Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Sydney – 7 August 2018

Members Present

Philip Lowe (Governor and Chair), Guy Debelle (Deputy Governor), Mark Barnaba AM, Wendy Craik AM, Philip Gaetjens, Ian Harper, Allan Moss AO, Carol Schwartz AM, Catherine Tanna

Others Present

Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Alexandra Heath (Head, Economic Analysis Department), Ellis Connolly (Deputy Head, Domestic Markets Department)

Anthony Dickman (Secretary), Andrea Brischetto (Deputy Secretary)

International Economic Conditions

Members commenced their discussion by noting that the global economy had continued to grow above trend. Indicators of global industrial production and trade had remained at relatively high levels, as had surveyed business conditions. Spare capacity had continued to be absorbed, especially in the major advanced economies. Headline inflation had moved a little higher since the beginning of the year, primarily as a result of higher oil prices. Core inflation had also increased in a few economies, including the United States, but had remained low elsewhere.

The Bank's forecast was for global growth to ease a little over the following few years, but to remain above trend. Members noted that, although this forecast was broadly unchanged from three months earlier, the risks to the international economic outlook had shifted. Although the direct effects of trade protectionism measures that had been implemented and further measures that had been proposed were expected to be small, the broader risk of adverse effects on investment decisions and confidence had increased. On the other hand, members observed that the large fiscal stimulus in the United States was occurring in a period of little spare capacity in the US economy. It was therefore possible that US growth and inflation could be stronger than expected. This could prompt a faster withdrawal of monetary stimulus than markets expected and lead to a broad-based appreciation of the US dollar. This scenario implied stronger global growth than forecast and could be associated with a depreciation of the Australian dollar, both of which would support the Australian economy.

The near-term outlook for growth had remained positive for the United States and Japan. In the June quarter, the US economy had received a boost from recent tax cuts and a pick-up in export growth, while growth in Japan was expected to have picked up, partly reversing the weak outcome in the March quarter. Both economies were expected to continue growing at an above-trend pace over 2018 and 2019; survey data had indicated that investment growth was expected to remain strong and labour market conditions were expected to support consumption growth. By contrast, in the euro area there had been signs that consumption growth and investment intentions had moderated a little since the beginning of 2018, although GDP growth was still expected to remain above trend over the forecast period. Across the advanced economies, unemployment rates had trended lower and surveys had suggested that more firms were facing labour shortages. Wages growth had picked up noticeably over the preceding few years, although it remained relatively low compared with its historical levels.

In China, GDP growth had eased slightly relative to a year earlier and growth had been weaker than expected in a number of sectors, including infrastructure construction. Nonetheless, steel production and prices had been high, which had supported Australian exports of bulk commodities. The Chinese authorities had tightened some regulations to reduce the build-up of financial stability risks, but had also introduced targeted fiscal stimulus and eased monetary policy to counter slowing growth in some sectors of the economy. Elsewhere in east Asia, year-ended output growth had been steady in the first half of 2018. Export growth had remained high and domestic demand had been increasingly contributing to growth. Members noted that many economies in the region were vulnerable to an escalation in trade tensions, given their high trade exposures and integration with global supply chains.

Domestic Economic Conditions

Members commenced their discussion of the domestic economy by observing that the outlook had not changed materially over the preceding three months. Growth was forecast to strengthen to be a bit above 3 per cent over 2018 and 2019, before easing to a little above trend towards the end of 2020 as the ramp-up in liquefied natural gas (LNG) production came to an end.

Non-mining business investment was expected to continue to grow over the forecast period, but at a more moderate pace than over the previous year. While quite lumpy, non-residential building approvals had fallen in trend terms since their peak in mid 2017. However, members noted that there was still a reasonable pipeline of building construction work, which should support growth in the near term. Work yet to be done on private infrastructure investment had also increased. Growth in investment in machinery and equipment was forecast to pick up further, consistent with an ongoing economic expansion. Mining investment was still expected to trough in coming quarters, but beyond that was expected to increase moderately as companies invested to sustain production.

Public demand was expected to make a significant contribution to growth over the period to the end of 2020, based on information provided in the state and federal budgets. Further expansion of the National Disability Insurance Scheme was expected to support public consumption, while infrastructure projects were expected to support public investment spending.

Drought conditions, particularly in New South Wales and southern Queensland, had affected the timing of crop harvests and had led to an increase in slaughter rates. This was expected to have contributed to a rise in rural exports in the June quarter. Members noted that the probability of an El Niño event, which would typically be associated with low rainfall in eastern Australia, had increased over 2018, implying downside risks to the forecasts for farm output and exports. Resource export volumes were expected to have been higher in the June quarter and to contribute to growth over the subsequent year or so, as LNG production continued to ramp up.

Commodity prices were little changed over the previous month. Trade tensions had contributed to falls in oil and base metals prices. Coking coal prices had fallen, partly as a result of Australian supply coming back on line, while prices of iron ore had risen and thermal coal prices had remained at a high level. Many rural commodity prices had increased, partly because drought conditions had restricted the supply of some rural commodities from Australia and other countries. Over the previous year, the terms of trade had held up at a higher level than previously forecast, largely reflecting higher thermal coal prices than had been expected. The terms of trade were expected to remain around their current level for a few quarters or so before declining moderately over the medium term.

In established housing markets, prices in Sydney and Melbourne had declined further in July and across a broader range of properties. Housing prices had also declined in Perth, but had increased in Hobart and been relatively stable in Adelaide and Canberra. Rental vacancy rates had been little changed in Sydney and Brisbane, and had continued to fall in Melbourne, where strong population growth had continued to outpace additions to the rental stock. Rental vacancies had remained high in Perth, but were lower than the peak in the previous year.

Despite the easing of conditions in the established housing market, dwelling investment was expected to remain at a high level, but not to contribute to growth, over coming quarters. Residential building approvals had trended lower, which was consistent with information from liaison contacts that there had been a decline in off-the-plan sales of apartments. Nevertheless, a significant pipeline of work remained to be done, particularly in Sydney and Melbourne. Liaison contacts had continued to report that capacity constraints had been limiting the pace at which the pipeline could be worked through, particularly in Sydney.

Recent data on consumption showed that retail sales in the June quarter had been consistent with steady growth in consumption in year-ended terms. Liaison contacts had also reported that retail trading conditions had been stable. Overall growth in consumption in the June quarter was expected to have been supported by growth in labour income. Growth in household disposable income had picked up over the year to the March quarter, reflecting an increase in growth in average earnings per hour and hours worked. Members noted that these increases, in combination with the more recent increase in minimum wages, the announcement of future tax cuts and expectations of a further tightening in labour market conditions, had reduced some of the uncertainty around the outlook for consumption.

Employment had increased by 51,000 in July, and employment growth had been a little above average over the first six months of 2018, although it had slowed from the very strong rate over 2017. The unemployment rate had declined slightly in recent months, but had remained around 5½ per cent since mid 2017. Leading indicators suggested that employment could be expected to grow at an above-average pace in the second half of 2018.

Members noted that the unemployment rate forecast profile was unchanged from three months earlier. With the extension of the forecast period to the end of 2020, the unemployment rate was expected to reach around 5 per cent by the end of the forecast period. Based on historical relationships, members noted that the level of vacancies was consistent with the forecast for a further gradual decline in the unemployment rate over the second half of 2018. However, there continued to be uncertainty about the extent of spare capacity in the labour market and how quickly this would translate into higher wage and price inflation over the forecast period. It was possible that ongoing above-trend growth in output could see the unemployment rate fall faster than expected and wages growth pick up more strongly as a result. Alternatively, it was possible that the flow of new entrants to the labour force could be stronger than usual, such that unemployment would decline more slowly than expected and wage pressures would take longer to emerge.

Headline and underlying inflation had both been around ½ per cent in the June quarter, in line with earlier forecasts. In year-ended terms, headline inflation had picked up a little to 2.1 per cent, while underlying inflation had remained close to 2 per cent. Strong competitive pressures and low growth in wage costs had been placing downward pressure on retail prices for some time. In an environment of falling wholesale prices and heightened competition in the retail energy sector, energy providers had reduced some retail prices in the June quarter and there had also been an unusually small increase in private health insurance premiums. Rents, which are a large item in the CPI basket, had been flat in the June quarter and year-ended rent inflation had been at its lowest rate since the mid 1990s. By contrast, inflation in new dwelling costs had risen.

Members noted that inflation in the September quarter was likely to be lower than previously forecast because of new government measures, including changes to childcare subsidies and TAFE and car registration fees, as well as some recent reductions in utilities prices. The forecast profile for inflation had otherwise been unchanged. Taking these effects into account, headline and underlying inflation were expected to be around 1¾ per cent over 2018, and then increase to around 2¼ per cent in 2020, in line with previous forecasts. Members noted that there was some risk that the recent decline in wholesale electricity prices could have more persistent effects on utilities prices than had been factored into the forecasts. At the same time, members noted that these price declines would boost real household disposable income.

Financial Markets

Members were briefed on developments in Australian dollar short-term money markets. Interest rates in these markets had been rising sharply towards the end of recent quarters, and only part of the rise had subsequently been unwound following the end of each quarter. As a result, the level of interest rates in these markets had been higher than in 2017, despite market expectations for the path of the cash rate having changed little over this period.

Members discussed a range of factors that may help to explain these outcomes, noting that it was difficult to be definitive about the cause. Around the end of the March quarter, the rise and fall of Australian dollar money market rates had been associated with a similar pattern for US dollar money market spreads, but in the June quarter the movements had been specific to Australia. Members noted that banks had become less inclined to supply liquidity to money markets in light of regulatory developments, although this development had also been experienced in money markets in other countries. As a result, interest rates appeared to have become more responsive to changes in demand and supply than had been the case previously. In particular, portfolio reallocation had lowered demand for bank bills issued by major Australian banks, which had contributed to the increase in the bank bill swap rate. In foreign exchange swap markets, where structural changes in liquidity conditions had also been apparent, interest rates had increased as a result of stronger demand for Australian dollars, partly reflecting the conversion back to Australian dollars of increased offshore bond issuance by Australian banks.

Notwithstanding these developments, domestic funding conditions had remained generally accommodative. Members noted that funding costs for the major banks had risen a little in 2018 as a result of the increase in short-term money market rates, but had remained low relative to history, consistent with the low level of the cash rate. In particular, the higher money market rates had to date not been reflected in significant changes in retail deposit rates. Banks' net bond issuance had remained strong in 2018 and bond spreads had remained low.

Members noted that the average interest rate on outstanding variable-rate housing loans had declined by around 10 basis points since August 2017. Some smaller lenders had increased their standard variable interest rates more recently, although other lenders had reduced interest rates on some mortgage products.

Housing credit growth had continued to ease over the first half of 2018, driven by a decline in credit growth for investors. Members noted that this appeared to have been mainly due to softening demand from investors in an environment of declining housing prices in some markets, although it was likely that there had also been some reduction in the supply of credit associated with tighter lending standards.

Turning to developments in global financial markets, members noted that global financial conditions continued to support economic growth. Monetary policy in the major economies remained accommodative, although central banks were at different stages of their monetary policy cycles.

In the United States, the Federal Reserve had continued to indicate that further gradual increases in the federal funds rate were likely over the next couple of years. Market pricing implied that the next policy rate increase was expected in September, but, beyond that, market expectations for the federal funds rate remained below those implied by the median projection of the members of the Federal Open Market Committee. The Bank of Canada and Bank of England had both raised their policy interest rates at their most recent meetings, as had been widely expected. Market pricing implied that the Bank of Canada would increase policy rates further over the coming year. The European Central Bank had indicated that negative policy rates were likely to remain in place until the latter half of 2019 and that it planned to end its net asset purchases by the end of 2018. At its July meeting, the Bank of Japan introduced forward guidance to the effect that its stimulatory policy settings will remain in place for an extended period. In an effort to help improve market functioning, the Bank of Japan had also announced a slightly wider trading range for 10-year government bond yields to meet its target of around 0 per cent.

Members noted that government bond yields in the major markets had risen moderately over the preceding month, but had generally remained low. In the United States, markets had continued to focus on the flattening of the US Treasury yield curve. Members noted that this flattening had been driven largely by rising short-end rates (consistent with increases in the federal funds rate) and a decline in the term premium for bonds, rather than by expectations for slower growth or lower inflation.

Equity prices had risen further in the advanced economies over the preceding month, supported by strong corporate earnings. US share prices had outperformed other markets over recent months, following particularly strong corporate earnings in the United States, share buybacks and merger and acquisition activity. Australian share prices, when compared on the basis of accumulation indices (which take account of dividend payments), had also outperformed other markets over recent months. By contrast, in China, equity prices had fallen sharply over recent months in response to slowing growth and rising international trade tensions.

Major advanced economy exchange rates had generally been stable since the previous meeting. This had followed a broad-based appreciation of the US dollar over the course of 2018. The Chinese renminbi had depreciated since May, in part reflecting the general appreciation of the US dollar, but international trade tensions, moderating growth and a targeted easing in monetary policy by the People's Bank of China were also likely to have contributed.

Conditions in some emerging financial markets had stabilised somewhat since the previous meeting. Earlier localised financial market stresses relating to country-specific concerns had eased in some markets in July, although concerns had remained in some others. Overall, most emerging markets had experienced capital outflows and a depreciation of their exchange rates relative to the US dollar in 2018.

The Australian dollar had been little changed against the US dollar since the previous meeting, but had appreciated slightly on a trade-weighted basis, reflecting the recent depreciation in the renminbi. The Australian dollar had remained within its trading range of the previous few years.

Financial market pricing implied that the cash rate was expected to remain unchanged for a considerable period.

Members concluded their review of developments in financial markets with a discussion of access to finance for small businesses. Members reviewed the issues raised by participants at the Bank's Small Business Finance Advisory Panel and two special roundtable events involving representatives from small business, lenders and the public sector. They noted that many small businesses looking to expand still found it challenging to access finance, particularly without providing real estate as security. Lenders had highlighted that they were keen to lend to small businesses, and that the higher cost of unsecured finance mainly owed to the associated risk. Members noted that there had been more funding available from private equity sources recently, but that the supply of venture capital remained small compared with some other markets.

Members discussed some initiatives suggested by market participants that could potentially improve access to finance for small businesses. Members were encouraged by the potential for comprehensive credit reporting and open banking to lower the cost of credit risk assessment for lenders. They also noted efforts to improve the financial capability of small businesses by encouraging better financial record-keeping. They observed that the reliance on real estate as collateral in small business lending could be reduced by making it easier to use other assets as security, such as machinery and equipment. Finally, members noted private sector initiatives in other jurisdictions designed to provide more equity funding for small businesses seeking to expand.

Considerations for Monetary Policy

In considering the stance of monetary policy, members noted that the global economic expansion had continued. This had contributed to higher commodity prices in 2018, which had increased upstream inflationary pressures globally and boosted Australia's terms of trade. A number of advanced economies were growing at above-trend rates and were experiencing increasingly tight labour market conditions. There had been further evidence of rising wage pressures in these economies. Although core inflation had remained below most central banks' targets, it had increased to be around the US Federal Reserve's target. Growth in the Chinese economy had slowed a little and the authorities had eased fiscal and monetary policy in a targeted way to support near-term growth, while continuing to pay close attention to risks in the financial sector. The direction of international trade policy in the United States continued to be a source of uncertainty for the global outlook.

Against this backdrop, global financial conditions had remained expansionary, although they were gradually becoming less so in some economies, most notably the United States where the Federal Reserve was expected to increase the federal funds rate further over 2018 and 2019. This had contributed to a broad-based appreciation of the US dollar. Although the Australian dollar had depreciated a little against the US dollar, in trade-weighted terms it had remained within its trading range of the previous two years.

The forecasts for the Australian economy were largely unchanged. GDP growth was expected to be a little above 3 per cent over 2018 and 2019, supported by strong public demand, resource exports, further growth in non-mining business investment and steady consumption growth. Business conditions remained positive, while recent data on wages growth and expectations of a further tightening in labour market conditions had provided more comfort that household income growth would continue to increase gradually and support the outlook for consumption. Members were cognisant of the effect of drought conditions on the rural sector.

Forward-looking indicators of labour demand, including vacancy rates, continued to point to above-average growth in employment in the near term. The unemployment rate was expected to decline gradually towards 5 per cent. Wages growth was expected to increase gradually as spare capacity in the labour market is absorbed over the forecast period. Year-ended inflation had been close to 2 per cent in the June quarter, which was in line with previous forecasts. Although inflation was expected to be temporarily lower in the September quarter, owing to falls in some administered prices, inflation was still expected to be around 2¼ per cent in 2020.

Housing prices had fallen moderately in Sydney and Melbourne, following significant growth over preceding years, while housing prices had been relatively stable in most other capital cities. Rent inflation had remained low. Housing credit growth had declined, mainly because investor demand had slowed noticeably. Lending standards were tighter than they had been a few years previously, partly reflecting the Australian Prudential Regulation Authority's earlier supervisory measures to help contain the build-up of risk in household balance sheets. Some further tightening of lending standards by banks was possible, although competition for borrowers of high credit quality remained strong.

Based on the forecasts, members assessed that the current stance of monetary policy would continue to support economic growth and allow further progress to be made in reducing the unemployment rate and returning inflation towards the midpoint of the target. In these circumstances, members continued to agree that the next move in the cash rate would more likely be an increase than a decrease. However, since progress on unemployment and inflation was likely to be gradual, they also agreed there was no strong case for a near-term adjustment in monetary policy. Rather, members assessed that it would be appropriate to hold the cash rate steady and for the Bank to be a source of stability and confidence while this progress unfolds.

Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

The Decision

The Board decided to leave the cash rate unchanged at 1.5 per cent.