Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Perth – 4 September 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)

Anthony Dickman (Secretary)

International Economic Conditions

Members commenced their discussion of the global economy by noting that GDP growth in most of Australia's major trading partners had remained above trend. Monetary policy settings had continued to be accommodative in most economies, although a few central banks had become less accommodative as spare capacity was absorbed and inflationary pressures had become more apparent.

Growth in global industrial production had been robust, particularly in the United States, euro area and smaller east Asian economies (that is, excluding Japan and China). Growth in global merchandise trade had eased to around its decade average. Growth in euro area exports, particularly to China, had declined since mid 2017, while export growth had remained strong in smaller east Asian economies. More generally, members observed that there were still significant tensions around global trade policy and that this represented a material risk to the outlook. The United States and China had increased bilateral tariffs further in late August, consistent with earlier announcements. On the other hand, the US and Mexican governments were close to finalising a new trade agreement.

In the advanced economies, spare capacity had continued to be absorbed. In the United States, the strong growth recorded in the June quarter seemed likely to have continued into the September quarter, supported by fiscal stimulus. Survey measures had pointed to further robust growth in investment. In the euro area, GDP growth had eased in most countries over the first half of 2018, but had remained above trend growth. The Japanese economy had expanded in the June quarter, following the small weather-related contraction in GDP in the March quarter. Consumption growth had picked up and continued to be supported by relatively strong growth in labour income. Tight labour market conditions had also been encouraging Japanese firms to invest in labour-saving technology. GDP growth had remained above trend in smaller east Asian economies; although business investment growth had slowed in a few economies, consumption growth in the region overall had remained strong.

Labour markets had continued to tighten in most advanced economies. In the United States, Canada and Sweden, wages growth had been increasing gradually and this had led to a gradual increase in core inflation. In the United Kingdom, the depreciation of the pound had also contributed significantly to inflationary pressures. However, core inflation had remained subdued in the euro area and Japan despite above-trend growth. In contrast, in India inflation had remained above the Reserve Bank of India's medium-term target; in response, monetary policy had been tightened in both June and July.

In China, growth in economic activity had slowed in a number of sectors. Growth in retail sales had been declining and infrastructure investment had been particularly weak. Domestic production of consumer-oriented goods, including white goods and textiles, had declined over time, with members noting that some production had been moved from China to other economies. In contrast, production of steel and glass, which are used extensively in construction, had increased.

The Chinese authorities had responded to the slowing in growth with targeted fiscal stimulus, including the announcement of new rail infrastructure projects and directives to hasten progress on some current infrastructure projects. Growth in total social financing had also increased in recent months, consistent with the authorities' encouragement of bank lending to certain sectors. Demand for housing had remained strong; property sales had increased and there had been a broad-based pick-up in growth in housing prices. The authorities in some cities had responded by strengthening regulatory measures.

The strength in Chinese crude steel production had supported imports of high-quality iron ore and coking coal. In turn, this had supported benchmark steel and iron ore prices, which had remained in a relatively tight range since the end of March, although the premiums for higher-quality iron ore had increased. Members discussed the variation in iron ore prices, reflecting different iron content and different physical characteristics including impurity levels. They noted that proposed replacement mines in Western Australia were expected to contribute to a higher average quality of iron ore product, which would also support prices received for Australian iron ore.

Movements in commodity prices had been mixed since the previous meeting. Benchmark iron ore prices had declined a little after the Chinese authorities announced a new round of environmental restrictions. Coking coal prices had increased over the prior month, but had declined from high levels since the start of the year. Thermal coal prices had remained at a high level, supported by strong demand from Asian economies.

Domestic Economic Conditions

Members began their discussion of the domestic economy by noting that conditions in Western Australia had improved after the decline resulting from the resource investment cycle. Survey-based reports of business conditions in Western Australia, which had previously been well below those reported for the rest of the country, had increased to be above historical averages, although still below the rest of Australia. Average hourly earnings in Western Australia were still around 10 per cent higher than average hourly earnings in the rest of the country, although the differential had narrowed in recent years. Population growth in Western Australia remained well below the national average, after earlier very rapid growth. Members noted that there continued to be net migration from Western Australia to other parts of the country. Conditions in Western Australian housing markets had been weak: dwelling investment and building approvals were stabilising at low levels, while housing prices and rents had continued to fall.

Members observed that the national accounts for the June quarter would be released the day after the meeting. Growth was expected to be above estimates of potential growth in year-ended terms. Members observed that data released since the previously published forecasts suggested there could be upward revisions to the recent history of GDP growth, which would boost measured year-ended growth.

Growth in household consumption was expected to have recovered in the June quarter; retail sales volumes pointed to a solid increase in consumption of goods. Retail sales data for July had been relatively weak, although online sales had continued to grow rapidly.

Dwelling investment was expected to have increased in the June quarter. Work done on both detached and higher-density dwellings had picked up, driven by increases in New South Wales (despite reports of capacity constraints) and Victoria; residential construction work done on new dwellings had continued to drift slightly lower in Western Australia and Queensland. Although residential building approvals had declined from their peak of a few years earlier, the pipeline of work to be done had remained around historically high levels in Sydney and Melbourne. Some sources of demand for new housing had eased somewhat. Notably, information from liaison with developers had indicated that off-the-plan sales of new apartments in the major east-coast cities had declined over the preceding year as a result of weaker demand from domestic investors and foreign buyers.

Established housing market conditions overall had continued to ease. Housing prices had been falling gradually in Sydney and Melbourne, and in recent months price declines had become more widespread across different suburbs and price segments. Although housing prices in Perth had also declined over recent months, prices in other capital cities had been little changed. Rent inflation had remained low.

Private business investment looked to have declined a little in the June quarter, based on partial indicators. Non-mining investment intentions for 2018/19 reported in the ABS Capital Expenditure survey had been revised higher, although firms still expected capital expenditure to be lower than in 2017/18. Mining investment was still expected to trough in late 2018 or early 2019, as the remaining large liquefied natural gas projects are completed. Business conditions more generally had remained well above average, according to a range of surveys, despite easing slightly since earlier in 2018.

Export volumes had increased strongly in the June quarter, led by rural exports. Drought conditions in some parts of Australia were expected to result in lower overall rural production and exports in the period following the June quarter, although members noted that a record crop was expected in Western Australia. The increased probability of an El Niño event suggested that the prospects for rain in drought-affected areas had fallen in the near term, which was likely to increase the magnitude of any fall in output from the farm sector.

Conditions in the Australian labour market had continued to improve. Consistent with above-trend growth in the economy, the unemployment rate had edged slightly lower over 2018, to be 5.3 per cent, which was the lowest rate since late 2012. Members observed that there had been a notable decline in youth unemployment rates in recent months. The level of employment had been little changed in July; growth in full-time employment had been offset by a decline in part-time employment. Leading indicators had suggested that employment growth would be slightly above average in the period ahead. In particular, job vacancies had increased to be at a record high as a share of the labour force. Members noted that labour market conditions had continued to vary across the country. Employment growth had been strong in New South Wales and Victoria and the unemployment rates in these states were around 5 per cent. The share of the population in employment had continued to be highest in Western Australia, despite the unemployment rate in that state increasing to around 6 per cent.

Wages growth had picked up slightly in the June quarter, with a quarterly increase of 0.6 per cent in the wage price index. In year-ended terms, wages growth had edged higher since late 2016 and this pick-up had been quite broadly based across industries, with the notable exception of the retail sector. Information from liaison had continued to point to a modest increase in private sector wages growth in coming quarters. Members noted that the effects of the recent increase in the minimum wage would boost wage outcomes in the September quarter.

Financial Markets

Members began their discussion of developments in financial markets by observing that broadly accommodative financial conditions had continued to underpin economic growth globally, and that the low volatility in financial markets in advanced economies contrasted with ongoing financial fragility in a number of emerging market economies.

In the United States, the Federal Open Market Committee (FOMC) was expected to increase the federal funds rate by another 25 basis points in September as the Federal Reserve continued gradually to withdraw monetary stimulus. Although financial conditions in the United States had tightened a little over the prior year, they remained expansionary overall. Market pricing continued to suggest a slower expected pace of policy rate increases than the median projection of FOMC officials. Members noted that in recent years, actual policy changes had been more closely aligned with the FOMC's median projections than with market expectations.

The Bank of England had increased its policy rate in August but was not expected to increase it again for at least another year, while the Bank of Canada had increased its policy rate in July and further increases were expected before the end of 2018. In Japan and the euro area, monetary policy was expected to remain highly stimulatory for some time. In both Australia and New Zealand, where official interest rates had not declined to the same extent as in other advanced economies, adjustments to the stance of monetary policy were also seen by markets as likely to be some way off.

Members noted that over the prior month, bond yields had declined slightly in most major markets and in Australia, and had remained at generally low levels for both sovereign and corporate issuers. However, Japanese bond yields had increased slightly in response to the announcement by the Bank of Japan of a wider trading range for 10-year government bond yields. In Italy, ongoing concerns about the future stance of fiscal policy following the change in government in May had resulted in wider spreads of Italian debt over German Bunds. However, the extent of the widening in spreads had been smaller than had occurred during the European debt crisis earlier in the decade, and spillovers to other markets had been relatively muted. Members noted that the budget plans of the coalition government in Italy, due to be tabled before parliament in late September, would be likely to be an important focus of financial market participants.

Strength in earnings had continued to underpin corporate debt and equity markets in the advanced economies, notably the United States, where the boost to economic activity, sales and profits from the recent tax cuts had contributed to generally positive earnings results. Share buybacks in the United States also had been boosted by recent tax reforms, which encouraged the repatriation of offshore earnings by multinational enterprises. Australian equity prices had been little changed over the preceding month, but accumulation indices (which take account of dividend payments) had continued to increase and the profit reporting period had been relatively positive. Members noted that the sharp decline in Chinese equity prices since the start of the year had occurred in an environment of weaker-than-expected indicators of growth and implementation of measures to contain financial risks, as well as rising trade tensions with the United States.

In foreign exchange markets, the US dollar had been little changed against the other major currencies over the preceding month, having appreciated by around 5 per cent on a trade-weighted basis since the start of the year. Along with other currencies, the Australian dollar had depreciated against the US dollar, and on a trade-weighted basis, but remained within the relatively narrow range of the preceding few years.

Members discussed developments in emerging markets, where capital outflows had continued over the previous month and exchange rates had depreciated, particularly in a few countries that had significant economic, financial and institutional vulnerabilities. In some markets, the authorities had responded to exchange rate depreciation by intervening directly in the foreign exchange market and/or by raising policy rates. In Turkey, rising political tensions with the United States, high inflation and the lack of credible policy responses had contributed to another sharp depreciation of the lira over the preceding month, which was around 40 per cent lower against the US dollar over the year. In Argentina, the peso had also depreciated sharply. The Argentine authorities had been in discussions with the International Monetary Fund to revise the terms of the current financial assistance package, with the potential to bring forward the disbursement of funds to support the exchange rate and shore up the government's financing needs.

Turning to financial market developments in Australia, members noted that interest rates on bank bills and other money market instruments had remained at a higher level compared with the average level of 2017, and that this had placed some upward pressure on banks' funding costs. Higher money market rates had led to a modest increase in overall funding costs, taking account of all sources of funding, including retail deposits, on which rates had remained low and been drifting down of late. Nonetheless, funding costs remained low relative to history, consistent with the low level of the cash rate.

By the time of the September meeting, lenders accounting for around 40 per cent of outstanding housing credit (including one major bank) had announced increases in mortgage lending rates in response to the increase in funding costs. Once they take effect, these increases would imply a small rise in the average outstanding variable housing loan rate, unwinding about half of the decline observed in the average housing loan rate over the preceding year. Members noted that there was evidence that banks had continued to compete strongly for new borrowers for housing, including by increasing discounts on published lending rates. For owner-occupiers, housing credit had been growing relatively strongly at around 7½ per cent annualised over the preceding six months, whereas growth in lending to investors had slowed noticeably.

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

Considerations for Monetary Policy

In considering the stance of monetary policy, members noted that the global economic expansion had continued at a solid pace. Although growth in the Chinese economy had slowed a little, 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. Global commodity prices had generally remained elevated, which had supported Australia's terms of trade in the first half of 2018, but ongoing uncertainty about trade policy had led to volatility in the prices of some commodities. More generally, the direction of international trade policy in the United States continued to be a source of uncertainty for the outlook for the world economy.

Most advanced economies were growing at above-trend rates and were experiencing increasingly tight labour market conditions as well as rising wage pressures. Although core inflation had remained subdued in the euro area and Japan, it had picked up to around central bank targets in the United States and a number of smaller advanced economies. Against this backdrop, a few central banks, including the Federal Reserve, were expected to continue gradually reducing the degree of monetary policy accommodation. This had been reflected in financial market pricing, most notably a broad-based appreciation of the US dollar. This appreciation had raised risks for some economies, particularly the more fragile emerging market economies, but the modest depreciation of the Australian dollar was helpful for domestic economic growth.

Recent data had suggested that domestic growth had been above potential over the year to the June quarter, supported by strong public demand, resource exports, non-mining business investment and steady consumption growth. Business conditions remained positive and recent data on labour market outcomes had been positive. The unemployment rate had declined to 5.3 per cent in July, which was its lowest rate since the peak of the mining investment boom in 2012.

Forward-looking indicators of labour demand, including vacancy rates and survey measures of employment intentions, 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. More generally, recent data had not changed members' assessment that GDP growth was likely to remain above potential throughout the forecast period and inflation was likely to increase over time. However, members recognised that there continued to be risks associated with uncertainties from abroad and low wages growth.

National housing prices had fallen moderately. In Sydney and Melbourne, price declines had followed significant growth over preceding years. Housing credit growth overall had declined, mainly because investor demand had slowed noticeably. Lending standards were tighter than they had been a few years previously, partly reflecting APRA'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 and associated risks, members assessed that the current stance of monetary policy would continue to support economic growth and allow for 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.