Domestic Economic Conditions – Monetary Policy Meeting of the Reserve Bank Board

The main economic news over the past month had been the inflation data. In the June quarter, the CPI had increased by 0.9 per cent, to be 3.6 per cent higher over the year. Measures of underlying inflation were running at 2½–2¾ per cent over the year, which was higher than in 2010.

The year-ended headline inflation rate continued to be boosted by increases in the price of fruit, in particular banana prices, which were nearly five times their pre-cyclone level. However, vegetable prices had fallen in the quarter as production recovered after the floods. Petrol prices had also risen in the quarter and the CPI measure of deposit & loan facilities – which would be removed from the CPI in the September quarter – was also estimated to have risen significantly. Utilities prices fell slightly in the quarter, reflecting seasonal factors, but would increase strongly in the September quarter. There had been larger-than-expected increases in a wide range of retail goods in the June quarter, notwithstanding the appreciation of the exchange rate and subdued level of consumer spending. While it was possible that this was a result of changes in the timing of discounting, it might also reflect cost pressures coming from an increase in global prices, as well as higher costs for a range of domestic inputs at a time when productivity growth was low.

There had been further evidence of cautious behaviour in the household sector. While there had been no official data on retail sales since the July meeting, the staff’s liaison suggested that retail spending had been weak since mid May. Measures of consumer confidence had declined recently and were now below average. Housing credit growth had slowed further and the rate of credit card debt repayment had picked up. Housing price data suggested that nationwide prices had fallen slightly over recent months, to be down by around 2 per cent over the past year. Members noted that some of the developments in the household sector over recent years, most notably the significant increase in the saving ratio from the low rates seen in the early 2000s, had reduced the medium-term vulnerabilities of the economy. In addition, they observed that, in contrast to these various signs of household caution, there had been very strong growth in overseas travel by Australians over recent months.

Survey-based measures of business conditions remained around long-run average levels, although there were very significant differences across sectors, and measures of confidence had fallen to below-average levels. While business credit had fallen over the past couple of months, members observed that lending to unincorporated businesses had been rising gradually since early in the year. Imports of capital and intermediate goods had been quite strong in recent months, consistent with a pick-up in investment in the resources sector. Members noted that the past month had seen the announcement of final investment approval for another large LNG project. The data on coal shipments from Queensland for June had shown a significant pick-up, although industry sources indicated that coal production may not return to normal levels until early in 2012.

The unemployment rate had held steady at 4.9 per cent in June. Employment growth had clearly slowed from the rapid pace over much of 2010 and the unemployment rate was no longer falling. The forward-looking indicators continued to point to moderate employment growth over the period ahead, although the staff’s liaison with businesses indicated some caution in hiring plans.

Members were briefed on the updated staff forecasts. The growth forecast for 2011 had been lowered to 3¼ per cent, 1 percentage point lower than the May forecast. This revision mostly reflected the delayed recovery in coal production, with the remainder largely accounted for by weaker growth in consumption. With some of the recovery in coal production pushed out to 2012 and investment picking up strongly, growth was expected to be around 3¾ per cent in both 2012 and 2013. Mining investment was expected to increase from its already elevated level of around 4 per cent of GDP to more than 6 per cent in 2012/13, and the terms of trade were forecast to remain very high, although down from current levels. Growth in consumption was expected to remain relatively subdued, with some further increase in the household saving ratio expected over the coming year. Members observed that significant structural adjustment was likely over coming years given the high level of the exchange rate relative to its average over the past decade or so.

In terms of inflation, the recent outcomes provided further evidence that the disinflationary influences stemming from the late 2008 slowdown had passed. However, subdued household demand and the appreciation of the exchange rate were likely to exert some dampening influence on inflation in the period ahead. In preparing the forecasts, the staff had included the estimated effects of the Government’s intention to introduce a price on carbon, which was expected to add around 0.7 percentage point to headline inflation in the second half of 2012, with a smaller effect on underlying inflation. Incorporating these effects, underlying inflation was forecast to be 3 per cent or a little higher over the next few years. The rate of CPI inflation was expected to be above 3 per cent at the end of the forecast period.

Members recognised that the effects of instability overseas could pose a downside risk to the domestic economy. Of the domestic risks, the main uncertainty was the behaviour of households, as saving could increase further in an environment of uncertainty. Members also noted the importance of productivity outcomes for growth and inflation. Australia’s productivity growth over the past five to ten years had been weak, with growth in output largely accounted for by growth in the factors of production. Growth in incomes had been held up by the rise in the terms of trade over this period. However, with the forecasts suggesting that the terms of trade were likely to be subtracting from income growth over coming years, a significant pick-up in productivity growth would be required to sustain real income growth around the rates seen in recent decades. Members noted that the task facing monetary policy in future would become more difficult if a continuation of poor productivity growth were combined with an expectation of growth in nominal wages and profits at the same sorts of rates seen over the past two decades.