RBA – Page 80 – Digital Finance Analytics (DFA) Blog

RBA Minutes For June Meeting Released

The latest minutes tells us little about future prospects for rate changes, the RBA is waiting to see what happens but with overall growth expectation weak. They recognise risks in the housing sector in some centres, but also see slow business investment and spare capacity in the system. Between a rock and a hard place!

International Economic Conditions

Members noted that data released over the past month confirmed that growth of Australia’s major trading partners had eased a little in the March quarter and were consistent with around-average growth in the period ahead. Measures of global headline and core inflation rates had remained subdued in April.

Following a moderation in growth in the March quarter, some of the recent Chinese data had been more positive. Growth of industrial production and retail sales had picked up a little and conditions in the property market had improved somewhat, particularly in the larger cities. However, growth of fixed asset investment, particularly in the real estate sector, had eased further. While the production of steel had increased over recent months, its rate of growth remained significantly lower than earlier trends. The Chinese trade data had indicated weakness in both exports and imports in recent months, although imports of Australian iron ore had continued to rise. Members noted that the Chinese authorities had eased a number of policies and announced initiatives intended to support growth.

In Japan, national accounts data for the March quarter showed that economic activity had grown at a moderate pace. Wage growth had increased over the past year and the unemployment rate had declined to its lowest level in almost 20 years. For the remainder of east Asia, GDP had grown slightly below its average pace of recent years in the March quarter and both headline and core inflation had eased. In India, economic conditions had improved over the past year or so.

In the United States, indicators of activity had been mixed, though more positive than suggested by the weak March quarter GDP data, which had largely reflected temporary factors. Labour market conditions had continued to improve and consumption growth had remained relatively strong. Business activity indicators had generally remained positive, though they were a little weaker than late in the preceding year.

Economic conditions in the euro area had continued to improve, but the recovery remained modest and inflation continued to be well below the European Central Bank’s target.

Overall, commodity prices had been little changed since the previous meeting. The prices of coal and base metals had fallen, while the price of iron ore had increased.

Domestic Economic Conditions

Members noted that the March quarter national accounts would be released the day after the meeting. The data available prior to the meeting suggested that GDP growth had been close to average in the quarter, although below average on a year-ended basis. Growth in household consumption for the March quarter was expected to have been around average, while both dwelling investment and resource exports appeared to have been growing strongly. In contrast, business investment was likely to have contracted. There continued to be spare capacity in product and labour markets, despite some improvement in labour market conditions over the past six months or so.

Members observed that the Australian Government Budget for 2015/16 had outlined a number of years of slightly larger deficits than had been forecast in the Mid-Year Economic and Fiscal Outlook update in December 2014. This mainly reflected lower commodity prices and weaker-than-expected growth of incomes. Members were informed that the budget policies were little different from what had been assumed for the forecasts presented in the May Statement on Monetary Policy. Members discussed the importance of including the fiscal positions of the states and territories in any assessment of the effect of fiscal consolidation on the aggregate economy.

Growth of retail sales volumes had been around average in the March quarter. Measures of consumer sentiment had picked up noticeably in May to be a bit above average. Much of this had been attributed to the Australian Government Budget and, in particular, the announcement of tax concessions for small businesses. Liaison suggested that there had been little change in the year-ended growth of the value of retail sales in April and May.

Dwelling investment looked to have grown strongly in the March quarter and forward-looking indicators of construction activity pointed to a further pick-up. Members noted that conditions in the established housing market had continued to vary across the country. Although housing price inflation had remained high in Sydney and, to a lesser extent, in Melbourne over recent months, there had been some divergence in price developments for different segments of these markets; price inflation of detached houses had increased, whereas price inflation for units had eased in both cities. Noting that housing price growth in other cities and regional areas had declined over recent months, members discussed the strength and composition of underlying supply and demand conditions in different parts of the housing market. They also observed that there was a relatively low stock of dwellings for sale in Sydney and Melbourne and that dwellings took only a short time to sell.

Members noted that housing credit growth overall had been broadly steady at around 7 per cent (on a six-month-ended annualised basis), though the latest data on loan approvals had showed a pick-up. Over the past six months or so, growth in investor credit had eased back to be running at an annualised pace of a bit above 10 per cent. However, over more recent months there had been solid increases in housing loan approvals to both owner-occupiers and investors, particularly in New South Wales, following earlier declines.

The available data suggested that private business investment had declined further in the March quarter, consistent with the forecast presented in the May Statement on Monetary Policy. Mining investment appeared to have fallen further, while non-mining investment looked to have been little changed over recent quarters. Members observed that there were diverging trends within the non-mining sector. Investment in some sectors, such as real estate and retail trade, had picked up in response to stronger growth in domestic demand, but investment had continued to fall in other sectors, such as manufacturing, where the rate of investment had been lower than the rate of depreciation in recent years. Members noted that a lower exchange rate would have an immediate beneficial effect on some sectors, such as tourism, but that it would need to be lower for a sustained period to have a significant effect on large investment decisions in other trade-exposed sectors.

Surveys of business conditions remained a bit above their long-run averages in April. In contrast, an economy-wide measure of business confidence had remained below its long-run average level, along with various measures of capacity utilisation. Also, the second reading from the ABS capital expenditure survey of businesses’ investment intentions for 2015/16 implied a fall in non-mining investment.

Trade data suggested that export volumes had increased strongly in the March quarter across most categories, including bulk commodities. Import volumes also appeared to have increased strongly, though capital imports had remained lower than their peak in 2012.

The labour force data continued to suggest that growth in employment and hours worked had been stronger over the past six months or so than the preceding period and the unemployment rate had been relatively stable at around 6¼ per cent. In April, employment had been little changed, the participation rate had ticked down and the unemployment rate had increased slightly to 6.2 per cent. Forward-looking indicators suggested that employment growth would be only modest in the coming months and most measures of job advertisements and vacancies were little changed since mid to late 2014.

Wage growth had declined a little further in the March quarter and remained lower than suggested by the historical relationship between wage growth and the unemployment rate. The rise in the private sector component of the wage price index had been the lowest outcome for many years (with the exception of the September quarter 2009) and wage growth over the year to March was below its decade average in all industries. Wage growth in the public sector had also remained low, in part because of delayed negotiations over enterprise bargaining agreements. Members considered several possible explanations for the slow growth of wages, including a more flexible labour market, the relatively long period of gradually rising unemployment over recent years and below-average levels of inflation expectations generally.

Financial Markets

Financial markets continued to focus on the current negotiations between Greece and its official sector creditors and the likely timing of interest rate rises in the United States. A sharp rise in 10-year bond yields was the main development across the major financial markets over the past month.

Members noted that the global rise in sovereign bond yields had been led by longer-maturity German Bunds, with those yields rising by as much as 65 basis points after reaching a historic low in mid April. The rise in yields was viewed primarily as a correction from unduly low levels, rather than a reaction to economic developments, and the sell-off only returned yields to their still low levels of late last year.

Longer-term sovereign yields in most other developed countries, including Australia, also rose significantly, while increases in yields on emerging market sovereign debt were generally smaller. Following the release of the Australian Government Budget, the Australian Office of Financial Management announced updated financing requirements for 2015/16, with net issuance of Australian Government Securities expected to be around $40 billion and net debt peaking at around 18 per cent of GDP in 2016/17.

In relation to the continuing negotiations between Greece and its official sector creditors, members observed that sizeable differences remained regarding the most substantive issues, including pensions and labour market reforms. Greece had been able to meet its scheduled payments to the International Monetary Fund (IMF) in May, but Greek officials had cautioned that payments due to the IMF in June would be difficult to make without an agreement being reached with the official sector creditors. Members also noted that, consistent with reports of deposit outflows, Greek banks’ use of emergency liquidity assistance had increased further during April and May.

In the United States, expectations about the timing of the first increase in the federal funds rate had changed little over the past month, with market pricing suggesting it would happen around the end of 2015, even though comments from the Federal Reserve suggested that the first increase would occur a little sooner than that. The People’s Bank of China had moved to ease monetary policy further in May when it announced another reduction in both benchmark lending and deposit rates in response to low inflation and slower growth in economic activity.

Turning to foreign exchange markets, members noted that the US dollar had reversed its recent modest depreciation against most currencies, reaching its highest level against the yen since December 2002. The Chinese renminbi was little changed against the US dollar over the past month, although it had appreciated further on a trade-weighted basis and had been assessed by the IMF as being no longer undervalued. The Australian dollar had depreciated over May to be a little above its trough in early April on a trade-weighted basis.

Equity prices in the major markets had shown little net change since the previous meeting. The broad index for Chinese equities had increased by 2 per cent over the past month, although the index had been volatile. Members also noted the high-profile collapses in the prices of two Hong Kong-listed Chinese companies in mid May. Australian equity prices had underperformed the major markets over May.

Pass-through of the reduction in the Australian cash rate target in May to lending and deposit rates had varied across domestic financial institutions and products. At the same time, a number of banks were reported to have tightened conditions on new loans to property investors and imposed restrictions on the extent of interest rate discounts. Members noted that it would take some time for the full effects of such changes to be evident in the housing loan approvals and credit data.

Market pricing indicated that the cash rate target was expected to remain unchanged at the present meeting.

Considerations for Monetary Policy

Members noted that information becoming available over the past month had not led to any material change to the global outlook, which was for growth of Australia’s major trading partners to be around average over the period ahead. After somewhat weaker-than-expected economic conditions in China earlier in the year, the authorities had eased a range of policies and announced initiatives to support growth, and some of the recent data had been slightly more positive. The Federal Reserve was expected to begin the process of raising its policy interest rate later this year, but some other major central banks were continuing to ease policy. Commodity prices had been mixed over the month and little changed overall, and were significantly lower than a year earlier.

Domestically, the available data suggested that output growth had continued at a below-trend pace over the past year and would remain a little below trend in the period ahead before picking up to around trend in the latter part of 2016. The national accounts data for the March quarter were expected to show that the key forces operating on the economy were much as they had been for some time. After picking up late last year, growth of household expenditure was expected to have remained strong, supported by low interest rates and strong population growth. Conditions in the housing market in Sydney and parts of Melbourne had remained very strong, though trends were more mixed in other cities. Survey-based measures of business conditions had remained around average levels. There continued to be spare capacity in labour and product markets, although there had been some improvement in labour market conditions over the past six months or so. Inflationary pressures remained well contained and were likely to remain so in the period ahead.

The exchange rate was close to the lowest levels seen earlier in the year, but members noted that the current level of the exchange rate, particularly on a trade-weighted basis, continued to offer less assistance than would normally be expected in achieving balanced growth in the economy. A further depreciation therefore seemed both likely and necessary, particularly given the significant declines in commodity prices over the past year.

Overall, in assessing domestic conditions and the international environment, the Board’s assessment was that the stance of monetary policy should be accommodative. Having eased policy at the previous meeting, members judged that it was appropriate to leave the cash rate unchanged and to assess information on economic and financial conditions as it became available. These data would inform the Board’s assessment of the state of the economy and the outlook and hence whether the current stance of policy would most effectively foster sustainable growth and inflation consistent with the target.

The Decision

The Board decided to leave the cash rate unchanged at 2.0 per cent.

Monetary Policy Transmission

Christopher Kent, Assistant Governor (Economic), gave a speech in Canberra at the Australian National University entitled “Monetary Policy Transmission – What’s Known and What’s Changed“. In the speech he dissects the way in which changes to monetary policy flows on through the economy to households and firms. Its a relevant discussion because the recent monetary easing has not so far translated into the desired outcomes in the current cycle. We think he is correct to assert that segmented analysis of households needs to be incorporated into the thinking, as based on our surveys we see that different household groups, are behaving in very different ways.

In responding to cyclical developments and inflation pressures, monetary policy has a significant influence on aggregate demand and inflation. The transmission of interest rates through the economy can be roughly described as follows. I’ll focus on an easing of monetary policy.

The Reserve Bank lowers the overnight cash rate.

Financial markets update expectations about the future path of cash rates and the structure of deposit and lending rates are quickly altered.

Over time, households and firms respond to lower interest rates by increasing their demand for credit, reducing their saving and increasing their (current) demand for goods, services and assets (such as housing and equities).

Other things equal, rising demand increases the prices of non-tradable goods and services. The price-setting behaviour of firms depends on demand conditions and the cost of inputs, including of labour. Higher aggregate demand leads to increased labour demand and a rise in wages.

The transmission mechanism depends crucially on how monetary policy affects households’ and firms’ expectations. Expectations about the future path of the cash rate will affect financial market prices and returns, asset prices and the expected prices of goods, services and factors of production (including labour). Expectations of more persistent changes in the cash rate will have larger effects.

The extent to which lower interest rates lead to extra demand will depend on how households and businesses alter their behaviour regarding borrowing and investing, as well as consuming and saving. These responses are often described as occurring via a number of different channels.

He concludes that monetary policy is clearly working to support demand, although it is working against some strong headwinds. These include the significant decline in mining investment, fiscal consolidation at state and federal levels and the exchange rate, which continues to offer less assistance than would normally be expected in achieving balanced growth in the economy. Model estimates that control for these and other forces provide tentative evidence that the monetary policy transmission mechanism, in aggregate, is about as effective as usual. However, it may be too early to pick up a statistically significant change using such models.

As usual, dwelling construction is growing strongly in response to low interest rates, and this is making some contribution to the growth of aggregate demand and employment. It may be that in parts of the country, any further substantial increases in residential construction activity might run up against some supply constraints, putting further upward pressure on housing prices. As the Bank has noted for some time now, large increases of housing prices, if accompanied by strong growth of credit and a relaxation of lending standards, are a potential risk for economic stability. Accordingly, the Bank is working with other regulators to assess and contain such risks that may arise from the housing market.

Consumption growth has picked up since 2013. But it is still a little weaker than suggested by historical experience. This may reflect a number of factors including some variation in the ways that the different channels of monetary policy are affecting households according to their stage in life. Some indebted households appear to be taking advantage of low interest rates to pay down their debts faster than has been the norm, perhaps in response to weaker prospects for income growth. Those relying on interest receipts may feel compelled to constrain their consumption in response to the relatively long period of very low interest rates. Meanwhile, the search for yield is no doubt playing a role in driving the strong growth of investor housing credit. This might provide some indirect support to aggregate demand, but this channel is not without risk.

In short, monetary policy is working. The transmission mechanism may have changed in some respects, and this could help to explain lower-than-expected growth of consumption and debt of late. But it is hard to be too definitive. To know more about this, it would be helpful to better understand the behaviours of different types of households using household-level data. To use a botanical analogy, to know more about a plant, it’s helpful to observe how its different types of cells work.

Aligning Growth Policy Levers

Glenn Stevens gave an address to the Economic Society of Australia in Brisbane where he discussed the need to align policy levers to drive growth and the limits of monetary policy.

The latest edition of the Australian National Accounts, released last week, shows the picture. The quarterly growth figure was stronger than what had been embodied in our forecasts in the May Statement on Monetary Policy, though that comes after a weaker-than-expected outcome in the previous quarter. Some of the strength resulted from unusually high export shipments of resources, which were less disrupted by weather conditions in the ‘cyclone season’ than has often been the case in the past. Indications are that this pace of growth wasn’t repeated in the June quarter, when shipments of coal in particular were affected by weather disruptions on the east coast.

Taking the results over the past four quarters, growth was ‘below trend’. Export volume growth contributed strongly, while domestic final demand increased by a bit under 1 per cent, which is quite a weak result. Housing construction rose strongly, and consumer spending over the year rose by more than real household income (that is, the saving rate fell). Both these results owe a good deal to low interest rates and rising asset values.

But other components of demand were weak. Business investment fell substantially, with mining investment falling quickly and, as best we can tell, non-mining capital spending also weak. Public final spending didn’t grow at all. Public investment spending fell by 8 per cent over the past year.

Overall, these outcomes are weaker that what, two years ago, we expected would be happening by now. Back then, the two-year-ahead forecast was for annual GDP growth to be in a range of 2½ to 4 per cent by mid 2015. The width of that range reflected the normal size of error margins, coupled with the inevitable uncertainty about the timing of when some components of demand outside of mining might strengthen, and the judgement that if accommodative monetary policy really was held in place for several years (which was a key assumption behind those forecasts), activity could at some point start to pick up quite quickly. It will be three months before we get the national accounts data for the June quarter, but at this point, with three of the four quarters available for the year to June 2015, it would appear that the outcome will be either right at the bottom of the range predicted two years ago or, more likely, a bit below it.

Of course, forecasts are hardly more than educated guesswork and two-year-ahead forecasts are even less reliable. That there are inevitably forecast errors is neither surprising nor new, and it is not any more concerning per se now than it always has been. This is far from the biggest forecast error I’ve seen over my three decades in this game.

But it is nonetheless useful to see what we can learn from those errors.

The following points are prominent:

The terms of trade, which two years ago were assumed to fall, have in fact fallen further – they are about 12 per cent lower than the assumed path. That means national income is lower, which means spending power is lower.

The exchange rate, which at that time was above parity against the US dollar, and was assumed to stay there, is now about 25 per cent lower. It has moved in the same direction as the terms of trade, which is normal.

The lower exchange rate has helped to produce a contribution to growth from ‘net exports’ much greater than earlier forecast, while that from domestic demand has been much weaker. The latter is mainly spread across non-mining business investment and weaker government spending, together with softer consumption on account of lower incomes. One thing which is not very different from the forecast from two years ago is that mining sector capital spending is falling sharply.

Because the net effect of the above factors is that GDP growth has been on the weaker side of expectations, the unemployment rate is about half a percentage point higher than forecast two years ago. Consistent with that, growth in wages is, as you would expect, lower than forecast.

Headline inflation is lower than forecast, largely because of the recent fall in oil prices. Underlying inflation is within the 2–3 per cent range that had been forecast. Again, the depreciation of the exchange rate has been a factor here.

The cash rate is 75 basis points lower than assumed two years ago, as monetary policy has used the room provided by contained inflation to try to do more to help growth. Lending rates have fallen on average by about 100 basis points over that period. This has produced a stronger result for housing construction than forecast and will also have contributed to the rise in dwelling prices.

In summary, the economy has in several important respects followed a different track from the one expected a couple of years ago. That is partly because conditions in the world economy were different from what had been expected and partly because several domestic factors were different.

Some in-built responses have been in evidence. For example the decline in the exchange rate, even if not by as much as we might have expected, has had the effect of supporting growth and keeping inflation from falling as much as it might have done. And, of course, monetary policy has also responded to the evolving situation, consistent with the Reserve Bank’s mandate. These responses have had the effect of lessening the extent to which growth and inflation have differed from the outcomes expected two years ago, but haven’t managed to eliminate those differences entirely, at least in the case of output growth.

The slowing in wage growth in response to soft labour market conditions has also undoubtedly helped to hold employment up. In fact wage growth appears to be somewhat lower than previous relationships between wages and unemployment would suggest. This may be a sign of increased price flexibility in the labour market and could help to explain why employment recently has looked a little higher relative to estimated GDP than might have been expected. These hypotheses can be advanced only tentatively, though, until we have more data.

Looking ahead, the most recent forecasts suggest that growth rates will be similar to those we have observed recently for a while yet. Residential investment will reach new highs over the period ahead. Household consumption is expected to record moderate growth. With national income growth reduced by a falling terms of trade, this requires a modest decline in the saving rate. It doesn’t seem reasonable to expect much more from consumption growth than that.

Resources sector investment has a good deal further to fall yet over the next two years. Other areas of investment seem very low and while I would have expected that by now these would have been showing signs of strengthening, the most recent indications are for, if anything, a weakening over the year ahead. Public final spending has not been growing and fiscal consolidation still has some way to run. Under the current macroeconomic conditions, it would seem inappropriate for governments to seek additional restraint here in the near term.

Inflation is likely to remain low. Growth in labour costs is very low and some of the forces that were pushing up certain administered prices have started to reverse. So even if the exchange rate were to fall further, which in my view it needs to, we seem unlikely to have a problem with excessive inflation.

Putting all that together, as things stand, the economy could do with some more demand growth over the next couple of years.

Of course, these are forecasts. They might be wrong. In fact, they will be wrong, in some dimension or other. Our published material goes to some lengths to articulate a range of ‘risks’. It is easy to think of ‘downside’ ones in the current mood of determined pessimism.

But it is not entirely impossible to think of upside ones as well. A further fall in the exchange rate, which is not assumed in the forecasts, would add both to growth and prices. If one thinks that such a decline at some point is likely, that constitutes an ‘upside’ risk. Of course, the list of countries that would prefer a lower exchange rate is a long one and we can’t all have it.

That being so, we might give some thought to trying to create some upside risks to the growth outlook through policy initiatives. The Reserve Bank will remain attuned to what it can do, consistent with the various elements of its mandate – including price stability, full employment and financial stability. We remain open to the possibility of further policy easing, if that is, on balance, beneficial for sustainable growth.

The temptation, of course, is to presume outcomes can be fine-tuned by policy settings and that we can simply dial up more or less demand in short order to avoid deviations from some ideal path. Reality is inevitably more messy than that and has not always been kind to such fine-tuning notions. As it is, some observers think monetary policy has done too little, while others think it already has done way too much. I think it has been about right for the circumstances.

But the bigger point is that monetary policy alone can’t deliver everything we need and expecting too much from it can lead, in time, to much bigger problems. Much of the effect of monetary policy comes through the spending, borrowing and saving decisions of households. There isn’t much cause from research, or from current data, to expect a direct impact on business investment. But of all the three broad sectors – households, government and corporations – it is households that probably have the least scope to expand their balance sheets to drive spending. That’s because they already did that a decade or more ago. Their debt burden, while being well serviced and with low arrears rates, is already high. It is for this reason that I have previously noted some reservations about how much monetary policy can be expected to do to boost growth with lower and lower interest rates. It is not that monetary policy is entirely powerless, but its marginal effect may be smaller, and the associated risks greater, the lower interest rates go from already very low levels. I think everyone can see that.

If I am correct about this, it really is very important that other policies coalesce around a narrative for growth. In this regard, I think the Government is on the right track in not seeking to compensate for lower revenue growth by cutting spending further in the short run. Of course, some resolution of long-run budget trends is still going to be needed to sustain confidence and that will not be an easy conversation.

Meanwhile, as often remarked, infrastructure spending has a role to play in sustaining growth and also in generating confidence. I am doubtful of our capacity to deploy this sort of spending as a short-term countercyclical device. The evidence of history is that it takes too long to start and then too long to stop. But it would be confidence-enhancing if there was an agreed story about a long-term pipeline of infrastructure projects, surrounded by appropriate governance on project selection, risk-sharing between public and private sectors at varying stages of production and ownership, and appropriate pricing for use of the finished product. The suppliers would feel it was worth their while to improve their offering if projects were not just one-offs. The financial sector would be attracted to the opportunities for financing and asset ownership. The real economy would benefit from the steady pipeline of construction work – as opposed to a boom and bust. It would also benefit from confidence about improved efficiency of logistics over time resulting from the better infrastructure. Amenity would be improved for millions of ordinary citizens in their daily lives. We could unleash large potential benefits that at present are not available because of congestion in our transportation networks.

The impediments to this outcome are not financial. The funding would be available, with long term interest rates the lowest we have ever seen or are likely to. (And it is perfectly sensible for some public debt to be used to fund infrastructure that will earn a return. That is not the same as borrowing to pay pensions or public servants.) The impediments are in our decision-making processes and, it seems, in our inability to find political agreement on how to proceed.

Physical infrastructure is, of course, only part of what we need. The confidence-enhancing narrative needs to extend to skills, education, technology, the ability and freedom to respond to incentives, the ability to adapt and the willingness to take on risk. It is in these areas too, where there are various initiatives in place or planned, but which often do not get enough attention, that we need to create a positive dynamic of confidence, innovation and investment.

That is the upside we need to create.

RBA Caused The Bubble – AFR

Strong piece from Chris Joye in the AFR today.

There’s only one party to blame for Australia’s unprecedented house price bubble. And it’s not buyers, vendors, developers, immigrants or local councils restricting new approvals. While they have all contributed to the underlying demand and supply dynamics, the unsustainable price growth across Sydney and Melbourne since January 2013 is squarely the responsibility of the monetary policy mandarins residing in the Reserve Bank of Australia’s Martin Place headquarters.

It is these folks who dismissed our repeated warnings that they were blowing the mother of all bubbles and instead decided that the cheapest mortgage rates in history—enabled by cutting the cash rate a full 100 basis points below its global financial crisis nadir – is the elixir required to maintain “trend” growth. Never mind that this might actually be bad, productivity-destroying growth based on distorted savings and investment decisions that will have to be reversed when the price of money normalises.

And let there be no doubt this bubble is without peer. The dollar value of our homes, mortgage debt and house prices measured relative to incomes, and the share of speculative investors purchasing properties, have never been higher. So as far as valuations and interest rates are concerned, we might as well be exploring the surface of the Sun.

Slashing the cash rate to 2 per cent in May – or about 50 basis points below Australia’s core inflation rate – in the name of centrally planning economic activity is having other deleterious consequences. Setting aside the adverse effects of the absurdly cheap 3.49 per cent fixed and 3.98 per cent variable loan rates now offered, we have banks like Macquarie claiming that the 1.9 per cent interest paid on its market-leading at-call deposit product is “healthy”. Every day I meet retail and institutional savers struggling to figure out how to earn a decent return without assuming unacceptable risks that could decimate their wealth. With the Australian sharemarket down more than 8 per cent from its April highs and major bank stocks off more than 16 per cent, chasing dividend yields is patently not the answer for the defensive part of your portfolio.

Cash Rate Unchanged Today

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

The global economy is expanding at a moderate pace, but some key commodity prices are much lower than a year ago. This trend appears largely to reflect increased supply, including from Australia. Australia’s terms of trade are falling nonetheless.

The Federal Reserve is expected to start increasing its policy rate later this year, but some other major central banks are continuing to ease policy. Hence, global financial conditions remain very accommodative. Despite some increases in bond yields recently, long-term borrowing rates for sovereigns and creditworthy private borrowers remain remarkably low.

In Australia, the available information suggests the economy has continued to grow, but at a rate somewhat below its longer-term average. Household spending has improved, including a large rise in dwelling construction, and exports are rising. But a key drag on private demand is weakness in business capital expenditure in both the mining and non-mining sectors and this is likely to persist over the coming year. Public spending is also scheduled to be subdued. Overall, the economy is likely to be operating with a degree of spare capacity for some time yet. With very slow growth in labour costs, inflation is forecast to remain consistent with the target over the next one to two years, even with a lower exchange rate.

In such circumstances, monetary policy needs to be accommodative. Low interest rates are acting to support borrowing and spending. Credit is recording moderate growth overall, with stronger lending to businesses and growth in lending to the housing market broadly steady over recent months. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities. The Bank is working with other regulators to assess and contain risks that may arise from the housing market. In other asset markets, prices for equities and commercial property have been supported by lower long-term interest rates.

The Australian dollar has declined noticeably against a rising US dollar over the past year, though less so against a basket of currencies. Further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices.

Having eased monetary policy last month, the Board today judged that leaving the cash rate unchanged was appropriate at this meeting. Information on economic and financial conditions to be received over the period ahead will inform the Board’s assessment of the outlook and hence whether the current stance of policy will most effectively foster sustainable growth and inflation consistent with the target.

Interest Rates Should Fall No Further: RBA Shadow Board

The RBA’s decision to cut the cash rate to 2% last month went against the recommendation of the CAMA RBA Shadow Board according to The Conversation. Since then economic data continues to show signs of weakness. Unemployment is up slightly, investment down, and consumer and business confidence remain fragile.

The international economy continues to pose a threat to the Australian economy and inflation remains comfortably within the RBA’s target band. But asset prices, Sydney house prices in particular, continue to post high gains.

The CAMA RBA Shadow Board on balance prefers to hold firm but believes the cash rate has bottomed and an increase is due in the near future. In particular, the Shadow Board recommends the cash rate be held at its current level of 2%; it attaches a 60% probability to this being the appropriate policy setting. The confidence attached to a required rate cut equals a mere 2%, while the confidence in a required rate hike stands at 38%.

According to the Australian Bureau of Statistics, Australia’s jobless rate edged up to 6.2% in April. Worryingly, in the same month full-time employment, total employment and the participation rate have fallen. Wage growth remains at a record low: the Australian wage price index increased by 2.3% in the last quarter, well below the average of 3.5% for the period 1998-2015.

The Australian dollar remains range-bound between US76¢ and US80¢. Yields on Australian 10-year government bonds have increased further, to 2.84%, from its recent low of 2.59%, implying a steepening of the yield curve, normally a bullish sign.

Regional housing markets, particularly Sydney and Melbourne, and domestic share prices remain buoyant. This remains a primary concern for many Shadow Board members as the asset price increases coincide with an increase in private sector leverage, leading to misallocated investment and opening up the possibility of a costly price correction. According to the Reserve Bank of Australia total housing credit grew by 7.2% (year-ended) in April 2015, compared to 6% in April 2014.

The international economy remains subdued. For Europe, a noticeable pickup in growth is not on the horizon, at least not until the Greek debt crisis is resolved. Recent revisions of US data indicate that US growth this year has been slower than initially thought, with some analysts suggesting the US economy actually contracted in the first quarter. Without a string of good news about the US economy, the Federal Reserve Bank’s increase of the cash rate is likely to be pushed back ever more. Commodity prices are likely to remain soft and possibly fall further.

Consumer and producer confidence measures continue to be mixed. However, of particular concern is the outlook for domestic investment. The ABS survey of chief financial officers conducted in April and May of this year reveals that total capital expenditure is still expected to fall significantly, with the current estimate for fiscal year 2015-16 being 24% less than the corresponding estimate for fiscal year 2014-15. The trend volume estimate for total new capital expenditure fell 2.3% in the March quarter 2015 while the seasonally adjusted estimate fell 4.4%.

What the Shadow Board believes

The Shadow Board’s confidence that the cash rate should remain at its current level of 2% equals 60%. The confidence that a rate cut is appropriate is a mere 2%, whereas the Shadow Board considers it much more likely (38%) that a rate increase, to 2.25% or higher, is the appropriate policy decision for this month.

The probabilities at longer horizons are as follows: six months out, the estimated probability that the cash rate should remain at 2% equals 23%. The estimated need for an interest rate increase lies at 76%, while the need for a rate decrease is estimated at 3%.

A year out, the Shadow Board members’ confidence in a required cash rate increase equals 81%, in a required cash rate decrease 2% and in a required hold of the cash rate 17%.

Total Housing At Record $1.46 Trillion in April

The latest data from the RBA, Credit Aggregates to end April 2015, shows that lending for investment property pushed higher again, whilst lending to business went backwards. Looking at the splits, overall housing credit was up 0.54% seasonally adjusted to $1.46 trillion, with owner occupied lending up 0.41% to $954 billion and investment lending up 0.79% to $503 billion. Personal credit fell 0.84% to $141 billion and lending to business fell 0.04% to $790 billion. As a result, the percentage of lending devoted to housing rose to 61% of total (excluding lending to government), up from 56% in 2010.

Tracking the relative monthly movements, highlights the concentration in the housing, and specifically the investment housing sector. We will see if recent moves by APRA and the banks tames the beast in the months ahead.

Looking at the housing data, the proportion of the portfolio in the more risky housing investment sector rose again, to 34.6%.

Further evidence of the unbalanced state of the economy.

Bank Capital And Liquidity

Philip Lowe, RBA Deputy Governor gave a speech entitled “The Transformation in Maturity Transformation“. He provided a useful summary of the current picture of bank funding. Banks capital has been increasing, as part of this global trend to higher and better quality capital, with an increase in common equity lifting the aggregate capital ratio from around 10½ per cent prior to the crisis to around 12½ per cent at end 2014. The recent capital announcements by some of the large banks will see this ratio rise further.

In terms of liquidity management he discussed two main initiatives.

The first is the introduction of a Liquidity Coverage Ratio (LCR) which, from the start of this year, has required banks to hold enough high-quality liquid assets to meet a stress scenario that lasts for 30 days. The challenge for the Australian banking system has been that the supply of such assets is limited due to the stock of government bonds on issue being small relative to the overall size of the financial system. To overcome this challenge, the RBA has provided banks with a Committed Liquidity Facility (CLF) under which it will make available sufficient liquidity (against eligible collateral) to address the shortfall in required holdings of high-quality liquid assets. The pricing of the CLF is aimed at replicating the cost of holding a sufficient volume of these assets, were they to be available in the marketplace. APRA administers the decisions as to which banks access the program, and the maximum amount available to each bank.

The second initiative is the Net Stable Funding Ratio (NSFR), which has a longer-term focus. It will establish a minimum amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one-year horizon. The new requirement here will not come into effect until January 2018.

This increased focus on liquidity is clearly evident in the balance sheets of the Australian banks. On the assets side, holdings of liquid assets have increased substantially, after they declined for many years. Australian dollar denominated liquid assets are now equivalent to about 7 per cent of banks’ total assets, up from around 1 per cent in early 2008. If the CLF is added in, the current figure is around 15 per cent.

There have also been significant changes on the liabilities side of the balance sheet. The most noticeable has been a shift away from short-term wholesale debt towards deposits. In early 2008, deposits accounted for around 40 per cent of the Australian banks’ total funding. Today, that figure is just a little below 60 per cent. In part, this switch has been driven by the judgement that the risk of a run by depositors is less than the risk of a run by investors in short-term wholesale debt. To the extent that this judgement is correct, this switch has increased the effective maturity of banks’ liabilities in a stress event, even if it has not increased the contractual maturity.

There has also been some lengthening in the average contractual maturity of the various types of liabilities. The share of deposits at the major banks with a maturity of less than three months has declined since 2007, although this share has increased a little more recently as competition for term deposits has waned. Similarly, there has been a noticeable increase in the maturity of banks’ other debt liabilities since 2007. Of particular note, the share of other debt liabilities with maturities of less than three months has declined substantially.

He made that point that taken as a whole, these measures have made the system more resilient. But they have increased the cost of financial intermediation somewhat. They have also increased the likelihood that such intermediation will take place outside the banking sector. After all, to some extent this is what was intended. So we need to keep a close eye on how the overall system responds and make sure that in addressing the very real risks associated with maturity transformation, that we don’t create a new set of risks. This is likely to be an ongoing challenge for us all.

It is also important to point out that while the various measures have made the system more resilient, they do not guarantee stability. Because of the very nature of the business that banks undertake, they can still find themselves in a liquidity crisis. Here the role of the central bank acting as a lender of last resort is critically important.

Card Payments Regulation

A speech was delivered today by Malcolm Edey, at the Cards & Payments Conference in Melbourne following on from the Murray Inquiry and the Reserve Bank Payments System Board (the PSB) own review following on from the Murray recommendations. As the PSB’s review process is still underway, Edey did not pre-empt any conclusions that might come from that. Instead he over viewed the PSB’s general approach to retail payments since it first entered the field. His comments on more recent developments does give some clues to issues ahead however, with specific reference to NPP, interchange arrangements and surcharging.

The PSB more recently undertook its Strategic Review of Innovation in the Payments System, the results of which were published in 2012. That review was conducted over a two year period and involved extensive consultations with both the payments industry and with users of payments services. It found a number of areas where there was scope for system improvements that could be achieved through coordinated action.

The key areas were:

same-day settlement of direct entry transactions;

faster payments and out-of-hours payments to be made generally available;

capacity for richer information with payments; and

an easy addressing solution for electronic payments.

The first one of these was delivered at the end of 2013 and essentially involved an acceleration of existing direct entry processes. The remaining three form a more ambitious agenda and are together being taken up as part of the industry’s New Payments Platform (the NPP project).

The NPP is a successful example of what can be done through collaboration between the industry and its regulator. It is also a good example of the catalyst role for the PSB in promoting system innovation that was envisaged by Wallis. While it is an industry-led project, it is strongly supported by the PSB, and the Board continues to encourage commitment to the project and to its timely completion.

The project was launched in early 2013 and is now well advanced. On current scheduling the NPP will deliver a fast payments service with rich information and addressing capabilities in the second half of 2017. It will be linked to a fast settlement service provided by the Reserve Bank, which will allow transactions to be cleared and settled 24/7 in close to real time. All of this will amount to a world-class payments infrastructure.

It will also be a platform for further innovation. One of the key decisions made at an early stage of the project was to separate the basic clearing and settlement infrastructure from the commercially based overlay services that would use it. The industry is committed to an initial overlay that is intended to provide an attractive service and drive early volume growth. But it is important to note that access to the overlay space has always been intended to be open and competitive. Over time, this structure will allow new and specialist providers to make use of the rich capabilities provided by the core infrastructure.

Before moving on to some more detailed regulatory matters, I will mention one more initiative to have come out the 2012 Strategic Review, and that is the establishment of new industry coordination and consultation arrangements. In line with a recommendation from the 2012 Review, a new industry coordination body, the Australian Payments Council, was launched last year. The Council is a high-level body representing a diverse range of industry participants including banks, payment schemes and other service providers. It will have the capacity to give strategic direction to the industry as well as engaging in dialogue with the PSB. At the same time, it is important that the policy process engages with users and not just suppliers of payment services. To facilitate that, the Reserve Bank has also set up a Payments User Consultation Group which began meeting late last year.

In summary then, the policy work of the PSB has been very much consistent with the philosophy and objectives of the original Wallis reforms. A good deal of that work has been what might be termed ‘co-regulatory’ in nature, in the sense that it involved promoting industry-led solutions rather than using formal regulatory powers.

But of course the PSB does have a regulatory mandate, and it has used its powers to regulate a number of aspects of card payments where it judged that there was a public interest case to do so. Probably the aspects of this regulation that have attracted the most attention have been those related to interchange and surcharging, and I would like to make some general comments about each of these.

First, interchange. The commercial function of interchange fees is a very interesting one. They serve as a device for shifting the benefit-cost balance between issuers and acquirers in a four-party scheme and therefore, indirectly, between cardholders and merchants. Payment schemes argue that this can be an important competitive device that can promote innovation, for example by being structured to encourage network growth or the take-up of new products. Typically, interchange flows from the acquirer to the issuer, and hence the fee structure tends to encourage issuance and use of a card, but may discourage acceptance by merchants if the fee is too high. For mature schemes, however, the capacity of merchants to refuse acceptance may be quite limited. As a result, it has been frequently observed that competition between schemes can have the effect of pushing fees up rather than down, in order to maximise incentives to issuers and cardholders.

The reason that this kind of outcome is possible is that there is a misalignment between the incidence of these fees and the structure of decision-making power in a typical transaction. In a nutshell, the cardholder chooses the payment instrument but the merchant pays the fee.

In designing its card payment reforms, both for credit and debit, the PSB concluded that competition of this nature was distorting price signals in a way that inefficiently encouraged the use of high cost cards and added to merchant costs. Hence, it judged that there was a case for interchange fees to be capped by regulation. A number of other jurisdictions have since taken a similar view.

The second aspect that I want to talk about is surcharging. The PSB has consistently taken the view that merchants should not be prevented from surcharging for higher-cost payment methods. Scheme rules that prohibited surcharging had the effect of reinforcing the distortive effects of interchange fees by preventing costs from being passed on to cardholders. They also reduced the flexibility of merchants in deciding how to respond to high-cost payment instruments. The ability to surcharge improves merchants’ bargaining position by allowing them a greater range of responses, rather than just being faced with a binary decision to accept or reject a particular card.

Efficient surcharging should of course reflect the underlying payment cost. The PSB’s initial reforms to credit and debit gave merchants the right to surcharge, while effectively relying on competition to ensure that surcharging would not be excessive. This regulation was revised in 2013 in response to concerns about practices that had developed since the initial reforms, particularly about surcharging that appeared excessive or unrelated to costs. The amended regulation still prevents schemes from imposing no-surcharge rules, but it allows them to limit surcharging to the reasonable cost of acceptance. In doing so it strikes a balance, at least in principle, between the rights of merchants and schemes. Merchants cannot be prevented from recovering reasonable acceptance costs, but they can be prevented by scheme rules from going beyond that. More on that in a moment.

The PSB’s reforms to surcharging and interchange have formed part of a broader package that also included rules relating to access and transparency. I don’t have time to cover all of that today. But taken together, the effects have been beneficial. The system has continued to innovate, and merchants’ card payment costs have fallen.[³] It is also notable that these costs are significantly lower in Australia than in a jurisdiction like the United States, where reforms to card systems have been much more limited.

The Murray Report last year broadly endorsed the PSB’s reform approach while flagging a number of areas for further consideration, particularly in relation to surcharging and interchange. These have now been taken up as part of the PSB’s card payments review.

The issue of surcharging remains contentious. Instances of apparently excessive surcharging have persisted. While they acknowledge arguments for what might be called a ‘no excessive surcharge’ regime, the schemes have argued that the current formulation is too complicated and difficult for them to enforce.

The card payments review is looking at several possible mechanisms for addressing this. One option proposed by Murray is a tiered approach that would allow tougher surcharging constraints to be placed on low-cost cards. A number of other options are available to strengthen enforcement and disclosure practices, for example allowing schemes to cap surcharges that are not percentage based at some low fixed amount.

On interchange fee regulation there are a number of issues to consider. These include the overall level of the interchange cap, the complexity and proliferation of interchange categories, the phenomenon of interchange ‘drift’ with the three-year compliance cycle, and the wide disparity between interchange rates for preferred merchants and those applying to others.

While it broadly endorsed the PSB’s regulatory approach to date, the Murray Report recommended that consideration be given to tightening existing interchange regulations in some significant respects. These included lowering the overall interchange cap, and broadening its coverage to include other incentive payments that serve a similar function. It argued that this would help to prevent circumvention and, in the case of companion card arrangements, would improve competitive neutrality.

Latest RBA Minutes Deliberately Gives No Forward Indication

The RBA released their board minutes from the Monetary Policy Meeting held earlier in May. They continue to balance generally weaker indicators with the risks of stoking the housing market in Sydney and Melbourne with a rate cut. They also agreed that, as at the time of the reduction in the cash rate in February, the statement communicating the decision would not contain any guidance on the future path of monetary policy.

International Economic Conditions

Members noted that growth of Australia’s major trading partners had eased a little in the early months of 2015, but was forecast to remain close to its long-run average in 2015 and 2016. Minor revisions to the outlook largely reflected weaker growth in China in the March quarter, which had also been reflected in lower bulk commodity prices and hence a slightly lower terms of trade than previously forecast by staff. Monetary conditions remained very accommodative across the globe and low oil prices were also supporting growth of Australia’s trading partners. Core inflation rates were below central banks’ targets in many economies.

Economic growth in China had eased further in the March quarter across a broad range of indicators. The Chinese property market had continued to be a source of weakness in the economy and represented a key source of uncertainty for the outlook, both through the effects on demand for industrial products and on the finances of local governments that relied on land sales to fund infrastructure projects. Members noted that residential property prices had continued to fall, albeit at a more gradual pace, and sales were lower than in the previous year. Chinese demand for steel had eased and had been accompanied by a fall in Chinese iron ore production and relatively flat imports of iron ore, although Australian iron ore exports to China continued to grow. Members noted that the authorities had introduced several measures to address the overhang of housing supply, while the People’s Bank of China (PBC) had lowered the reserve requirement ratio for banks.

Although the prices of iron ore, thermal coal and oil prices had rebounded somewhat from recent lows, members observed that the slowing in the growth of Chinese demand for steel had contributed to declines in the prices of bulk commodities since the start of 2015. As a result, the terms of trade had declined and were expected to continue doing so as lower spot prices gradually fed their way into contract prices for commodities, including liquefied natural gas (LNG). Notwithstanding this, members noted that the forecast terms of trade were considerably higher than they had been prior to the mid 2000s.

Growth in the US economy had moderated in the March quarter, largely reflecting the temporary effects of disruptions related to severe weather and industrial action in West Coast ports. Over the same period, conditions in the labour market had continued to improve. Non-farm payrolls employment had continued to grow strongly over the past six months and the unemployment rate had declined further. The Federal Open Market Committee (FOMC) had indicated that it was likely to begin the process of normalising interest rates in the second half of the year as long as economic conditions continued to evolve as expected.

Growth in the Japanese economy looked to have been modest in the March quarter and there were signs that tight labour market conditions were generating stronger wage growth. In the rest of east Asia, growth of both exports and domestic activity appeared to have slowed a little in the March quarter. Economic activity in the euro area had continued to recover gradually over past few months.

Domestic Economic Conditions

Members observed that the forces underpinning developments in the domestic economy were much as they had been for some time. The available data suggested that growth in the domestic economy had continued at a pace a bit below average in the March quarter. Members noted that growth was expected to continue at a similar pace over the coming year before picking up gradually to an above-average pace over the course of 2016/17.

Household consumption growth had picked up late in 2014 and recent indicators were consistent with expectations that consumption would continue to rise gradually, supported by very low interest rates, relatively strong population growth and a gradual decline in the saving ratio. Members noted that if households respond to very low interest rates and higher asset prices to a similar degree as they had in the period prior to the global financial crisis, expected outcomes would include a lower saving ratio and higher consumption growth than embodied in the forecasts. Alternatively, if households were less inclined to bring forward their consumption than had been factored into the forecasts, perhaps to limit the increase in their leverage, consumption growth would be likely to be weaker and the saving ratio higher than forecast.

Conditions in the established housing market had remained strong in Sydney and Melbourne. However, across the rest of the country, which accounts for around 60 per cent of Australia’s dwelling stock, housing price growth had declined. The available data suggested that dwelling investment had grown strongly in the March quarter, supported by low interest rates and above-average population growth. Forward-looking indicators, including residential building and loan approvals, suggested that dwelling investment would continue to grow strongly in the next few quarters. Members noted that growth of housing credit for both owner-occupiers and investors had remained relatively stable in recent months, with overall credit growth broadly in line with longer-term income growth.

Survey data had suggested that business conditions in the non-mining sector were around average and that business credit had picked up of late. However, forward-looking measures of business confidence had remained a little below average and non-residential building approvals had also been running at a relatively low level. Members noted that non-mining business investment was expected to recover later than had been thought at the time the forecasts for the February Statement on Monetary Policy had been prepared. This reassessment was consistent with the weak reading on investment intentions for 2015/16 from the December quarter ABS capital expenditure survey as well as business liaison by the Bank, which had suggested for some time that businesses would commit to increasing investment only after observing a durable improvement in the growth of demand. Members noted that exchange rate developments were also likely to remain important for investment decisions. Uncertainty about both the timing and speed of the recovery in non-mining business investment remained key risks to the forecasts. Mining investment was still expected to decline sharply, but the speed of that decline continued to be uncertain.

Resource export volumes had grown strongly in the March quarter, in part reflecting the absence of substantial weather-related disruptions across the country. Resource exports were expected to continue making a strong contribution to growth as new production, particularly of LNG, came on line over 2015. Members noted that the capacity to maintain production plans in the face of lower commodity prices had been enhanced by further cost-cutting by producers, and that this had been assisted by the decline in the price of oil (an input into production) over the past year.

Fiscal consolidation by the federal and state governments was expected to contribute to subdued growth of domestic demand over the forecast period. Members noted that the Commonwealth Budget, which would be announced the following week, would provide important information for updating these forecasts.

The most recent labour force data indicated that employment growth had been increasing over the past six months or more, to be a little above the rate of population growth. Members noted that the revised labour force data also indicated that the unemployment rate had been stable through most of this period at about 6¼ per cent, and observed that the extended period of slow wage growth may help to reconcile these data with the below-trend growth in the economy over 2014. Forward-looking indicators of labour demand had continued to point to modest growth of employment over coming months.

Members noted that the delayed pick-up in GDP growth in the revised outlook meant that the unemployment rate was forecast to rise further, before starting to decline gradually towards the end of the forecast period. Wage growth was not expected to increase from current low levels for some time. Members discussed the possibility that employment growth could grow fast enough such that the unemployment rate did not increase, especially if there was ongoing moderation in wage growth.

Inflation in the March quarter had been broadly as expected. CPI inflation had slowed over the past year, reflecting the large falls in fuel prices and repeal of the carbon price. Underlying inflation had remained around ½–¾ per cent in the quarter and 2¼–2½ per cent over the past year. Domestic inflationary pressures – as indicated by non-tradables inflation – had remained below average, consistent with the extended period of slower wage growth. Inflation in consumer prices related to housing was marginally above its historical average, driven by inflation in new dwelling costs reflecting the strength of the housing market. Tradables inflation (excluding volatile items and tobacco) had picked up in response to the depreciation of the Australian dollar over the past year or so.

Members noted that the inflation forecast had been revised down slightly since February, reflecting the expectation that growth of economic activity would remain below trend for a little longer than previously forecast. Domestic labour cost pressures were expected to remain well contained and underlying inflation was expected to remain consistent with the inflation target over the forecast period. Headline inflation was forecast to remain below 2 per cent in year-ended terms through to mid 2015, before picking up to be consistent with the inflation target thereafter.

Financial Markets

The Board’s discussion of financial markets commenced with the unusual trading in the Australian dollar in the period immediately prior to the announcement of the Board’s decisions in February, March and April. Members were briefed on the Australian Securities and Investment Commission’s preliminary finding, which had been announced the previous day, that each of those moves in the Australian dollar had been a result of ‘normal market operations in an environment of lower liquidity immediately ahead of the RBA announcement’.

Members observed that financial markets continued to focus on the situation in Greece and monetary policy developments in the major economies.

Negotiations between the Greek Government and its official sector creditors remained at an impasse. Greece appeared to have sufficient funds to meet its scheduled payments in May only after the introduction of further stopgap measures. The next Eurogroup meeting was scheduled for 11 May and at least partial agreement would be needed on Greece’s reform agenda before further assistance funds were released. Overall, Greek banks’ reliance on emergency liquidity assistance had increased significantly recently and total Eurosystem lending to Greek banks now exceeded one-quarter of their total liabilities.

Members noted that the apparent deadlock in Greece had had little impact on broader financial markets until recently, when spreads on the debt of other euro area periphery countries – including Portugal and Spain – had increased as concerns surrounding Greek finances continued to rise.

In contrast, yields on German and other highly rated European sovereign debt fell to new lows in April following the continued expansion of the European Central Bank’s balance sheet, with the 10-year Bund yield declining to 8 basis points. In recent days, however, there had been a marked retracement, with 10 year yields rising by more than 30 basis points in Germany and the United States.

In the United States, market pricing continued to suggest that the first increase in the US policy rate could be closer to the end of the year, and the subsequent pace of policy tightening could be slower than that envisaged by members of the FOMC as published in mid March.

In China, the PBC had taken steps to boost liquidity by reducing the reserve requirement ratio. This step had partly sought to offset the reduction in liquidity resulting from sales of foreign reserves by the PBC in recent months. Equity prices had continued to record particularly large rises in mainland China, leading to prices more than doubling since mid 2014. Members noted that the rally in the Chinese share market had coincided with rapid growth in retail financial investments funded by debt, which raised concerns about the sustainability of the rise in share prices and the potential effects of any decline.

The appreciation of the US dollar since mid 2014 had continued its modest reversal over the past month, resulting in a depreciation of the US dollar against most currencies. Reflecting that, together with recent domestic data, the Australian dollar had appreciated by 3 per cent against the US dollar and by 2½ per cent on a trade-weighted basis over the past month. Nevertheless, compared with its level in mid 2014, the Australian dollar remained around 17 per cent lower against the US dollar and around 10 per cent lower on a trade-weighted basis. In contrast, the Chinese renminbi had been little changed against the US dollar over the past month and in trade-weighted terms remained around 12 per cent above its level in mid 2014.

Members noted that equity prices in the major developed economy markets had risen during April, with the exception of Europe, where equity prices fell a little after large rises earlier in the year. In Australia, equity prices also recorded a small decline in April, although the resources sector had outperformed, with energy sector share prices rising following an increase in the oil price.

Corporate bond issuance by Australian entities remained robust in both domestic and international markets amid favourable pricing conditions. In the money market, pricing on money market instruments pointed to around an 80 per cent chance of a reduction in the cash rate target at the present meeting.

Considerations for Monetary Policy

Members assessed that the outlook for global economic growth had been revised only marginally lower in the near term and would continue to be supported by stimulatory monetary policies and the low price of oil. They noted that growth appeared to have slowed in China and that the weakness in the Chinese property market continued to represent a significant risk both for Chinese growth and demand for construction-related commodities. Lower growth in the demand for commodities had contributed to the lower prices of Australia’s key commodity exports since the beginning of the year. As a result, Australia’s terms of trade were expected to decline a little more than was forecast three months ago.

In their discussion of the appropriate course for monetary policy, members noted the revised staff forecasts for the domestic economy. Although the recent flow of data had been generally positive, there had also been indications that future capital spending in both the mining and non-mining sectors would be weaker than expected. Overall, compared with the previous set of forecasts, growth was now expected to take longer to strengthen and the unemployment rate was likely to remain elevated for longer. This change, and generally subdued growth of domestic costs, including wages, implied that inflation was expected to be slightly lower than in earlier forecasts though still consistent with the target. On the face of it, this meant that it would be appropriate to consider an easing of monetary policy.

Members also discussed the potential risk that low levels of interest rates could foster imbalances in the housing market. While concerned about the very strong pace of growth of housing prices in Sydney, and observing that conditions in Melbourne were strong, members saw much more muted trends in other capital cities. As at previous meetings, they acknowledged the risks that could accompany a sustained increase in leverage from already high levels, should that occur, and that the expansionary effects of lower interest rates could be less than in the past. On the data available for this meeting, however, it did not appear that the growth of housing credit, either for investment or owner-occupancy purposes, had been increasing over recent months. The Bank would continue to work with other regulators to assess and contain the risks arising from the housing market.

More broadly, members noted that the low levels of interest rates were helping to support demand in the face of a number of persistent headwinds and that a further reduction in the cash rate would provide some additional support to economic activity by reinforcing recent encouraging trends in household demand. In turn, this would support non-mining business investment insofar as demand conditions were the main factor constraining these decisions. Such outcomes would be expected ultimately to lead to stronger labour market conditions. Members also noted that further depreciation of the exchange rate seemed to be both likely and necessary, particularly given the significant declines in key commodity prices, and that such an outcome would help to achieve more balanced growth in the economy and assist with the transition to a lower terms of trade.

Members discussed the timing of any interest rate adjustment. They could see cases both for moving at this meeting or at the subsequent meeting. The latter course would bring the advantage of additional information on the economy, including details of the forthcoming Commonwealth Budget. On the other hand, with the revised staff forecasts scheduled to be released a few days after the meeting, members acknowledged that the challenges of communication might be more effectively met with a reduction in the cash rate at this meeting.

On balance, taking all these factors into account, the Board decided that the best course was to ease monetary policy further at this meeting. Members agreed that, as at the time of the reduction in the cash rate in February, the statement communicating the decision would not contain any guidance on the future path of monetary policy. Members did not see this as limiting the Board’s scope for any action that might be appropriate at future meetings.

The Decision

The Board decided to lower the cash rate by 25 basis points to 2.0 per cent, effective 6 May.