period, but taken together, the weight of evidence suggested that the best course for monetary policy was to maintain the existing setting for the time being, but to be ready to tighten should signs of a strengthening of price pressures emerge. the june quarter cpi data, available for the august meeting, showed some pick up in inflation. together with a stronger growth outlook, this information led us to expect a somewhat higher path for inflation over the horizon of the coming one to two years. the judgement we reached was that the risk of unnecessarily damaging growth with a modest rise in interest rates was small, whereas the cost of not responding to a deterioration in the outlook for inflation could well, in the longer term, be substantial. on straightforward macroeconomic grounds, therefore, there was a clear case to make an adjustment to monetary policy. as our statement on wednesday of last week set out, the board considered the recent events in international credit markets in coming to our decision. here, mr chairman, it is worth taking a few moments to set out some history. for some years now, many long term observers, market participants and officials have been troubled by very narrow pricing for risk. in other words, it has been easier and cheaper than had been normal in the past for risky borrowers to access funding. investors were prepared to take more risk in pursuit of returns in a world of low global interest rates. somewhere or other, returns were eventually bound to disappoint someone. as it turned out, the problems emerged in the us housing sector. lenders into the so called “ sub prime ” market attempted to keep the pace of business up as the us housing sector slowed during last year. but they could do this only by lowering lending standards. before long, arrears began to rise as some borrowers struggled to meet their commitments. once this deterioration in underlying asset returns had occurred, those with exposures inevitably began to see losses. because this type of lending was via securitised structures sold into global capital markets, losses have been coming to light right around the world. in most cases, the losses are embarrassing rather than fatal for the institution concerned. the exceptions have been where particular funds invested mainly or solely in these types of risky assets, and especially where leverage was involved. several hedge funds have borne large losses, including some in australia. all of this created a climate in july and early august in which investors retreated and pricing of risk started to return to levels that could be regarded as

pace of growth in labour costs overall has remained relatively contained. in thinking about why growth has picked up somewhat more than had been expected, we should not overlook the fact that the global economy has surprised, once again, by its strength. the most recent forecasts for global growth made by the imf were revised upward only a few weeks ago, with growth now thought likely to be over 5 per cent in 2007, close to the 2006 result. the us economy has slowed but greater strength elsewhere has, to date, more than outweighed the us softening. australia ’ s terms of trade have kept rising and stand at a five decade high. this has added about 1½ per cent of gdp to the annual growth in australia ’ s national income over the past couple of years, which is quite an expansionary force. some of the resulting demand spills abroad, but there is also a stimulus to spending on non tradeable goods and services arising from the income gains being experienced. the rise in property prices in western australia is a case in point. it would be imprudent to assume that this trend will continue indefinitely. nonetheless, it has already gone considerably further than most observers anticipated. when we lift our gaze beyond the conventional forecasting horizon, the big picture is that the emergence of potentially very large economies like china and india, at such a rapid pace and with such consistency, is unlike anything we have lived through before. we cannot be confident, therefore, that the cyclical experience of the past few decades is necessarily a reliable guide to how things will develop. in its policy deliberations over several months, the board has weighed conflicting trends. when we were last before you, we were observing an apparent moderation in inflation. we were, as you know, at that time still of the view that there could be a need to tighten monetary policy further at some stage. but having made three adjustments in 2006, we believed that the improving short term trend in inflation afforded us time to watch developments. information that came in over the ensuing period suggested stronger than expected demand in the economy. this meant that the longer term risk of higher inflation was increasing, not diminishing. hence, the likelihood that interest rates would need to be increased at some stage was rising. moderate price and wage outcomes continued, however, for some months, suggesting that, at least temporarily, the supply side of the economy was managing to respond to stronger demand. it was doubtful that this could continue over an extended