Statement on Monetary Policy – August 2009 Economic Outlook

The international economy

At the time of the May Statement, there were only tentative signs of stabilisation in the global economy. Since then, conditions in global financial markets have improved and measures of household and business confidence suggest that the extreme pessimism that took hold in late 2008 has eased noticeably. More generally, the significant policy stimulus in a number of countries is having a marked effect, particularly in China and some other economies in east Asia.

Given these developments, the RBA staff's central forecast for global economic growth has been revised upwards. This revision is mostly in Asia, with growth prospects improving in the large emerging economies (China and India), some of the higher-income economies (Korea, Singapore and Taiwan) as well as in Japan. The outlook in North America is also somewhat firmer, but there has been limited improvement in prospects for European growth. Overall, output in Australia's trading partners (weighted by export shares) is expected to grow in the second half of 2009, although given the earlier weakness, a contraction in year-average terms of around 1 per cent is expected for the year as a whole. Year-average growth of nearly 3½ per cent is then expected in 2010 (Graph 85). This outlook is somewhat more positive than that implied by the July forecasts from the IMF, especially for the rest of 2009 and for east Asia.

More broadly, the pace of the global recovery over the next few years is still expected to be relatively subdued, especially in the larger advanced economies. Notwithstanding previous experience that recoveries out of deep recessions can be quite strong, many advanced economies will face significant headwinds as the household and financial sectors consolidate their balance sheets. In addition, governments will be under pressure to consolidate their budgetary positions after a very significant easing in the past year or so, which in some cases may raise medium-term sustainability concerns unless remedial action is taken.

The weakness in the global economy over the past year has contributed to a significant decline in commodity prices and Australia's terms of trade, although spot prices for coal and iron ore and for exchange-traded commodities have generally strengthened over the past three months. Overall, given the earlier large decline in bulk commodity contract prices, the terms of trade are expected to record a fall of just over 20 per cent from their 2008 peak (Graph 86). This would nonetheless still leave the terms of trade around 45 per cent above the average level that prevailed between 1980 and 2000.

Domestic activity

Recent data suggest that the domestic economy is also performing better than had been expected, benefiting from the significant stimulus delivered by fiscal and monetary policy as well as the stronger growth in China. In contrast to the experience in most other countries, export performance has remained solid. In addition, consumer and business confidence have rebounded, and there has been a fairly broad-based improvement in the outlook for domestic spending.

The forecasts presented below are based on the assumption that the exchange rate remains around its current level and that oil prices move broadly in line with near-term futures pricing. In previous Statements the forecasts were prepared using the additional technical assumption that the cash rate remained constant throughout the forecast period. In the current environment, however, it is not particularly realistic to assume that the cash rate remains at the historically low level of 3 per cent out to the end of 2011. Given this, the current forecasts have been prepared on the technical assumption of a return towards a more normal setting of monetary policy over the forecast horizon. This use of a more realistic technical assumption by the Bank staff in no way constitutes a commitment by the Board to a particular future path of the cash rate.

As discussed in the ‘Domestic Economic Conditions’ chapter, the different measures of GDP growth in the March quarter suggest quite different pictures about the underlying momentum of the economy in the first part of the year, although the average of the measures showed stronger growth than was generally expected. These measurement issues – which raise the possibility of larger-than-usual revisions – make forecasting the growth outcome for 2009 more difficult than usual. With this qualification in mind, the Bank's central forecast is now for the economy to grow by around ½ per cent over 2009, compared with a forecast contraction of 1 per cent at the time of the May Statement (Table 14). About half this revision reflects the stronger-than-expected March quarter outcome. But the forecasts also embody more genuine strength in the economy than had been expected a few months ago.

The composition of spending over the second half of the year is expected to be somewhat different from that in the first half, when household consumption was quite strong and business investment and home-building were weak. Looking forward, consumption spending is likely to slow as the boost from the fiscal payments to households fades. In addition, while asset prices have recovered over recent months, the decline in net worth over 2008 is likely to continue to contribute to higher rates of household saving than seen over much of this decade. In contrast, home-building is likely to pick up, reflecting the lower level of mortgage rates and the increase in grants for first-home buyers, although the outlook for apartments looks less promising due to financing difficulties in that sector. Public spending is now also growing strongly as a result of the stimulus-related expenditure on schools, home insulation and public infrastructure.

The economy is forecast to gradually strengthen through 2010 and 2011, with growth expected to be around 3¾ per cent, or moderately above-trend, by the end of the forecast period. In year-average terms, GDP is expected to grow by ½ per cent in 2009/10 and 2½ per cent in 2010/11. These would represent better outcomes than those expected for most other advanced economies, with Australia's medium-term growth prospects bolstered by its relatively fast rate of population increase and the strong growth in the capital stock over recent years (Graph 87). In addition, Australia's exposure to China, India and elsewhere in Asia – where the demand for resources continues to rise – supports a robust outlook for resources investment in the medium term. While exports are expected to increase only slightly in 2009, they are forecast to grow more strongly in 2010 and 2011 as global demand recovers, especially in the emerging economies.

Although some further weakness in labour market conditions is expected in coming months, leading indicators suggest that the pace of deterioration is easing, with the unemployment rate now expected to rise by less than had been expected.

Inflation

Although underlying inflation remains high in year-ended terms, it has begun to fall. Inflation is expected to continue to moderate due to the easing in capacity pressures and labour costs. Recent weakness in economic conditions has led to some moderation in private sector wage growth, and evidence from business surveys and liaison suggests that further slowing is likely. The easing in inflation is, however, expected to be gradual, given that price pressures in the non-tradables component have been significant and broad-based in recent years and have only begun to moderate recently. In addition, the depreciation of the exchange rate in the second half of 2008 will exert some further upward pressure on tradables prices, although the recent appreciation will help moderate these pressures.

Overall, the Bank's central forecast is for underlying inflation to decline, reaching a trough of around 2 per cent by mid 2011. This is an upward revision relative to the forecasts at the time of the May Statement, mainly reflecting the improvement in the outlook for the domestic economy.

The near-term profile for year-ended CPI inflation is noticeably different from that for underlying inflation. This reflects large movements in a few CPI components in recent quarters, particularly petrol prices and the ABS estimate of deposit & loan facilities prices, which together are likely to subtract nearly 2 percentage points from CPI inflation in the year to the September quarter 2009. Year-ended CPI inflation is expected to remain at around 1½ per cent in the September quarter, and then is projected to move broadly in line with underlying inflation from around mid 2010 once these factors have dropped out of the calculation of the annual rate.

Risks

The risks around these central forecasts are viewed to be broadly balanced. This follows a period in which the downside risks appeared larger than those on the upside.

Internationally, the risk of a further sharp downturn in the global economy is lower than at the time of the May Statement. Notwithstanding this, the possibility of another adverse shock in some part of the global financial system cannot be ruled out, and this could serve as the catalyst for a return to the very low levels of confidence seen late last year. There is also some possibility that the current strong rebound in Asia may not be sustained in the face of continuing weak consumer demand in the advanced economies. In the other direction, there is some probability that the recent global pick-up in confidence becomes self- reinforcing, particularly given the substantial monetary and fiscal stimulus that remains in place, contributing to a more rapid recovery than is currently expected by most forecasters.

Domestically, the main downside risk is that some of the recent improvement in economic indicators simply reflects changes in the timing of overall spending, partly due to fiscal measures, and that over the second half of the year private sector demand will weaken again. In the other direction, the recent pick-up in confidence could see the economy grow more strongly than expected and, over a slightly longer horizon, there is an increasing probability that investment will recover more strongly than in the central forecast, particularly in the resources sector. In this scenario, inflation would be unlikely to fall as much as in the central forecast.