the preceding two years or so relative to the US dollar and in trade-weighted terms.
Members discussed developments in money markets in some detail, noting that increases in US dollar borrowing rates (above changes arising from US monetary policy) had influenced money market rates for a number of other currencies, with Australian markets particularly affected. This link reflects the fact that Australian banks raise funds in US dollar markets to help fund their Australian dollar assets. Members noted that persistently higher borrowing costs in short-term money markets would increase the overall cost of funds for a range of financial institutions and some corporate borrowers. Rates on wholesale deposits offered by banks had also increased accordingly. Members noted that, more recently, money market spreads had declined a little from the levels reached around the end of the March quarter.
In Australia, corporate bond spreads, including for financial institutions, had risen slightly over the preceding month, closely in line with developments in international markets, but remained at relatively low levels. The overall funding composition of banks had been quite stable for a number of years. Members noted the staff assessment that the aggregate cost of both short- and long-term debt funding had risen since February. The overall effect on bank funding costs had been less than the rise in the cost of wholesale debt funding since February, in part because there had been little change in interest rates for retail deposits, which account for around one-third of total bank funding.
The rise in funding costs was expected to flow through to a slight increase in lending rates for larger businesses. However, to date, the average variable housing lending rate on the outstanding stock of loans had declined since late 2017. Growth in housing credit had stabilised in 2018 following declines in the growth rates of lending to both owner-occupiers and investors in 2017. Members noted that the Australian Prudential Regulation Authority (APRA) had been conducting a targeted review of lenders’ assessments of reasonable household expenditures in loan applications as part of efforts to improve lending standards, and that lending standards might be tightened further in the context of the current high level of public scrutiny of banks.
Pricing in money markets implied that the cash rate is expected to remain unchanged for a considerable period, with a 25 basis point increase expected in mid 2019.
Considerations for Monetary Policy
In considering the stance of monetary policy, members noted that the flow of economic data over the preceding month, for both the global economy and Australia, had pointed to a continuation of the broad trends over the preceding year or so. Conditions in the global economy had remained positive and there had been further signs of a gradual strengthening in the Australian economy.
The global economic environment was expected to remain favourable over the next couple of years, with most of Australia’s major trading partners generally expected to grow at or above their trend growth rates. Inflation had remained low but had increased a little in some economies and further increases were expected, given the already tight labour markets, particularly in the major advanced economies. Against this backdrop, a number of central banks had withdrawn some monetary stimulus and further moves in this direction were expected. The Chinese economy had continued to grow solidly, with the authorities paying increased attention to the risks in the financial sector and the sustainability of growth. How the Chinese authorities navigate these various challenges would be important for growth in Australia and the rest of the world. Developments in US–China trade relations would also be important for the outlook for the global economy.
Long-term bond yields in the advanced economies and, more recently, credit spreads had risen, but remained low and financial conditions generally remained accommodative. Higher costs of borrowing in US dollar short-term money markets had flowed through to higher short-term interest rates in some other countries, including Australia. Equity market volatility had increased from the very low levels of 2017, in part reflecting concerns over the direction of international trade policy in the United States. The Australian dollar had remained in its narrow range of the preceding couple of years.
Domestically, inflation had remained low. The recent inflation data were in line with the Bank’s expectations, with both CPI and underlying inflation running marginally below 2 per cent. Business conditions had remained positive and non-mining business investment had been growing strongly. There had been increasing indications of emerging capacity constraints, although this had not yet translated into a material pick-up in wages growth. The strength in employment had supported solid growth in consumption and this momentum looked to have continued into 2018.
Housing market conditions had eased a little further in Sydney and Melbourne, and had been little changed elsewhere. Tighter credit standards and APRA’s supervisory measures had been helpful in containing the build-up of risk on household balance sheets. However, household debt levels remained high, which members noted continued to pose an element of uncertainty for the outlook for consumption growth.
The low level of interest rates, along with the global economic upswing, had continued to underpin growth in the Australian economy, with progress having been made over the preceding year in reducing unemployment and having inflation return towards the target range. Further progress on these goals was expected over coming years. However, this progress was expected to be gradual. The Bank’s central forecast for the economy to grow by a little above 3 per cent from late 2018 was expected to be enough to bring about a modest decline in the unemployment rate over that period. As demand strengthens, so too should wages growth and inflation, with underlying inflation expected to move higher later in the forecast period. The increase in wages growth and inflation was expected to be gradual because spare capacity in the economy was expected to be reduced only slowly.
Members noted that there were risks to the forecasts in both directions. Among these, an appreciation of the Australian dollar would be expected to result in a slower pick-up in economic activity and inflation than otherwise. Members also noted that a further tightening in lending standards in Australia, particularly in the context of the current high level of public scrutiny of banks, was possible, which would affect household borrowing and spending. In the other direction, it was possible that global inflation could turn out to be higher than expected. Domestically, there were uncertainties around the extent and speed of the pick-up in wages growth and inflation that might occur as the unemployment rate declined.
In the current circumstances, members agreed that it was more likely that the next move in the cash rate would be up, rather than down. As progress in lowering unemployment and having inflation return to the midpoint of the target range was expected to be gradual, members also agreed that there was not a strong case for a near-term adjustment in monetary policy. Rather, members assessed that while this progress was unfolding, it would be appropriate to hold the cash rate steady and for the Reserve Bank to be a source of stability and confidence.
Taking into account the available information, the Board judged that holding the stance of monetary policy unchanged would be consistent with sustainable growth in the economy and achieving the inflation target over time.
The Board decided to leave the cash rate unchanged at 1.5 per cent.