Statement on Monetary Policy · Statement on Monetary Policy February 2002 2 half of 2002 and...

February 2002Reserve Bank of Australia Bulletin

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The Australian economy has remainedresilient in the face of the slowdown in worldgrowth that occurred during 2001. Real GDPincreased at an annual rate of 4 per cent overthe first three quarters of 2001, andindications to date suggest growth continuedat a good pace in the December quarter. Therelatively strong performance of the Australianeconomy during the current global downturnhas reflected, at least in part, an absence ofthe structural imbalances which have beenassociated with cyclical downturns in theAustralian economy in the past. For example,with the level of business investment quitemoderate, there has been no accumulation ofwidespread over-capacity such as hadoccurred in some previous cycles. In addition,wage and inflationary pressures have remainedcontained, which allowed domestic policysettings to be eased last year to support growthin the face of the contractionary effects of theworld recession.

Nevertheless, there are clear signs that theworld growth slowdown is affecting theAustralian economy. After a period where theexternal sector had made a substantialcontribution to output growth, it reducedgrowth in the second half of 2001, as demandfell in most of Australia’s major exportmarkets. The synchronised nature of thecurrent international slowdown has limitedthe scope for Australia’s exporters to divert

sales to other markets, although the low levelof the exchange rate has continued to helpexporters. A factor assisting the Australianeconomy over recent years has been thefavourable trend in the terms of trade.Australia’s commodity prices have increasedin foreign-currency terms and, even more so,in terms of Australian dollars, since theirtrough in 1999, providing a significant boostto export incomes over much of that period.

While the world recession has reduced thevolume of exports, domestic demand hasstrengthened. Household spending hascontinued to grow at a solid pace, despite asubdued labour market, and consumerconfidence in recent months has been high.Further increases in household wealth,together with moderate increases in incomesand the boost to spending power from lowerpetrol prices and interest rates, haveunderpinned the growth in consumption. Aslong as the labour market remains relativelyweak, however, there is some risk thatconsumption growth may moderate in theperiod ahead.

The rebound in the housing sector provideda boost to growth over the second half of 2001,although even abstracting from thecontribution of that sector, the economy hasbeen expanding at a solid pace. Forwardindicators of housing activity indicate that thisboost to growth is likely to fade in the second

Statement onMonetary Policy

Statement on Monetary Policy February 2002

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half of 2002 and activity in the sector mayeven decline, though the size of any downturnshould be significantly smaller than thatexperienced in the second half of 2000.

There is some prospect that the effect ofany slowdown in the housing sector ondomestic demand will be counterbalanced bya pick-up in business investment. Activity inthe non-residential construction sector isclearly picking up after remaining subdued forthe past couple of years, boosted by a numberof large infrastructure projects. Surveys ofbusiness confidence suggest that it hasrebounded from its post-September lows, andindicators of investment intentions arepointing to a pick-up in investment in somesectors, most notably mining. Should theinternational outlook improve in comingmonths, a more broad-based pick-up ininvestment and hiring intentions may becomeevident.

Over the past few months, there have beena number of indications of a more positiveoutlook for the world economy. This isparticularly the case in the United States, butthere are also signs of recovery in a numberof east Asian countries. The US nationalaccounts reported marginally positive growthin the December quarter, a stronger resultthan most had expected. Consumer andbusiness sentiment have improved from theirpost-September lows and businesses havebeen able to clear at least some of their excessinventories. There has also been some recoveryin sentiment evident in Europe. Theinformation and technology sector, which hadbeen an important contributing factor in theinitial stages of the global downturn, isshowing signs of stabilisation with ITCequipment spending edging slightly higher inthe US and a pick-up in production in someeast Asian countries.

Against this background, the downgradesto international growth forecasts that hadcontinued throughout 2001 appear to haveceased, and most observers expect a recoveryin the global economy to get under way duringthe course of 2002, underpinned by theexpansionary policy settings now in place.

Nevertheless, at this stage it appears that sucha recovery is likely to be modest, and wouldstill imply a substantial degree of excesscapacity for some time ahead. While the USeconomy appears to have stabilised, existingimbalances may constrain the strength of itsrecovery for some time. The most significantrisk to a sustained recovery in the worldeconomy may lie with Japan, where there issome possibility that the economy coulddeteriorate sharply in 2002. Continuedweakness in the Japanese economy may limitthe recovery in other Asian countries.

The improving world outlook has beenreflected in a number of ways in financialmarkets: expectations of further monetaryeasing have been scaled back sharply in mostcountries; longer-term interest rates haverisen; credit spreads on corporate debt havenarrowed again; and share markets haverecovered strongly from their post-Septemberlows. These features have been common toall major countries, with the exception ofJapan where markets remain gloomy about theeconomic outlook. Conditions in emergingmarkets have also generally improved recently;the default by Argentina on its sovereign debtand its subsequent devaluation did not spillover into adverse consequences for othermarkets.

The improvement in economic prospectshas meant that recent high-profile corporatecollapses in the US have had a limited impacton markets. Nonetheless, there is a feeling ofwariness in markets about the possibility ofmore negative surprises, which has led to fallsin share prices. There has also been a lot ofquestioning of the adequacy of accounting andcorporate governance arrangements.

In Australia, signs of increased confidencein financial markets have, in many respects,been more pronounced than in othercountries because of the continuing relativelygood growth of the Australian economy. Thisrelative economic strength has been reflectedmost clearly in the performance of thedomestic share market, which remains closeto its peak; markets in other countries aregenerally down 20–30 per cent from their


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early 2000 levels. There has been a resumptionof portfolio equity flows into Australia fromabroad, after a period in 2000 when suchinvestment had largely ceased. Together withincreased inflows into Australian dollar bonds(particularly by Japanese retail investors), thishas helped to steady the exchange rate overmost of the past year, after the sharp fall thatoccurred during 2000 and early 2001.

Underlying inflation in the Decemberquarter was broadly in line with the outlookpresented in the November Statement, whichhad indicated that inflation would exceed thetarget for a temporary period before decliningto around the middle of the target range. Inthe quarter, the CPI was boosted by sharpincreases in the prices of a number of items,particularly some food products, which arelikely to be relatively transient. Working in theother direction, the CPI was reduced bydeclining petrol prices. Both the CPI andunderlying measures show inflation on agradual upward trend over the past few years,with the underlying measures picking up froma little below 2 per cent in 1999 to around31/4 per cent currently. This pick-up hasreflected a rebuilding of margins in responseto the depreciation of the exchange rate andother cost pressures, including the rise inpetrol prices that occurred during 2000.

These factors are unlikely to result in aninflation rate which stays above the target foran unacceptable time. The exchange rate hasbeen relatively stable since early 2001 intrade-weighted terms. Hence, while the earlierdepreciation has clearly placed upwardpressure on prices in the tradables sector, theeffect on the rate of inflation can be expectedto diminish over time. The growth of wagecosts remains moderate, and productivitygrowth appears to have returned to the strongpace evident over the second half of the 1990s,after a cyclical slowdown in 2000. Thesetrends point to growth of unit labour costs ata rate consistent with attainment of theinflation target in the medium term.Moreover, with inflation expectations firmlyanchored, and labour market conditionsrelatively subdued at present, there is little

likelihood that wage pressures will increasein the period ahead.

Of a more immediate nature, the fall inpetrol prices over the past year has eased costpressures on business, although some costpressures still remain including risinginsurance premiums and electricity charges.Indicators of upstream price pressures havealso been suggesting slower overall growth ininput costs in recent quarters. Given all thesefactors, the Bank’s assessment is that inflationis currently at or near its peak and that it willdecline to around the middle of the target overthe year ahead, both in terms of the CPI andin underlying terms. The assessment as tounderlying inflation is broadly the same as thatpresented in the November Statement,although the risks around this outlook nowappear more evenly balanced, rather thanbeing weighted to the downside.

The stance of monetary policy wasprogressively eased over the course of 2001as the extent of the slowdown in world growthbecame apparent. This easing continued inDecember, when the cash rate was reducedto its lowest level in almost 30 years, bringingthe cumulative reduction in the cash rate to200 basis points. As a result of these reductionsover the past year, policy settings are nowclearly expansionary and supporting growthin the domestic economy.

At its February meeting, in view of therecent changes in the balance of risks for theglobal economy and for domestic inflation, theBoard decided to leave the cash rateunchanged. While the global economy remainsweak at present, there have been a number ofmore promising signs in recent months. In thefinal months of 2001, the main risks to theworld outlook were clearly on the downside,with consequent risks for the Australianeconomy. In recent months these risks appearto have lessened, as confidence around theworld has improved and signs of stabilisationhave emerged. Hence, while a significantglobal recovery in 2002 is not yet assured, itdoes appear more likely than was the case afew months ago. Downside risks to the globaleconomy include the fragility of the Japanese


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economy and the possibility that more adversenews could emerge in coming months aboutthe US corporate sector. On the other hand,the stimulatory policy settings now in placein the major countries may engender astronger recovery than currently envisaged. Allof this will have important implications for

Australia, since a solid global recovery wouldclearly make it easier for the Australianeconomy to maintain its recent strength. Asalways, the Bank will continue to assess thesemedium-term developments with a view topromoting sustainable growth consistent withthe inflation target.


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International Economic Developments

The world economy slowed through 2001,with growth for the year expected to be abouthalf the pace recorded in 2000 (Graph 1).GDP is likely to have contracted in Japan, theUS, Germany and several Asian countries inthe second half of the year. While the terroristattacks in the US complicated the analysis ofmuch of the economic data in the latter partof the year, in recent months signs ofimproving conditions have emerged in the USand some Asian economies, though prospectsremain bleak in Japan. There are someindications that demand is stabilising in theinformation technology and communications(ITC) sector, which has been a major sourceof weakness in the current downturn, withsemiconductor sales and ITC production inparts of Asia picking up recently.

The IMF forecasts released in Decemberproject only a gradual recovery in 2002 withworld growth forecast to remain at just under

21/2 per cent, although they do imply anoticeable pick-up in growth over the courseof 2002. If realised, these forecasts wouldresult in the weakest two consecutive years ofgrowth since the mid 1970s for theG7 countries and for Australia’s major tradingpartners.

The widespread easing of monetary policyand, in a number of countries, fiscal policy in2001 should support growth in comingmonths, and lower oil prices will be beneficialfor growth in the industrialised countries andmuch of Asia. There is some chance that thestimulus from these sources will result inhigher-than-expected growth, but thereremain significant risks to the world outlookon the downside, although less so than inrecent months. Financial imbalances andpossibly excessive investment continue to posea threat to the speed of the US recovery, andsignificant risks surround the outlook forJapan, with the possibility of adversedevelopments there jeopardising recovery inthe rest of Asia.

The AmericasThe US economy contracted over the

second half of 2001, with output in theDecember quarter 0.3 per cent lower than theJune quarter level (Graph 2). In the Decemberquarter, strong growth in consumption andpublic spending was almost fully offset byanother large rundown in inventories and afurther decline in business investment(Table 1). Business investment has contractedfor four consecutive quarters to be 9 per centlower over 2001, with expenditure onequipment and buildings and structuresdeclining at a similar rate.

Private consumption held up reasonablywell in 2001, as continued robust growth inwages and the boost to spending power fromhome equity accessed through mortgagerefinancing offset the effects of thedeterioration in the labour market. In theDecember quarter, it received an additional

Graph 1

GDP Growth*World

30-year average

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%%

%%

G7 countries

* Purchasing power parity weightedSource: IMF

■ Forecasts

1984 1990 1996 200219781972


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inventory correction may be nearing its endin other areas, particularly in ITC inventories,which have declined to levels last seen in 1995.ITC shipments have also stabilised and neworders for ITC equipment have recorded threeconsecutive months of increase. Thesedevelopments contributed to an improvementin the Institute of Supply Management (ISM,formerly the National Association ofPurchasing Managers (NAPM)) measure ofmanufacturing sentiment. Nevertheless,manufacturing production continued todecline through the December quarter,although at a slower rate than earlier in theyear.

Graph 2

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United States – Real GDPPercentage change

%

Year-ended

%

Quarterly

20011993 1997198919851981Source: Thomson Financial Datastream

Table 1: United States National AccountsPercentage change

September December Year to:quarter 2001 quarter 2001 December 2000 December 2001

Private consumption 0.2 1.3 4.2 3.0Residential investment 0.6 –1.7 –1.2 2.4Business investment –2.2 –3.4 8.9 –9.2Public demand 0.1 2.2 1.2 4.9Change in inventories(a) –0.3 –0.6 –0.6 –1.8Net exports(a) 0.0 –0.2 –0.9 –0.1– Exports –5.1 –3.3 7.0 –11.3– Imports –3.4 –0.9 11.3 –7.5GDP –0.3 0.1 2.8 0.1

(a) Contribution to GDP growth

Source: Thomson Financial Datastream

boost from strong growth in motor vehiclesales in response to zero-interest financingprovided to purchasers by vehiclemanufacturers. Abstracting from motorvehicle sales, household spending stillincreased by 0.4 per cent in the quarter. Theunemployment rate reached a six-year highof 5.8 per cent late in 2001 (Graph 3) andclaims for unemployment benefits and thelevel of job advertisements suggest littleimprovement in the near term, although theseindicators appear to have stabilised recently.

Strong growth in sales of motor vehicleshelped to reduce inventory levels in that sectorand there are also indications that the

Graph 3

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20021994 1998 2002 1994 1998* Formerly the NAPM indexSource: Thomson Financial Datastream

United States%

Index

%ITC production

ISM*

Unemployment rate

Inventory to sales

Year-ended change

Ratio


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Lower energy prices have underpinned areduction in consumer price inflation to11/2 per cent over the year to December(Graph 4). However, the core measure ofinflation has remained around 23/4 per centas rises in services prices – particularly formedical care, transport and housing – offsetdeclining goods prices. The weakening in thelabour market has not yet caused anysignificant decline in wages growth, whichremained around 4 per cent over the year toDecember.

‘International and Foreign Exchange Markets’chapter.) Other economies in Latin Americahave suffered from the slowdown in worldgrowth, particularly Mexico, but to date, thereis little evidence of contagion from the eventsin Argentina.

Asia-PacificJapan

The Japanese economy contracted again inthe September quarter and indications are thatthe economy remained weak in the Decemberquarter (Graph 5). Over the year toSeptember, Japanese GDP fell by 1/2 per cent,due largely to a decline in exports of nearly10 per cent and a decrease in consumption.

Further falls in manufacturing productioncontributed to another shift down in theoverall business activity indicator in the latterpart of 2001. The weakness in themanufacturing sector has been broad-based,with ITC manufacturing output and exportvolumes both over 30 per cent belowlate-2000 levels, and non-ITC manufacturingoutput is well below Asian-crisis levels. Thecontraction in manufacturing output throughthe second half of 2001 has been reflected inweak investment and employment outcomes(Table 2). In the rest of the economy,sentiment, profits and orders of machineryhave been more resilient, but employment inDecember was still no higher than a yearearlier.

Graph 5

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Japan – Economic ActivityYear-ended percentage change

2001

%

GDP

Overallbusiness activity

%


1998199519921989

In response to the economic softness andthe continuing downside risks to the USoutlook, the US Federal Reserve easedmonetary policy by 25 basis points inDecember, bringing the cumulative easing inthis interest-rate cycle to 475 basis points.However, in response to signs of a turningpoint in the economy and in light of thealready stimulatory stance of monetary policy,the Fed left rates unchanged at its Januarymeeting. Fiscal policy also provided somestimulus in the second half of 2001, in theform of income tax cuts, emergency relieffollowing the terrorist attacks and expenditurerelated to the war on terrorism.

Continuing economic and political turmoilin Argentina culminated with the governmentdefaulting on its debt and the abandonmentof the decade-long currency board.Subsequently the peso has depreciatedsharply. (Further details are provided in the

Graph 4

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United States – Wages and PricesYear-ended percentage change

2001

CPI

Employment costindex

Core CPI

19991997199519931991

% %



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The deterioration in the labour market hasseen the unemployment rate reach a recordhigh of 5.6 per cent in December. This,together with falling wages, has contributedto weakness in incomes and henceconsumption. Consumer prices havecontinued to fall, with the core measure ofdeflation around 3/4 per cent over the year toDecember 2001.

In line with its pledge to limit new bondissuance to 30 trillion yen, the governmentsees little or no scope for further fiscalstimulus. Initial budget plans for fiscal year2002 suggest a reduction in general spendingof 21/4 per cent. With no latitude for officialinterest rates to be reduced, the Bank of Japan

has responded to the deterioratingcircumstances by implementing measuresdesigned to boost the level of settlement fundsheld by the banking system, including thepurchase of Japanese government bonds.

Non-Japan Asia

The downturn in world growth through2001 has had a marked effect on growth innon-Japan Asia, although the impact acrosscountries has been far from uniform (Table 3).Most countries have experienced largedeclines in exports, greater than that whichoccurred during the Asian crisis, with thelargest falls occurring in those countries witha high concentration of semiconductors and

Table 3: Non-Japan AsiaPercentage change

GDP Exports(a) Industrialproduction(a)

Latest quarter Year to latest Six months to latest month

Hong Kong 0.4 –0.7 –0.4 –7.1Indonesia 2.4 3.5 –16.4 naKorea 1.2 1.6 10.0 4.5Malaysia –0.6 –1.3 –4.7 3.6Philippines 1.0 3.8 3.0 2.3Singapore –2.9 –5.6 –8.8 –3.3Taiwan –1.3 –4.2 –2.9 –0.5Thailand 0.0 1.4 –9.9 3.0China na 7.3(b) –0.8 7.1Non-Japan Asia(c) 0.3 –0.1 –7.2 2.6

(a) Seasonally adjusted by RBA

(b) Year average for 2001

(c) GDP-weighted of all countries listed excluding China

Source: CEIC

Table 2: Japanese Labour Market

Annualised growthPercentage change, year to December

Average 1997–2000 2001

Employment –0.1 –1.2– Manufacturing (20 per cent of total) –2.3 –5.6– Non-manufacturing (80 per cent of total) 0.6 0.0

Unemployment rate (per cent) 4.2 5.6



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monetary policy was eased further in recentmonths in the Philippines, Taiwan andThailand.

New Zealand

Following robust growth in the June quarter,GDP grew only marginally in the Septemberquarter to be 21/2 per cent higher over the year.The weaker growth reflected a decline inexports, and particularly tourism, whichaccounts for around 5 per cent of GDP.Consumer spending has remained relativelyrobust with steady employment growthand wage increases contributing togrowth in household incomes. Inflation fellto 1.8 per cent in the December quarter aftera period at the upper end of the RBNZ’s targetband. The RBNZ reduced the official cash rateby a further 50 basis points in November to4.75 per cent.

EuropeConditions across the euro area weakened

in the second half of 2001, with GDPincreasing only slightly in the Septemberquarter, reflecting a slowing in privateconsumption growth and a rundown ininventories. Output contracted in Germanyin the September quarter – mostly due toa decline in investment which was around5 per cent lower over the year – whereas GDPincreased by around 1/2 per cent in France.Activity appears to have remained subduedin the December quarter, with manufacturingproduction falling further, particularly inGermany and Italy.

The labour market has weakened across theeuro area since the middle of the year, withemployment growth slowing in all majorcountries and unemployment rates plateauingafter falling over the first part of 2001. Loweroil prices resulted in inflation fallingfrom 31/2 per cent over the year to May to21/2 per cent over the year to January(Graph 7). However, the core measure ofinflation drifted higher to be 2.3 per cent overthe year to December.

Growth in the UK continued to be strongerthan in the euro area over the second half of2001, but there has been a marked dichotomy

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Non-Japan Asia – Output of Selected IndustriesJune quarter 1997 = 100

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Source: CEIC

Manufacturing

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Services

Construction

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Graph 6

other ITC products, notably Singapore,Taiwan, Hong Kong and Malaysia. These fourcountries have also experienced declines indomestic demand, reflecting weak businessinvestment and rising unemployment. Koreais an exception; despite being a large ITCproducer, it experienced robust growth in thelatter part of 2001 reflecting a pick-up inpublic spending and strong growth inconsumption. Relatively robust rates of GDPgrowth were also recorded in China, Indonesiaand the Philippines in 2001.

The manufacturing sector in non-Japan Asiahas borne the brunt of the slowdown, withoutput declining by a similar amount to thatexperienced during the Asian crisis. There wasa small increase in manufacturing output inthe September quarter, with industrialproduction data indicating further gains inthe December quarter in the majorITC-producing countries, mostly driven by apick-up in ITC goods production. In contrastto the Asian crisis, the services sector, whileslowing, has continued to grow over the pastyear, and there has been little change in outputin the construction sector which had collapsedduring the Asian crisis (Graph 6).

Inflation has declined in most non-JapanAsian economies, due to falling demand andlower oil prices, with China, Hong Kong,Singapore and Taiwan recording price falls inyear-ended terms. Reflecting the weakness ineconomic activity and subdued inflation,


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between the manufacturing sector and the restof the economy. Manufacturing output wasaround 5 per cent lower in the Decemberquarter than a year earlier, while the servicesector has expanded by around 31/2 per centover the same period. Inflationary pressureshave also eased in the UK, with consumerprices excluding mortgage interest paymentsincreasing by 1.9 per cent over the year toDecember.

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Euro Area InflationYear-ended

%

CPI

%

Excluding foodand energy

2000 200219981996Source: Thomson Financial Datastream

Graph 7


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International and Foreign ExchangeMarkets

Short-term interest ratesWhile there have been some further

reductions in official interest rates indeveloped countries in recent months, thecycle of global monetary easing that began inJanuary 2001 could be nearing an end.Measured in terms of the number of centralbanks changing policy, the easing processgathered momentum through the first fivemonths of 2001, paused around the middleof the year, and then resumed. Central bankactivity peaked in September when all majorcentral banks eased monetary policy, but ithad already picked up in August, ahead of theterrorist attacks, as the outlook for economicactivity in many countries had already startedto deteriorate by then (Table 4). ByDecember, the number of central banks easinghad slowed to three, while in January 2002,only one central bank eased.

Perhaps most significantly, the US Fed leftinterest rates unchanged at its end-January

meeting after having cut interest rates at everypolicy meeting in 2001, as well as on threeoccasions between meetings. In total, thetarget rate for Fed funds has been reduced by475 basis points, to 1.75 per cent, its lowestlevel since the early 1960s and 125 basispoints below the low point seen in theearly-1990s recession (Graph 8). In realterms, the Fed Funds rate is near zero (usingthe core personal consumption expendituredeflator) or negative (using the core CPI as adeflator). On both measures, it is close to thelows reached in the early 1990s.

With the current level of the Fed funds rateunusually low, and financial marketsbecoming more optimistic about the USeconomic outlook, markets have turned theirfocus to the question of when a tightening inUS policy might occur. The futures market ispricing-in the likelihood that monetarytightening will begin around the middle of thisyear.

After the Fed, the largest cumulative cutsince the start of 2001 has been by the Bankof Canada, which has cut its overnight cashrate by 375 basis points to 2.0 per cent. Afterthat came the Bank of England and the RBA,both of which cut rates by 200 basis points

Table 4: Number of Interest RateCuts by Developed Country

Central Banks(a)

Jan 2001 3Feb 2001 4Mar 2001 5Apr 2001 5May 2001 6Jun 2001 1Jul 2001 2Aug 2001 5Sep 2001 10Oct 2001 5Nov 2001 6Dec 2001 3Jan 2002 1

(a) Countries included: US, Japan, Canada,Australia, NZ, UK, euro area, Sweden, Denmark,Switzerland

Graph 8

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1996 1997 1998 1999 2000 2001Sources: Central banks

2002


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during 2001, followed by New Zealand andSwitzerland, which cut rates by 175 points,and the ECB, which cut rates by 150 points(Table 5).

The Bank of Japan (BoJ), having earlierreduced rates to zero, continued to direct itsmonetary policy to boosting banks’ reserves.When its reserve-targeting policy was firstannounced in March 2001, the target was5 trillion yen, which was around 20 per centabove the reserve holdings over the previousyear. Subsequently, the BoJ has several timesincreased the target, and it now stands at10–15 trillion yen. The Bank of Japan has infact pushed reserves above target levels inrecent months.

Several other central banks in Asia haveeased monetary policy a little further overrecent months. Short-term interest rates inAsia (with the exception of Indonesia and thePhilippines) are currently in the range of 1 to5 per cent, whereas a year ago they had beenin the range of 3 to 7 per cent. As in the majorcountries, the current level of interest rates inthese countries is very low by historicalstandards (Graph 9).

Short-term interest rates in other emergingmarkets have generally been steady with theexception of Argentina where interest rateshave risen sharply as the financial crisisdeepened. Short-term interest rates on pesodeposits in Argentina fluctuated between 50

and 120 per cent in the months leading up tothe formal default on sovereign debt inDecember. Since then, controls on bankdeposits have prevented the normal operationof the banking system.

Long-term interest ratesLong bond yields around the world have

increased significantly over recent months.Yields on US government 10-year debt, afterfalling to as low as 4.2 per cent in earlyNovember, have since risen by around80 basis points to around 5 per cent. This isthe same as their level a year earlier, beforethe Fed started easing, though still 150 points

Graph 9

Table 5: Policy Interest Rate ChangesBasis points

2001 2002 Cumulative Currentchanges level

Jan to Jun Jul to Dec Jan since Jan 2001 Per cent

US –275 –200 –475 1.75Canada –125 –225 –25 –375 2.00UK –75 –125 –200 4.00Australia –125 –75 –200 4.25NZ –75 –100 –175 4.75Switzerland –25 –150 –175 1.75Euro area –25 –125 –150 3.25Sweden –25 –25 3.75Japan –25 –25 0.00

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South Korea

Thailand

M S2000 2001

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Indonesia

Source: Bloomberg

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below their peak in early 2000 (Graph 10).The recent increase was mainly due toimproved confidence among marketparticipants about an early recovery in the USeconomy, although it may also have reflectedthe significant deterioration in the US’s fiscalposition that also occurred at the same time.

The improved US economic outlook is alsoevident in the corporate bond market, wherecredit spreads have moderated noticeably(Graph 11). This has been most apparent inthe spread between riskier classes offixed- income debt and government securities.The spread on ‘junk’ bonds (i.e. yields onnon-investment grade securities above US

Treasuries) has fallen by 300 basis points sinceits peak in early November, to the lowest levelseen since May 2000.

The rise in long-term yields has meant thatthe yield curve in the US has steepenednoticeably; 10-year US government bondyields are now trading at 330 basis pointsabove the Fed funds target, similar to thereading in the early 1990s (Graph 12). Thiswide gap indicates that monetary conditionsin the US are highly accommodative atpresent.

In European bond markets, yields havefollowed a similar but more subdued patternthan that seen in the US; yields on German10-year Government bonds have increased by60 basis points from their November trough,to around 4.85 per cent. This is around thesame level as US yields. During the late 1990sthe differential in yields between these twocountries had averaged about 100 points. Theclosing of this gap over the past year hasmirrored the closing in the growth differentialbetween the US and Germany that had alsobeen apparent in those earlier years.

Yields on Japanese government bonds havebeen at the top of the band in which they havetraded over the past year or so, rising about1.5 per cent in early February. The risereflected concerns that ratings agencies wouldfurther downgrade Japan’s sovereign creditrating.

Graph 10

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10-year Bond Yields%

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Source: Bloomberg

2002

Graph 12

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Spread Between US Treasury Bondsand Fed Funds

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Graph 11


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Spread Between US Corporate andTreasury Bond Yields

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Equity marketsAfter falling rapidly in the weeks following

September 11, equity markets rallied stronglyover October, November and December.Initially, this was due to the abatement of theextreme uncertainty that followed theSeptember events, but the rise was sustainedby growing expectations that the US economicrecovery would start in 2002. This viewremains, though concerns that the UScompany reporting season now underwaywould produce disappointing earnings, as wellas several high profile bankruptcies which haveled to some questioning of the earningsmeasures used by companies, have causedshare prices to retrace somewhat in January.

In the US, the Wilshire Index, the broadestmeasure of US share prices (accounting forover 90 per cent of listed companies) is14 per cent above its 21 September trough,but down 7 per cent from its early January2002 peak (Graph 14). Likewise theNASDAQ is up 27 per cent from itsSeptember trough, but is down 12 from itsearly January peak. Despite the recent gains,the Wilshire remains 31 per cent below itspeak in March 2000, while the NASDAQremains down 64 per cent.

The recent rally in share prices appears tobe anticipating a large increase in companyearnings in the year ahead. The latest availabledata on actual earnings, however, still show avery weak picture. Profits announced byS&P 500 companies in aggregate were downby between 33 per cent and 61 per cent in theyear to the September quarter, depending onthe measure used. Earnings announcementsby companies have become difficult to followbecause of the range of measures announcedby each company (see Box A). The NationalIncome and Product Accounts measure ofnon-financial corporate profitability, whichprovides a consistent series, fell 22 per centin the year to the September quarter (the latestdata available). This is the largest one-year fallin at least 50 years. As a share of GDP, non-financial corporate profits fell to 7.5 per centin the September quarter – the lowest levelseen since December 1982 (Graph 15).

Graph 14


50

70

90

110

30

50

70

90

110

US Share Indices

Index

Dow Jones

S&P 500

Wilshire

Index3 January 2000 = 100

Source: Bloomberg

NASDAQ

S2002

M J S D M J D M2000 2001

In the months leading up to the default byArgentina, yields on its sovereign debtincreased significantly, with the spread to USTreasuries peaking at over 3000 basis points,effectively ending the government’s ability torollover maturing debt. There has to-date beenvery little contagion from these events to otheremerging market economies. In fact, despitethe troubles in Argentina, spreads betweenboth emerging European and Asian sovereigndebt and US Treasuries have narrowed byaround 210 basis points and 70 basis points,respectively, since the end of October(Graph 13).

Graph 13

l l l l l l l0

500

0

500

Emerging Market SpreadsRelative to 10-year US Treasuries

Bps

20001996 1998

Bps

LatinAmerica*

Asia

Europe, Africa,Middle East

1 000

1 500

1 000

1 500

* Break in series due to removal of restructured Argentine debt.Source: Bloomberg

2002


15

As has usually been the case over recentyears, share prices in other countries – withthe exception of Japan – have generallyfollowed those in the US. The Euro STOXXindex (a broad index of 310 major euro areacompanies) has risen 22 per cent since itsSeptember trough while the FTSE 100 is now

14 per cent up from its trough. However, asin the US, both these markets remain welldown from their 2000 peaks – the euroSTOXX by 37 per cent and the FTSE 100by 27 per cent (Table 6).

In Japan, shares have been weak. There hasnot been the strong recovery from theSeptember trough seen in other countries,with the Topix Index continuing to fall overrecent months, touching levels not seen since1985. The very weak state of the economy andinvestor concerns about the health of theJapanese financial system have been thereasons for this weakness in share prices.Japanese share prices are now only aroundone-third of their peak level in 1990.

In aggregate, equity prices in emerging Asiahave appreciated strongly over recent months,and are now 29 per cent higher than theirlate-September trough (Graph 16). Marketsare hoping that the expected recovery in theUS economy will see the Asian economies alsorecover over the coming year.

Graph 15

7

8

9

10

11

12

13

7

8

9

10

11

12

13

US Non-financial Corporate Profits

%%

Source: BEA

Percentage of non-financial corporate GDP

200119961991198619811976

Table 6: Changes in Major Country Share PricesPer cent

Change Change Change sincesince over 21 Sep 2001

2000 peak 2001 trough

United States– Wilshire –31 –12 14– Dow Jones –18 –7 17– S&P 500 –29 –13 12– NASDAQ –64 –21 27Euro area– STOXX –37 –20 22United Kingdom– FTSE –27 –16 14Japan– Topix –47 –20 –8Australia– ASX 200* –1 7 16Canada– TSE 300 –34 –14 15

* Peak was in 2001


16

Exchange ratesThe increased optimism that the US will

lead the world out of recession has given aboost to the US dollar over the past fewmonths. The trade-weighted value of theUS dollar has appreciated by 4 per cent overthe past three months, and touched a new15-year high in January (Graph 17). The riseof the US dollar has been broadly based, withthe unit up against all major currencies sincethe end of October. The most significant gainshave been against the Japanese yen, againstwhich it has risen 9 per cent since the end ofOctober. The yen has been very weak in itsown right over this period, falling significantly

against all the major currencies as a result ofthe continued deterioration of the Japaneseeconomy.

Reflecting the strength of the US dollar, theexchange rate of the euro against the dollarhas again fallen in recent months, and is nowtowards the lower end of the range it has beenin since weakening in 2000 (Graph 18). Itremains around 25 per cent below the levelat which it came into existence.

The safe-haven flows that were evident inthe aftermath of the terrorist attacks, whichsaw funds flow to countries with largefinancial surpluses such as Switzerland andJapan, seem to have been largely reversed.These flows had caused the Swiss franc to riseby about 7 per cent against the US dollar inthe days after September 11, but most of thisrise has since been unwound. The appreciationof the yen which occurred during that periodhas been more than reversed.

The Argentine peso was devalued by29 per cent on 7 January with an official rateof 1.40 peso per US dollar operating for tradeand capital transactions, and a floating rateapplying for retail and tourist transactions.However, most foreign exchange transactionswere undertaken at the floating rate, with theofficial rate abandoned in early February.Since the devaluation, trading in the peso hasbeen very thin, with the floating ratefluctuating between 1.7 and 2.2 pesos per

Graph 18

l l l l l l l l l l l l l105

110

115

120

125

130

135

1.00

0.95

0.90

0.85

0.80

US Dollar against Yen and EuroUS$Yen

US$ per Euro

Yen per US$

2001A O D F

Source: Bloomberg

F J A2002

(RHS, inverted)

(LHS)

Graph 17

l l l l l l l l l l l l l98

100

102

104

106

108

110

98

100

102

104

106

108

110

US TWI

Index Index

2001

March 1973 = 100

Source: US Federal Reserve2002

F A J A O D F

Graph 16

l l l l l l l40

60

80

100

120

140

40

60

80

100

120

140

Asian Share Prices

Index

Asia

2 January 1995 = 100Index

1996 1998 2000Source: RBA

2002

(excludingJapan and China)


17

US dollar. In contrast, the Brazilian andChilean currencies have appreciated againstthe US dollar. Currencies of Asian emergingmarkets that float have been broadly stableover the past few months.

Australian dollarThe past three months have been a fairly

steady period for the Australian dollar, withthe exchange rate generally in the range of51–52US cents (Graph 19). It has risenagainst most other major currencies in recentmonths, particularly against the Japanese yen.The exchange rate against the yen has recentlybeen close to 70, which is the highest readingfor a couple of years and about 25 per centabove the recent low in September 2001. Therate against the euro has risen to a little under60, towards the top end of the range it hasbeen in since late 1999. The close correlationbetween the Australian dollar and the eurothat had been a focus of market attention,particularly in 2000, seems to have brokendown somewhat recently, as the economiccircumstances of Australia and Europe havediverged.

Reflecting this strength against these majorcurrencies, the TWI has risen over the pastfew months. It is up about 2 per cent from itsaverage level in the second half of 2001. Thecurrent level of the TWI, at 50.4, isnonetheless about 10 per cent below itslong-run average.

Apart from the instability that followed theterrorist attacks, the Australian dollar has beenin a fairly steady range since April last year.This stands in sharp contrast to the fall ofabout US15 cents (or 25 per cent) that tookplace over the previous 15 months.

As discussed in earlier Statements, capitalflows data seem to confirm that internationalfund managers lost interest in the Australianequity market in 2000, most likely because ofthe then fashionable view that Australia wasan ‘old’ economy. Foreign portfolioinvestment into Australian equities turnednegative in 2000, whereas it had been runningat around $15 billion a year through 1998 and1999. At the same time, investment in foreignequities by Australian fund managers alsoincreased (Graph 20). The puzzle was that allthis took place at a time when the US share

Graph 20

1991

Net portfolio equityA$b

Portfolio Equity FlowsMoving annual total

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

Foreign investment in Australia

Australian investment abroad

A$b

A$b

A$bA$b

1993 1995 1997 1999 2001

A$b

Source: ABS

Graph 19

l l l l l l l l l l l l l l l l l l l l l l l l l l0.45

0.50

0.55

0.60

0.65

40

44

48

52

56

Australian Dollar

US$ IndexDaily

TWI

US$ per A$

M J S D2001

M J S D M2002

Source: RBA

(RHS)

(LHS)

2000


18

1. In terms of impact on the exchange rate, Uridashi issuance may be more significant than ‘headline’ dual currencyissuance. For a new Uridashi issue, the impact on the A$ is equal to the full principal of the bond at the time ofpurchase. However, Australian dollar flows associated with a dual currency issue are less than the bond’s full facevalue, because not all of the associated cash flows are in A$.

market was falling sharply, while theAustralian market continued to strengthen.Since the start of 2000, US share prices havefallen by 26 per cent, while Australian shareshave risen by 10 per cent.

The strong outperformance of theAustralian share market appears to have beenrecognised more recently. Inflows of portfolioinvestment into Australian equitiesstrengthened markedly again by mid 2001(the latest data available are for the Junequarter 2001), returning to around their levelsof 1998 and 1999. This apparent reversal insentiment towards Australian investments may

have been a factor in the greater stability ofthe exchange rate over the past 10 months.

Flows into Australian bonds have alsoturned positive again, after having beennegative for most of the period since 1997(Graph 21). The widening interest differentialin Australia’s favour over the past year wouldhave been an important factor in this.Increased demand by Japanese retail investorsfor Australian bonds has been particularlynoticeable. Following a period of minimalflows between 1997 to 2000, Australian dollarEurobond issuance made to the Japanese retailmarket, known as A$ Uridashi issues,increased sharply over the second half of 2001(Graph 22). About A$5.0 billion of suchissues were made in the second half of lastyear, which was greater than the previous peakseen in the mid 1990s (though not as large asthe dual currency issues of the mid 1990s).1

Net flows of direct investment into Australiaremain negative (Graph 23). This is notbecause foreign companies have stoppedinvesting in Australia; the flow of investmentinto Australia from foreign companies remainssolid. Rather, Australian companies have

Graph 22

0

2

4

6

8

10

12

14

16

0

1

2

3

4

5

6

7

8

A$ Eurobond Issuance in Japan

1999 2001Source: Westpac

1995

■ A$ dual currency (LHS)■ A$ Uridashi (RHS)

A$b A$bSemi-annual totals

1997

Graph 21

1991

Net bondsA$b

Bond FlowsMoving annual total

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

-10

-5

0

5

10

15

-10

-5

0

5

10

15



A$b

A$b

A$bA$b

1993 1995 1997 1999 2001

A$b

Source: ABS


19

Graph 23

1991

Net direct investmentA$b

Direct Investment FlowsMoving annual total

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

-5

0

5

10

15

-10

-5

0

5

10

15

-10

-5

0

5

10

15



A$b

A$b

A$bA$b

1993 1995 1997 1999 2001

A$b

Source: ABS

sharply increased their direct investmentabroad.

Given the recent stability of the exchangerate and orderly market conditions, the RBAhas not undertaken any foreign exchangeintervention over the past three months. Salesof foreign exchange to the Government havetotalled $1.6 billion, but these have beenlargely offset by earnings in reserves and otherforeign exchange transactions. As such, therehas been little change in net reserves over thepast three months.


20

Box A: US Corporate Earnings

Interpretation of earnings data from UScompanies has become more difficultrecently as different measures are showingquite wide divergences (Graph A1).

which would be classified as ordinaryexpenses and hence subtracted fromearnings calculated under GAAP.

Over 1999 and 2000, the S&P measuresof earnings rose much faster than theNational Accounts measure. An importantreason for this is said to have been thepractice of firms not including the cost ofoptions granted to employees as an expense.The National Accounts adjusts for this. Also,throughout this time operating earningsremained higher than ‘as reported’ earnings.

More recently, the S&P measures havefallen sharply. In the year to the Septemberquarter 2001, ‘as reported’ earnings ofS&P 500 companies fell by 61 per cent and‘operating’ earnings fell by 33 per cent. TheNational Accounts measure fell by22 per cent over the same period.

The divergence in earnings reportshas complicated the calculation andinterpretation of traditional benchmarks ofshare valuation such as price earnings ratios.Historically, P/E ratios for the S&P 500 havebeen calculated by dividing the current levelof share prices by the latest actual 12 monthsof ‘as reported’ earnings. Using this method,the P/E ratio for the S&P 500 has recentlyrisen strongly, to around 40 – well above thehistorical average of around 14, and thehighest level seen over the past century. Usingthe last 12 months of ‘operating’ earnings asthe denominator, the S&P 500 P/E ratio isaround 26. While this is below the P/E ratiocalculated using ‘as reported’ earnings, itremains well above the historical average.

When valuing shares, it is future earningswhich are most relevant. The aggregateP/E ratio for S&P 500 companies, based onestimates of the coming year’s operatingearnings, is 21. This is below the othermeasures, but still relatively high. Theassumed rise in operating earnings in thecoming year, which underlies this figure, is36 per cent. This would require a very strongrecovery in the US economy. R

The National Accounting estimate ofprofits remains the best available, as it isconsistent over time, and captures all profitsearned by US companies. However, equitymarkets focus mainly on aggregate earningsfor the companies in the S&P 500.

There are several ways in which S&P 500earnings are reported. Historically the focuswas on ‘as reported’ earnings, which includesall receipts less expenses, as defined bygenerally accepted accounting principles(GAAP). However, over recent years marketanalysts and companies have increasinglyfocused on ‘operating’ earnings (also knownas ‘pro forma’ or ‘as if ’ earnings). These areintended to adjust for special one-off itemsto give a clearer picture of ongoing profits.The problem, however, is that there are noofficial guidelines for what items can beadded in or taken out, as ‘operating’ earningsis not a concept defined under GAAP. TheWall Street Journal has estimated that morethan 300 companies in the S&P 500 nowpublish measures of operating earningswhich fail to take full account of expenses,

0

50

100

150

200

250

300

0

50

100

150

200

250

300

Earnings Measures

1992 1995

IndexIndex

Sources: BEA; Standard and Poor’s

1988 = 100

1998 2001

S&P 500 ‘Operating’earnings

S&P 500 ‘Asreported’ earnings

Nationalaccounts profits

1989

Graph A1


21

Domestic Economic Activity

Growth in the Australian economystrengthened over the course of 2001 againsta backdrop of weakening world economicconditions. GDP increased at an annualisedrate of 4 per cent over the three quarters toSeptember 2001, after a period of decliningoutput over the second half of 2000(Graph 24, Table 7). The deterioration in theworld economy has been reflected in a switchin the composition of Australian growth fromexternal to domestic demand, with theexternal sector subtracting from growth overthe second half of 2001 after contributing2 percentage points to growth over thepreceding year. Growth in final demandaccelerated in most states over the year to theSeptember quarter 2001, with WesternAustralia and Queensland amongst the fastestgrowing states over this period, while NSWcontinued to lag behind.

The outlook for domestic demand remainspositive. Forward indicators suggest that thedwelling sector should continue to contribute

to growth in the first half of this year.Businesses are also expected to increaseinvestment over the course of 2002, with nosign at an aggregate level of a significantinvestment or inventory overhang. Indices ofconsumer and business confidence have alsoimproved and are currently at levels typically

Table 7: National AccountsPercentage change

Six months to: SeptemberDecember June quarter

quarter 2000 quarter 2001 2001

Private final demand (a) –2.6 1.9 1.9Consumption 0.6 2.6 0.8Dwelling investment –31.2 2.4 13.7Business investment (a) –2.0 –2.7 1.9Public final demand (a) 0.1 1.0 0.5Domestic final demand –2.0 1.7 1.6Change in inventories (b) 1.0 –0.6 –0.9Exports 2.2 1.5 –1.6Imports –2.8 –3.1 –1.0Net exports (b) 1.1 1.0 –0.1Gross domestic product –0.1 1.8 1.1

(a) Adjusted for transfers between the public and private sectors

(b) Contribution to GDP growth

Source: ABS

Graph 24

l

l

l

ll ll

l

l

l

140

150

160

140

150

160

Real GDP

2001

$b

Latest three quartersannualised

Six-month changes,at annual rates

6.8%

3.1%

5.4%

2.8%-0.3%

3.6%

4.0%

200019991998

$b

Source: ABS


22

associated with at least trend growth in output.However, the contribution to growth fromdwelling investment is likely to fade aroundthe middle of 2002, and may subtract fromgrowth in the latter part of the year. There isalso some risk that weakness in the labourmarket may dampen consumer spending.

Household consumptionGrowth in household spending was firm

throughout 2001 following a period ofweakness over 2000. Consumer spending roseby 0.8 per cent in the September quarter tobe around 31/2 per cent higher than a yearearlier. Growth in the volume of retail salesslowed in the December quarter, with salesincreasing by 0.5 per cent, to be 4.8 per centhigher than a year earlier (Graph 25). Theslowdown was largely a result of a decline inspending on hospitality and services, in partreflecting a drop-off in tourism. Over thecourse of the year, household spending ongoods accelerated modestly while spending onservices grew quite rapidly.

The increase in the growth of theconsumption of goods reflects the flow-onfrom the rebound in housing activity topurchases of household furnishings, with salesof household goods and sales at departmentstores recovering over the year. Food retailerscontinue to experience strong growth inturnover, although this partly reflects higherprices. Sales of motor vehicles have steadiedfollowing a GST-related surge in the secondhalf of 2000.

Spending on health services has continuedto make a large contribution to growth inconsumption. While comprising only5 per cent of consumption expenditure, healthspending has accounted for around one-thirdof the increase in consumption over the pastyear. This mainly reflects the rise in demandfor health services associated with the largeincrease in the number of people taking outprivate health insurance over the past few yearsin response to government initiatives. With theproportion of the population with healthinsurance levelling out, growth in spendingon health services may ease in comingquarters. In contrast, spending on hotels, cafes

and restaurants has weakened in recentmonths, after growing strongly earlier in theyear, reflecting the adverse effects on thedomestic tourism industry of the recentdownturn in overseas arrivals and the collapseof Ansett.

The solid pace of consumption growthseems consistent with trends in consumersentiment. According to the Westpac-Melbourne Institute measure, consumersentiment has rebounded in recent months,to be well above the level prevailing prior tothe terrorist attacks in the US. The indices ofsentiment relating to personal finances andeconomic conditions remain above theirlong-run average levels, with the latter atparticularly high levels. Sentiment towardsbuying a major household item has risen toits highest level since mid 1999.

$bConsumption Indicators

8

9

10

11

12

13

24

27

30

33

36

39

40

50

60

70

40

50

60

70

60

80

100

120

60

80

100

120

Retail trade

Consumer sentiment

Motor vehicles

Index

$b

Volumes

Values

(RHS, quarterly)

(LHS, monthly)

Long-run average = 100

’000 ’000

Index

* Seasonally adjusted by RBASources: ABS; Federal Chamber of Automotive Industries;

Westpac-Melbourne Institute

1999199619931990 2002

VFACTS sales*

ABSregistrations

Graph 25


23

Household income growth has not beenoverly supportive of consumption, with realgross household income increasing at anannualised pace of 2 per cent in the six monthsto September, mainly reflecting the subduedgrowth in employment over this period.Nonetheless, household spending power hasbeen boosted by the decline in petrol prices,which fell by about 12 per cent over the yearto the December quarter. Household interestexpenses also declined over the course of2001, in line with the easing in monetarypolicy.

Consumption spending has been supportedby the high level of household assets and anongoing expansion in debt (Graph 26). Thevalue of household assets declined marginallyin the September quarter, with strong gainsin dwelling prices more than offset by a sharpfall in equity values. However, equity marketshave subsequently retraced these losses.Higher household asset values have supportedcontinuing strong growth in householdindebtedness by bolstering sentiment andboosting collateral values for existing owners

of assets. Household credit grew at anannualised rate of 161/2 per cent over the sixmonths to December, up from 13 per centover the six months to June, driven bysignificant increases in lending for housing toboth owner-occupiers and investors. Growthin personal credit has slowed, though someof the growth in housing indebtedness mayreflect drawdowns of existing home loans tofinance consumption spending. Growth inhousehold borrowing has led to a furtherincrease in the ratio of household debt todisposable income, a trend evident in Australiaover the past decade.

Over that period, the Australian householdsector has moved from having a relatively lowlevel of debt by international standards to aposition where the debt-to-income ratio iscomparable to that in other countries(Graph 27), consistent with an adjustment toderegulated financial markets and lowerinterest rates. It is not clear what would be asustainable debt-to-income ratio in the longerterm, but some deceleration in the growth ofhousehold indebtedness would be desirablein coming years. While both balance-sheet andcash-flow measures, such as assets-to-debtand interest-payments- to-income ratios, showthat the aggregate household financial positionis sound, the increase in indebtedness leavesthe sector more sensitive to changes in interestrates and asset values.

84

88

92

96

84

88

92

96

300

400

500

600

700

300

400

500

600

700

Consumption to income %

Household IndicatorsPer cent of household disposable income

Assets to income %%

%

2001Sources: ABS; RBA

1996199119861981

Graph 26

20

40

60

80

100

120

20

40

60

80

100

120

Household DebtPer cent of disposable income

2001

%

* Excludes unincorporated enterprises, data up to September 2001Sources: national sources; OECD; RBA

Australia*

%

19971993198919851981

NewZealand

Japan

UK

Canada

US

Graph 27


24

HousingDwelling investment rebounded strongly in

the second half of 2001. The recovery beganearlier in the smaller states, which had adisproportionate take-up of governmentincentives for first-home buyers. Constructionof new dwellings increased by 23 per cent inthe September quarter while spending onalterations and additions continued to rise,albeit less rapidly. The high level of buildingapprovals and loan approvals for newconstruction in the second half of 2001suggests that dwelling investment willcontinue to contribute to growth over the nextcouple of quarters.

There are signs, however, that buildingapprovals may have reached a peak, with amoderate easing in approvals data in recentmonths (Graph 28). Loan approvals for newconstruction have also fallen and in Novemberwere 5 per cent lower than their peak in July.Information collected by State RevenueOffices indicates that the number of FirstHome Owner Grants paid fell in December(Graph 29). A fall was also evident, but lesspronounced, in the CommonwealthAdditional Grant paid for new housing.

In November, the Government announcedsome changes to the CommonwealthAdditional Grant, which should reduce thetransitional impact when the scheme expires.The changes extend the scheme from endDecember 2001 to end June 2002, while

reducing the amount of assistance in theinterim period from $7 000 to $3 000. Theexpiration of the scheme should not have aslarge an effect on the dwelling cycle as theintroduction of the GST. The scheme onlyaffects first-home buyers, who accounted fora little more than 30 per cent of loan approvalsfor owner-occupation (excluding refinancing)in the second half of 2001, compared with anaverage share of around 26 per cent over thepast decade.

Nonetheless, the strength of buildingapprovals in the second half of 2001 suggestssome moderate degree of oversupply isdeveloping in parts of the housing market.Oversupply is particularly evident inmedium-density dwellings, where there arehigh vacancy rates in some states. Vacancyrates for rental accommodation in Sydneyare at a high level of just over 4 per cent,while the vacancy rate in Melbourne, at almost5 per cent, is at its highest level since the early1990s.

The strong growth in housing demand hasmaintained upward pressure on house pricesin most capital cities (Graph 30). Accordingto stratified ABS data, which attempt toremove the effect of compositional change inthe sample of houses sold, the larger capitalcities all recorded growth in house prices ofmore than 5 per cent over the year to theSeptember quarter. Melbourne recorded the

4

6

8

10

12

14

16

18

2

3

4

5

6

7

8

9

Dwelling Investment Indicators

2001

’000

Building approvals

’000

Loan approvals for new construction

19971993198919851981

(RHS)

(LHS)

Source: ABS

Graph 28

Graph 29

0

4

8

12

16

0

4

8

12

16

First Home Owner Grants Paid

D

’000

2001OAJADO

2000

’000

A

Commonwealth Additional Grant

Source: Commonwealth Treasury

F


25

strongest increase – over 30 per cent – thoughSydney, Adelaide and Canberra also recordeddouble-digit growth. The strength inMelbourne house prices is consistent withVictoria’s relatively strong economicperformance in recent years and the resultantnet inflow of migrants from other states whichhave increased demand for property.

The business sectorWhile output continued to expand at a solid

pace over 2001, there has been a change inthe composition of growth (Table 8). Theupswing in the residential construction cycleand the continued strength in retail trade inrecent quarters has flowed on to the wholesaleand manufacturing industries. The farm sectorhas also recorded solid growth in recentquarters, reflecting, in part, a recovery in theAustralian wheat crop and strong beef and vealproduction.

In contrast, growth in the service sectors,which has contributed strongly to economicgrowth in recent years, is beginning to slow.Growth in business services has eased further

in recent quarters due mainly to the shake-outin the telecommunications industry. Recentadverse developments in the tourism sectormay result in a further slowing in thehousehold services sector. Domestic aircraftmovements at major airports have recoveredfrom the disruption in September, but remainbelow their usual levels. Internationalpassenger movements, which have increasedsignificantly from their recent trough, alsoremain below normal. Bookings with inboundtour operators point to the possibility offurther weakness in international arrivals incoming months. Reflecting developments inthe airline industry, hotel occupancy continuesto be low, especially in areas reliant on businessand overseas travel. This has been partiallyoffset by increased tourism activity in someregions that are readily accessible by car.

Business surveys have generally reported arebound in business conditions to a levelconsistent with robust growth (Graph 31).The economy-wide quarterly NAB businesssurvey reported that the index of businessconditions in the December quarter remainedabove its long-run average, with improvementsreported by the transport and storage, retailand rural sectors, although conditions incommunications, finance, business andproperty services and recreational andpersonal services were reported to havedeteriorated. The NAB quarterly surveyreported a decline in business confidence, butthe more recent monthly survey for Decembershowed a marked rebound in confidence. The

Table 8: Non-farm OutputPercentage change

Six months to:

March Septemberquarter 2001 quarter 2001

Goods production –3.1 3.8Goods distribution 0.4 2.1Business services 3.4 2.1Household services 2.2 0.4

Source: ABS. For details of sector classifications referto ‘Box A: The Service Sectors’ in the November 2001Statement on Monetary Policy.

Graph 30

House PricesIndex 1987 = 100

2001

Logscale

Sydney

199719931989

Logscale

Logscale

Logscale

100

150

225

100

150

225

100

150

225

100

150

225

CanberraPerth

Brisbane

Adelaide

Melbourne

Hobart

Source: ABS

75 75


26

ACCI-Westpac survey and other surveyspertaining to the manufacturing sector havereported that business conditions in theDecember quarter remained strong, asmanufacturing continues to benefit from theflow-on effects of the increase in residentialconstruction activity. Business conditions ofsmall and medium-sized enterprises, asreported in the Yellow Pages survey, improvedin the three months to October though theyare not as strong as the economy-widemeasures.

Business investment increased in theSeptember quarter by nearly 2 per cent involume terms, with investment in machineryand equipment and buildings and structuresboth rising. Investment in intangible fixedassets has contracted over the last two quartersafter recording very strong growth in previousyears. The fall in the September quarter wasprimarily driven by declines in mineral andpetroleum exploration. Expenditure oncomputer software, which accounts for mostof intangible fixed asset investment, roseslightly in the September quarter after falling

in the previous period, though growth remainsrelatively subdued in the context of generallyweak conditions for the ITC sector.

Investment as a share of GDP remains lowby historical standards, indicating that thereis scope for a recovery in investment in theperiod ahead (Graph 32). The ABS capitalexpenditure (Capex) survey indicatesmoderate growth in overall businessinvestment this financial year though theexpected increase in investment is narrowlybased. Much of the growth is expected tocome from the mining sector, reflecting strongprofits in that sector in recent years as well asa relatively high level of capacity utilisation,though investment in the transport andstorage sector is also expected to contributesignificantly. Investment intentions for2001/02 in most other industries declined inthe September quarter. Strong growth inmining-sector investment intentions is alsoreflected in the Access Economics InvestmentMonitor.

Investment intentions for machinery andequipment, as reported in the Capex survey,suggest modest growth in 2001/02 in nominalterms. The large upward revision to expectedinvestment in the transport and storage sectoris most likely due to planned fleet expansionsand upgrades being undertaken by the

Graph 31

NAB SurveyNet balance; deviations from long-run average

2001

%

Quarterly

199819951992

%

Monthly

Business confidence

Business conditions

For the period ahead

1989Source: NAB

-20

0

20

-20

0

20

-40

-20

0

20

-40

-20

0

20

% %

0

2

4

6

8

10

12

0

2

4

6

8

10

12

Business Investment*Per cent of GDP, current prices

2002

%

* Investment intentions for 2001/02 are adjusted for 5-yearaverage realisation ratios.

Source: ABS

Total

200019981996199419921990

%

Total

Non-mining

Mining

(national accounts)

(Capex)

(Capex)

(Capex)

Graph 32


27

domestic airlines. Machinery and equipmentinvestment in the manufacturing andcommunication industries is expected todecline in 2001/02.

Forward-looking indicators of buildings andstructures investment suggest that a recoveryin this type of investment is underway. Thevalue of commencements and work yet to bedone on engineering construction by theprivate sector rose strongly in the Septemberquarter. The latter probably reflected thecommencement of two major projects – thefourth train expansion of the North-WestShelf LNG plant, projected to cost $1.6 billionover three years, and the Darwin-AliceSprings railway line, projected to cost$1.3 billion over the same period. A numberof resource-related projects are also expectedto commence in the next two years. Non-residential building activity was broadly flatover most of 2001, but the strength inapprovals during the year and the build-up inwork yet to be done in recent quarters suggeststhat a pick-up in non-residential constructionactivity can be expected. The low levels ofvacancy rates for office property in the capitalcities remain broadly supportive forinvestment, though there has been a mildincrease in vacancies in recent quarters, in linewith some rationalisation in the finance,insurance and technology sectors.

The softness in investment in recentquarters and the expectation of only moderategrowth in the near term has been reflected inbusiness funding (Graph 33). Thedeceleration in the pace of growth of externalfunding over the second half of 2001 primarilyreflected weakness in intermediated businessborrowing. However, the quarterly patternsuggests a mild acceleration in the pace ofgrowth of business credit in recent monthsand business loan approvals also appear tohave stabilised. Market capital raisingscontinued apace, with equity raisings inparticular remaining at high levels, in line withstrength in equity prices.

Corporate sector profits as measured byGOS were little changed in the Septemberquarter, and as a share of GDP they remainedat levels slightly below the average of the past

Graph 33

decade (Graph 34). Reflecting the strength indomestic demand, domestically orientedsectors reported improved profitability in theSeptember quarter after falling substantiallyover the preceding year. The profitability ofsmall businesses, as measured by GOS ofunincorporated enterprises, increased by5.7 per cent in the September quarter, after aperiod of subdued performance, reflecting thepick-up in the housing and retail sectors.

Aggregate indicators suggest that thefinancial position of businesses remains sound.The interest burden remains at very low levels,with recent reductions in official interest ratesserving to lower the cost of funds to corporates

Graph 34

5

10

15

20

25

5

10

15

20

25

Profitability*Gross operating surplus, per cent of GDP

2001

% %

19971993198919851981* Adjusted for privatisationsSources: ABS; RBA

Total

Corporate sector

Unincorporated sector

-5

0

5

10

15

20

-5

0

5

10

15

20

Business Sector Funding and InvestmentPer cent of GDP

2001

%

External funding

%

Investment*

Internal funding*

1997198919851981* Estimates for 2001 use the three quarters to September.Sources: ABS; ASX; RBA

1993


28

further (Graph 35). The recent emphasis onequity raisings, rather than debt, hascontributed to a lower aggregate corporatedebt-to-equity ratio.

The labour marketThe recovery in output growth in 2001 is

not yet evident in the labour market, whichremains weak (Graph 36). Employment grewmarginally in the December quarter and wasonly 0.9 per cent higher over 2001. Full-timeemployment grew by 0.1 per cent in theDecember quarter but was 1.1 per cent lowerover the year. Part-time employment alsoincreased by 0.1 per cent in the Decemberquarter, but was 6.2 per cent higher over theyear. The weak demand for labour has seenthe unemployment rate rise by almost3/4 of a percentage point from its trough inSeptember 2000. The participation ratecontinues to be volatile, but has been broadlyflat over the past two years.

Reflecting the developments in economicactivity, there continue to be divergent trendsin employment growth across industries(Table 9). The most significant weakness hasbeen in business services employment, whichfell by 3.6 per cent in the December quarterand by 4.7 per cent over the year. Employmentin the household services sector rose slightlyin the December quarter, followingdisruptions to activity in the tourism industry.The recovery in the dwelling sector has been

%

Employment

Labour Force

8.0

8.5

9.0

8.0

8.5

9.0

0

1

0

1

61.5

62.0

62.5

63.0

63.5

64.0

5

6

7

8

9

10

Contributions to quarterly growth

%

MM

Part-time

Full-time

20011989 19981992 1995Source: ABS

%pts

%pts

Participation rate(RHS)

Unemployment rate(LHS)

Graph 36

reflected in strong growth in employment inconstruction and, to a lesser extent,manufacturing.

Labour productivity, as measured by outputper hour worked in the economy, increasedby 2.0 per cent in the September quarter andby 4.2 per cent over the year (Graph 37). Thissuggests that the higher trend productivitygrowth that has been observed over the 1990shas been regained, after a cyclical slowdownin 2000. Labour productivity in theconstruction sector has returned to morenormal levels having been unusually low in2000/01, as employment in the constructionsector has continued to improve, but at aslower pace than the rebound in housingactivity.

Queensland recorded the fastestemployment growth over the year to theDecember quarter, although theunemployment rate in that state remainsabove the national average (Table 10). NSWwas the only state to record a fall inemployment in the December quarter and,

0

10

20

30

0

10

20

30

Interest PaymentsPer cent of GOS

2001

%

Corporate sector

%

Unincorporated sector

19971993198919851981Source: ABS

(net)

(gross)

Graph 35


29

with the exception of Tasmania, had the lowestgrowth in employment over the year. Therelatively weak labour market performance inNSW has been associated with the largestincrease in state unemployment rates.

Forward-looking indicators of the labourmarket have stabilised in recent months butremain at relatively low levels (Graph 38).All measures of job vacancies remainsignificantly lower than their peaks inmid 2000. The sharp increase in the ANZseries in January has brought it back into linewith the Department of Employment andWorkplace Relations (DEWR) series, whichwas broadly unchanged in January, followinga strong increase in December. The ABSemployer-based measure of vacancies fell by1.9 per cent in the December quarter to be23 per cent lower than a year ago, whichrepresents a continued easing in the rate ofdecline in this measure. Survey-basedmeasures of employment intentions remain

Table 9: Employment(a)

Per cent

Growth

Share of total December Year to December2001 quarter quarter

Goods production 21 1.6 –0.5Manufacturing 12 0.7 –2.8Construction 7 3.5 3.2Goods distribution 24 0.9 2.5Retail and wholesale 20 1.1 2.9Transport and storage 5 –0.1 1.0Business services 17 –3.6 –4.7Property and business services 12 –3.1 –7.0Finance and insurance services 4 –2.2 5.7Communication services 2 –8.9 –10.2Household services 28 0.2 3.8Accommodation, cafes and restaurants 5 –2.1 –4.8Education 7 –0.2 4.2Health and community services 10 1.4 6.6Cultural and recreational services 2 3.7 1.0

(a) For details of sector classifications refer to ‘Box A: The Service Sectors’ in the November 2001 Statement onMonetary Policy. Excludes agriculture and public administration.

Source: ABS

Graph 37

ProductivityYear-ended percentage change

-4

-2

0

2

4

6

-4

-2

0

2

4

6

-2

0

2

4

-2

0

2

4Output per hour worked

Output

Aggregate hours worked

% %

% %

20011998199519921989Source: ABS


30

at, or above, levels that are consistent withtrend employment growth. On balance, theseindicators present a firmer tone than in recentquarters, but suggest that labour marketconditions are not likely to change significantlyin the near term.

Graph 38

Indicators of Labour Demand

50

100

150

200

50

100

150

200

-25

0

25

-25

0

25

-4

0

4

-4

0

4

Job vacancies*

ABS

ANZ Bank

20021999199619931990

Index Index

Employment intentions**

NAB survey

ACCI-Westpacsurvey

* September quarter 1990 = 100; per cent of labour force** Net balance, deviation from average since September quarter 1989Sources: ABS; ACCI-Westpac; ANZ; DEWR; NAB

For the quarter ahead

% %

Employment growth% %

DEWR

Year-ended

(skilled vacancies)

Table 10: Labour Market by StatePer cent

Employment growth Unemployment rate

December Year to December December Year-endedquarter quarter quarter change

NSW –0.6 0.5 6.4 0.9Victoria 0.2 0.9 6.6 0.7Queensland 0.3 1.7 8.0 0.4WA 0.8 0.7 7.0 –0.2SA 1.0 1.1 6.4 0.4Tasmania 1.3 –1.2 8.6 0.0Australia 0.1 0.9 6.8 0.6

Source: ABS


31

Balance of Payments

After a couple of years of strong growth, theexport sector contracted in the second half of2001 as the world slowdown took effect(Box B). With export volumes falling in theDecember quarter, and stronger domesticdemand contributing to a significant increasein import volumes, net exports subtractedconsiderably from growth in GDP in thequarter, following a modest subtraction in theSeptember quarter. Export prices, which hadbeen resilient to the slowing world economy,fell slightly in the December quarter,contributing to a small decline in the termsof trade. As a result of these movements, thebalance of trade moved into deficit in theDecember quarter, following three quartersof trade surpluses. Assuming the net incomedeficit remained constant as a share of GDP,this implies that the current account deficitin the December quarter is likely to haveincreased from its recent low of 1.6 per centof GDP in the September quarter, to bearound 31/2 per cent of GDP (Graph 39).

In contrast to the previous period oftrading-partner weakness during the Asiancrisis, the synchronised weakness in the worldeconomy has limited the scope for exportdiversion. Nonetheless, Australian exportersappear to be making some inroads intomarkets in the Middle East and south Asia,with merchandise exports to these regions stillgrowing strongly (Table 11). Exports to east Asia,however, have been weak: total exports ofresources to Singapore and Indonesia almosthalved over the past year, while total exportsof manufactures to Singapore, Hong Kongand Taiwan have fallen by almost 25 per cent.Exports to Korea have held up due to thestrength of domestic demand there. Exportsto Japan have fallen over the past year, withresource exports, which constitute around70 per cent of Australia’s merchandise exportsto Japan, accounting for much of the slowing.While merchandise exports to China fell overthe past three months, this follows a period ofvery strong growth.

Resource exports appear to have fallen inboth value and volume terms over the secondhalf of 2001, after growing solidly over theprevious two years (Graph 40). Exports ofcoal have levelled out after recording stronggrowth over 2000. Demand for thermal coalis expected to remain firm owing to thecontinued commissioning of new coal-firedpower stations in Asia and the reduction insubsidies paid to European coal producers inrecent years, though Australia is facingincreased competition from China. Cokingcoal exports are also expected to remain at ahigh level, with the expected fall in Japanesesteel production offset by increases in Korea,Taiwan and some European countries; inaddition, lower US and Canadian coking coaloutput has led to tighter supply conditions.Aluminium demand, along with demand for

Graph 39

Balance of Payments*Per cent of GDP

16

18

20

22

16

18

20

22

●

-8

-6

-4

-2

0

-8

-6

-4

-2

0

2002

Imports

Exports

Goods and services balance

Current account balance

% %

% %

* December quarter 2001 estimate for current account balanceassumes unchanged net income deficit; data exclude RBAgold transactions

Sources: ABS; RBA

1999199619931990


32

price of rural commodities, with rural exportvolumes declining over the course of 2001.Cereal export volumes have fallen modestly,following very strong wheat production in thelast two financial years. Further falls in wheatproduction in 2001/02 are expected by theAustralian Bureau of Agricultural andResource Economics (ABARE), though thefall in exports is expected to be smaller dueto a rundown in stocks. Meat export volumesremain at a high level, though beef and vealproduction is expected to be slightly weakerin the current financial year. With consumerdemand for beef in Japan falling following thedetection of ‘mad cow’ disease in Japaneseherds, and exports to the US running upagainst import quotas, some beef is beingdiverted to other markets, particularly in eastAsia. Wool export volumes have fallen overthe past 18 months as a consequence ofreduced supply, due to a switch in farmingproduction from wool to meat. Supply hasbeen tightened further by the elimination ofthe wool stockpile last August.

Graph 40

the other major base metals, has fallen inrecent months amid ongoing economicweakness in the US and Japan, andcontractions in demand from south-east Asiaand Europe.

The growth in rural export values over thepast year has reflected large increases in the

Table 11: Merchandise Exports by Destination(a)

Per cent

Growth

Year to December Year to December Share of totalquarter 2000 quarter 2001 2001

Japan 29.8 –4.7 20.0Europe 9.1 4.9 11.8United States 32.3 –6.4 10.2East Asia (excluding Japan) 41.5 –3.5 33.0– Korea 27.0 11.7 7.5– China 57.9 10.3 6.5– Taiwan 42.7 –21.8 4.3– Singapore 82.1 –15.6 3.6– Indonesia 47.0 –3.4 2.7– Malaysia 18.0 3.6 2.1New Zealand 10.9 2.8 6.1Middle East 46.1 24.7 4.9South Asia 11.3 17.9 2.3Rest of the world 34.4 1.8 11.8

(a) Excludes gold

Source: ABS

Rural$b

Export Values*

3

5

7

9

2

4

6

8

5

6

7

9

12

15

Resources

Services Manufactures

* Excludes RBA gold transactions and re-exported gold; RBAestimates for December quarter 2001

Sources: ABS; RBA

$b

$b $b

200119981995 200119981995

Quarterly


33

The effect of the slowdown in worldeconomic conditions has been mostpronounced in manufacturing and serviceexports. Manufactured export volumesrecovered slightly in the December quarterafter falling by 81/2 per cent over the previoustwo quarters. Machinery exports fell by22 per cent over the same period, butincreased in the December quarter. Exportsof transport equipment were flat over the pastyear, though this follows annualised growthof 141/2 per cent over the preceding two years.

Service exports fell in the December quarterowing mainly to the adverse effect on globaltourism of the September terrorist attacks inthe US (Table 12). In line with global trendsin passenger movements, short-term visitorarrivals to Australia in the December quarterfell by 14 per cent, following a 1 per cent fallin the previous quarter. Short-term arrivalsfrom the US, UK and east Asia (excludingJapan) fell sharply following the terroristattacks in the US, but by December they hadrecovered most of the fall. In contrast, arrivalsfrom Japan and New Zealand remain on adownward trend.

Import values have been weaker over thepast year owing to a fall in volumes(Graph 41). In the December quarter,however, import volumes increased. Thestrength in imports of consumption goods inthe quarter was mainly accounted for by food

and beverages and motor vehicles. Imports ofcapital goods, which experienced particularlylarge falls towards the end of 2000 and in early2001, rebounded strongly in the second halfof the year, reflecting a rise in machinery andequipment investment. Further rises in capitalgoods imports are expected during 2002 as aresult of fleet expansions and upgrades beingundertaken by the domestic airlines. Inaggregate, imports from east Asia and the UShave fallen in recent months, while importsfrom Japan, and particularly Europe, have heldup over this period.

Consistent with lower interest rates globally,the net income deficit narrowed further in

Graph 41

Table 12: Short-term Visitor Arrivals(a)

Per cent

Growth

December Year to December Share of totalquarter 2001 quarter 2001 2001

East Asia (excluding Japan) –12.2 –9.3 26.5New Zealand –8.4 –27.5 15.2Japan –17.7 –29.1 14.0United Kingdom –8.3 –3.7 12.8Europe (excluding UK) –10.4 –11.6 12.1United States –13.9 –17.7 9.2Total –13.7 –16.6 100.0

(a) Seasonally adjusted by RBA

Sources: ABS; RBA

2001

Consumption$b

* Excludes RBA gold transactionsSource: ABS

Import Values*Monthly

2

3

4

5

1.5

2.0

2.5

3.0

2.0

2.5

3.0

1.5

2.0

2.5

19981995 20011998

$b

$b $b

Capital

Intermediate Services


34

the September quarter, to 2.8 per cent ofGDP. Debt-servicing ratios remain low byhistorical standards, with the ratio of netinterest payments to exports remainingaround 9 per cent in the September quarter.

Australia’s net foreign debt increased in theSeptember quarter to $331 billion, equal to49 per cent of GDP (Graph 42). Consistentwith trends over the past couple of years, theincrease was driven primarily by debt inflows,with the modest depreciation of the Australiandollar in the quarter also boosting theAustralian-dollar value of foreign-currencydenominated debt. Net foreign equityliabilities also rose, despite net equity outflowsfrom Australia. The rise primarily reflected thevaluation effect of the strength in theAustralian share market relative to thoseabroad. Overall, net foreign liabilitiesincreased to around 60 per cent of GDP.

however, an agreement from majornon-OPEC countries, including Russia andNorway, to cut production in conjunction withOPEC’s own cuts has contributed to a mildrecovery in the oil price around the turn ofthe year. Since the end of 2000, OPECproduction quotas have been reduced on fourseparate occasions, amounting to a 19 per centreduction in quota volumes.

The RBA commodity price index, in SDRterms, has increased in recent months tobe just below its recent peak and around19 per cent higher than its low point in 1999(Graph 44, Table 13). In Australian dollarterms, the index is 42 per cent above thetrough reached in May 1999. Base metalsprices have recovered in recent months owingto a reassessment by markets of the risks tothe world outlook, as well as cutbacks inproduction of a number of base metals,though stocks continue to rise. The increasein aluminium prices has been more muted.Some cuts in aluminium production havebeen announced, but have been offset bysubstantial increases in production in Chinaand Russia.

Rural commodity prices eased towards theend of 2001, but have recovered strongly inthe new year and are around 28 per centhigher than the lows recorded in the late1990s. Beef and veal prices, after falling

Commodity pricesOil prices in recent months have traded at

levels well below those prevailing during theprevious two years (Graph 43). The weakerworld economic outlook, and the reluctanceof non-OPEC oil-producing countries tocooperate with OPEC in cutting productionlevels, contributed to the weakness in oil pricesin the latter part of 2001. More recently,

Graph 43

l l l l l l l l l l l l l l l l l10

16

22

28

34

10

16

22

28

34

Oil PricesUS$/barrel

OPEC’stargetrange

OPEC basket

DOAJA

US$/barrel

West Texas Intermediate

2000 2001Source: Bloomberg

F2002

DO F

0

10

20

30

40

50

60

0

10

20

30

40

50

60

Net Foreign LiabilitiesPer cent of GDP

%

Total

%

Debt

20011997199319891985

Equity

Source: ABS

Graph 42


35

Graph 44 towards the end of 2001, have recovered owingto stronger US demand. Wool prices havemoved higher again and are back above theirtwo-year highs reached in April 2001. Verytight supply conditions – Australian woolproduction is at a 50-year low – have morethan offset weaker consumer demand for woolproducts from Japan and the US, whileChinese demand appears to be picking up.Wheat prices remain high owing to reducedoutput by major wheat exporters. Sugar priceshave been on a downward trend over thesecond half of 2001 due to upward revisionsto estimates of world production, particularlyfrom Brazil.

Non-rural commodity prices have changedlittle over the past three months. Gold pricesgradually moved higher over 2001 as thedownward trend in gold production, whichhas been evident for several years, continued.Reports of likely oversupply of thermal coal,arising from increased Chinese supply, led toa fall in the spot price during November fromthe high levels prevailing in the previous

Table 13: Commodity PricesSDR terms, percentage change

January Latest 3 months Year to latest3 months

Rural 6.1 –1.0 1.4– beef and veal 6.8 –5.3 19.2– wool 15.0 3.4 2.0– wheat 1.4 1.6 1.6– sugar 0.3 –2.4 –21.4Base metals 3.9 3.4 –13.0– aluminium 2.3 2.5 –10.9– copper 3.2 4.7 –16.8– nickel 13.1 9.0 –21.6– lead 5.7 6.2 7.9Other resources 0.8 0.6 12.8– gold 2.7 0.8 6.3RBA Index 2.8 0.5 5.2Memo items:Oil in US$ (a) 1.6 –23.2 –36.7Coal in US$ (b) –5.3 –11.5 5.6

(a) Oil prices are not included in the RBA Index

(b) Spot price for steaming coal from the Australian Coal Report; latest observation is for December

Commodity Prices1994/95 = 100

2002

95

105

115

125

95

105

115

125

70

80

90

100

110

70

80

90

100

110

SDR

A$

RuralBase

metals

Index(SDR)

200019981996

IndexIndex

Index(SDR)

Source: RBA

1994

Non-rural(excluding base metals)


36

couple of months. More recently, prices havesteadied around US$27 per tonne, therebyrestoring the typical gap between the contractand spot price (Graph 45). Contract pricesfor thermal and coking coal and iron ore arecurrently being renegotiated, with newcontract prices to become effective in April.

Graph 45

20

25

30

35

40

20

25

30

35

40

Thermal Coal PricesSpot and contract prices per tonne

2002

US$

* To JapanSources: ABARE; Australian Coal Report

Contract*

US$

Spot

1999199619931990


37

Box B: Direct Effects of a Weakening WorldEconomy on Australia

The world economy has a significantinfluence on developments in the Australianeconomy through its effects on Australia’sexports, both in terms of the amount soldand the price received for them, relative tothe cost of imports. The scope of this channelhas increased through time as the Australianeconomy has become more open.

The current slowdown in world growth isforecast by the IMF to be of a similarmagnitude to the early-1990s slowdown forthe industrial countries, but not as large asthat in the mid 1970s or early 1980s.Reflecting the global slowdown, Australianexport volumes declined in the Septemberand December quarters. The terms of tradehave remained relatively resilient. Despitefalling in the December quarter, they are stillhigher than a year earlier, as import priceshave fallen further than export prices (inforeign-currency terms).

To provide some context for the currentsituation, Table B1 documents episodes overthe past 40 years where declines in exportvolumes or the terms of trade havesubtracted at least 1 percentage point fromdomestic incomes. The table shows thatsome of these episodes occurred when theworld economy was in recession, but a

number of episodes were associated withonly a relatively mild slowdown in worldgrowth. Some of these differences reflect theextent to which Australia’s trading partnerswere affected relative to the rest of the world.The table also shows that significant declinesin export volumes and the fall in the termsof trade have rarely occurred simultaneously,with the Asian crisis being a notableexception. In that episode, the combinedeffects of a decline in export volumes andlower prices reduced Australian nationalincome by around 21/2 per cent –considerably more than in any of the threeworld recessions of the 1970s, 1980s andearly 1990s.

These three world recessions hadcontrasting effects on the external sector. Thedecline in export prices in foreign-currencyterms was considerably larger in the early1990s than in the other two episodes,although the terms of trade decline wasgreatest following the 1970s recessionreflecting rapid growth of import prices.However, whereas export volumes declinedin both the 1970s and 1980s episodes, inthe early 1990s, export volumes grew at arelatively rapid pace, increasing by 13 percent in 1991 and by 51/2 per cent in 1992.

Table B1: External Slowdowns and Domestic IncomeContribution to year-ended gross domestic income growth, percentage points

Episode (year-ended) Export volumes Episode (year-ended) Terms of trade

December 1960 –1.7 March 1965 –1.0March 1974 –1.4 March 1971 –1.7December 1980 –1.1 March 1975 –1.7June 1998 –1.0 September 1977 –1.4

March 1986 –1.6June 1991 –1.2June 1993 –1.0December 1998 –1.5


38

In each of these three episodes, the effectof lost foreign earnings on national incomewas not large enough, in itself, to cause arecession – even allowing for the operationof a multiplier as demand and productionresponded to the initial loss of income. Whileinternational forces contributed to theseverity of the recessions in the 1970s and1980s, it was a contraction in domesticdemand that was the more powerful force.This was even more the case in the early1990s, where international factors did nothave a significant negative effect on theeconomy through the external sector, yetAustralia experienced a recession becausedomestic demand fell sharply during theprocess of unwinding the imbalances of the

late 1980s. During the Asian crisis, incontrast, the strength of domestic demandkept the economy growing quite strongly,despite the pronounced contractionaryinfluence from abroad.

This simple analysis suggests that while apronounced weakening in global growthdoes affect Australia, whether or not thisleads to a recession depends critically on theextent to which the Australian economy isalready suffering from domestic problems.If the economy is relatively free ofimbalances, there is a good chance that, eventhough the pace of GDP growth willmoderate, an outright contraction ineconomic activity can be avoided. R


39

Domestic Financial Markets

Market interest ratesAt the time of the last Statement, in

early November, short-term interest ratesreflected expectations of substantial furthermonetary easings over the following sixmonths; they amounted to between 75 and100 basis points from the then cash rate of4.5 per cent (Graph 46). These expectationswere significantly unwound over the followingweeks as concerns faded about the impact ofthe events of September 11 on global activity.Some of this had already happened by the timeof the RBA’s December Board meeting andits decision to ease by 25 points at thatmeeting was in line with market expectations.After that meeting, there were lingeringexpectations for a few weeks of another25 point easing some time in the first half of2002, but over recent weeks those too havedisappeared as economic data here and in theUS have continued to improve. This trend wasreinforced by the Australian CPI result for theDecember quarter being higher than marketexpectations.

These changing expectations have not hadmuch impact on yields on 90-day bills. Theyhave been around 4.25 per cent over the past

two months – i.e. broadly in line with thecurrent cash rate. The changes have been moreevident in slightly longer-term yields, such ason 180-day bills. These have risen from around4.2 per cent in early December to around4.4 per cent in early February. This representsa return to a more normal relationshipbetween the yields on the two maturities aftera period of close to a year when yields on thelonger bills were typically below those on90-day bills.

With the same decline in cash rates here asin the US over the last quarter, the spreadbetween the cash rate in the two countries hasremained unchanged at 250 basis points.Markets expect this differential to narrowmarginally over coming months on the backof tightening of policy in the US from thesecond quarter of 2002 (Graph 47).

Graph 46

l l l l l l l l l l l l l l l l l l l3

4

5

6

3

4

5

6

Australian Cash Rate% %

ActualExpectations

Source: RBA2001 2002

F

7 Feb

7 Nov

3 Dec

A N M AMF

Graph 47

Movements in yields on medium tolong-term bonds have been more pronouncedthan movements at the short end of the yieldcurve (Graph 48). Yields on 10-year bondsreached a low point of around 5 per cent inearly November. This was about 50 basispoints below their level at the start of 2001

1986Source: RBA

1990 1994 1998

Spread between Australian and US Cash Rates

Bps Bps

2002

1 000 1 000

-200

0

200

400

600

800

-200

0

200

400

600

800

-200

0

200

400

600

800

-200

0

200

400

600

800


40

and, aside from a brief period in 1998, thelowest level of bond yields since the late 1960s.Subsequently, improving confidence andreduced expectations of policy easing sawyields rise by 50 basis points, by earlyDecember, and by a further 40 basis pointssince (Graph 49).

The rise in Australian bond yields overrecent months has been largely in line withincreases in yields in the US. The differentialbetween Australian and US bond yields hasremained within the range of 70 to 100 basispoints that has prevailed since the middle oflast year. More recently, the differential hasbeen at the higher end of this range (Graph 50).

Corporate bond yields have risen by lessthan government bond yields over the pastfew months. As a result, spreads on bondsrated A or above have narrowed and are nowbelow their pre-September 11 levels. Spreadson BBB-rated bonds remain, on average,about 10 basis points above their Septemberlevels. In general, spreads on corporate bondsin Australia have narrowed by more than, andremain well below, those in the US (Graphs51 and 52).

The recovery in corporate bond spreads hasbeen most pronounced for A to AA-gradebonds. Investors appear confident that thesebonds are more likely to have their credit

Graph 48

Graph 51

l l l l l0

25

50

75

100

125

0

25

50

75

100

125

Bps

1997 1998 1999 2000

Corporate Bond Spreads

A

AA

AAA

Sources: RBA; UBS Warburg Australia Ltd

Bps

BBB

20022001

l l l l l l l l l l l3.0

3.5

4.0

4.5

5.0

5.5

6.0

3.0

3.5

4.0

4.5

5.0

5.5

6.0

% %

Source: RBA

Australian Yield Curves

Cash 21 3Years

7 February 2002

3 December 2001

7 November 2001

4 5 6 7 8 9 10

Graph 49

l l l l l4

5

6

7

8

4

5

6

7

8

Australian 10-year Bond Yields% %

Source: RBA

1997 1998 1999 2000 2001 2002

Graph 50

l l l l l-0.5

0.0

0.5

1.0

-0.5

0.0

0.5

1.0

% %

Source: RBA

Differential between Australian and US 10-year Bonds

1997 1998 1999 2000 2001 2002


41

rating upgraded than downgraded. Telstra, forexample, recently had its credit ratingupgraded by Standard and Poor’s to AA– fromA+. Expectations of actual default are very

Graph 52 low. Despite a number of prominent corporatecollapses last year, there were no defaults oninvestment-grade bonds (the only kind onissue in Australia). In contrast, Standardand Poor’s report that 0.3 per cent ofinvestment-grade bonds worldwide defaultedin 2001, close to a record level.

Intermediaries’ interest ratesThe December easing of policy was passed

fully onto households, with mortgage andcredit card rates falling by 25 basis points.

The latest reductions in housing rates haveseen them fall almost 0.5 percentage pointsbelow their 1998/99 cyclical lows (Table 14).The current standard variable rate, at6.05 per cent, and the basic mortgage rate(5.50 per cent) remain the lowest mortgagerates since March 1970 and July 1968respectively (Graph 53).

Table 14: Banks’ Indicator Lending RatesPer cent

Current level Change since Change since Cyclical low(early February) October 2001 January 2001 1998/99

HouseholdMortgages– Standard variable 6.05 –0.25 –2.00 6.50– Mortgage managers 5.75 –0.25 –2.05 6.10– 3-year fixed 6.30 0.00 –0.65 6.40Personal lending– Residential secured 6.20 –0.25 –2.00 6.60– Credit cards 15.65 –0.35 –1.05 15.25Small businessResidential secured:– Overdraft 6.80 –0.15 –1.80 6.95– Term loan 6.25 –0.20 –1.95 6.65– 3-year fixed 6.70 0.50 –0.30 6.50Other security:– Overdraft 7.50 –0.15 –1.70 7.45– Term loan 6.85 –0.30 –1.85 7.05Large business– Overdraft 7.85 –0.20 –1.90 7.95– Term loan 7.70 –0.25 –1.90 7.90Cash rate 4.25 –0.25 –2.00 4.75

Source: RBA

l l l l l25

50

75

100

125

150

175

25

50

75

100

125

150

175

Credit Spreads

Bps

US 3-5 year

Australia 2-4 year

2000 2001199919981997

BpsA-rated corporate less government debt

Sources: Bloomberg; RBA

2002


42

As with previous easings in monetary policyin 2001, pass-through to small business rateshas been incomplete. Margins on smallbusiness loan indicator rates have been driftingup since November 1999 (during both thetightening and easing phases of monetarypolicy). They have increased most foroverdrafts and loans secured by assets otherthan residential property (Graph 54). Despitethis, the margin between the weighted averagerate actually paid by small businesses and thecash rate has fallen slightly over the sameperiod. This suggests that businesses havebeen able to offset the rising margins onindicator loans either by taking up specialoffers or switching to lower-cost products orlenders.

Interest rates on fixed-rate loans for housingand small business have risen in recentmonths, in contrast to the declines in interestrates on variable-rate loans (Graph 55). Theseincreases have been smaller than those of swaprates, from which intermediaries price theirfixed-rate loans, and fixed rates remain aroundthe lowest seen in recent years. However, theproportion of loans at fixed rates has beendeclining, most likely due to the falls invariable rates. This is true for both householdsand small businesses.

Capital markets developments

Debt markets

Issuance of both corporate and asset-backedbonds in the December quarter was down byaround 20 per cent from that in the previousquarter (Graph 56). This was a fairly goodoutcome given the slow start to the quarterand the usual December inactivity. Corporateissuance was boosted by one large raising of$1 billion. The size of this raising is indicativeof the improved capacity of the domesticcorporate bond market. The raising in

Graph 53 Graph 54

1

2

3

4

5

1

2

3

4

5

Margins on Small Business LoansMargin between indicator rate and cash rate

%Weighted average

variable rate

%

1996 1998 2000 2002

Overdraft othersecurity*

Overdraft residential security*

* Break in series is due to changes in bank’s methods ofcharging risk margins.

Source: RBA

Term loan residentialsecurity*

Graph 55

0

10

20

30

40

50

0

10

20

30

40

50

Fixed-rate LoansPer cent of total

1993

%

(per cent of loans outstanding)

Sources: ABS; RBA

Small business%

Owner-occupied housing(per cent of total approvals)

1995 1997 1999 2001

4

5

6

7

8

9

10

4

5

6

7

8

9

10

Housing RatesEnd month

Major banks’basic product

% %

Mortgage managers’standard variable

Cash rate

Major banks’standard variable

2002200019981996Source: RBA

1994


43

question was the largest without creditenhancement yet to be made by a domesticnon-financial corporate.

Strength in the first three quarters of theyear meant that non-government bondissuance was substantially higher in 2001 thanin 2000 ($33.6 billion compared to $28 billion)(Table 15). Domestic asset-backed issuance forthe year was particularly strong and includeda large increase in the number of smallernon-residential mortgage-backed issues. At$13.7 billion, issues of asset-backed bondswere more than twice their level two yearsearlier. There was also around $14 billion ofasset-backed issuance into offshore marketsduring 2001.

Asset-backed issuance into offshore marketshas matched domestic issuance for severalyears and there are outstandings of about$35 billion in each market segment. Foreigninvestors are attracted to Australian issues dueto the default history of home loans inAustralia being lower than in the US and theUK, and by credit enhancement of the bondsprovided by mortgage insurance. For theissuers, offshore markets are attractive becausethey are able to absorb large deals more readilythan the domestic market.

In the domestic corporate market,one notable trend through the year was thatnon-residents’ share of corporate issuancedeclined markedly. Early in the year, they hadaccounted for over half the corporate issuesin Australia, but by the fourth quarter thisproportion was down to 10 per cent. Thoseearlier large issues reflected opportunities forforeign companies to reduce funding costs byborrowing in Australia and swapping theproceeds back to US dollars. By late in theyear, changes in spreads meant that theseopportunities had been largely removed.Nonetheless, for the year as a whole,non-residents were the largest group of bondissuers in Australia.

Issues by financial institutions were up alittle on the previous year but well down onearlier years. In 1999, for example, financialinstitutions accounted for around a half ofbond issuance, and two-thirds the year beforethat. Issuance by domestic non-financial

Table 15: New Domestic Issuance by Sector$ billion

Sector 1999 2000 2001 2001:Q1 2001:Q2 2001:Q3 2001:Q4

Financials 10.4 5.1 6.0 2.1 1.0 1.7 1.2Non-residents 5.6 3.5 7.8 3.8 2.4 1.2 0.4Pure corporates 5.5 8.6 6.1 0.5 1.9 1.5 2.2Total corporate 21.5 17.2 19.9 6.4 5.3 4.4 3.8of which:– Credit-wrapped – 3.8 2.0 – 1.2 0.8 –– Floating rate notes 1.1 6.5 5.3 1.6 1.5 1.4 0.8Asset-backed 6.4 10.8 13.7 3.0 2.7 4.5 3.5Total new issuance 27.9 28.0 33.6 9.4 8.0 8.9 7.3

Graph 56

0

2

4

6

8

0

2

4

6

8

Domestic Non-government Bond Issues

1997

$b

* Includes financials, pure corporates and non-residentsSource: RBA

1998 1999 2000 2001

$b■ Corporate bonds*■ Asset-backed bonds


44

corporates (‘pure corporates’) declined a littlein 2001 from the high figure the previous yearwhen debt financing by former public utilitiessuch as electricity generators and airportsmade large issues. There was also a declinelast year in the proportion of bond issuescarrying a floating interest rate.

After a number of years of very stronggrowth, outstandings of non-governmentbonds levelled out in the second half of 2001,at around $100 billion, as maturities largelyoffset new issues (Graph 57). Analysts expectthis to be temporary, with new issuanceoutweighing maturities in the year ahead.

economy. Corporate profitability in Australiahas remained much more robust than in theUS.

The recent strength has been in both theresource sector and the bank and insurancesector (Graph 59). The resource sector hasbeen buoyed by good profits and takeoveractivity. With a solid domestic economy, bankshares have also been in strong demand asmarkets see little prospect of recent strongearnings growth being interrupted. The lossesincurred by NAB on its HomeSide subsidiaryhave been seen by markets as largely one-off,and as such have not had a lasting impact on

Graph 57

0

20

40

60

80

100

0

20

40

60

80

100

Domestic Non-government Bonds Outstanding

1995

$b

* Includes financials, pure corporates and non-residentsSource: RBA

Total bondsoutstanding

$b

Corporatebonds*

Asset-backedbonds

1997 1999 2001200019981996

Graph 58

l l l l l l l l l l l l70

80

90

100

110

120

130

70

80

90

100

110

120

130

Australian and US Share Prices

Index

Wilshire 5000

End December 1998 = 100Index

ASX 200

Source: Bloomberg

S M1999 2000 2001 2002

S MS MM

Graph 59

l l l l60

80

100

120

140

160

60

80

100

120

140

160

Australian Share Prices

Index

Banks and insurance

End December 1997 = 100Index

Resources

Otherindustrials

1999 2000 20011998 2002

Sources: Bloomberg; RBA

Equity markets

Australian share prices continue to bestronger than those in most other majorcountries, including the US. Like marketselsewhere, the Australian marked recoveredstrongly from the fall that followed theSeptember events. But whereas some marketshave declined again in the past month,particularly in the US where there are growingconcerns about corporate governance, theAustralian market has risen further. It is theonly major market in the world where shareprices remain close to their peak (Graph 58).In other markets, they are down around30 per cent from their early-2000 peaks. Thisstronger outcome is largely mirroring therelatively strong performance of the Australian


45

the overall banking index. Bank share pricesalso have not been materially affected by thecollapse of Enron in the US. At $562 million,the four major banks’ combined unsecuredexposure to Enron increases their impairedasset ratios only a little, to around0.65 per cent from around 0.60 per cent oftheir on-balance sheet assets. By historicalstandards, this figure remains very low.

Share valuations relative to the latest profits(i.e. P/E ratios) have again risen in recentmonths, taking them further above thelong-run average. The current aggregateP/E ratio for the Australian market is 26, upfrom 23 in October. The long-run average isabout 15. The ratio is being supported bybullish profit expectations in the period ahead;in the current year, analysts expect industrialcompanies’ profits to increase by 14 per cent,a very strong rate of increase.

Net equity issuance slowed during theDecember quarter to around $3.5 billionfrom $5.7 billion in the previous quarter, but

Graph 60

-6

-4

-2

0

2

4

6

8

-6

-4

-2

0

2

4

6

8

Equity RaisingsQuarterly

1997

$b■ Buybacks ■ Other raisings ■ IPOs

1998 1999 2000 2001

Net

$b

Source: ASX

was broadly in line with raisings during thefirst two quarters of the year (Graph 60). Netequity issuance for the whole of 2001, at$15.4 billion, was slightly stronger than in2000.


46

Assessment of Financial Conditions

Financial conditions continue to beexpansionary. Monetary policy was eased by25 basis points in December, reducing thecash rate to its lowest level in almost 30 years(Graph 61). The easing has translated intofurther falls in interest rates on loans fromfinancial intermediaries, supporting strongexpansion in credit to households; growth inbusiness credit, however, remains subdued.Yields on financial market debt instruments

are still at low levels by historical standards,notwithstanding a rise in yields onlonger-dated maturities over the past coupleof months that has made the slope of the yieldcurve more positive. Increases in equity priceshave encouraged a high level of equity raisings.The real exchange rate remains low and issupportive of the traded sector.

Interest ratesThe 25 basis point easing in monetary

policy in December took the cumulativeeasing this cycle to 200 basis points. Anapproximate benchmark for assessing thestance of policy is the average real cash rateover the period since 1992, a period in whichthere has been stable inflation and strongeconomic growth. A range of measures of realinterest rates are presented in Table 16, all ofwhich show that real interest rates arecurrently below that average. Based on ameasure calculated from underlying inflation,the real cash rate appears highly expansionary,being 21/2 percentage points below average.The deviations from average are smaller whenreal interest rates are calculated using inflationexpectations derived from the bond market

0

5

10

15

20

0

5

10

15

20

Cash Rate

2002

%

Source: RBA

%

19961990198419781972

Graph 61

Table 16: Real Interest RatesPer cent

Using weighted Using bond market Using consumermedian inflation inflation expectations inflation expectations

Level Deviation Level Deviation Level Deviationfrom average(a) from average(a) from average(a)

Cash rate 1.0 –2.5 2.1 –0.6 0.4 –1.0Home loan rate 2.7 –3.3 3.9 –1.4 2.2 –1.7Business indicator rate 4.6 –2.4 5.8 –0.4 4.0 –0.8

(a) Percentage point deviation from 1992–2001 average.

Current interest rates use the weighted median inflation or average inflation expectations for the Decemberquarter 2001.

Sources: ABS; Melbourne Institute; RBA


47

or consumer surveys. Real home loan interestrates are clearly expansionary on any of thesemeasures, reflecting the fall in marginscharged by intermediaries on housing loansover the 1990s. Real lending rates charged tobusiness are also below average, though by asmaller margin than is the case for housingloan rates.

The slope of the yield curve in Australia, asmeasured by the difference between 10-yearbond yields and the 90-day bank bill rate, hassteepened over recent months (Graph 62).This reflects more accommodative monetarypolicy, which has pushed short-term interestrates lower, and bond market perceptions thatprospects for economic recovery haveimproved, which has shifted long-term interestrates higher.

Financing activityCredit grew at an annualised rate of around

71/2 per cent over the six months to December,somewhat below the rate recorded over theprevious six months (Graph 63). Borrowingactivity continues to be dominated byhouseholds. Lending to households increasedby an annualised rate of around 161/2 per centover the six months to December, comparedwith a small decline in business credit. The

rapid expansion in household borrowing,driven by lending for housing, reflects lowinterest rates in the housing sector and theimpetus from the Government’s First HomeOwner Grant. On the business side, surveysconfirm that interest rates are not a constrainton business activities, and on-market raisingsthrough debt and equity have maintained asolid pace. As outlined in the chapter on‘Domestic Economic Activity’, the slower paceof overall business borrowing activity in 2001is broadly consistent with the easing ininvestment expenditure over the past year orso. Loan approvals data suggest that thedivergence between growth in household andbusiness credit will narrow in coming months.

On the liability side of intermediaries’balance sheets, growth in the broadermonetary aggregates accelerated over thelatter part of 2001. Broad money grew at anannualised rate of 131/2 per cent over the sixmonths to December, up from 91/2 per centin June. With growth in domestically sourcedliabilities now outstripping that in assets,financial intermediaries reduced their offshoreborrowings over the period, in markedcontrast to the strong growth in offshoreborrowing recorded in recent years.

Graph 62

-6

-4

-2

0

2

4

-6

-4

-2

0

2

4

-6

-4

-2

0

2

4

-6

-4

-2

0

2

4

Yield Spread

2002

%

199819941990

%

Difference between 10-year bond and90-day bank bill

Source: RBA

Graph 63

-10

-5

0

5

10

15

20

-10

-5

0

5

10

15

20

Credit GrowthSix-month-ended annualised rate

2001

Household

19991997

Total

Business

% %

Source: RBA199519931991


48

Real exchange rate

As discussed in the chapter on ‘Internationaland Foreign Exchange Markets’, theAustralian dollar was relatively stable in 2001.In December, the real exchange rate, whichadjusts for differences in inflation across ourtrading partners, was close to its level of a yearearlier, remaining around 14 per cent belowits 1990s average (Graph 64). More recently,the trade-weighted value of the currency hasrisen a little, primarily reflecting anappreciation against the yen.

Graph 64

80

90

100

110

80

90

100

110

Real Exchange Rate*Average of 1990s = 100

2002

Index Index

* March 2002 estimate assumes exchange rates on 7 Februaryare maintained for the remainder of the quarter, and usesDecember quarter 2001 core inflation rates.

Source: RBA

1998199419901986


49

Inflation Trends and Prospects

Recent developments in inflation

Consumer prices

The Consumer Price Index (CPI) increasedby 0.9 per cent in the December quarter, afterrising by 0.3 per cent in the Septemberquarter, to be 3.1 per cent higher over 2001(Graph 65). The increase in the quarterreflected sharp rises in the prices of some fooditems and the cost of airline travel which werepartly offset by a further fall in petrol prices.

Measures of underlying inflation areproviding different estimates of the rate of coreinflation. Measures that use statistical criteria,such as the weighted median and trimmedmean, suggest core inflation was around0.7 per cent in the December quarter andaround 31/4 per cent over the year (Table 17).Other measures which are based on theexclusion of a fixed basket of items, such asmarket sector goods and services excludingvolatile items, increased by around 1 per cent

in the quarter and by 3.6 per cent over theyear. The differences reflect the differingapproaches to constructing these underlyingmeasures: the fixed-basket measures includethose factors that on this occasion are adding

Graph 65

-2

0

2

4

6

-2

0

2

4

6

Inflation*Year-ended

2001

%

CPI

%

CPI excluding tax changes**

CPI excluding tax changes**

19991997199519931991* Excluding interest charges prior to September quarter 1998** RBA estimateSources: ABS; RBA

(quarterly)

Table 17: Measures of Consumer PricesPercentage change

Quarterly Year-ended

September December September Decemberquarter quarter quarter quarter

2001 2001 2001 2001

CPI 0.3 0.9 2.5 3.1– Tradables –0.6 0.8 2.5 3.1– Non-tradables 1.1 1.0 2.6 3.1Underlying inflationWeighted median(a) 0.7 0.7 3.0 3.2Trimmed mean(a) 0.7 0.7 2.9 3.3CPI excluding volatile items 0.7 0.9 2.9 3.6Market goods and services 0.7 1.1 2.8 3.6 excluding volatile items

(a) For details on the calculation of these measures, see ‘Measuring Underlying Inflation’, RBA Bulletin,August 1994, available at www.rba.gov.au/publicationsandresearch/bulletin/index.html#1994.

Sources: ABS; RBA


50

to inflation (meat and air travel), whileremoving the main negative influence (petrol),resulting in a relatively high figure. Onbalance, the statistical measures are probablyproviding a more reliable indication ofunderlying inflation at present.

Although higher prices were recorded foralmost all food categories, sharp increases inthe prices of some fruit and vegetables madethe largest contributions, reflecting weather-and disease-related supply problems. Meatprices again rose sharply, boosted by strongworld demand for Australian meat products.Higher dairy prices also reflected strong worlddemand as well as a partial unwinding ofearlier price falls associated with therestructuring of the industry. Excluding food,the CPI rose by 0.5 per cent in the Decemberquarter and by 2.2 per cent over the year.

Domestic holiday travel andaccommodation prices increased by7.7 per cent in the December quarter, butwere flat over the year. The rise in the quarterreflected a seasonal rise in price as well asrecent developments in the airline industry,including the introduction of the Ansett andinsurance airfare levies. These developmentsare likely to have some further effect in theMarch quarter. The cost of house purchaseagain rose by around 1 per cent in theDecember quarter, consistent with therecovery of the housing market. Othersignificant price increases were recorded forsome items of women’s clothing andtelecommunications. Despite recording aslight fall in the quarter, insurance costs roseby 6 per cent over 2001 (see Box C).

The most substantial offset to the generalincrease in prices in the December quarterwas a 3.7 per cent fall in petrol prices, whichbrought the fall over 2001 to 12 per cent.Audio, visual and computing equipmentprices also continued to fall in the quarterwhile lower health costs mostly reflected theseasonal effect of the Pharmaceutical BenefitsScheme.

Both tradables and non-tradables pricesincreased by 3.1 per cent over the year to the

December quarter. Excluding petrol and food,tradables prices have been growing at a fasterpace, rising by 31/2 per cent over 2001(Graph 66). This may reflect continuedpass-through of the earlier exchange ratedecline and may persist for a while yet,although the exchange rate has been relativelystable over the past year.

Graph 66

Producer prices

Input cost pressures continued to moderateover the course of 2001. Over the year toDecember, producer prices at all stagesincreased by less than 2 per cent, down fromrates of over 5 per cent a year earlier(Table 18). A significant cause of themoderation has been falling oil prices, withthe Asian benchmark oil price declining by20 per cent in the December quarter followinga 10 per cent fall in September.

In contrast to the September quarter,import prices generally increased, apart fromoil and computer equipment prices, withstrong growth recorded in the prices ofindustrial machinery and motor vehicles. Onan industry basis, producer price inflationremains moderate with a few exceptions, suchas real estate agent services, which have risenby 10 per cent over 2001. There was also an

-2

0

2

4

6

8

-2

0

2

4

6

8

Tradables and Non-tradables PricesYear-ended percentage change

2001

%

(excluding petrol and food)

Sources: ABS; RBA

Tradables

1999199719951993

Non-tradables

%


51

increase in building construction prices,consistent with the upturn in activity in theconstruction sector. The prices of materialsused in manufacturing fell by 1.9 per cent inDecember, whereas the prices of articlesproduced fell by 0.6 per cent.

Recent business surveys also suggest thatupstream inflationary pressures havecontinued to moderate, and that growth infinal prices is expected to remain low as aresult. The economy-wide NAB survey reportsthat purchase costs increased by only0.4 per cent in the December quarter and thatfirms expect costs to increase by an averageof just 1/4 per cent in the March quarter(Graph 67). The latest ACCI-Westpac surveyreported a further easing in inflationarypressures in the manufacturing sector. The netbalance of firms expecting cost increases fellfurther in the December quarter.

Graph 67

Table 18: Stage of Production Producer PricesPercentage change

Dec qtr Year to Year to2001 Dec qtr 2000 Dec qtr 2001

Preliminary –0.4 10.2 –0.4– Domestic –0.3 7.5 0.8– Imported –1.7 27.1 –6.9

Intermediate 0.1 8.4 1.0– Domestic 0.3 6.4 2.0– Imported –0.7 21.8 –4.8

Final(a)

Domestic 0.4 4.1 1.8 – Consumption 0.2 4.0 2.0 – Capital 0.5 4.0 1.7 Imported 1.3 10.6 1.0 – Consumption 1.3 11.3 1.7 – Capital 1.5 9.9 0.3 Total 0.6 5.2 1.7 – Excluding oil 0.8 3.9 2.7 – Consumption 0.5 5.4 1.9 – Capital 0.7 5.1 1.4

(a) Excluding exports

Source: ABS

Purchase Costs

2001

NAB SurveyPer cent

%

Expected

0.0

0.5

1.0

1.5

0.0

0.5

1.0

1.5

-25

0

25

50

-25

0

25

50

%

% %

19991997199519931991

ACCI-Westpac SurveyNet balance reporting increases

Actual

Quarterly change

Sources: ACCI-Westpac; NAB


52

Labour costsWage pressures remain well contained,

reflecting the subdued conditions in the labourmarket (Graph 68). Growth in the Wage CostIndex (WCI) for total pay eased slightly inthe September quarter to 3.6 per cent overthe year, after having drifted up over theprevious eighteen months. By industry, amongthe fastest rises in wages continued to be inproperty and business services and education,which both increased by 4.4 per cent over theyear, while the retail sector again recorded theslowest growth, at 2.3 per cent. Data onenterprise bargaining agreements also indicatemodest wage pressures. New federalenterprise agreements ratified in theSeptember quarter provided an averageannualised wage increase of 3.9 per cent, thesame as in the previous quarter. Measures ofunit labour costs have also eased in recentquarters to be growing at a rate of around13/4 per cent over the year to September.

than a year ago, down from 5.3 per cent inthe June quarter.

According to the latest Mercer Cullen EganDell Quarterly Salary Review, the averageannual wage increase for office workers edgedup to 41/2 per cent in the December quarter.The base salary of executives rose by5 per cent over the course of 2001, up slightlyfrom the pace of around 43/4 per cent reportedin the previous couple of quarters. Recentbusiness surveys also report that wagepressures remain in check, with the latestquarterly NAB survey reporting modestgrowth in labour costs in the Decemberquarter and firms expecting this to continuein the March quarter. Firms report littledifficulty attracting suitable labour, consistentwith the relatively low levels of the major jobvacancy series.

The Australian Industrial RelationsCommission (AIRC) is expected to decide onthe 2002 Safety Net Review of award wagesin May. It is considering an applicationby the Australian Council of Trade Unions(ACTU) to increase all award rates of pay by$25 per week.

Inflation expectationsThe inflation expectations of consumers

have remained in a range between 31/2 and41/2 per cent since mid 2000 (Graph 69). TheMelbourne Institute survey reported thatconsumers’ expectations for inflation over the

Graph 68

0

2

4

6

8

0

2

4

6

8

Wage IndicatorsYear-ended percentage change

2001

%

AWOTE

1998199519921989

%

WCI

Sources: ABS; NAB

NAB quarterly(actual)

The average weekly earnings surveycontinues to be affected by compositionalchanges, which reduce its usefulness as anindicator of wages growth. The past couple ofquarters have also been affected by ahigher-than-usual sample rotation. Averageweekly ordinary-time earnings of full-timeadults (AWOTE) rose by 1.4 per cent in theSeptember quarter to be 5 per cent higher

Graph 69

0

2

4

6

8

0

2

4

6

8

Indicators of Inflation Expectations% %

2002

Melbourne Institute survey

Indexed bond measure

Sources: Melbourne Institute; RBA

20001998199619941992


53

coming year rose to 4.5 per cent in Januaryfrom around 31/2 per cent in November andDecember. Recent business surveys indicatethat businesses have continued to moderatetheir expectations for inflation. Theeconomy-wide NAB survey reported thatinflation in final product prices and retailprices was expected to be 0.3 per cent in theMarch quarter. The NAB survey alsoindicated that medium-term inflationexpectations of businesses fell in theDecember quarter. A little less than10 per cent of businesses expect inflation toaverage more than 4 per cent in the mediumterm (compared with around 30 per cent inthe mid 1990s), while almost 40 per cent ofrespondents expect inflation to average lessthan 3 per cent (compared with around10 per cent in the mid 1990s). The latestACCI-Westpac survey reported an easing ininflation expectations in the manufacturingsector for the March quarter.

In contrast, longer-term inflationexpectations of investors, measured by thedifference between 10-year bond yieldsand indexed bonds, have moved higher inrecent months to average between 21/4 and21/2 per cent in December and January.Similarly, most financial-market economistssurveyed by the Bank have made upwardrevisions to their forecasts for inflationfollowing the release of the December quarterCPI (Table 19). The median inflationforecasts for the years to June 2002 and June2003 have both increased to 2.4 per cent.Trade union officials surveyed by the

Australian Centre for Industrial RelationsResearch and Training (ACIRRT) have alsorevised up their expectations for inflation.

Inflation outlookThe various measures of underlying

inflation give a range of readings for coreinflation in the December quarter but, asdiscussed above, the Bank’s assessment is thatunderlying inflation was around 31/4 per centover the year to December, continuing thegradual upward trend in underlying inflationevident since 1999. This is in line with theforecasts presented in previous Statements,which indicated that underlying inflationwould exceed the target for a short period.

Some of the sharp price rises thatunderpinned the December quarter outcomeare likely to be temporary. Half of the increasein the CPI in the quarter was due to food,and it is probable some of these increases, inparticular for fruit and vegetables, will bepartly reversed over coming quarters. Theprices for other items, such as meat and dairyproducts, may remain high in the near term,but should not continue rising at their currentpace. Domestic travel and accommodationprices increased significantly in the quarter,consistent with previous seasonal patterns, butalso reflected recent developments in theairline industry that are likely to provide afurther boost to prices in the March quarter.The price increases for some categories ofclothing and furniture follow a period ofextensive discounting and may continue in thenext few quarters as retailers seek to rebuild

Table 19: Median Inflation ExpectationsPer cent

Year to June 2002 Year to June 2003

August November February August November February2001 2001 2002 2001 2001 2002

Market economists(a) 2.3 2.0 2.4 2.5 2.2 2.4Union officials(b) 4.0 2.9 3.3 3.8 3.1 3.9

(a) RBA survey

(b) ACIRRT survey


54

margins. The increase in house purchase costscould also persist for the next few quartersuntil activity in the housing sector slows. Thuswhile some of the sector-specific pricepressures evident in the December quartershould dissipate, others may persist foranother quarter or so.

However, the outlook for the medium-termdeterminants of inflation has not changedsubstantively in light of the recent data. Wageand labour cost growth remain contained andare likely to continue to be so given theprevailing weakness in the labour market. Thestability of the exchange rate over the past year,combined with downward pressure on worldprices from the subdued global economy,suggests that there will be little inflationarypressure from import prices in the mediumterm. Producer price data and businesssurveys suggest that upstream price pressureshave continued to ease, underpinned by thedecline in oil prices.

Given that the medium-term influences oninflation remain broadly unchanged, theBank’s assessment continues to be thatunderlying inflation is at or near its peak andwill decline to around 21/2 per cent through2002. CPI inflation should remain close tothe underlying measures. This is based on theassumption that the exchange rate remains at

recent levels, and that oil prices driftmoderately higher over the coming year.

The November Statement considered thatthe risks to the central forecasts were slightlyweighted to the downside. The recent datasuggest that upside risks to the outlook forinflation have subsequently increased,particularly in the near term. The currentstrength of the economy may result in moremargin building in the quarters ahead than iscurrently allowed for. This would maintain theinflation rate at or near the top of the targetand could lead to an upward shift in inflationexpectations. In these circumstances, if thedomestic economy were to gather strength,there would be a risk of inflation remainingabove the target for a longer period.

At the same time, the downside risks to theinflation outlook identified in the NovemberStatement remain. If the downturn in theglobal economy is more protracted thanexpected, there would be further downwardpressure on international prices, in particularoil prices. This would contribute to slowerthan anticipated growth in the Australianeconomy and a more prolonged period ofweakness in the labour market, furtherrestraining wage and price increases. Atpresent, the Bank considers these risks to theinflation outlook to be more evenlybalanced. R


55

Box C: Insurance Prices

The price of insurance has risen markedlyover the past year and further price rises arelikely in the period ahead. This followssubstantial losses in the global insuranceindustry in recent years, an escalatingassessment of future insurance payouts, thecollapse of HIH and lower returns on theassets held by insurance companies.

The rise in reinsurance premiumsfollowing large losses due to natural andman-made catastrophes is one of the mainreasons for an increase in costs to theAustralian insurance industry (Graph C1).In 1999, there were an unusual number oflarge natural catastrophes around the world,including the Sydney hailstorm that was theeighth largest insured loss in the world inthat year. The insured loss from the eventsof 11 September is likely to exceed thelargest preceding single-event loss,Hurricane Andrew in 1992, when theinsurance industry paid claims of roughlyUS$20 billion (in 2001 prices).

Graph C1

As a consequence of these large losses,reinsurers’ capital reserves have declined,and this has led to a contraction in the supplyof reinsurance. In combination with anincrease in demand for reinsurance, this hasresulted in a sharp increase in price. Inaddition to this, a more long-lasting effecton insurance premiums from recent eventswill depend upon the extent to which therisk of both natural and man-madecatastrophes is reassessed. A further reasonwhy costs faced by the Australian insuranceindustry have increased is that the Australiancommunity is becoming more willing toclaim for losses incurred. This has led to anincrease in the actuarial assessment ofexpected payouts, particularly for productssuch as public liability insurance.

As well as changes in costs, insurancepremiums are influenced by the degree ofcompetition in the insurance market. Inrecent years the Australian general insuranceindustry has been characterised by strongcompetition which has held down directinsurance premiums despite the rising costs.An important factor behind this was HIH’spolicy of aggressively building market shareby offering lower premiums. With this effectno longer operating, a return to more normalpractices would see some rise in premiums.

Effects on the CPIInsurance premiums affect the CPI

directly through households’ purchases ofcar, house and contents insurance which hasa weight of 1.5 per cent in the CPI. The priceof household insurance services in the CPIhas increased by 6 per cent over the past year.However, there is also an indirect effect asrising commercial premiums for businessesare passed through to consumer prices.

0

5

10

15

20

25

30

35

0

5

10

15

20

25

30

35

Worldwide Insured Loss due to Catastrophe

2001

$b

Source: Swiss Re Economic Research and Consulting, sigma

Man-made catastrophe

199619911986198119761971

$b

Natural catastrophe

US$, 2001 prices


56

Insurance industry surveys, such as theJP Morgan-Trowbridge Consulting-Deloittesurvey, suggest that even prior to the eventsof September, industry observers wereexpecting some classes of commercialinsurance premiums to rise by up to20 per cent over the year to June 2002. Thelargest increases are expected for professional

indemnity, public liability and commercialproperty insurance, as these areas are mostaffected by the problem of higher numbersof claims and higher reinsurance costs. Morerecently, the cost of products such as airlineliability insurance have increased and havebeen passed on quickly to consumers. R

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