Statement on Monetary Policy – February 2006 Introduction

Global economic conditions are continuing to provide a favourable environment for the Australian economy. The expansion underway over the past few years was initially led by the United States and China, but it has become more broadly based over time. Conditions in Japan have improved markedly over the past year, and there has been good growth elsewhere in east Asia and in other emerging economic regions. There have also been some signs of improvement recently in the euro area. Growth in world GDP is estimated to have been well above average in 2005, and most observers expect this to continue in 2006. The most recent economic indicators have tended to strengthen these expectations.

Against this background central banks in the major economies, with the exception of Japan, have begun normalising official interest rates from the unusually low levels they reached in the early part of the decade. The United States is now quite advanced in this process, with the Fed funds rate back to a level generally regarded as close to normal. Central banks in other major countries are at a much earlier stage, however, and world policy rates on average remain well below normal. Long-term interest rates are also relatively low, having remained broadly steady in the face of rising official rates. The combination of strong economic growth, low inflation and low interest rates has contributed to buoyant conditions in world financial markets. Spreads on emerging market and corporate debt have narrowed, and global equity prices have increased solidly in each of the past three years.

An important consequence of the strong global expansion has been an increase in commodity prices, most noticeably the rise in world oil prices over recent years. While supply disruptions have undoubtedly contributed to oil price fluctuations during this period, the increase appears to have been mainly a result of the upswing in global demand. Hence observers have generally maintained strong expectations of global growth throughout the period when oil prices have been rising. The main effect of the higher oil prices to date has been to raise headline measures of consumer price inflation, though in underlying terms inflation in most countries remains contained.

For a resource exporter such as Australia, the more significant aspect of global commodity trends has been the broad-based nature of the price increases seen over recent years, with sharp rises in the prices of coal, iron ore and a wide range of other minerals. This has contributed to a substantial lift in Australia's terms of trade, which have increased by around 30 per cent over the past three years, their largest cumulative increase since the 1970s.

The increase in the terms of trade is one of a number of important factors influencing growth of the Australian economy at present. In combination with strong corporate balance sheets, favourable financial conditions and high capacity utilisation, the rise in the terms of trade has contributed to a highly stimulatory environment for the business sector. Business investment is now undergoing a major upswing, having expanded by 18 per cent over the past year and at an average annual rate of 14 per cent over the past three years. While this growth has been led by the resources sector, it has been quite broadly based across a range of industries. The general strength of the business sector has also been evident in the growth of corporate profits and in the performance of the share market. Share prices in the Australian market have outperformed those overseas in recent years and, unlike most other major markets, have surpassed their 2000 peak.

In contrast to the business sector, households have moderated the growth of their spending in the past year or two. Previously, households had been expanding their borrowing and spending at rates that could not be sustained, but they now appear to have entered a period of financial adjustment. They are still increasing their levels of debt, but are doing so at a slower pace than they were a couple of years ago. Another moderating influence on the growth of household spending has been the mild downturn in the housing construction cycle. At the same time, moderate spending growth continues to be supported by growth in employment and real wages, and by rising household wealth stemming from the buoyant equity market.

Australia's export performance over recent years has been disappointing, despite the generally favourable international conditions. While export earnings have picked up strongly, this has been mainly driven by rising prices, with only very limited increases to date in volumes. At the same time, imports have continued to grow at quite a fast pace, though moderating recently. Hence Australia's current account deficit has remained relatively high, at around 6 per cent of GDP in recent quarters. With substantial investment in the resources sector and in related infrastructure projects currently underway, it is likely that export volume growth will pick up, though the expected improvement has been slow to eventuate.

The net effect of these various influences on the Australian economy is that growth of domestic spending has remained quite solid over the past couple of years, though it has eased from the unusually rapid rates seen previously. Growth of the economy overall has been a little below average recently, at an annual rate of around 3 per cent over the two latest quarters for which GDP data are available. Given the continued strength of the business sector and the prospect of some improvement in export volumes, growth is likely to continue at a similar or higher pace in the period ahead.

Notwithstanding the inevitable short-term fluctuations in growth, the Australian economy over recent years has been more stable than most, and is now in its fifteenth year of expansion. In the course of the expansion to date, the economy has substantially re-employed unused resources of both labour and capital. The unemployment rate has declined from a peak of around 11 per cent in 1993 to a current level of just over 5 per cent, which is around its lowest since the 1970s. For the past year or so, many businesses have been in the unusual position of reporting that scarcity of labour was a bigger constraint on their activities than more traditional concerns about the adequacy of demand or sales. Surveys also report that businesses are operating at cyclically high levels of capacity utilisation, though parts of the manufacturing sector are an exception to this. While strong business investment will contribute to the growth of productive capacity in due course, the current outlook suggests the economy will continue to operate with much smaller margins of spare capacity for the time being than was the case earlier in the expansion.

Consumer prices increased by 0.5 per cent in the December quarter, and by 2.8 per cent over the past year. The annual figure was boosted by rising fuel prices, and underlying inflation measures have remained broadly stable at around 2½ per cent. At the current stage of the expansion there are a number of factors that could be expected to put upward pressure on inflation in the period ahead. Aggregate wages growth has picked up over the past year, reflecting the tight conditions in the labour market, though these may have eased a little recently. Rising world commodity prices have resulted in some large increases in businesses' raw materials costs. More generally, with the economy operating at a high level of capacity utilisation, any acceleration in demand would more readily put pressure on the economy's productive capacity than at earlier stages of the expansion. The main factor likely to be working in an offsetting direction for the inflation outlook is the continued global disinflationary pressure on prices of manufactures and some services in the tradables sector.

The relative strength of these influences is of course difficult to gauge. One risk is that the tightness of the labour market gives rise to significant further wage and price pressures, but it is also possible that global disinflationary forces will prove stronger and more persistent than expected. On balance, underlying inflation is expected to increase modestly to 2¾ per cent by the end of this year. Given the current level of oil prices, this would mean that headline CPI inflation remains close to 3 per cent in the short term.

The Australian cash rate has been unchanged since March last year, at a level that is in line with its average over the low-inflation period. Interest rates of financial intermediaries remain a little below average, however, reflecting the compression of lending margins relative to the cash rate over recent years. Strong growth in credit suggests that businesses and households are finding it attractive to borrow at prevailing interest rates. In the household sector, while the demand for credit has cooled considerably since around the end of 2003, credit growth seems to have flattened out at an annual rate of around 12 per cent. Businesses have until relatively recently been much more conservative than households in their borrowing behaviour. However, in the past two or three years, this has been changing as businesses have begun to take advantage of their strong balance sheet positions and the favourable climate for investment. Business credit has strengthened quite markedly during this period, so that it is now growing at an annual rate of 16 per cent, well above that for the household sector.

In summary, the economic situation reviewed by the Board at its recent meetings was one where the broad international forces influencing the Australian economy, namely the global expansion and rising commodity prices, have remained favourable for growth. Domestically, these trends are contributing to a strong upswing in business investment, though at the same time there has been a moderation of growth in household spending. The Board's assessment overall is that demand and output can be expected to grow at a pace broadly in line with the economy's productive potential over the period ahead. Given the prevailing levels of capacity utilisation and labour market tightness, this outlook is consistent with a modest increase in underlying inflation.

In these circumstances, the Board decided at its February meeting to hold the cash rate unchanged. However the Board recognises that policy would need to respond in the event that demand or inflation pressures prove stronger than currently expected. The Board will continue to monitor developments and make policy adjustments as required to promote sustainable economic growth with low inflation.