Statement on Monetary Policy – May 2008 International Economic Developments

Growth in the world economy has slowed in recent months, as economic conditions in the United States have deteriorated, growth in other major countries has moderated, and global financial markets have remained turbulent. However, economic activity has remained fairly strong in emerging market economies, particularly in China and the smaller east Asian economies where, despite recent falls in equity prices, financial conditions are generally supportive of domestic demand.

Official and private sector forecasts of global growth have been revised down since the start of the year. A period of weak economic conditions is expected in the G7 economies along with a mild slowdown in emerging Asian economies, which have grown rapidly in recent years. In early April the IMF lowered its forecasts for global growth by ½ percentage point for 2008 and 2009 compared with those published in late January (Graph 1 and Table 1). The most significant downward revision has been to the outlook for the US economy, with the IMF now expecting GDP to fall by 0.7 per cent over the year to the December quarter 2008 before picking up by 1.6 per cent over 2009. Growth forecasts for emerging market economies have also been lowered. The global forecasts, which are similar to the Bank's, are discussed further in the ‘Economic Outlook’ chapter. While these forecasts would imply the slowest pace of world growth in five years, growth would still be well above the rate recorded during the global slowdown in 2001.

Consumer price inflation has picked up globally in recent months, mainly as a result of rising oil and food prices (Graph 2). Oil prices have reached new highs in US dollar terms, with West Texas Intermediate trading at around US$120 per barrel in early May, around 35 per cent higher than its level at the time of the February Statement. Despite this, ‘core’ measures of inflation have remained fairly contained in the industrial countries. In east Asia, CPI inflation has been more affected by the sharp increase in the price of food, which accounts for a relatively large share of the consumption basket in low- and middle-income countries, but measures of underlying inflation that exclude food have also been on a rising trend. Monetary policy has been tightened in China, Indonesia and Singapore in recent months, and several Asian countries have implemented trade restrictions in an effort to minimise increases in the local retail price of food.

In addition to oil and food, other commodity prices have also increased noticeably over the past three months. Base metals prices have generally strengthened, led by increases in copper and aluminium prices, and Australian resource producers have secured substantial increases in contract prices for 2008/09, which will provide another large boost to Australia's terms of trade in the coming year.

Major developed economies

The March quarter national accounts indicate that economic activity was subdued in the United States in the quarter, and other recent indicators confirm the weakness of the economy. Real GDP has now grown by 0.1 per cent in each of the past two quarters, and a range of indicators are suggesting that the slowdown – which had for some time been confined to the housing sector – has now spread to other areas of spending (Graphs 3 and 4). Household consumption increased by 0.2 per cent in the March quarter – its slowest pace in 13 years – and consumer sentiment weakened further in April. Residential and business investment fell in the quarter and forward-looking indicators suggest more weakness in coming months. In contrast, solid growth in exports has continued, supported by the depreciation of the US dollar and firm growth in many of America's trading partners.

The labour market has also weakened significantly since the start of the year, with payrolls employment declining by around 250,000 jobs. Employment in the construction and manufacturing industries has fallen further, and employment growth in the rest of the private sector has also weakened (Graph 5). The unemployment rate has risen by 0.6 percentage points from its trough in early 2007, to be 5.0 per cent in April.

Conditions in the housing market remain weak, with housing starts and permits down by around 60 per cent from their peaks around the end of 2005, and the number of home sales falling to its lowest level in over a decade (Graph 6). The stock of unsold homes remains elevated, which is putting downward pressure on house prices. The Case-Shiller measure of house prices, which covers houses sold in 20 major cities, has fallen by 15 per cent from its peak in mid 2006 and the National Association of Realtors measure of the median house price has also declined significantly. The ongoing falls are likely to further dampen household spending through their impact on household wealth and confidence. They are also affecting banks' willingness to lend; the Federal Reserve's Senior Loan Officer Survey reported that an increasing number of banks tightened their lending standards in the three months to April and that demand for credit eased further during this period.

In response to the deterioration in the outlook, the Federal Reserve cut the fed funds rate by a further 100 basis points in March and April, to 2 per cent, and has introduced new operating procedures designed to boost liquidity in the financial sector (see the ‘International and Foreign Exchange Markets’ chapter for details). While the Fed has noted concerns about inflation – consumer price inflation was 4 per cent over the year to March while the core measure was 2.4 per cent – it continues to expect a moderation in coming quarters.

Conditions have also moderated in other major developed economies. In Japan and the euro area household and business sentiment have declined further in recent months, although business sentiment remains more positive than household sentiment in both regions (Graph 7). Business conditions have been supported by continued growth in exports, particularly to emerging economies. Conditions have also softened in the United Kingdom, particularly in the housing sector where prices have started to decline. In response to the deteriorating outlook, the Bank of England has cut its policy rate by 50 basis points over the past three months, to 5 per cent.

Other major trading partners

In contrast to the developed countries, conditions have remained strong across the Asian region. Growth in China's GDP was estimated to be 10½ per cent over the year to the March quarter, down somewhat from the exceptionally rapid pace recorded in the past two years (Graph 8). The slowing appears to be concentrated in the external sector, with growth in exports moderating and imports growth picking up. The available indicators suggest that domestic demand growth remains strong; nominal spending on fixed-asset investment increased by 27 per cent over the year to March and retail sales volumes are estimated to have grown by around 14 per cent over the same period. Growth in industrial production has recently been volatile due to severe weather that disrupted activity early this year, but appears to remain firm.

Growth remains solid elsewhere in the Asian region; preliminary estimates of GDP growth in the March quarter suggested a strong outcome for Singapore but a more moderate one for Korea. Growth in industrial production and exports has picked up since the start of the year and has been broad-based across the region; industrial production in east Asia (excluding China) increased by 11 per cent over the year to February and the value of exports grew by 19 per cent over the same period (Graph 9). While growth in exports to the United States and the other major developed economies has slowed, this has been more than offset by a pick-up in exports to other emerging economies, including China, Russia and the Middle East (Graph 10). In India, GDP growth was 8.5 per cent over the year to the December quarter, with little evidence of any emerging weakness in the available data for 2008.

Commodity prices

Overall commodity prices have strengthened in recent months, as higher prices for coal and base metals have more than offset declines in wool and wheat prices. The RBA's index of commodity prices has risen by 17 per cent (in SDR terms) since January, and has doubled over the past four years (Graph 11). Further gains in the index are expected over coming months, due to substantial increases in coal and iron ore contract prices for 2008/09.

Coal contract prices have been settled by a number of Australian companies at significant premiums over 2007/08 prices, the result of tight supply and continuing strong demand from developing Asia (Graph 12). Contract prices for coking coal – for which Australia accounts for almost 60 per cent of world exports – will increase by more than 200 per cent, well above market analysts' expectations from a few months ago. Thermal coal contract prices are set to rise by around 125 per cent, with power shortages in South Africa and temporary restrictions on coal exports from China accentuating existing supply concerns. Iron ore contract price increases of at least 65 per cent appear likely based on various agreements to date, although negotiations between Australian exporters and foreign steel producers have not been concluded. These developments by themselves imply an increase of around 20 per cent in the level of the terms of trade over 2008.

The RBA index of base metals prices has risen by 10 per cent over the past three months, pushed up by strong gains in copper and aluminium prices. Copper prices have increased by 19 per cent since January, partly reflecting falling inventories, which are around historically low levels. Aluminium prices have risen in response to disruptions to production in South Africa and China as well as rising energy costs (aluminium production is highly energy intensive). Gold prices have been volatile, reflecting the turbulence in financial markets; prices reached a (nominal) record of just over US$1,000 per ounce in early March, before falling back to a level similar to that at the time of the February Statement.

Rural commodity prices fell by 3 per cent over the three months to April due to weaker wool and wheat prices. After increasing strongly over the second half of 2007, wool prices have fallen by 6 per cent since January, reflecting the uncertainty surrounding future demand in the developed world and the improving outlook for production in Australia. Wheat prices have been volatile in response to the ongoing uncertainty over the size of this year's global wheat crop; overall, prices have fallen in recent months but remain at relatively high levels. As discussed in the February Statement, wheat inventories are around historical lows, and prices are around 60 per cent higher than a year ago.

The high wheat price has occurred against a backdrop of rises in other global food prices. The IMF Commodity Food Price Index has increased by 33 per cent over the past year in SDR terms, driven by broad-based strength in crop prices (Graph 13). In addition to wheat, world prices for maize, soybeans, rice and palm oil recorded increases of between 30 and 90 per cent over the past year. Crop failures and food export restrictions in some countries, combined with growing demand for food in developing countries and from biofuel producers, have been cited as the main determinants behind the strength in these prices.