Statement on Monetary Policy – August 2006 Introduction

International economic conditions are continuing to support growth in Australia. The world economy is now in its fourth successive year of above-average growth, and most observers expect this to continue in the year ahead. While there have been signs of some moderation in the United States recently, this is currently being offset by stronger growth in other parts of the world. The Japanese economy is experiencing its best period of sustained expansion for some time. In China, recent indications are that the pace of growth has picked up this year from an already high rate. The performance of the smaller east Asian economies has remained solid, benefiting from the strength in China and in global electronics demand. There has also been a gradual improvement in conditions in the euro area.

The strength of the global economy over recent years has been accompanied by sustained upward pressure on commodity prices. One important element of this has been the increase in crude oil prices during this period. Although events in the Middle East have recently contributed to the pressure on oil prices, their upward trend over the past few years has been mainly a consequence of strong global demand. The increases in commodity prices have been broadly based. Prices of Australia's base metals exports have increased by 40 per cent since the start of the year, following on from strong increases in each of the previous two years. In addition, contracts finalised in recent months for Australia's bulk commodity exports have provided for further rises in iron ore prices, while coal prices have fallen only modestly after their near-doubling last year. Overall, Australia's terms of trade are estimated to have increased by 6 per cent over the year to the June quarter, and by a cumulative 34 per cent since 2002.

These global trends have also been associated with upward pressure on consumer price inflation in the major countries. Headline inflation around the world has been pushed up by higher fuel costs, but there have also been signs of more widespread price pressures, with some upward drift in core inflation rates. In the United States, the core CPI inflation rate has picked up by around half a percentage point since the start of the year. In Japan, consumer prices have begun to rise, and there have been increases in inflation rates in a number of other Asian economies.

Against this background, it is not surprising that interest rates in the major economies have been increasing. Long-term bond yields have risen noticeably since the start of the year. Central banks in the major economies have been in the process of normalising their interest rates after a period when they had been unusually low. The United States is the furthest advanced in this, but the European Central Bank has also been gradually raising its policy rate since late last year and the Bank of Japan has recently started to increase its interest rate after a lengthy period when it had been held at zero. In Australia, short-term market interest rates increased over recent months in response to stronger economic data, such that by late July the prospect of an increase in the cash rate at the August Board meeting was fully reflected in market yields.

The Australian economy has continued to grow at a good pace recently, with GDP expanding by around 3 per cent over the year to the March quarter. The expansion has been driven by domestic spending, with business investment the fastest growing component. Growth in investment spending has been broadly based, though the strongest part has been the mining industry, where investment has roughly doubled over the past year. Combined with moderate increases in spending by other domestic sectors, the rapid growth in business investment has meant that total domestic spending has been expanding at an above-trend pace.

More recent information on domestic activity and finance suggests that conditions may have strengthened further over recent months. Employment posted strong gains in the June quarter, and business surveys have continued to report above-average trading conditions for the economy overall. Retail sales, though moderating recently, appear to be on a firmer trend than last year. While rising fuel costs may be having a dampening effect on discretionary spending, the tax cuts that came into effect in July, coupled with growing employment, will boost household incomes and should add to spending in the second half of the year.

Evidence of strong domestic conditions can also be seen in the increasing demand for finance. The growth of household credit picked up to an annualised pace of almost 15 per cent over the six months to June, compared with a rate of 11 per cent at the end of last year. Monthly data for credit and loan approvals suggest that the demand for finance by households was strengthening further in May and June. Business credit has also continued to expand at a fast pace, reflecting favourable business conditions and rapid expansion in investment spending. Over the past six months, business credit grew at an annualised rate of 18 per cent. It is clear from these trends that both households and businesses have found it attractive to borrow at recently prevailing interest rates.

One of the factors stimulating credit growth has been the compression of margins by lenders. This has had the effect of limiting the rise in interest rates paid by borrowers over the past couple of years. While the cash rate is now modestly above its average for the low-inflation period since 1993, compression of lending margins over recent years means that interest rates paid by both housing and business borrowers are still a little below average, and will remain so even after allowing for the expected pass-through of the August policy change.

The increased household demand for finance has been accompanied by signs of firmer conditions in the established housing market. House prices nationally have been rising gradually since late last year, and preliminary indications are that they also rose in the June quarter. However, the national average has been pushed up by large increases in Perth, where prices rose by more than 30 per cent over the past year. Prices have been broadly flat in Sydney over the year, while rising in the other capitals. These differences have in part been a reflection of the broader regional disparities in demand and output, with the resource-rich states of Western Australia and Queensland growing more strongly than the south-eastern states.

As has been the case for some time, the strength of the economy over the past year has reflected contrasting contributions from domestic spending and exports. Despite the strong conditions prevailing internationally, Australia's export performance has been disappointing. While it is true that export revenues have been growing strongly, and thus have added to the growth of national income, this revenue growth has been largely accounted for by higher prices, with volumes increasing only modestly. Nevertheless, while the expected pick-up in export volumes has been slow to materialise, prospects for growth in resource-based exports should be assisted by the substantial investment underway in that sector.

The national economy is now at a stage of the economic cycle where spare capacity is rather limited. Capacity utilisation levels reported by businesses in the June quarter were close to their highest levels in more than a decade. Labour market conditions are tight, with the unemployment rate at its lowest point since the 1970s, while job vacancies are at a record level. Business surveys and liaison reports continue to indicate that labour scarcity is a significant concern, with many businesses reporting that this is a bigger constraint on their activities than traditional concerns about the adequacy of demand. These indications of tight capacity are not surprising in an economy in its fifteenth year of continued expansion. Looking ahead, it appears likely that growth of the economy in the next year or two will on average be somewhat higher than it was over the year to the March quarter. This outlook implies that capacity is likely to remain tight over the period ahead.

The combination of rising world commodity prices, strong domestic demand and tight capacity has contributed to increased inflationary pressure in Australia. Raw materials costs have picked up as a result of broad-based increases in global commodity prices, and there has been a general pick-up in output prices at all stages of production. Wages growth, although more stable recently, has been somewhat higher than its average of the past few years, particularly in the private sector. There has also been an increase in underlying consumer price inflation. Over the year to the June quarter, underlying inflation is estimated to have picked up to a rate of just under 3 per cent, continuing the upward drift that had started to become apparent in the previous quarter. These developments indicate that underlying inflationary pressures have been a little stronger than was expected at the time of the May Statement.

Although the increase in the June quarter headline CPI was much larger than estimates of the underlying rate, reflecting fuel price increases and a sharp rise in the price of bananas in the wake of Cyclone Larry, it is important to abstract from temporary influences in assessing the medium-term outlook. Overall, the Bank's assessment following receipt of the June quarter prices data was that underlying inflation would remain somewhat higher than had previously been forecast. This assessment was based on the gradual increase in underlying inflation this year, and the wider background of above-average global growth and strong domestic demand. Taking into account the expected effect of the August policy decision, the Bank's current forecast is that underlying inflation over the next two years will be around 3 per cent. In the short term, headline CPI inflation can be expected to remain significantly higher than that, but will decline to the underlying rate when temporary factors drop out of the calculation.

In summary, the situation reviewed by the Board at its recent monthly meetings was one in which evidence of stronger domestic conditions and inflation pressures was accumulating. The global economy was maintaining its strong pace of growth, while inflation in a number of countries was rising. In Australia, national accounts data indicated a pick-up in the pace of growth in demand and output in the early part of the year, while more recent data pointed to further strength, with business surveys reporting good conditions in the June quarter and employment posting large gains. In addition it was apparent that the household sector's demand for finance had been increasing through the first half of the year. Data on producer and consumer prices for the June quarter indicated that these domestic and international developments had been accompanied by stronger inflationary pressures.

As a result of these considerations, the Board judged at its August meeting that a further increase in the cash rate was warranted in order to contain inflationary pressures in the medium term. The Board will continue to monitor developments and make such policy adjustments as may be required to promote sustainable expansion of the economy consistent with low inflation.