Reserve Bank of Australia Bulletin August 2004 Statement on Monetary Policy Economic developments over recent Japanese economy is now in a solid expansion, months point to continued good growth of recording its best conditions since the bursting the Australian economy. The global upswing of the asset-price bubble more than a decade has maintained its momentum since the early ago. In China, growth has been exceptionally part of the year and should provide an strong, prompting the Chinese authorities to improving environment for Australian take action to rein in overheated sectors of exporters. Business and consumer confidence the economy. These measures have had some are at high levels. At the same time, adjustment success in restraining growth but, even so, the is occurring in the Australian housing market, pace remains very fast by the standards of any which is no longer in the overheated condition other country. Other parts of Asia are also seen at the end of last year. showing continued economic strength, The renewed pick-up in global economic supported in most countries by growth in growth has been underway for more than a domestic demand as well as a continued rapid year now and has become increasingly broadly expansion of trade with China. The euro area based. The US recovery is firmly established, economy, though still lagging the rest of the with business investment contributing world, has shown further signs of strongly to the expansion along with consumer improvement over recent months. demand. With healthy employment growth Against the background of the firming US over recent months, initial concerns about a economy, financial markets had fully ‘jobless recovery’ have faded. Core inflation anticipated the Fed’s decision to raise official in the US remains relatively low but has picked interest rates at its late June meeting, and the up noticeably since the start of the year, so announcement passed largely without market that earlier concerns about the risk of deflation reaction. With US interest rates still well below have also moved off the agenda. Reflecting the historical norms, markets expect additional strong growth prospects for the economy and tightening, and a further increase in the funds the pick-up in price pressures, the Federal rate of 100 basis points is currently priced in Reserve has begun the process of normalising over the next six months. Several other central official interest rates from their historical low banks – the Bank of England, the Reserve point, lifting the fed funds rate by 25 basis Bank of New Zealand and the Swiss National points to 1.25 per cent at its end-June meeting. Bank – have also raised their interest rates Other parts of the global economy are also recently. In Australia, market interest rate enjoying strong or improving conditions. The expectations remained broadly steady through 1 Statement on Monetary Policy August 2004 this period, with markets assessing that Australia’s terms of trade. In the March Australian rates were closer to normal than quarter the terms of trade were 10 per cent in most other countries. The market continues higher than a year earlier, and they are likely to expect that Australia’s cash rate will remain to have risen further in the June quarter. The unchanged in the next few months but that resultant increase in incomes is one of the some further tightening will occur in due factors that have supported domestic spending course. growth. The exchange rate of the Australian dollar In addition, it now seems clear that, after has remained in a range well below the peak an extended period of weakness, the level of reached earlier in the year. The main reason exports has passed its trough. At this stage, for this change in sentiment towards the the pick-up in exports has been quite narrowly Australian dollar was the growing prospect of based. Much of it has been driven by the US monetary tightening, and the expectation improvement in rural conditions and the that it would mean a narrowing of Australia’s recovery in international tourism, while interest differential against the US. In late resource and manufactured exports have been July/early August the Australian dollar was relatively flat. Factors that may have trading around US70 cents, 12 per cent below contributed to the subdued performance in its February peak, and 9 per cent down in these sectors include the appreciation of the trade-weighted terms. exchange rate during 2002 and 2003, which The Australian economy is continuing to may have dampened growth in manufactured expand at a good pace. Consumer confidence exports in particular, and capacity constraints is at its highest level in a decade and consumer in the resources sector. However, these effects spending has started to receive a significant are likely to wane, with the exchange rate boost from the additional benefit payments having been well below its peak in recent and tax cuts announced in the federal Budget. months, while the resources sector will benefit Business surveys are reporting better-than- from the significant new capacity starting to average conditions and, with strong come on stream this year. Hence, given a profitability and an improving international supportive global environment, there are good environment, the situation appears favourable prospects that export growth will become to further expansion in business investment. more broadly based over time. Consistent with the general strength of the Australia’s inflation rate in underlying terms economy, the unemployment rate has trended remains relatively low. The June quarter CPI down over the past year to around the lowest showed a rise in the annual inflation rate to level seen over the past two decades. 21/2 per cent, from a rate of 2 per cent in the The growth of the economy has for some March quarter, but this movement largely time been driven by very strong growth in reflected the effects of petrol price fluctuations domestic demand, which has been partly on the year-ended calculation. Looking offset by the external sector. With the through the volatility, the various underlying international economy picking up, it has been measures suggest an underlying inflation rate reasonable to expect a gradual rebalancing of of just over 2 per cent, which is down by growth to get underway, involving a stronger around a percentage point from its recent export performance and less reliance on peak. It is unlikely, however, that this will growth in domestic demand. To date, while decline much further, if at all. At present, the economy has maintained a strong pace inflation is still being held down by the overall, this rebalancing has been slow to ongoing effects of the 2002–2003 exchange materialise. There are, however, some rate appreciation, but it can be expected to indications that the economy is now benefiting move higher in due course as those effects from the global upswing. One mechanism for wane. While this has been broadly the this has been the lift in global commodity expectation for some time, it now appears prices and the associated improvement in likely that the trough in underlying inflation 2 Reserve Bank of Australia Bulletin August 2004 will turn out to be somewhat higher than outlook for growth and inflation in Australia. envisaged in previous Statements. The Bank’s The international situation is one in which current assessment is that underlying inflation interest rates in the major countries are likely will remain close to 2 per cent for a little while to be increasing from their current abnormally longer, probably through to around the end low levels. Australian interest rates were never of this year, and then start rising to around reduced to the extreme position adopted in a 21/2 per cent by the end of 2005. Beyond that number of other countries, and there is no period, it could be expected to rise further if automatic reason that they will need to be the current strength of domestically sourced moved up in line with the increases that are inflation persists. likely to occur overseas. On the other hand, Developments in the housing market, and with the policy stance in Australia still mildly the associated growth in credit, have had an accommodative, and the global economic important bearing on assessments of the environment likely to remain favourable to economic situation in the recent period. The growth, it would be surprising if Australian overheating in the housing market last year interest rates did not have to increase further carried the potential to destabilise the broader at some stage in the current expansion. economy, the more so the longer it continued. At present the Australian economy is There are clear indications, however, that the continuing to experience a good pace of situation has now changed. After the rapid growth with relatively low inflation. The part increases in house prices up to the end of last of the economy that had been most prone to year, the available indicators suggest that overheating in the recent period was the prices declined in the first half of 2004. housing market and, as noted above, this is Auction clearance rates fell sharply around the now in a process of adjustment. At the same turn of the year and have since remained well time, it has become apparent that the below average, suggesting vendors’ price restraining influence of the exchange rate on expectations are not being met. There has also inflation has now reached its point of been an easing in the demand for housing maximum effect, so that the underlying finance, particularly from investors, though inflation rate can soon be expected to start this will need to adjust further if the growth increasing.