Statement on Monetary Policy – November 2007 International Economic Developments

The world economy grew strongly in the first half of 2007, and momentum appears to have remained solid in the September quarter in most economies. Global financial markets experienced significant turbulence in August and September as the fallout from the deteriorating conditions in the US housing sector led to a general re-pricing of risk across a range of assets. While conditions have been more settled in the past month or so – helped in large part by the Federal Reserve's 50 basis point reduction in the fed funds rate in mid September – credit spreads have remained wider than before the onset of these developments (for more details, see the ‘International and Foreign Exchange Markets’ chapter).

In response to these developments, most forecasters have revised down their outlook for global growth. The IMF has lowered its forecast for 2008 by around ½ percentage point, to 4¾ per cent, although if achieved this would still be well above the long-run average pace (Table 1). Much of this downgrade reflects a reduction in expected growth in the larger developed economies; emerging economies are expected to continue to grow strongly (Graph 1). Growth in the United States is expected to remain below trend in 2008, and forecasts for Japan and the euro area have been revised down to around long-run average rates, reflecting both domestic and external factors. Strong growth is expected to continue in India, China and the rest of east Asia. Growth in Australia's major trading partners is forecast to slow by ½ percentage point in 2008 to 4½ per cent, which would still be above average.

Although forecasts have been revised down, most available activity indicators still cover the period before the onset of the financial turbulence and hence there is little evidence so far of the impact of these events on global activity. The timeliest indicators are for consumer and business confidence, although it must be recognised that these surveys have sometimes proven unreliable signals of the strength of activity. Bearing this caveat in mind, these indicators suggest that sentiment in September and October weakened to a little below average levels in the United States but remained above average in Japan and Europe (Graphs 2 and 3).

Notwithstanding the turbulence in financial markets, commodity prices have increased over the past three months. Rural prices have continued to rise, partly reflecting higher wheat prices. The outlook for bulk commodity prices has strengthened since the last Statement ; analysts are expecting contract prices for iron ore and coal to rise significantly in 2008 due to ongoing strong demand from emerging Asia. While base metals prices fell in August as risk aversion affected commodity markets, they have since recovered. Oil prices have also reached record nominal levels over the past month.

Major developed economies

Recent data for the United States indicate that moderate growth is continuing, notwithstanding the downturn in housing construction. GDP grew by 1.0 per cent in the September quarter and by 2.6 per cent over the year (Graph 4). Consumption growth picked up in the quarter after posting a weak result in the June quarter, while modest growth in business investment continued. Exports grew at a healthy pace in the quarter, and are expected to be boosted further by the depreciation of the US dollar.

Residential investment fell by 5½ per cent in the September quarter, to be 24 per cent below its peak in late 2005. Forward indicators of construction activity, such as housing starts and permits, are at their lowest levels since the early 1990s and suggest further falls in activity in the period ahead (Graph 5). In addition, the inventory of unsold homes has increased to around 10 months of sales, up from around 5 months two years ago, which is placing downward pressure on house prices. Nationwide house price growth has slowed significantly, with some measures suggesting that prices have fallen over the past year. The ongoing interest rate resets on sub-prime loans and tightening of lending standards are likely to prolong these weak conditions.

Despite the downturn in housing construction and prices, household consumption growth was solid in the September quarter. Consumption increased by 0.7 per cent, to be 3.0 per cent higher over the year, aided by strong growth in real household disposable income. However, the outlook is for softer growth; the pace of housing-backed borrowing has eased with the slowing of house prices, and the tightening in financial conditions may reduce the availability of consumer credit. Growth in monthly payrolls employment has declined a little in recent months, to around 110,000 jobs per month (equivalent to 1 per cent annualised growth) over the four months to October compared with average monthly growth of around 135,000 jobs in the first half of the year; this primarily reflects a fall in jobs in the housing construction industry (Graph 6). Thus far, however, the weakening in labour market conditions has not been large; weekly initial jobless claims, which are a timely indicator of labour market conditions, remained relatively low in late October.

Business investment increased by 1.9 per cent in the September quarter, to be about 5 per cent higher over the year. Growth in non-residential construction continued, and the pace of growth in equipment investment picked up, boosted by a rebound in spending on motor vehicles. While timely indicators of investment – such as core capital goods orders – have increased only modestly in recent months, the fundamentals continue to suggest a favourable outlook: capacity utilisation remains high, corporate balance sheets are healthy and profits are high.

Headline consumer price inflation has been volatile during 2007, and stood at 2.8 per cent over the year to September (Graph 7). Measures of underlying inflation have moderated in line with the slower pace of growth in activity; core CPI inflation (which excludes food and energy) was 2.1 per cent over the year to September, compared with around 2¾ per cent late last year. The easing of inflation in the United States has increased the scope for monetary policy to respond to potential weakness in the economy; the fed funds rate was reduced by 50 basis points in mid September and by a further 25 basis points in late October.

In Japan, GDP was estimated to have fallen slightly in the June quarter and year-ended growth slowed to 1.7 per cent, with much of the weakness due to unexpected falls in business and residential investment. However, more timely data suggest a firmer picture. Growth of industrial production has been solid and picked up in the September quarter, and business conditions remain positive; sentiment has stayed above average levels, capacity utilisation is high, corporate balance sheets are healthy, and firms' investment intentions point to solid growth in the coming year (Graph 8). Labour market conditions are also generally favourable. Employment growth has been solid and the unemployment rate is around its decade low, although it has ticked up a little in recent months. Firms' hiring intentions are at high levels and consumer surveys indicate households are also positive about their employment prospects. Changes in building standards, however, led to a sharp fall in housing starts in the September quarter, which will further reduce residential investment in the short term.

While there is some evidence that price pressures at the firm level in Japan are increasing, this has not flowed through to sustained increases in consumer prices. Corporate goods prices increased by 1.7 per cent over the year to September, but the headline and core CPI (which excludes food and energy prices) both fell by around ¼ percentage points over the same period.

Growth in the euro area has slowed somewhat, with the moderation in growth broad-based across countries. Slower growth has been mostly attributable to a moderation in business investment from its rapid pace in 2006. Nonetheless, business conditions generally remain at high levels, despite the large appreciation of the euro. Household consumption growth has also been solid. Labour market conditions continue to improve, with large increases in participation over several years supporting growth in real disposable income. The unemployment rate fell to 7.3 per cent in September, its lowest rate in more than 15 years (Graph 9).

Headline inflation picked up to 2.6 per cent in October, well above the European Central Bank's reference value. This largely reflected movements in food and energy prices; core inflation (which excludes food, energy, alcohol and tobacco) was steady at 1.8 per cent in September.

The UK economy has continued to expand at a solid pace, with GDP increasing by 0.8 per cent in the September quarter, to be 3.3 per cent higher over the year. Despite a run on deposits at Northern Rock, the United Kingdom's fifth largest mortgage lender, consumer sentiment remained firm in October and other indicators suggest the economy has continued to grow solidly (for further details on Northern Rock, see the ‘International and Foreign Exchange Markets’ chapter). Headline inflation has eased to below the Bank of England's target of 2 per cent, with year-ended inflation in September at 1.9 per cent. Core inflation (which excludes food, energy, alcohol and tobacco) has also eased in recent months, and stood at 1.5 per cent over the year to September.

Other major trading partners

Conditions in Australia's other major trading partners remain strong, with continued rapid growth in China and India, and strong growth in the rest of east Asia.

China's growth eased only slightly to 11.5 per cent over the year to the September quarter (Graph 10). The external sector has continued to make a solid contribution to growth, reflecting strong export growth; although exports to the US economy have remained significant, Europe has recently overtaken the United States as China's largest export market. However, in recent years the expansion in domestic demand – both consumption and investment – has made the largest contribution to China's growth. The pace of investment has been especially strong in 2007 after a policy-induced slowdown in late 2006. Consumption indicators have been growing at a slower pace than investment, with much of the recent pick-up in growth in retail sales values due to rising food prices (for further discussion of China's growth performance, see ‘Box A: The Composition of China's Growth’).

Inflation has picked up in China, with both the headline CPI and corporate goods prices rising by around 6 per cent over the year to September. Much of this growth reflects higher prices for food, which accounts for around one-third of the CPI; excluding food, consumer price inflation has been broadly steady at around 1 per cent. The People's Bank of China has further increased the reserve requirement ratio and benchmark deposit and lending rates, citing rising inflation pressures.

Growth has also been strong elsewhere in east Asia, with GDP increasing by 5.7 per cent over the year to the June quarter, mostly attributable to the expansion in domestic demand. Preliminary estimates for Korea and Singapore suggest these economies continued to expand at a strong pace in the September quarter. Across the region, growth in industrial production has picked up in recent months, partly reflecting a rebound in ITC goods production. Growth in merchandise exports has also been solid (Graph 11). Labour market conditions remain favourable. In headline terms, inflation has been picking up in the region, rising to 3.1 per cent over the year to September. This increase has been mostly due to higher food prices; excluding food and energy, core inflation has been around 2½ per cent.

Growth in India has remained rapid, with real GDP increasing by 9.3 per cent over the year to the June quarter, driven by growth in the services and manufacturing sectors (Graph 12). More recently, industrial production grew by 11 per cent over the year to August, and export growth has also been strong. Year-ended wholesale price inflation has eased to 3.3 per cent in September, below the Reserve Bank of India's target rate of 5 per cent.

In New Zealand, GDP increased by 3.2 per cent over the year to the June quarter and the unemployment rate has continued to fall. Some recent data, including for retail sales and housing turnover, suggest that earlier increases in official interest rates may now be restraining spending, although the recent run-up in the price of dairy exports will be an offsetting influence. Headline CPI inflation slowed to 1.8 per cent in the September quarter, while underlying inflation was around 2½ per cent.

Commodity prices

During the period since the release of the August Statement, commodity prices initially weakened in response to the financial sector developments, but have since strengthened noticeably. Overall the RBA's index of commodity prices rose by 3 per cent (in SDR terms) over the three months to October, to show growth of 6 per cent over the year, a more modest pace than in recent years (Graph 13, Table 2). Much of the recent growth reflects price increases for gold and rural commodities.

Rural prices rose by 17 per cent over the past three months, largely driven by a sharp increase in the price of wheat. Wheat prices have risen by around 36 per cent since July as downward revisions to Australian crop production for 2007/08 have added to existing tight conditions in the global market (Graph 14). Futures markets suggest prices will ease somewhat by the time the northern hemisphere crop is harvested in the middle of next year, but that they will remain well above the average levels of recent years. Consistent with movements in wheat and a number of other food prices, the IMF commodity food price index has risen by around 20 per cent (in SDR terms) over the past year, to be at its highest level since the mid 1980s.

Base metals prices have recently been close to the levels prevailing at the time of the last Statement, but significantly lower than the peaks seen in early May. Prices of base metals initially fell amid the market turmoil in August and early September, but have since recovered due to tight supply conditions and increased investment demand. Futures markets suggest base metals prices will remain around current levels – which are still well above their long-run averages – over coming years.

The outlook for iron ore and coal prices has strengthened since the last Statement. Robust growth in demand, capacity constraints and the depreciation of the US dollar have contributed to expectations that iron ore and coal contract prices will rise further next year. Strong growth in Chinese steel production continues to underpin growth in demand for iron ore and, while the growth in supply from countries such as Australia and Brazil has been sizeable, the market remains tight. Reflecting this, spot iron ore prices have increased sharply in recent months. The consensus forecast is for iron ore contract prices to rise by around 30 per cent for the year starting in April 2008, compared with an expectation of around 15 per cent three months ago (Graph 15). Coal prices on the spot market also remain well above this year's contract price, fuelling expectations of a sizeable increase in contract prices next year.

While the financial market turbulence weighed on oil prices during August, prices recovered during September and in nominal terms have recently reached record highs (Graph 16). The price rise in part reflects falls in inventories and geopolitical tensions, although US dollar weakness has also contributed; oil prices rose somewhat more modestly in SDR terms. As of early November, West Texas Intermediate traded at around $95 a barrel, while Malaysian Tapis – the benchmark crude most relevant for Australian petrol prices – traded slightly higher. Futures markets point to some easing in oil prices over coming months.