Statement on Monetary Policy – August 2006 International Economic Developments

Global economy

The world economy has continued to grow strongly during 2006. US economic growth remains solid, although it moderated somewhat recently; the rapid growth in the Chinese economy shows no signs of slowing; and Japan's economic expansion is looking increasingly robust. Growth has also continued at a firm rate in the rest of east Asia, and the economic recovery in the euro area is progressing, albeit at a moderate pace. Following the favourable economic outcomes during the first half of 2006, the Consensus forecast for world growth in 2006 was revised up again over the past three months and now stands at 5 per cent, well above the trend rate of growth (Table 1). World growth is also expected to remain firm in 2007. The overall growth outlook for Australia's major trading partners in 2006 and 2007 is similar to that for the world as a whole.

The strong growth performance has underpinned continuing high prices for energy and other commodities. Oil prices have recently traded around US$75 per barrel, up slightly from their level around the time of the last Statement, with recent strength largely reflecting events in the Middle East (Graph 1). Prices have increased from around US$60 per barrel at the start of the year, to be triple the oil price level prevailing as recently as 2002, but most of this rise reflects ongoing strong global demand and low spare capacity in global supply. Looking ahead, although the International Energy Agency revised down its forecast for growth in world oil demand for 2006 and increased its forecast for oil production for 2007, long-term futures prices remain at high levels, suggesting that market participants expect prices to stay around current levels for an extended period.

In response to the strong economic growth and high oil and other commodity prices, CPI inflation has increased in most regions. ‘Core’ inflation has also increased in some countries, leading to concerns that the higher energy prices may be feeding through to second-round price effects. These developments have prompted central banks around the world to tighten monetary policy. Nonetheless, inflation has generally been more contained than past experience might suggest, due in large part to solid productivity growth and continued well-anchored inflation expectations.

United States

After several years of above-trend growth, surplus capacity in the US economy appears to have been substantially removed. Real GDP growth slowed to 0.6 per cent in the June quarter and 3.5 per cent over the year, as demand has started to respond to the increases in interest rates over the past couple of years, the recent slowing in the housing market, and high energy prices (Graph 2).

Consumption increased by 0.6 per cent in the June quarter, below the average quarterly growth rate of 0.9 per cent in recent years, to be 3.0 per cent higher over the year. This slowing may partly reflect an easing in the pace of house price growth that, through strong household wealth effects, had boosted consumption growth over the past couple of years. The rise in gasoline prices since the start of the year is also reported to have reduced consumer spending on other items. Nonetheless, the strength in the labour market has helped to support household spending. Although non-farm payrolls growth slowed to 0.2 per cent over the June quarter, the unemployment rate continued to fall, to be at a five-year low of 4.6 per cent in June.

After several years of strong performance, conditions in the US housing market have eased. The 30-year fixed mortgage rate has continued to drift higher, averaging 6.8 per cent in July compared with 5.7 per cent a year earlier, which has dampened home sales. As a consequence, the stock of unsold new and existing houses has increased to around six months of current monthly sales from around four months over much of the past decade. Residential investment fell by 1.6 per cent in the June quarter, following small falls in the previous two quarters. Leading indicators such as housing starts and permits to build have fallen noticeably since the start of the year, while builders' confidence is at the lowest level since the early 1990s. House price growth has eased. Growth in the Office of Federal Housing Enterprise Oversight (OFHEO) repeat sales index of house prices slowed to 2.0 per cent in the March quarter, the lowest quarterly rate for two years, and the National Association of Realtors' (NAR) existing home sales series suggests an even sharper slowing (Graph 3).

Growth in business investment moderated in the June quarter, to be 0.7 per cent for the quarter, and growth in core capital goods orders also slowed. Nonetheless, the outlook for business investment remains favourable: capacity utilisation is high, profits continue to grow strongly and business sentiment remains at a healthy level.

Net exports contributed 0.1 percentage points to growth in the June quarter, as the volume of exports increased while imports were flat. In nominal terms, the trade deficit in the June quarter was steady at 5.9 per cent of GDP.

Energy price increases pushed headline inflation up to 4.3 per cent over the year to June, and core inflation picked up to 2.6 per cent, its fastest pace in over four years (Graph 4). Some indicators suggest that inflation expectations have increased, although productivity growth has remained firm. The Federal Reserve has continued to tighten monetary policy, raising the federal funds rate by a further 25 basis points to 5.25 per cent at the June meeting of the Federal Open Market Committee.

Asia-Pacific

Japan

The economic expansion in Japan has continued, with growth broadly based across domestic private demand and the export sector. Real GDP increased by 0.8 per cent in the March quarter, to be 3.5 per cent higher over the year. In the June quarter, year-ended growth in industrial production remained solid at around 4 per cent and the ongoing global ITC recovery continued to underpin strong merchandise export growth of 15 per cent over the year. A more confident business sector has remained an important feature of the recovery, reflecting solid balance sheets and profitability, as well as strong domestic and external demand conditions. Investment increased by 3.1 per cent in the March quarter, with year-ended growth at 7.4 per cent. The investment outlook remains favourable: machinery orders continue to trend upwards, and capacity utilisation rates for both the manufacturing and non-manufacturing sectors are at high levels. Investment intentions in the June quarter Tankan survey were revised up significantly, with business conditions reported at their highest level since the early 1990s.

Conditions in the household sector have continued to strengthen. Consumption increased by 2.4 per cent over the year to the March quarter, and consumer sentiment remains well above its long-run average, helped by a further improvement of the labour market (Graph 5). The unemployment rate is around an eight-year low, the participation rate has stabilised following a protracted decline, and the job offers-to-applicants ratio has been above one since late 2005. Positive sentiment about future employment conditions suggests a favourable outlook.

Consumer prices have continued to record modest annual increases in recent months, providing further evidence that the deflation period has ended. As a consequence, after an extended period when interest rates were held at zero per cent, the Bank of Japan increased the short-term interest rate to 0.25 per cent at its July meeting. This is a further step toward policy normalisation that began with the termination of the quantitative easing policy in March, although the Bank noted in its recent statement that rates are likely to remain low for some time.

China

Rapid growth in the Chinese economy continues to support growth elsewhere in Asia, Australia and around the world. Real GDP is estimated to have increased by more than 11 per cent over the year to the June quarter, its fastest pace in over a decade. Growth was again concentrated in business-sector activity and net exports. Fixed asset investment increased by 34 per cent over the year to June and industrial production increased by 20 per cent. Retail sales are also growing at around their strongest pace in more than a year. Growth in exports, at 22 per cent over the year to June, continued to run somewhat ahead of the growth in imports. The monthly trade surplus in the first half of 2006 averaged US$12.5 billion, nearly 50 per cent larger than the monthly average during the first half of 2005.

The strong growth in the Chinese economy has been accompanied by stimulatory financial conditions, with recent rates of money and credit growth around two-year highs. In response, the People's Bank of China increased lending rates in April and has raised the required reserve ratio by 1 percentage point (to 8.5 per cent), and in the past few months the government introduced tax measures designed to cool the housing sector. While producer price inflation has picked up, the official measure of consumer price inflation has remained low, at 1.5 per cent over the year to June.

Other Asia-Pacific

In the rest of east Asia, solid growth is being supported by healthy domestic demand, global demand for ITC goods and strong demand from China. Real GDP in the region increased by 1.0 per cent in the March quarter, to be 6.0 per cent higher in year-ended terms (Graph 6). Most countries have experienced favourable outcomes, but a decline in confidence in response to a rise in consumer credit card defaults has led to weaker growth in Taiwan, and growth has slowed in Indonesia in response to high interest rates and a fall in government consumption.

The generally solid growth performance of the region has reflected firm domestic and external demand. On the domestic side, low real interest rates and good labour market conditions underpinned private consumption growth in most countries in the March quarter. In addition, business investment rebounded in the quarter after the surprising weakness seen in 2005. More timely indicators suggest that this strength in domestic demand continued into the June quarter. On the external side, merchandise exports grew by more than 15 per cent over the year to May, and the continued improvement in ITC demand indicators suggests that external demand will remain strong in coming months.

Inflation has drifted higher across the region over the past couple of years in line with oil prices, especially in the countries that have reduced oil subsidies. Central banks across the region have raised rates, with Korea, Thailand and Taiwan recently tightening policy further, although real interest rates have mostly remained low. In contrast, interest rates in Indonesia were lowered by 50 basis points over the past three months in response to slower economic growth and an easing of the inflationary pressures evident in the second half of 2005.

The Indian economy expanded particularly strongly in the March quarter, taking year-ended growth to 9.3 per cent, its fastest pace for over two years. Construction and services remained the strongest performing sectors. Growth in industrial production has also strengthened, to be 10 per cent over the year to May. Wholesale price inflation picked up to close to 5 per cent over the year to June from 3½ per cent in August 2005. In response, the Bank of India has raised its policy rate by 50 basis points since the last Statement.

In New Zealand, economic growth rebounded to 0.7 per cent in the March quarter, after outcomes close to zero in the second half of 2005, and GDP was 2.0 per cent higher over the year. However, more recent indicators suggest domestic demand remains relatively subdued, and consumer and business confidence measures have been weak. Nevertheless, the labour market remained tight in the March quarter, with employment increasing by 2.6 per cent over the year and labour costs continuing to rise strongly. Year-ended consumer price inflation increased to 4.0 per cent in the June quarter, and the Reserve Bank of New Zealand has noted that it remains concerned about inflationary pressures.

Europe

The recovery in the euro area is progressing. Following a weak December quarter, growth was 0.6 per cent in the March quarter and 2.0 per cent over the year (Graph 7). Growth in Germany and Italy improved in the March quarter after flat December quarter outcomes, while French growth remained solid and the Spanish economy continued to expand strongly.

Consumption increased by 0.6 per cent in the March quarter and was broadly based across the region. While the increase in German consumption only unwound the fall in the December quarter, recent indicators suggest that consumer spending in Germany may improve further, after stagnating for the past five years or so. Consumer confidence is above its long-run average level, employment has increased and unemployment is trending downwards. While recent strength in consumption may partly reflect the staging of the FIFA World Cup in Germany, developments have generally been positive across the euro area as a whole.

Business conditions remain buoyant, with euro area business confidence and the manufacturing PMI advancing steadily over the past year, to be well above their long-run averages. Much of the positive sentiment in the business sector has stemmed from strong external demand; merchandise exports increased by 12 per cent over the year to May and foreign manufacturing orders increased strongly. Industrial production in the euro area continues to expand, increasing by almost 5 per cent over the year to May, and profits increased further in the March quarter.

The European Central Bank (ECB) has continued to tighten policy, with the repo rate rising by 25 basis points to 2.75 per cent in June, the third increase since December 2005. Nevertheless, the ECB views monetary policy as remaining accommodative and expects that, on the basis of their current assumptions, some further tightening will be required. Headline inflation is above the ECB's 2 per cent reference rate, at 2.5 per cent in July, although core inflation has been lower at around 1½ per cent.

Economic growth in the UK continued to recover in the June quarter, and was 2.6 per cent over the year. Growth has been led by the consumer sector; consumer sentiment remains above its long-run average and house price growth continues to recover, although the unemployment rate increased to 5.4 per cent in May from a low of 4.7 per cent during 2005. Headline inflation picked up to 2.5 per cent over the year to June, but underlying inflation remained low, at 1.2 per cent over the same period. In recent months, the Bank of England held its policy rate unchanged at 4.5 per cent.