Statement on Monetary Policy – February 2008 Domestic Economic Conditions
Economic activity has continued to grow strongly, although data revisions suggest the pace of growth in 2006/07 was somewhat lower than initially estimated. In the September quarter, real GDP increased by 1.0 per cent, to be 4.3 per cent higher over the year (Graph 30, Table 6). Domestic spending appears to have remained firm in the December quarter, with retail trade and sales of motor vehicles increasing in the quarter, surveys suggesting business conditions remain well above average, labour market conditions staying tight, and imports rising strongly. In contrast, recent export growth has been subdued due to the effect of the drought on rural production and temporary supply and infrastructure disruptions in the resources sector. Following the recent rainfalls, the outlook for the rural sector in the year ahead has improved substantially.
The available data suggest the recent difficulties seen in global credit markets have not significantly affected domestic demand and activity to date. As discussed below, while the pace of household borrowing has slowed a little in response to a tightening of financial conditions during the second half of 2007, business borrowing has continued to grow strongly. However, the pass-through of higher funding costs to borrowers has become more widespread over the past month or so – most banks have now increased interest rates across their lending products – and this could dampen credit growth and activity somewhat further in the period ahead. In addition, the persistence of significantly tighter conditions in capital markets may lead to some easing of growth in business borrowing.
Household sector
The household sector has remained relatively resilient to the tightening in financial conditions to date. Consumer spending picked up in recent quarters; consumption grew by 1.2 per cent in the September quarter, to be 4.5 per cent higher over the year. More timely indicators suggest the pace of consumption growth remained solid in the December quarter, with real retail sales increasing by 1.6 per cent to be 5.7 per cent higher over the year (Graph 31). Motor vehicle sales to households have been firm, increasing by 3 per cent in the December quarter and by 10 per cent over the year. Measures of consumer sentiment in January were modestly above their long-run average levels, although they have been declining over recent months. Liaison with retailers indicates that spending remains solid across different classes of expenditure.
The ongoing strength of consumption expenditure reflects the strong financial position of the household sector. Real household disposable income has been increasing rapidly, rising by almost 2 per cent in the September quarter and by 8 per cent over the year (Graph 32). Growth in disposable income has been driven by the favourable labour market conditions, while the income tax cuts that came into effect in July 2007 provided additional impetus in the September quarter. Household assets grew strongly over 2007; equity prices increased by 12 per cent over the year, although most of this gain was reversed in the first weeks of 2008. The household sector overall appears to be handling its debt-servicing obligations well, with only a small share of households experiencing difficulties making their required payments. The household saving rate has also been rising; net saving was around 3 per cent of household disposable income in the September quarter, its highest rate in seven years.
The generally healthy state of finances has provided support to the housing sector, especially the established housing market. Average nationwide house prices increased strongly in 2007; ABS data show that capital city house prices rose by 3 per cent in the December quarter, to be 12 per cent higher over the year (Graph 33, Table 7). These data are broadly in line with other measures of house prices, which use different techniques to control for changes in the composition of houses sold. House price growth was strongest in Adelaide, Brisbane and Melbourne over 2007, with average increases of close to 20 per cent. Sydney house prices increased more moderately, while house prices in Perth were broadly flat following very strong growth over the previous three years. Consistent with the strength seen in the upper end of the Melbourne and Sydney housing markets, residential auction markets in these cities remained buoyant through to the end of 2007. Nonetheless, recent data suggest housing credit growth and loan approvals slowed slightly in late 2007 compared with the first half of the year (Graph 34); these data would not yet reflect much of an impact from the November tightening in the cash rate nor any impact from the latest cash rate rise and the additional increases in bank lending rates early this year.
Growth in housing construction has remained relatively subdued, following several years of weakness. Dwelling investment increased modestly over the first three quarters of 2007. Although there was a large fall in December, the number of building approvals increased by 7.5 per cent over the year to the December quarter; the strength was mostly in the medium-density sector. Compared with previous cycles, trends in housing construction have been quite divergent across the states in recent years (Graph 35). The shortfall in the supply of new dwellings relative to underlying demand remains evident in the rental market; vacancy rates are close to historical lows in most cities, and rents have continued to accelerate.
Business sector
Business conditions in the non-farm sector are favourable. Private-sector surveys suggest that, while overall conditions eased slightly in the second half of 2007, they were still well above average levels, and that conditions in the manufacturing sector remained stable (Graph 36). The NAB survey reported that non-farm capacity utilisation is at its highest level since the survey began in 1989, while capacity utilisation in the manufacturing sector also remained high (Graph 37). Nonetheless, liaison suggests there remains a divergence in outcomes within the manufacturing sector, with conditions for firms relatively exposed to the resources and non-residential construction sectors stronger than for firms exposed to the farm sector and foreign competition.
The pace of growth of private-sector profits eased to around 6 per cent over the year to the September quarter, compared with average annual growth of 10 per cent over the previous two years. Profits outside of the mining sector grew solidly over the year, while mining profits declined due to the slowing of growth in commodity prices and an increase in costs. However, at 31 per cent of GDP, the profit share was close to its highest level in more than three decades (Graph 38). Equity analysts' expectations for private non-financial sector profit growth in 2007/08 have been revised lower over the past six months, although they expect a rebound in profit growth in both the mining and non-mining sectors in 2008/09.
New business investment increased by ½ per cent in the September quarter, to be 10 per cent higher over the year (abstracting from the reclassification of Telstra). As has been the case for some time, the growth in investment was driven by increased spending on buildings and structures. Forward-looking indicators point to further solid growth. There is a substantial stock of work already in the pipeline and additional infrastructure and resource-related projects are close to commencement, which should boost non-residential construction in the period ahead. The October/November capital expenditure survey's estimate of spending plans for 2007/08 pointed to moderate growth in machinery & equipment investment. While disruptions in capital markets over the past six months have resulted in an increase in external funding costs for businesses, the rapid growth in business credit suggests that firms retain a strong appetite for, and ready access to, debt to fund their investment plans. The ongoing high level of investment is supporting growth in the capital stock, and hence adding to the growth of the economy's productive capacity (for further details see ‘Box B: Investment and the Productive Capacity of the Economy’).
Farm sector
Overall conditions in the rural sector have been weak. Based on information from the Australian Bureau of Agricultural and Resource Economics (ABARE) and other rural agencies, farm output is expected to increase only slightly in 2007/08, after falling substantially in 2006/07 (Table 8). The 2007 wheat crop was estimated by ABARE in December to be 12.7 million tonnes; although this was around 30 per cent higher than the 2006 crop, it was well below the average annual crop. Overall, the growth in cereals output in 2007/08 is expected to be mostly offset by weakness in other components of farm production.
However, climatic conditions in the farm sector have improved over recent months. A La Niña weather system (which is normally associated with higher-than-average rainfall) has become firmly established in the Pacific region. Consistent with this, recent rainfall across many of the major cropping regions has been well above average; severe flooding was experienced in north-east New South Wales and south-east Queensland. While heavy rains are likely to disrupt farm production in the short term, the outlook is becoming more positive for 2008/09.
The recent rain has resulted in a significant improvement in flows into the Murray-Darling system in January, while water storage in Queensland has also increased significantly (Graph 39). Nevertheless, given the earlier degree of dryness in most agricultural regions, it is likely that a sustained period of well-above-average rainfall will be needed to return the irrigated sector to more normal conditions over the medium term.
External sector
Following strong growth in the September quarter, export volumes are estimated to have increased slightly in the December quarter, to be 4¼ per cent higher over the year (Graph 40).
Resource export volumes are estimated to have risen modestly in the December quarter, with year-ended growth – at around 6½ per cent – above the average rate of the past decade. Exports of oil grew strongly in the quarter, and recently completed projects are expected to provide additional support in coming quarters. Coal exports also increased in the December quarter, though growth was somewhat hampered by port construction activity. Continued strong growth in iron ore exports is expected over the next few years as new capacity comes on line and demand conditions remain favourable, particularly in China. Since 2002, iron ore export volumes to China have expanded at an average annual rate of about 25 per cent, while volumes to more traditional export markets – such as Japan – have increased only modestly (Graph 41). China now accounts for one-half of Australia's iron ore exports.
Services exports volumes have expanded solidly over the past year, underpinned by strong growth in education exports. Since 2002, the volume of education exports has increased at an average annual rate of 11 per cent, primarily reflecting strong growth in the number of Chinese and Indian students studying in Australia – which has almost tripled over this period – although there has also been solid growth in the number of students from other parts of the Asian region (Graph 41).
Import volumes have grown strongly, rising by around 4 per cent in the December quarter and 10 per cent over the year, reflecting the strength of domestic demand and the appreciation of the exchange rate over the past few years. The trade deficit is expected to have widened to around 2½ per cent of GDP in the December quarter, from 1.6 per cent in the September quarter. Assuming the net income deficit remained constant at around 4 per cent of GDP, the current account deficit is estimated to have widened to around 6½ per cent of GDP in the quarter.
The real trade-weighted exchange rate has depreciated slightly in recent months, although it remains high at 24 per cent above its post-float average (Graph 42). While the appreciation of the exchange rate over recent years has had a contractionary impact on some exports, the economy as a whole has benefited from the increase in Australia's terms of trade, which are more than 40 per cent above their post-float average.
Labour market
Labour market conditions remain strong across most industries and states. In the December quarter, employment increased by 0.6 per cent, to be 2.7 per cent higher over the year (Graph 43). Growth has been stronger for full-time employment, which increased by 3.3 per cent over the year. The participation rate also increased further, reaching a new high of 65.2 per cent in the December quarter. Part of this increase may reflect additional labour supply in response to welfare-to-work policies that became effective in mid 2007, although any effect of these reforms on the measured unemployment rate appears to have been muted; the unemployment rate has been largely unchanged since July, at around 4¼ per cent.
Employment growth in 2007 was broad-based across industries. Over the year to the December quarter, the largest increase in employment was in retail trade, with the transport & storage, education, health & community services and manufacturing industries also showing strength. Construction and mining made relatively small contributions to employment growth after a period of exceptional strength.
Across the states, employment growth continued to be strong in the resource-rich states. Nonetheless some convergence has been observed over the past two years as year-ended growth eased in Queensland while most other states saw employment growth increase (Graph 44, Table 9). Unemployment rates fell in all states except Western Australia over 2007 (where unemployment was already very low), while participation rates rose across the country.
Job vacancies data from the ABS continue to signal a tight labour market. At the national level, the ratio of vacancies to employment reached a three-decade high of 1.7 per cent; vacancies rose by 6 per cent in the three months to November and by 13 per cent over the year. Firms continue to experience difficulty in finding suitable labour, with some surveys suggesting that labour shortages have worsened in recent months (Graph 45).