Via the RBA:
International Economic Conditions
Members commenced their discussion of the international economy by observing that global growth had eased in the second half of 2018 and looked to have continued at around this more moderate rate in 2019. Growth in Australia’s major trading partners was also expected to continue at around this slower pace over 2019 and 2020. Members also observed that the outlook for China continued to be a significant uncertainty for the global growth outlook, as were trade tensions, which had escalated again between the United States and China immediately prior to the meeting. Global financial conditions had become more accommodative since the turn of the year. Members noted that this could lead to stronger growth than expected, although there were still risks of events occurring that could lead to both tighter financial conditions and lower global growth.
March quarter GDP growth had been stronger than expected in the United States and the euro area, but had been quite weak in a number of trade-intensive economies in east Asia. The latest monthly data had shown that growth in Chinese industrial production, fixed asset investment and total social financing had increased, suggesting momentum had picked up in response to targeted policy easing by the Chinese authorities. Conditions in Chinese property markets had also strengthened. Members noted that economic sentiment in China had improved since the beginning of the year, partly because small to medium-sized businesses were obtaining improved access to finance and government infrastructure spending was boosting demand.
Members noted that the sharp slowing in global trade had been related to slowing growth in China. The decline in the value of Chinese imports had been broadly based across regions, although the large decline in the value of trade with the United States suggested that trade diversion as a result of new tariffs had also been a factor. Growth in China was expected to slow gradually over the forecast period to the middle of 2021. This was expected to continue to weigh on external demand for trade-intensive economies in east Asia and the euro area; recent data on export orders in east Asia had been subdued.
Members discussed various longer-term policy initiatives in China, including policies on investment abroad and modernisation of China’s manufacturing sector. China’s infrastructure investment abroad had served to support land and sea trade routes, although there had been some challenges that Chinese authorities had been addressing. Members also noted the authorities’ efforts to promote innovation, particularly in China’s technology sector, and to upgrade the Chinese manufacturing sector significantly.
For some economies, the slowing in external demand had been accompanied by lower investment and investment intentions. In some east Asian economies in particular, including South Korea, the turn in the cycle in the global electronics industry had dampened exports and investment. Members noted that firms would also be less likely to commit to long-term investments given the uncertainty around the evolution of international trade policy.
In many economies, domestically focused sectors, such as services and retail trade, had been more resilient than externally focused sectors. This was particularly the case in the advanced economies, where tight labour market conditions had supported growth in spending. Unemployment rates had remained around multi-decade lows in many advanced economies and wages growth had increased noticeably. In the United States and Japan, recent wage increases had been larger for low-wage earners than high-wage earners.
Core inflation had remained subdued in most economies and, following weaker inflation data in the United States, was below target in the three major advanced economies.
There had been some large movements in commodity prices over recent months. Iron ore prices had remained high as a result of supply disruptions in Brazil and Australia. Oil prices had also risen, which had led to higher headline consumer price inflation in most economies and was expected to flow through to higher prices for Australian liquefied natural gas exports over the following couple of quarters. As a result, the forecast for Australia’s terms of trade had been revised higher, but they were still expected to decline over the forecast period to the middle of 2021.
Domestic Economic Conditions
Members commenced their discussion of the domestic economy by noting that growth had been subdued in the second half of 2018. Indicators of household consumption suggested that growth had remained subdued in the March quarter. In addition, demand for new dwelling construction was expected to have remained weak. These factors had been the main drivers of a downward revision to the domestic growth outlook in the near term. Beyond 2019, these effects were broadly offset by upward revisions to export growth and some newly announced mining investment projects. Members noted that, overall, the Bank expected year-ended GDP growth to be 2¾ per cent over 2019 and 2020.
Growth in consumption had been weaker than expected in the second half of 2018 and retail sales data for the March quarter suggested that this weakness had continued into 2019. Members noted that, as had been the case for some time, the outlook for growth in consumption was a key uncertainty for the overall growth outlook. The risks to consumption were tilted to the downside, given the extended period of low income growth and the adjustment occurring in housing markets. The forecast for an improvement in growth in consumption depended on an increase in growth in household disposable income over the forecast period. The forecast increase in household disposable income growth was supported by employment growth, a pick-up in wages growth and lower growth in tax payments, partly because of the introduction of the low- and middle-income tax offsets announced in the Australian Government 2019-20 Budget. Members noted that there was uncertainty about the outlook for fiscal policy and how this might affect the outlook for growth in household disposable income.
Housing markets had remained weak in the preceding month. The rental vacancy rate in Sydney had increased to the highest level in around 15 years and housing prices in established markets had continued to decline. More positively, the pace of price declines had moderated and the modest recovery in auction clearance rates since the start of the year had been sustained.
Information obtained through the Bank’s liaison program continued to indicate that sales conditions for off-the-plan apartments and new detached housing had been difficult. The spike in residential building approvals in February had largely been unwound in March, confirming that underlying conditions for new dwelling activity remained weak. Data released since the previous meeting had shown that the pipeline of residential work to be done had decreased in the December quarter, but remained high. Members noted that the forecasts for dwelling investment suggested that population growth could exceed growth in the stock of housing towards the end of the forecast period, and that this possibility had been suggested by a number of the Bank’s liaison contacts.
Survey measures of business conditions had moved a little higher in March and April and had remained slightly above average, though well below the high levels that had prevailed throughout most of 2018. Forward-looking indicators of non-mining business investment had been mixed; non-residential building approvals had declined, but the pipeline of infrastructure work remained high. Non-mining business investment was expected to support growth in output over the forecast period.
Mining investment had declined in the December quarter, but was expected to increase over the forecast period, reflecting investment required to sustain current production levels and an expectation that a number of new projects would commence towards the end of the forecast period. Recent trade data suggested resource exports would contribute to output growth in the March quarter, and exports were expected to contribute to output growth throughout the forecast period. Members noted that the forecast pick-up in rural exports from 2020 depended on a return to normal weather conditions.
Public demand was expected to continue to support aggregate growth over the forecast period; a significant share of this expenditure was associated with delivering goods and services to households, such as the National Disability Insurance Scheme. Members noted that the Victorian Government had announced measures to contain growth in labour costs in an environment of expected lower stamp duty revenues.
Growth in employment in the March quarter had been strong, following similar outcomes over much of 2018. Most of the growth in employment since mid 2018 had been in full-time employment. The unemployment rate had remained around 5 per cent in March. Members observed that conditions in the labour market had signalled a significantly stronger pace of economic activity since mid 2018 than indicated by the GDP data. Leading indicators of labour demand had eased over recent months and provided a mixed picture of the near-term outlook. As a result, employment growth was expected to be similar to the growth rate of the working-age population in the near term. The unemployment rate was expected to remain around 5 per cent through most of the forecast period, before declining to around 4¾ per cent in 2021.
Members noted that the forecasts for the labour market suggested that there would be some spare capacity in the labour market throughout the forecast period, although there was uncertainty about how quickly the spare capacity would decline and how progress would feed into wage pressures. The central forecast was for wages growth to pick up gradually. In combination, the forecasts for wages growth and consumer price inflation implied that real consumer wage growth would be low but positive over the forecast period.
The inflation data in the March quarter CPI release were noticeably lower than expected. The CPI increased by 0.1 per cent (seasonally adjusted) in the quarter, while the underlying rate of inflation was ¼ per cent. In year-ended terms, headline inflation was 1.3 per cent, with the underlying rate at 1½ per cent. The earlier exchange rate depreciation and the drought-related increase in some food prices had led to relatively strong retail price inflation in the March quarter. However, these inflationary pressures had been more than offset by broad-based weakness in other CPI components, which was likely to be more persistent.
Rental inflation had remained low, driven by a marked slowing in rental inflation in Sydney; data on newly advertised rents suggested that rents had started to pick up in Perth. Developer discounts and incentives had weighed on the prices of newly built homes, particularly in Melbourne and Brisbane. A range of government policy decisions had contributed to lower inflation in administered prices in recent quarters. Market and survey-based measures of inflation expectations had declined in recent months, as had been the case in other advanced economies.
Members noted that the recent CPI data had led the Bank to reassess the disinflationary effects of the weak housing market. Combined with the lower GDP growth outlook, this had led to a downward revision to the inflation outlook, although there was also some uncertainty about the persistence of downward pressure from utilities and administered price changes and the effect of housing market weakness. The central forecast scenario was for underlying inflation of around 1¾ per cent over 2019, 2 per cent over 2020 and a little higher after that.
Financial Markets
Members commenced their discussion of financial market developments by noting that global financial conditions were accommodative and had eased significantly since the start of the year. Market expectations for the future path of monetary policy in a number of economies had declined earlier in the year, in line with guidance from major central banks that policy was likely to be more accommodative than previously expected. The expectation that policy rates would remain little changed for some time had contributed to very low levels of volatility in most financial markets.
In the United States, with inflation close to but a bit below target and the federal funds rate close to neutral, the Federal Reserve (Fed) had reiterated that it would take a patient and flexible approach to its policy decisions. While the Fed’s recent forecast update implied that one more policy rate increase was likely by the end of 2020, market pricing implied that the Fed was expected to lower its policy rate around twice over that period. At its April meeting, the European Central Bank had reiterated that it expected policy rates to remain at current levels at least through to the end of 2019. The Bank of Japan had indicated that its very stimulatory policy settings will remain in place until at least mid 2020. Market participants expected the next moves in policy rates in Canada, New Zealand and Australia to be down.
Government bond yields remained at very low levels in the advanced economies, having declined since late 2018 in line with downward revisions to growth and inflation projections, and the lowering of policy rate expectations by market participants. In Germany and Japan, long-term bond yields were around zero, close to the record lows of 2016. Members noted that Australian government bond yields had declined by more than those in other major markets over the preceding six months, following weaker-than-expected inflation data and a lower expected path for monetary policy. By contrast, Chinese government bond yields had increased over the preceding month, as signs emerged that policy stimulus there was providing support to economic activity.
Members noted that, following the brief inversion of segments of the US yield curve in March, the slope of the US yield curve had increased a little in April. While market commentators had noted that past episodes of yield curve inversion had tended to precede recessions, the decline in credit spreads and rise in equity valuations in 2019 suggested market participants did not perceive this to be a particular risk.
Members observed that financing conditions for corporations remained favourable. In the advanced economies, corporate bond yields had declined, partly because of a decline in spreads. In addition, equity prices had increased substantially since the start of 2019 to be at their highest levels in over a decade, including in Australia.
In China, growth in total social financing had been steady in recent months and a little higher than in 2018, supported by bank lending and bond issuance. Off-balance sheet financing had continued to decline, reflecting the authorities’ efforts to discourage riskier forms of financing. Members noted that the Chinese authorities had introduced additional measures to encourage banks to lend to small private sector firms, which had previously made use of off-balance sheet financing that was now less readily available. Members also noted the substantial local government bond issuance to finance infrastructure projects, which was a key part of the authorities’ stimulus measures.
In foreign exchange markets, volatility had remained low over the preceding month, including in most emerging markets. Members noted, however, that risks remained pronounced for a small number of economies with specific vulnerabilities, most notably Turkey and Argentina, where financial conditions had tightened again.
The Australian dollar had depreciated a little following the weaker-than-expected March quarter CPI release, but overall had been little changed over recent months and remained around the lower end of its narrow range of the past few years. Members noted that this reflected the offsetting influences of the rise in commodity prices and decline in Australian government bond yields relative to those in the major markets over 2019. The difference between long-term government bond yields in the United States and Australia had increased to a historically large 75 basis points.
Housing credit growth had slowed over the preceding year, but the monthly pace of growth had stabilised over recent months. In three-month-ended annualised terms, growth in housing lending was around 4½ per cent for owner-occupiers and ½ per cent for investors. Loan approvals also appeared to have stabilised in recent months. Members noted that, although lending practices were tighter than they had been for some time, the decline in housing credit growth over the preceding year had been driven largely by weaker demand for finance, associated with the decline in housing prices.
The average interest rate charged on outstanding variable-rate housing loans had remained broadly steady. While banks had increased their standard variable reference rates since mid 2018, rates on new loans had remained materially below the average of those on outstanding loans. Members noted that banks had recently reduced the rates charged on new fixed-rate loans.
Funding costs for the major banks had declined to record lows in preceding months, as the increase in short-term money market rates in 2018 had been fully unwound and retail deposit rates had continued to edge lower. Despite the low cost of funding, bank bond issuance in 2019 so far had been a little below the average of recent years. Issuance of bonds by other corporations and of residential mortgage-backed securities had been broadly in line with the average of recent years.
The pace of growth in business lending had been maintained in recent months at rates that were above those of the preceding few years, driven by lending to large businesses. Lending to small businesses had declined over the preceding year. Interest rates on variable-rate loans to large businesses, which are linked to bank bill swap rates, had declined in the March quarter. Members observed that the rates charged on small business loans remained markedly higher than those on large business loans, with the gap between small and large business loan rates having doubled following the global financial crisis.
Financial market participants’ expectations of cash rate cuts were brought further forward following the release of the March quarter CPI. Financial market pricing implied that the cash rate was expected to be lowered by 25 basis points within the next three months and again by the end of 2019.
Considerations for Monetary Policy
In considering the stance of monetary policy, members observed that growth in Australia’s major trading partners had slowed, driven by a sharp slowing in global trade associated with slower growth in China. Members also noted, however, that targeted stimulus measures in China appeared to be having an effect and global financial conditions remained very accommodative. In a number of advanced economies, labour markets had continued to tighten and wages growth had increased, but inflationary pressures had remained subdued.
Domestically, members noted that the sustained low level of interest rates over recent years had been supporting economic activity and had contributed to a decline in the unemployment rate. However, household income growth had remained low and the March quarter inflation data indicated that the inflationary pressures in the Australian economy were lower than previously thought.
After updating the forecasts for the new information, the central forecast scenario remained for progress to be made on the Bank’s goals of reducing unemployment and returning inflation towards the midpoint of the target, but at a more gradual pace than previously expected. Under the central scenario, GDP growth had been revised lower in the near term, but was expected to pick up to be around 2¾ per cent over 2019 and 2020. The unemployment rate was expected to remain around 5 per cent over 2019 and 2020 before declining a little to 4¾ per cent in 2021. This implied that spare capacity would remain in the economy for some time. Given this, and the subdued inflationary pressures across the economy, underlying inflation was expected to be 1¾ per cent over 2019, 2 per cent over 2020 and a little higher after that.
Members noted that the central forecast scenario was based on the usual technical assumption that the cash rate followed the path implied by market pricing, which suggested interest rates were expected to be lower over the next six months. This implied that, without an easing in monetary policy over the next six months, growth and inflation outcomes would be expected to be less favourable than the central scenario.
At the same time, members also recognised that there were risks to the forecasts in both directions. The risks to the global economy remained tilted to the downside, with uncertainty remaining around the evolution of international trade policy. Domestically, the outlook for household consumption remained a key uncertainty, with the risks tilted to the downside given ongoing low income growth and the adjustment occurring in housing markets. On the upside, it was possible that the combined effects of continued accommodative financial conditions, the increase in Australia’s terms of trade, a renewed expansion in the resources sector and the expected lift in household disposable income growth would result in stronger growth in output than in the central forecast scenario.
Members discussed the outlook for the domestic labour market in some detail. As in the previous meeting, members discussed the scenario where inflation did not move any higher and unemployment trended up, recognising that in those circumstances a decrease in the cash rate would likely be appropriate. As noted at the previous meeting, members recognised that the effect on the economy of lower interest rates could be expected to be smaller than in the past, given the high level of household debt and the adjustment that was occurring in housing markets. Nevertheless, a lower level of interest rates could still be expected to support the economy through a depreciation of the exchange rate and by reducing required interest payments on borrowing, freeing up cash for other expenditure.
In light of the recent run of inflation data, the Board then discussed the likelihood that the economy could sustain a stronger labour market with lower rates of unemployment than previously estimated, while achieving inflation consistent with the target. In this context, members observed that the recent international experience was that inflation had remained low despite historically low rates of unemployment. Given the international evidence and the recent Australian inflation data, members agreed that a further decline in the unemployment rate would be consistent with achieving Australia’s medium-term inflation target. Given this, members considered the scenario where there was no further improvement in the labour market in the period ahead, recognising that in those circumstances a decrease in the cash rate would likely be appropriate.
Taking into account all the available information, including the various uncertainties about the outlook, members judged that it was appropriate to hold the stance of monetary policy unchanged at this meeting, noting that holding monetary policy steady had enabled the Bank to be a source of stability and confidence over recent years. In view of the spare capacity that remained in the economy, however, members agreed that it was important to continue to pay close attention to developments in the labour market and set monetary policy to support sustainable growth in the economy and achieve the inflation target over time.
Farewell Phillips Curve. Rate cuts are go even with unemployment unchanged.
