Following a decision taken by the Board at its meeting yesterday, the
Bank will be operating in the money market this morning to increase the
cash rate by 25 basis points, to 6.0%. The decision reflects
the Board’s assessment that economic activity remains strong and that
inflation pressures have increased.

Growth of the Australian economy is taking place against the background
of strong international conditions. The world economy is in its fourth
successive year of above-average growth, and official and
private-sector forecasts are that this will continue next year, despite
some moderation in the United States. The general strength of the
global economy has been reflected in further increases in commodity
prices since the start of the year. These increases have been broadly
based and are adding to the growth in Australia’s national income and
spending.

Despite regional differences, most indicators suggest that demand and
output in Australia have strengthened over recent months. A favourable
business climate, strong profitability and high levels of capacity
usage are contributing to rapid growth in investment spending. Even
with moderate growth in household spending, this has underpinned a
solid rate of expansion in domestic demand and a pick-up in employment
over recent months.

Strong demand for finance over the past few months indicates that
households and businesses have continued to find it attractive to
borrow at recently prevailing interest rates. Compression of lending
margins over recent years has contributed to a lowering of borrowing
costs relative to the cash rate. This has meant that although the cash
rate has recently been slightly above its average for the low-inflation
period since 1993, interest rates paid by borrowers have remained below
average.

The growth of demand, against the background of an economy operating
with limited spare capacity, has contributed to increased inflationary
pressures this year, and businesses report that labour market
conditions are tight. Raw materials costs have picked up as a result of
broad-based increases in global commodity prices, and there has been a
more general pick-up in output prices at all stages of production.

These pressures have also been evident in underlying consumer price
inflation. In the June quarter, underlying inflation is estimated to
have picked up to a rate of just under 3%, confirming the
upward drift that had started to become apparent in the previous
quarter. Although the increase in the headline CPI was much larger,
reflecting fuel price increases and a sharp rise in the price of
bananas in the wake of Cyclone Larry, the Board recognises that it is
necessary to abstract from temporary influences in forming its policy
assessments. Overall the Board’s assessment, based on the gradual
increase in underlying inflation this year, and the wider background of
above-average global growth and strong domestic demand, was that
underlying inflation in the period ahead was likely to exceed previous
forecasts.

Given these circumstances, the Board judged that an increase in the
cash rate was warranted in order to contain inflation in the medium
term.

Peter Fray

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