Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Hybrid – 5 July 2022

Members participating

Philip Lowe (Governor and Chair), Michele Bullock (Deputy Governor), Mark Barnaba AM, Wendy Craik AM, Ian Harper AO, Carolyn Hewson AO, Steven Kennedy PSM, Carol Schwartz AO, Alison Watkins AM

Others participating

Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets)

Penelope Smith (Acting Secretary)

Alexandra Heath (Head, International Department), Bradley Jones (Head, Economic Analysis Department), Marion Kohler (Head, Domestic Markets Department)

International economic developments

Members commenced their discussion of international developments by noting that inflation had increased further to multi-decade highs and that the outlook for growth in a number of advanced economies had become more uncertain. Risks to global growth had become skewed to the downside. This reflected the decline in households' purchasing power and the ongoing tightening in financial conditions as central banks were expected to lift policy rates substantially in the period ahead.

Consumer price inflation remained high. The continuing fallout from Russia's invasion of Ukraine was evident in increases in the prices of fuel, electricity and food in many economies, which had boosted headline inflation in May and June. Crude oil prices were below their peaks earlier in the year but remained high, while gas prices in Europe and Asia had increased further. Core inflation had also remained high in recent months; services inflation had continued to rise, largely reflecting the rebound in activity in the services sector and, in some economies, high rates of wages growth. However, there were signs that price pressures in parts of the global economy had started to abate. Growing concerns about the outlook for global growth had prompted large declines in base metals prices in recent weeks. Goods inflation in some advanced economies was beginning to ease as the supply of and demand for goods became more balanced. Shipping costs had levelled out at high levels. There were also signs of improvement in global supply chain bottlenecks; increased production of consumer durables and electronics in east Asia had contributed to this.

Activity in China had rebounded in May following the relaxation of COVID-19-related mobility restrictions and in response to ongoing policy stimulus. Industrial production and retail sales had recovered around one-third of the earlier declines and export volumes had bounced back; there did not appear to have been widespread disruptions to Asian supply chains from the COVID-19-related mobility restrictions in parts of the country. Timely surveys of business activity also indicated a further rebound in economic conditions in June. Nevertheless, the economic outlook in China continued to be clouded by the possibility of rolling lockdowns related to COVID-19 outbreaks and ongoing imbalances in the property sector. While public spending had supported fixed asset investment in China in recent months, iron ore prices had declined notably over the June quarter alongside falls in Chinese steel prices.

Members noted that consumer spending in advanced economies had generally been resilient to higher inflation and interest rates over recent months. Strong labour markets had supported household consumption and, outside of the United States and the United Kingdom, household saving rates in advanced economies remained high. Some households had also accumulated large saving buffers during the pandemic. However, the expectation that central banks would need to raise interest rates substantially over the second half of 2022 to bring inflation back to target was clouding the outlook and had prompted analysts to lower their growth forecasts substantially. The erosion of household purchasing power had occurred alongside a material decline in consumer sentiment. In some economies, the most interest-rate-sensitive forms of spending (especially housing-related spending) had begun to slow as financing costs increased. Timely survey measures of production and new orders in the United States and the euro area had also declined materially in June.

Domestic economic developments

Members noted that the resilience of the Australian economy continued to be evident in the labour market. Full-time employment had risen strongly again in May, to be around 6 per cent higher than its pre-pandemic level. The participation rate and employment-to-population ratio had also risen to record highs. The unemployment rate was at its lowest level in nearly 50 years, and broader measures of spare capacity were at their lowest levels in many years. Job vacancy rates remained very high across most industries, pointing to continued strong employment growth, at least in the near term; this was consistent with reported hiring intentions of employers in the Bank's liaison program. The increased availability of workers from overseas had yet to have much effect in easing labour shortages, based on reports from firms in the Bank's liaison program.

Other information received in June had affirmed the outlook for faster wages growth in the period ahead. The Fair Work Commission had announced a 5.2 per cent increase to the national minimum wage. An increase in modern award wages of between 4.6 per cent and 5.2 per cent had also been announced, with lower-paid workers set to receive increases at the upper end of this range. These increases in the national minimum wage and modern award wages were the largest since 2006, reflecting the Fair Work Commission's desire to support real wages for low-paid workers during a period of higher inflation. Separately, the New South Wales and Tasmanian governments had announced increases in their wage caps for public sector workers, while the Queensland Government had removed its wage cap. Members noted that this would support aggregate wages growth in the period ahead, given state governments are large employers. Further, around 60 per cent of private sector firms in the Bank's liaison program had reported that they expect wages growth to pick up over the coming year. Some contacts had highlighted the increase in inflation and the recent Fair Work Commission decision as relevant considerations in this assessment, as well as the need to respond to higher rates of voluntary turnover. Notwithstanding this more recent information, members observed that the Wage Price Index had increased by only 2.4 per cent over the year to the March quarter.

Ahead of the release of the June quarter Consumer Price Index (CPI) at the end of July, members noted that domestic inflationary pressures, including those outside of the labour market, continued to build. Non-labour input cost pressures were evident across a range of industries. Adverse weather conditions had affected the prices of some fresh produce. Rents were expected to pick up in response to tightening rental market conditions across most of the country. Wholesale electricity and gas prices had also increased sharply in recent months, reflecting domestic supply disruptions during a period of increased demand. The effect of these increases on retail electricity and gas prices was expected to be evident later in the year, since state subsidies and hedging arrangements had limited the near-term pass-through. More generally, firms in the Bank's liaison program had indicated a greater propensity to pass through cost increases to consumer prices. As a result of these price pressures, inflation was expected to increase in year-ended terms through the remainder of 2022.

Members noted that housing prices had declined in some cities in recent months. In Sydney and Melbourne, turnover and clearance rates had declined and the number of properties listed for sale was higher than over recent years. In other capital cities and regional areas, housing prices had continued to increase, albeit at a slower rate over recent months, supported by lower-than-average volumes of properties for sale. Rental market conditions remained tight, supported by low vacancy rates, lower average household size and strong household income growth.

Timely data indicated that growth in domestic demand had remained solid in the June quarter, led by household spending. Although consumer sentiment had declined notably, household consumption was supported by growth in disposable income, the increase in saving and wealth that occurred earlier in the pandemic, and the rebound in discretionary services spending. The pipeline of residential dwelling construction and infrastructure activity remained large, although capacity constraints were slowing the pace at which the pipeline could be worked through. Business surveys and information from the Bank's liaison program suggested the investment intentions of non-mining firms remained at or above average levels. Recent state government budgets also pointed to continued strength in public demand, supported in part by higher-than-projected revenue. Nevertheless, members agreed that the outlook for domestic economic activity had eased a little, with a key source of uncertainty relating to the response of households to rising inflation, higher interest rates and declining housing prices in some cities.

International financial markets

Members commenced their discussion of international financial markets by noting that global financial conditions had tightened further over June. A number of central banks had continued to withdraw some of the substantial policy stimulus that had been in place and had highlighted their willingness to raise policy rates more quickly and above neutral levels if inflation remained high. A number of central banks had also acknowledged that policy rates above neutral and declines in real household incomes were likely to result in lower growth. Reflecting this, financial markets had become more concerned about the outlook for global growth.

The US Federal Reserve had increased its policy target range by 75 basis points at its June meeting, which was more than had been expected a month earlier; members of the Federal Open Market Committee had also projected that the policy rate would be increased further to a contractionary setting before the end of 2022. The European Central Bank had indicated that it would increase its policy rate for the first time in 11 years at its July meeting and confirmed that it would end net asset purchases that month. The Bank of Japan was the only major central bank indicating it would continue to add to its bond holdings. Members noted that Japan had experienced low inflation for a long time, and that both households and businesses expected this to continue despite the significant depreciation of the yen.

Government bond yields had risen in the first half of June, reflecting higher-than-expected inflation in the United States and a number of other countries, and the associated upward revisions to expected policy rates. Later in the month, however, long-term government bond yields had declined, reflecting increasing concerns that higher policy rates would result in lower growth. As a result, long-term yields were little changed since the previous meeting in most advanced economies, including Australia, while shorter-term rates had increased a little. Market pricing continued to suggest that market participants expected inflation to be high over the coming year, but that the tightening in monetary policy would be sufficient to bring inflation back down towards target levels relatively quickly after that. Members noted that these expectations were also consistent with the view that supply disruptions would ease over the coming year.

Private sector financing conditions had tightened further over the prior month. Equity prices had fallen sharply and corporate bond spreads had risen noticeably across most major markets, including Australia. The US dollar had appreciated further, consistent with the relative increase in short-term US Government bond yields this year. The Australian dollar had depreciated over the prior month, alongside declines in commodity prices and concerns around global growth, but remained around its level at the beginning of the year on a trade-weighted basis.

In China, financial conditions remained accommodative, with a range of policy measures in place to stabilise growth and support private investment. Private-sector demand for credit continued to be relatively weak, while equity prices had partially recovered from their recent lows following the easing of some COVID-19-related restrictions. Chinese property developers remained under severe stress. By contrast, financial conditions had tightened across other emerging market economies, reflecting domestic policy rate rises in response to higher inflation, the policy tightening in advanced economies and increasing concerns around global growth.

Domestic financial markets

Members noted that Australian financial conditions had tightened further in June, reflecting the larger-than-expected increase in policy rates at the June meeting and market expectations for a sharper policy tightening over the period ahead. Accordingly, money market rates had increased further in the month and Australian long-term government bond yields had risen to 2014 levels before declining later in the month. Market pricing implied that market participants expected the cash rate target to reach around 3 per cent by December. Members noted this was considerably higher than market economists' expectations. Nevertheless, both groups attached a high probability to a 50 basis point increase at the present meeting.

Banks' funding costs had risen considerably in preceding months in response to the rise in money market rates. Members observed that most lenders had passed on the policy rate increases in May and June in full to existing variable-rate housing borrowers and to most variable-rate small business borrowers. Fixed-rate loans accounted for almost 40 per cent of outstanding housing credit, and pass-through to these loans was expected to occur progressively over the following couple of years or so. Pass-through to deposit rates had been more selective to date.

Members noted that the stock of housing credit as a share of household disposable income was around three times higher than in the 1990s, which suggested the cash-flow channel of monetary policy had become larger over this period. In net terms, the ratio of debt to income was relatively steady over the prior decade as borrowers accumulated significant balances in offset and redraw accounts. These balances had increased further during the pandemic and could provide some buffer before rising interest payments affected consumption, although the distribution of these buffers was likely to vary significantly across different types of borrowers.

Growth in total credit had remained strong in May, at around its fastest pace in more than a decade. Lending to large and medium-sized businesses continued to grow strongly, supported by economic growth. Demand for housing finance remained high, although owner-occupier housing credit growth had eased in recent months and commitments for housing loans for both owner-occupiers and investors had edged down from their recent peaks. This was consistent with some signs of activity easing in the housing market.

The neutral interest rate

Ahead of their discussion about monetary policy, members considered the staff's estimates of the neutral real interest rate for Australia. The neutral rate is the real policy rate that is neither expansionary nor contractionary. It is one benchmark for assessing the stance of monetary policy.

Any development that affects the desired levels of saving or investment will affect the neutral rate. This includes slow-moving influences, such as trend productivity growth and demographic change, and more rapidly evolving influences, such as persistent changes in risk appetite. In a small open economy like Australia, where capital flows freely across borders, the neutral rate is determined by both global and domestic factors. Estimates of the neutral rate tend to be correlated across countries over time, reflecting similar global influences on saving and investment as well as spillovers across borders. In recent decades, estimates of the neutral rate have drifted lower in major advanced economies and in Australia.

Members noted that gauging the level of the neutral rate is challenging in practice because it cannot be directly observed and must instead be inferred from the data. The staff apply a range of methods for estimating the neutral rate, each with its own advantages and disadvantages, and each method produces a different estimate. The range of estimates is wide.

Members also observed that the cash rate is set in nominal terms, while the neutral rate is defined in real terms. Translating estimates of the neutral rate to a nominal interest rate involves adding inflation expectations. Like the neutral rate, economy-wide expectations for inflation cannot be directly observed and must be inferred from the data, adding an additional layer of uncertainty. Members observed that estimates of the nominal neutral rate were above the cash rate in the decade prior to the pandemic. This was a period when inflation was low, and potentially indicated limitations of the framework as a benchmark for the stance of policy.

In the context of the significant degree of uncertainty about estimates of the neutral rate and the limitations of the framework, members discussed three points. The first was that the current level of the cash rate is well below the lower range of estimates for the nominal neutral rate. This suggests that further increases in interest rate will be needed to return inflation to the target over time. The second was that the neutral rate framework indicates that if inflation expectations rise, the level of nominal interest rates required to return inflation to the target will be higher than otherwise. And the third was that the neutral rate framework provides only a general guide and any specific estimates need to be treated with caution.

Considerations for monetary policy

In considering the policy decision, members observed that inflation in Australia had increased significantly and was expected to increase further in the near term. Global factors, including COVID-19-related disruptions to supply chains and the war in Ukraine, accounted for much of the increase in inflation. However, domestic factors were also playing a role. Strong demand, a tight labour market and capacity constraints in some sectors were contributing to the upward pressure on prices. The east coast floods earlier in the year had also affected some prices, and the July floods would likely result in this persisting for a longer period of time.

Members noted that inflation is forecast to peak later in 2022 and then decline back towards the 2 to 3 per cent range in 2023. Inflation is expected to moderate as global supply-side problems continue to ease and commodity prices stabilise, even if at a high level. Higher interest rates will also help establish a more sustainable balance between the demand for and the supply of goods and services. A full set of updated forecasts will be published in August following the release of the June quarter CPI.

Members discussed the ongoing resilience of the Australian economy. Growth had been supported by household and business balance sheets that are generally in good shape, an upswing in business investment and the large pipeline of construction work to be completed. Macroeconomic policy settings were also supportive of growth and higher commodity prices had provided a boost to national income.

The resilience of the economy was most evident in the labour market. Employment had grown significantly in preceding months and the unemployment rate was at a multi-decade low. Job vacancies and advertisements were at high levels and further declines in unemployment and underemployment were expected. Information from the Bank's liaison program continued to indicate that wages growth would increase from the low rates of recent years as firms compete for staff in a tight labour market.

Members considered the evolving risks to household consumption, including how households would adjust their spending in response to higher prices and interest rates, and the impact of higher interest rates on the housing market. The recent spending data had been positive, although household budgets are under pressure from higher prices and higher interest rates. The household saving rate is also still higher than it was before the pandemic. Many households have built up large financial buffers and are benefiting from stronger income growth. Housing prices had declined in some markets over preceding months, but remained significantly higher than prior to the pandemic, thereby supporting household wealth and spending. Members agreed it was important to continue to monitor these various influences on household spending when assessing the appropriate setting of monetary policy.

Members also considered the risks to the global outlook, which remained clouded by the war in Ukraine and its effect on the prices of energy and agricultural commodities. Members noted that real household incomes are under pressure in many economies and financial conditions are tightening, as central banks increase interest rates. There are also ongoing uncertainties related to COVID-19, especially in China.

In making their policy decision, members considered the possibility of raising interest rates by 25 basis points or 50 basis points. Members agreed that arguments for raising interest rates by 50 basis points were stronger. The level of interest rates was still very low for an economy with a tight labour market and facing a period of higher inflation. Members viewed it as important that inflation expectations remained well anchored and that the period of higher inflation be temporary. If medium-term inflation expectations were to adjust upward, the task of returning inflation to the target would be more difficult and would come at a higher cost in terms of activity and employment. Members noted that, while short-term inflation expectations had risen with actual inflation, longer-term measures of inflation expectations were well anchored.

Members agreed that further steps would need to be taken to normalise monetary conditions in Australia over the months ahead. The size and timing of future interest rate increases will continue to be guided by the incoming data and the Board's assessment of the outlook for inflation and the labour market, including the risks to the outlook. The Board remains committed to doing what is necessary to ensure that inflation in Australia returns to the target over time.

The decision

The Board decided to increase the cash rate target by 50 basis points to 1.35 per cent. It also increased the interest rate on Exchange Settlement balances by 50 basis points to 1.25 per cent.