Statement on Monetary Policy – May 2009 Introduction

The world economy experienced a marked contraction in late 2008 and early 2009, with large declines in industrial production and international trade. Almost all developed countries recorded a decline in output in the December quarter, and most appear to have experienced a further decline in the March quarter. Growth also slowed significantly in all emerging market countries.

The sharp and synchronised nature of the downturn is largely accounted for by the substantial falls in consumer and business confidence that followed the financial events in September 2008, including the failure of Lehman Brothers in the United States. As confidence declined and uncertainty and risk aversion increased, both consumers and businesses delayed or cancelled their spending and production plans, especially for consumer durables and capital goods. Credit conditions simultaneously tightened considerably around the world, as severe strains developed in the global financial system.

While the recent GDP outcomes for most countries have been very weak, there are signs that the rate of contraction in output is abating. It is likely that the half year to the March quarter will prove to have been the period of greatest contraction, with the IMF's recently revised forecasts consistent with a modest increase in global GDP over the second half of 2009. Industrial production and exports have picked up in Asia, after earlier steep falls, and growth in the Chinese economy has sped up recently. There has also been some improvement in consumer and business confidence in a range of countries from the very low levels of late last year.

These signs of a turning point are a positive development. However, given the scale and nature of the downturn, the recovery of the world economy is likely to be gradual and to involve an extended period of sub-par growth. The outlook for investment in many countries is particularly weak, weighed down by rising excess capacity, much tighter credit conditions and declining profitability.

Reflecting the recent signs of stabilisation in the global economy, sentiment in financial markets has improved in recent weeks. Global equity markets have risen by around 30 per cent from their troughs in mid March, with a number of financial institutions reporting better-than-expected profits. There has also been a further easing of credit spreads, and businesses and financial institutions have found it easier to issue debt. Encouragingly, over the past month, a number of banks – including those in Australia – have been able to issue long-term debt without a government guarantee.

The improvement in sentiment is also evident in commodity markets. After the very large falls in the second half of last year, the prices of many commodities, including base metals, have strengthened a little over recent months. While Australia's terms of trade are declining as lower contract prices take effect, they are expected to hold up at a high level.

Although sentiment in many markets and the economy more generally has improved, confidence is still clearly vulnerable to setbacks, especially the possibility of more unexpected losses by financial institutions. As has been the case for some time, prospects for a sustained recovery in the United States, in particular, depend critically on a resolution of the current problems in the financial sector.

The downturn in the global economy has had a significant effect on output growth in Australia. Activity contracted in the latter part of 2008 and this has continued into 2009. The economy is, however, still expected to record better outcomes in 2009 and 2010 than those in most other advanced countries. This reflects, among other things, the stronger state of the Australian banking system, the significant policy stimulus to date and the depreciation of the currency that took place in the second half of 2008. Since September last year, the cash rate has been lowered by 4¼ percentage points and, unlike in many other countries, the bulk of this reduction has been passed on to end borrowers, particularly households. There has also been a very substantial easing of fiscal policy.

In the current environment, household spending is being influenced by a number of countervailing forces. Disposable income has been boosted by government transfer and tax bonus payments, and households with a mortgage have benefited from the very large reduction in debt servicing costs. Working in the other direction, aggregate household wealth has seen a major decline, and households have become more concerned about the prospect of unemployment, although consumer confidence remains substantially higher in Australia than in many other countries. Overall, consumer spending appears to have grown at a modest pace over recent months.

Housing construction remains weak, but there are some signs that activity will pick up in the second half of 2009. Loan approvals for new construction have increased and a relatively high proportion of households report that now is a good time to buy a dwelling. Borrowing for housing has also increased, particularly by first-home buyers. Nationwide measures of housing prices have been mixed although, on balance, they suggest that prices were little changed in the March quarter, after declining by around 3 per cent over 2008. Strong demand by first-home buyers has seen increases in the prices of lower-priced dwellings, while prices at the top end of the market have continued to decline.

Recent indicators of business confidence suggest some improvement, although confidence remains low. After a number of years of very high levels of investment, many firms have scaled back their investment plans over recent months and there has been a sharp drop in capital imports. This reflects a number of factors including the general deterioration in the economic outlook, a significant increase in uncertainty and risk aversion, and tighter financial conditions. These tighter conditions are most evident for the property development industry, where construction activity is expected to fall further over the period ahead.

In this more difficult environment, many businesses have reduced their demand for debt as they seek to reduce leverage. This has contributed to a significant slowing in borrowing by the business sector. Credit extended by financial institutions to businesses has declined a little over recent months, although debt raisings have recorded a small increase, with some large firms tapping capital markets for funding.

Reflecting the slowing in the economy, labour market conditions have weakened. Employment has started to fall and the unemployment rate has increased to around 5½ per cent from its low of 4 per cent in early 2008. There has also been a substantial rise in the number of employees working shorter hours. Forward-looking indicators, including job advertisements and business surveys, suggest a further decline in employment over the months ahead.

Recent data confirm that price pressures are gradually abating. Over the year to the March quarter, the CPI increased by 2.5 per cent, the midpoint of the Bank's 2-3 per cent medium-term inflation target. This follows a period in which inflation was well above the target, peaking at 5.0 per cent over the year to September 2008. This recent decline in headline inflation is largely accounted for by a significant reduction in oil prices and in the ABS estimate for the price of deposit & loan facilities facing the household sector. In underlying terms, inflation was around 1 per cent in the March quarter and around 4 per cent over the year.

Taken together, the last two quarters indicate a modest decline in the pace of underlying inflation from its peak last year, and a further decline is likely over the period ahead. Capacity utilisation is declining and, with the labour market weakening, there are early signs of a slowing in wage growth. Upstream price pressures also appear to be moderating and measures of inflation expectations have moved to the bottom of the range seen over the inflation-targeting period, after they were at high levels a year ago. The decline in inflation is, however, expected to be gradual, partly due to higher prices for imported goods as a result of the depreciation of the exchange rate last year.

Overall, the marked deterioration in the global economy in the latter part of 2008 and early this year has led to considerable slowing in the Australian economy. While near-term outcomes are likely to be weak, there are reasonable grounds to expect that a recovery will begin by the end of the year, provided global conditions continue to stabilise. The recovery, however, is likely to be gradual at first, largely reflecting developments abroad, where growth is forecast to be below trend for some time.

The Board has responded to the deterioration in the global and domestic environment that has taken place since September 2008 by easing monetary policy significantly. Short-term interest rates are currently at their lowest level since the early 1960s. Much of this easing took place in expectation of the current weak economic conditions and before the emergence of clear evidence that inflation was declining. Together with the substantial fiscal initiatives, the lower interest rates are providing significant support to domestic demand, and will continue to do so over the period ahead.

With interest rates at historically low levels, and some signs of stabilisation in the world economy, the Board has recently viewed it as appropriate to make smaller and less frequent adjustments to the cash rate than was the case up until February when conditions were deteriorating rapidly. In assessing whether further reductions are appropriate over the period ahead, the Board will continue to monitor the implications of both economic and financial developments for prospects of a sustainable recovery in the Australian economy.