Statement on Monetary Policy – February 2007 International Economic Developments

Global economy

The world economy continued to expand at a strong pace in 2006, led by rapid growth in China and other emerging economies (Graph 1). The United States grew at a robust pace in 2006 despite the slowdown in the housing sector. While conditions in Japan remain supportive of its expansion, growth there has softened in recent quarters. The upswing in the euro area continued and economic activity in the east Asian region remains healthy.

Consensus forecasts are for above-trend global growth of 4.7 per cent in 2007, down from 5.4 per cent in 2006, reflecting moderation in growth in most of the major regions (Graph 2). A key risk to the global economy has been that the US economy might slow more sharply than expected if prolonged weakness in the housing sector spreads to the rest of the economy. However, to date the US economy has proved resilient. In addition, the rise of China and other emerging economies, and the expansions underway in Japan and Europe, are likely to support global growth in the event of a slowing in the United States.

Headline inflation eased significantly in most industrialised countries towards the end of 2006 reflecting lower oil prices. However, core inflation has picked up over the past year in a number of countries. With many economies operating much closer to capacity after several years of expansion, central banks remain concerned about upside risks to inflation.

United States

The US economy continued to expand at a healthy pace over 2006. Real GDP increased by 0.9 per cent in the December quarter, defying earlier expectations of only soft growth, to be 3.4 per cent higher over the year (Graph 3). Strong consumption and exports drove growth in the quarter. The downturn in housing construction continued and there were cutbacks in production in the auto sector in part because consumers are switching to more fuel-efficient foreign-made vehicles. However, other parts of the economy proved resilient.

Consumption grew by a strong 1.1 per cent in the December quarter. Although slowing house price growth is likely to be weighing on consumption, buoyant financial markets and the decline in petrol prices are likely to be providing some offset. Tight labour markets also continue to bolster household spending. Payrolls employment growth remained firm at 1.6 per cent over the year to January, and at 4.6 per cent the unemployment rate was close to recent lows (Graph 4). Measures of consumer sentiment are positive.

The US housing market cooled over 2006 after a strong upswing during the preceding four years (Graph 5). Residential investment contracted by 5.2 per cent in the December quarter, to be 12½ per cent lower over the year: the largest year-ended fall since 1991. The stock of unsold new houses is high, and further falls in residential investment are expected in the first half of 2007. House price growth has continued to slow. The Office of Federal Housing Enterprise Oversight (OFHEO) repeat sales measure of house price growth eased to 6.0 per cent in year-ended terms in the September quarter and some other price series have recorded falls. However, some indicators of housing demand have been more positive: mortgage applications have increased in line with lower 30-year mortgage rates, home buyers' sentiment has also improved markedly, and home sales have levelled out after falling sharply until mid 2006.

Conditions in the business sector remain generally positive despite weakness in some sectors. Manufacturing production was weak in the December quarter reflecting softness in construction-related sectors and falling motor vehicle production. Outside of these sectors, production is stronger and business confidence is generally positive. Although there was a pause in growth in business investment in the December quarter, financing conditions remain supportive of solid investment growth as corporate balance sheets are strong and the cost of capital is low.

CPI inflation has fallen significantly since the middle of 2006, largely reflecting lower oil prices (Graph 6). Core inflation has also been more subdued in recent months, although the year-ended rate, 2.6 per cent in December, remains high relative to recent years. The Federal Reserve expects inflation to continue to ease as a result of lower energy prices and moderating domestic demand growth, although upside risks remain, especially from the tight labour market.



Growth in Japan slowed over 2006, and recent revisions have reduced the reported year-ended GDP growth rate by about 1 percentage point, to 1.7 per cent over the year to the September quarter. This followed growth of 2.9 per cent over 2005. However, conditions remain supportive of continued growth.

Business investment increased by 7.7 per cent over the year to the September quarter and more timely indicators are consistent with continued investment growth. Corporate balance sheets are healthy, and firms are positive about their own financial positions and the financing environment. Production and exports have continued to expand, and according to the December quarter Tankan survey, capacity is stretched in many sectors of the economy and firms have continued to revise up their near-term investment intentions.

After increasing over 2005, consumption growth appears to have slowed in 2006. To some extent this probably reflects a slowing in growth in household earnings, which were broadly flat over 2006 (Graph 7). However, continuing favourable conditions in the labour market suggest that the weakness in earnings and consumption is unlikely to persist. The unemployment rate was 4.1 per cent in December, close to an 8-year low, and job offers exceeded applicants. Surveys suggest both employers and employees continue to be positive about future labour market conditions.

Growth in consumer prices has been modest, with the CPI increasing by 0.3 per cent over 2006. Core inflation, as measured by the CPI excluding food and energy prices, remained negative, though the pace of decline in prices has slowed slightly to 0.3 per cent. Upstream prices continue to rise more quickly, with corporate goods prices rising by 2.5 per cent over the year to December.


Chinese GDP increased by 10.4 per cent over 2006, the fourth year of growth around 10 per cent. While consumer spending is expanding at a strong pace, growth has been concentrated in the business sector as rapid investment drives the development of the economy and the expansion of manufacturing capacity, and thereby exports. However, there were signs of a slowing in growth in fixed-asset investment in the second half of 2006 following various policy initiatives aimed at restraining some forms of investment. Most recently, this involved 50 basis point increases by the People's Bank of China in its reserve requirement ratio in both November and January, the third and fourth such increases since June 2006. Nevertheless, growth in credit has eased only a little from the high rates reached in mid 2006 and financial conditions are very buoyant.

External demand continues to support growth, though export growth slowed slightly in recent months to be 24 per cent over the year to December. Year-ended growth in imports remained lower, at 14 per cent in December, and so the trade surplus widened further in the December quarter to US$54 billion, compared with US$23 billion a year earlier.

Growth in upstream prices has continued to run ahead of consumer prices, but strong productivity growth appears to be keeping inflation in check. Over the year to December, producer prices increased by 3 per cent, while year-ended growth in urban incomes was around 15 per cent, indicative of continued rapid wages growth. Growth in Chinese export prices also appears to have picked up moderately; the growth of the prices of goods re-exported through Hong Kong increased over 2006, to be 2 per cent over the year to November. Consumer price inflation picked up somewhat to 2.8 per cent over the year to December, though this appears to largely have reflected growth in food prices.

Other Asia-Pacific

GDP growth in the rest of east Asia continued at a healthy pace in 2006. GDP in the region increased by 5.3 per cent over the year to the September quarter (Graph 8). Growth in Korea, the largest economy in this group, was slower at 4 per cent over the year to December in response to policy tightening during the year. There were some indications that growth in the ITC sector moderated in mid 2006, leading to a slight easing in industrial production and export growth from their earlier rapid rates, though growth in goods exports from the region remained solid at 13 per cent over the year to November. Favourable labour market conditions also continue to support consumption throughout much of the region. However, inflation is contained; year-ended inflation for the region as a whole slowed to 2.7 per cent over 2006.

The Indian economy continues to grow rapidly, with real GDP increasing by 9.2 per cent over the year to the September quarter. Industrial production increased strongly in November, to be 15 per cent higher over the year. Domestic demand remains the major driver of growth, and credit and asset prices are growing strongly. Furthermore, after four years of growth averaging around 8 per cent, infrastructure bottlenecks are intensifying. Wholesale price inflation remained high at 5.6 per cent over 2006, although recent monthly inflation outcomes have been subdued.

In New Zealand, GDP growth in the September quarter was again soft at 0.3 per cent in the quarter and 1.3 per cent over the year. Domestic demand growth weakened during 2006 in response to higher interest rates. However, consumer sentiment increased strongly in the December quarter – to be back above long-run average levels – buoyed by lower petrol prices, renewed strength in the housing market and continuing favourable labour market conditions. Year-ended consumer price inflation eased to 2.6 per cent in the December quarter, reflecting lower petrol prices, after peaking at 4.0 per cent in mid 2006.


The expansion in the euro area economy has continued, though growth moderated in the second half of 2006 after strong growth in the first half of the year. GDP increased by 0.5 per cent in the September quarter, to be 2.8 per cent higher over the year. External demand has provided a considerable impetus to growth, with exports increasing by 12 per cent over the year to November. However, domestic demand also picked up in 2006 driven by investment, which increased by 4.6 per cent over the year to the September quarter. In Germany, investment is being boosted by increasing construction activity, which had been in decline for a decade. For the euro area, business confidence remains well above long-run average levels, and over the year to November industrial production increased by 2.5 per cent and industrial orders for manufactured goods rose by 6.2 per cent (Graph 9).

While there are some signs of improvement in the household sector as well, consumption growth has remained subdued. Labour market conditions are strengthening and the euro area unemployment rate has fallen steadily to 7.5 per cent in December from a peak of 8.9 per cent in mid 2004. In addition, consumer sentiment has increased to be around its highest level since mid 2001. However, year-ended growth in consumption was still moderate at 1.8 per cent in the September quarter, and retail sales growth was subdued in the December quarter. This was despite some apparent pull-forward of expenditure ahead of the increase in the VAT in Germany at the start of 2007.

Headline inflation in the euro area has eased in line with oil prices to be just below the European Central Bank's (ECB) reference rate of 2 per cent, after an extended period around 2½ per cent (Graph 10). While core inflation, which excludes the effect of petrol prices, remained lower at 1½ per cent over 2006, upstream price pressures persist. Year-ended growth in core producer prices was 3.4 per cent over 2006. The ECB raised its policy rate by 25 basis points in December to 3.5 per cent and noted that the stance of policy remains stimulatory.

Growth in the United Kingdom has remained firm. GDP rose by 3.0 per cent over 2006, driven by the ongoing investment upswing and solid growth in household spending, which was supported by rising house prices. Headline inflation picked up to be 3.0 per cent over 2006, above the Bank of England's target of 2 per cent. The Bank of England raised its policy rate by 25 basis points to 5.25 per cent in January, noting that limited spare capacity in the economy appears to be placing upward pressure on inflation, with the risks to inflation judged to have moved further to the upside.

Commodity prices and Australia's terms of trade

Strong global economic growth and demand for commodities, in particular from China, have driven a substantial upswing in the prices of Australia's resource exports over the past three years. With expansions in supply beginning to come on line for some commodities, and possibly some slowing in the growth of demand, in recent months increases in prices of commodities have been much more moderate. The RBA's index of commodity prices (ICP) was broadly flat (in SDR terms) over the three months to January after rising by 16 per cent over the prior twelve months (Graph 11, Table 1). The base metals price index, which had roughly trebled since 2003, fell by 2 per cent over the most recent three months. The small change in this index disguised large offsetting movements in the prices of different metals. The price of copper fell by 25 per cent over the three months to January. The fall followed a very substantial run-up in the price and no doubt reflected a combination of news about fundamentals – in recent months the growth in production outpaced the growth in demand – and reversal of earlier speculative sentiment. In contrast, the prices of most other base metals continued to increase. In addition, oil prices (not in the ICP) have fallen by around 7 per cent since the last Statement and are around 25 per cent lower than their peaks in July. The decline in oil prices appeared to reflect a combination of increasing supply from non-OPEC countries, some softening in growth of demand, and some easing in speculative pressures.

Benchmark contract prices for coking coal and iron ore for 2007/08 have already been settled, though steaming coal contract prices are still being negotiated (Graph 12). Iron ore prices were settled at a 9½ per cent premium over 2006/07, underpinned by expectations of continued strong demand from Chinese steel producers. In contrast, key coking coal prices will fall by 15–20 per cent, as large increases in global supply are expected over the next year or so, much of it coming from Australia. However, this would leave the price around 110 per cent higher than the 2003/04 contract price. The combined impact of the new bulk commodity contracts should leave the ICP marginally lower.

Rural commodity prices rose by 3½ per cent over the three months to January (Graph 13). Wool prices have risen by around 25 per cent over the past few months reflecting concerns about the effect of the drought on Australian wool production, which accounts for around a quarter of global production and roughly two-thirds of global exports. Wheat and beef prices have fallen in recent months though they remain at relatively high levels.

Commodity prices are generally expected to moderate in 2007, but to remain at historically high levels. Analysts' forecasts and futures market pricing both suggest that base metals prices are expected to fall as new mine production comes on stream following the large run-up in prices in recent years. In addition, developments in the coal and iron ore markets suggest that significant additional price growth is unlikely for those commodities.

Australia's terms of trade continued to rise solidly through 2006 (Graph 14). Export prices rose by around 7 per cent, mostly due to the strength of commodity prices. Import prices were broadly unchanged over the year. The increase in the terms of trade over the three years to the December quarter was around 33 per cent, taking them to the highest level since the 1950s wool boom.