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r901128a_BOA

australia

A Proper Role for Monetary Policy

fraser

They would no doubt argue that to have two objectives is like trying to have your cake and eat it too. I think this is an unreasonable simplification caused by taking the language too literally. An analogy might help here. If I am driving to Canberra, I might say that I wish to get there as quickly as I can, but I do not mean it literally. If my only objective was speed, I would drive recklessly and risk not getting there at all. In reality, of course, there are two objectives - to get there quickly, but also to maintain certain standards of safety along the way. Similarly, monetary policy aims to get results on inflation, but also to avoid excessive costs in terms of lost output, unemployment and business failures along the way. If we pursued one task to the exclusion of the other, the overall result would be unsatisfactory. In practice, no one gives all the weight to inflation and none to the "cycle". No one has argued that interest rates should not have been reduced to some extent during the course of l990. The fact that some lowering of rates was widely seen as necessary can be taken as general acceptance of the proposition that monetary policy cannot sensibly be confined to squeezing out inflation. If that was the only objective, the maximum effect would have been achieved by keeping rates at their earlier peaks (or even raising them further). Last month in Hobart, I talked about monetary policy and the banks, and various other issues. Tonight I want to concentrate on the role of monetary policy. In particular, I want to expand on what I see as its dual roles - to keep downward pressure on inflation, while seeking to avoid excessive swings in economic activity. I said in Hobart that the monetary authorities have "set themselves not one but two tasks - to avoid (in the current downward phase of the cycle) too severe a contraction in domestic activity and, at the same time, to stay in the fight against inflation." I went on to say "I believe it is entirely appropriate - and accords with economic and political realities - for the Reserve Bank (as well as the Government) to fix upon both objectives, even though two balls are harder to keep in the air than one." This seems to me to be a proper, commonsense approach to monetary policy, and one that would be generally endorsed by practitioners in most countries. Some purists, Similarly, it would be unwise to conduct monetary policy only with a view to smoothing the cycle - a shorthand for seeking to avoid excessive economic fluctuations, whatever their source. A couple of decades ago many countries did so but this approach came to grief as inflation rose around the world. Monetary policy everywhere now has price stability as a major objective. If the cycle was the only objective, interest rates would be lower than they are now. To get the balance right, we need to see the effect of monetary policy on the two objectives and how they interact. Although the weight attached to it has varied at different times, smoothing the cycle has been a major focus of monetary policy in recent years. By early l988, for example, it was apparent that spending in the economy was beginning to run too fast and between April l988 and mid l989 short term interest rates were raised progressively by 7 percentage points. For a time these rising rates had little effect in slowing the economy - the fastest rates of demand growth were recorded in the December quarter l988 and the March quarter l989. This situation can be explained in part by the euphoria associated with sharp increases in asset prices and sustained growth in business profits - conditions which encouraged further borrowing, notwithstanding very high interest rates. In a deregulated financial market, such as we now have in Australia, credit cannot be rationed by quantitative means. Instead, it is necessary to change the price of credit, as measured by its real interest rate. As Graph l shows, when the authorities saw that too much use was being made of credit, they raised its price very sharply. Why businesses continued to borrow - and banks to lend - at such historically (and internationally) high real rates of interest remains a puzzle. Rising asset prices - and the associated inflation and tax biases favouring investment in property - are part of the explanation, but only part. Why, we might ask, did borrowers and lenders continue to expect large, on-going increases in asset prices when history would have told them that boom conditions do not last forever? In such a market, no one knows what level interest rates would have to reach to choke off the boom. Prime rates of 20 per cent plus did not work quickly to turn things around. Should we have tried rates of 30 per cent? I think not. Rates as high as that could well have been needed to chop off the borrowing (and lending) excesses but they would have been absolutely devastating for the rest of the economy, including the household sector and the traded-goods sector. That was hardly a price worth paying to prevent some highly geared asset speculators (and their bankers) from going too far. By the middle of l989, high interest rates were starting to bite into cash flow and profit prospects, and these in turn affected asset values. By the beginning of l990, the economy was slowing and asset prices were recording further falls. Monetary policy responded to this new phase of the cycle; in five steps interest rates have fallen 5 percentage points since January. The lower interest rate will ease the strain on cash flows and improve the arithmetic of prospective investment projects. The exchange rate is also one of the transmission channels of monetary policy. Interest rate changes clearly have implications for the exchange rate but, as the events of l990 illustrate, other factors are sometimes more important. Indeed, prior to the most recent reduction in interest rates on l5 October, the about the same against the TWI) than it was in January, before the easing of monetary policy commenced. It was a surprising show of strength by the $A, given both the sharp decline in interest rate differentials (particularly against the Yen - see ) and the steady downward trend in commodity prices - see . It was also an unsustainable degree of strength, in the sense that the $A needed to be lower to help reduce the current account deficit and contain the growth of foreign debt. influence on the economic cycle. This is not the place to canvass particulars of whether or not policy needs to be eased further but a few general observations can be made: the 5 percentage point reduction in short term interest rates since the beginning of l990, together with the l0 per cent depreciation of the $A, amounts to a substantial easing of monetary policy; that easing can be expected, with lags, to have a reviving effect on spending - the extent of the lags will depend on several factors (including confidence levels among consumers and investors) but, provided the world does not slide into deep recession economy should be looking healthier in the second half of 1991; and while we should strive to avoid wide fluctuations in the cycle - and the lost production and other costs that go with them - we have to accept that monetary policy cannot "fine tune" the economy to smooth out all the bumps. There are significant and unavoidable lags in recognising turning points, and in framing and implementing policy measures. In addition, Australia, more than most countries, is subject to frequent external shocks. Regrettably, policy can never fully (or even largely) offset the swings of the cycle. If we try to force monetary policy to do more than Since the end of September, however, the $A has depreciated, in an orderly way, by about 10 per cent against the TWI. Against the $US it has fallen 7 per cent, and against the Yen, 15 per cent. This fall in the value of the $A will also lend some support to demand, through encouragement of exports and import replacement. In summary, and with due allowance for lags, monetary policy clearly has a substantial reminder of how quickly inflation can ratchet up to a higher level and how difficult it is to wind down again: even with modest economic growth in the second half of the l970s, inflation remained stubbornly ingrained at around l0 per cent. Substantial progress was made in l983/84, when the combination of the l982 wage freeze, a slack economy and the Accord brought about a significant step down in inflation. This progress was lost in l985 and l986, when the terms of trade deteriorated and the exchange rate fell sharply, increasing import prices - during the same years, of course, most OECD countries were benefiting from the lower oil and commodity prices. We should have been able to wind back some of this deterioration after l987, with the terms of trade improving and the exchange rate rising but, by then, the economy was growing so fast as to push up prices. More recently, there has been a sharp deceleration in Australia's inflation rate - which is all the more notable for occurring at a time when inflation in almost all OECD countries has moved up. The gap between Australia and the seven major OECD countries is now smaller than it has been for some time, but we cannot take any particular pleasure in the deteriorating performance overseas. Nor should we set our sights on only matching some OECD average inflation rate; we should aim to do better. This is not because lower inflation is a goal in itself but because lower inflation can bring substantial economic and social benefits. I have talked earlier about the benefits of lower inflation - and of the costs of higher inflation. Although the costs are difficult to quantify, persistent inflation of even moderate proportions raises important equity issues. We all know how some people not only protect themselves from the adverse effects of inflation, but actually profit from them. For everyone who benefits, there will be someone who loses, and the losers usually come from the weaker groups in the community. Inflation also harms incentives. Again, we have all seen how people, in harnessing it is capable of, we will be disappointed not only in its counter-cyclical performance, but also in its anti-inflation role. This brings me once more to the topic of inflation, which I am delighted to see featuring so prominently in public discussion of economic affairs. Indeed, there is now the very real prospect of Australia joining the ranks of the low inflation countries. We must not allow this once-in-a-decade opportunity to slip through our fingers. Only when it is clear that inflation is well and truly under control can we look forward to sustainably lower interest rates. We are not yet there - the petrol price rises have still to be absorbed and the December quarter numbers will be less flattering - but we are knocking on the door. shows, Australia held its own with the low inflation countries during the l960s and it is not being fanciful to imagine that we can be in that position again. The dramatic step-up in inflation in the early l970s reflected the boost given to demand by the commodity price boom, as well as the cost-push pressures associated with oil price rises and some unfortunate policy decisions. The same period also serves as a inflation for their own profit, distort investment flows, both in the type of investment undertaken and the time horizon of investment projects. We are up to our ears in office buildings when what we need most is more long term investment in export competing and import replacing industries. shows, the prices received by producers in exporting and importing competing industries, relative to prices in the domestic economy as a whole, have slipped a good deal over recent years, i.e. prices in the non-traded goods sector have risen faster than prices in the traded goods sector. There are many factors at work here but a better investment mix could be expected if domestic inflation were lower. commodity prices) helped to push up the exchange rate, which served to "spill" some of the excess demand into imports and to lower import prices, with favourable effects on inflation. The cost, of course, was the loss of international competitiveness shown in . The more recent fall in the exchange rate will unwind the process to some extent but not enough to restore competitiveness to the levels achieved in l986. Falls in the exchange rate pose dangers for our inflation rate. That is why we have to concentrate on containing inflation, rather than trying to achieve a particular exchange rate in order to improve competitiveness. Greater competitiveness is essential if we are to lower the current account deficit, but this improvement has to come about through keeping the domestic economy running at an even pace and keeping our inflation rate down - not by inflating faster than the rest of the world and attempting to offset this by continuing depreciations. One thing that is very clear is that we cannot improve our competitiveness in a structural sense by pursuing a loose monetary policy. In the short run, monetary policy can influence the exchange rate but over the longer term the main contribution monetary policy can make to international competitiveness is through helping to create a low inflation In terms of international competitiveness, Australia has lost much of its earlier gains over recent years (see ). Again, there are many factors involved, only one of which is the exchange rate. But where does the exchange rate fit into current monetary policy? One consequence of the deregulatory process is that monetary policy no longer works solely through interest rates and bank balance sheets: an important part of the channel now is through the exchange rate. This could be seen clearly in l988 and l989, when higher interest rates (along with higher to be lowered too far now, it would risk having policy too loose when the economy moves into the next upswing. The gains now emerging on inflation have entailed considerable pain and we need to ensure that these gains are not frittered away when the economy picks up again. The authorities are very much alive to these risks. Apart from maintaining a firm hand to avoid such risks, what else can be done to build on the present opportunity to push inflation sharply lower? In essence, we have to find an acceptable and effective way to reduce price expectations. This is the element of inertia that stops prices from falling in response to slower activity; they effectively put a floor under price increases. When people build higher price expectations into their price and wage decisions, it becomes harder to wind inflation down, even after the active forces driving it (such as overheated demand and cost-push pressures) have abated. How do we affect expectations? Some have suggested that the best way is to limit the discretion of the authorities by tying their hands with "targets" of one kind or another - such as a monetary aggregate, or inflation, or a specific exchange rate. The idea is that a "target" - effectively a pre-determined commitment that limits the room for the authorities to manoeuvre - would prevent policy from being diverted by short term considerations. This is also seen as having a favourable effect on price expectations. None of this has much appeal to me: We flirted with monetary targeting in the late l970s and early l980s but, for whatever reasons, it clearly did not deliver lower inflation. There is no point in having a fixed monetary rule if it gives the wrong answer - and the evidence of the l980s everywhere is that there is no holy grail - no simple, golden rule which policy makers can follow in order to avoid inflation. At the end of the day there is no substitute for the exercise of judgment. Whether an inflation target - such as a commitment to achieve a certain rate of environment. Lasting encouragement to producers in the export and import competing sectors will come not from a loose monetary policy pushing down the exchange rate, but from lower inflation and other fundamental changes which encourage saving and investment in internationally competitive areas. Monetary policy, then, has to be concerned with both prices and output. Moreover, as well as trying to keep both balls in the air, policy makers should also allow for the system's bias towards higher, rather than lower, inflation. there is usually a greater readiness on the part of the authorities to respond to a weakening economy than to an economy which is tending to overheat; producers and workers are more ready to raise their prices and wages when demand is strong than they are to lower them when demand is weak; and inflationary expectations are more easily ratcheted up than down. From the point of view of inflation control, these biases probably require policies to be somewhat firmer than they would need to be if the implications for inflation were symmetrical throughout the cycle. At the very least, they require that the authorities not allow cyclical objectives to overwhelm inflation objectives, even when taking short term action to counter excessive swings in activity. In the current context, this means being careful not to chase the economy all the way down, i.e. not pushing interest rates down every time we get news of further weakness in activity and employment. While there is little danger that a lower rate of interest now would cause the economy to immediately get up and run away, the real risks are in the lags and biases referred to earlier: if interest rates were inflation within a set period - would possess sufficient credibility to influence price expectations would depend on a number of factors. As a minimum, it would need to be a government (not just a central bank) target, and be backed by all available policy instruments (not just monetary Tying a country's currency to that of a lowinflation country has succeeded in lowering inflation in several European countries, albeit at some costs in terms of lost output and employment during the transition. This approach, however, works best for groups of countries which have similar productive structures. It would not make sense for Australia, with its particular industrial structure and heavy dependence on certain commodities, to tie its exchange rate to a country (e.g. Japan) with very different structures - it would rule out exchange rate changes when they might well be a critical part of the adjustment to external shocks. If simple rules and "targets" are out, what are the alternatives? Would tough talk quickly change expectations? All the evidence says that this does not work: the authorities have to be tough as well as talk tough. How tough? If we were to run the economy well below capacity for a prolonged period, this would probably do the job - but the costs would be unacceptably high. This leaves us with the current strategy. In this approach, the authorities emphasise their commitment to reduce inflation in the medium term and back this by firm, credible but non-doctrinaire actions. Credibility is critical in determining the costs of reducing price expectations: the public need to be convinced that inflation can be lowered without putting the economy on the rack. Credibility, it has been said, is "difficult to acquire, easy to lose and never to be taken for The present strategy is credible. It is delivering results, as the numbers over the past year or so (and not just the September quarter bond yields suggests that price expectations are coming down, while the wage/tax tradeoff announced last week is an example of a response which can consolidate and build on these expectations. We are now well placed to really push price expectations lower. Apart from uncertainties over oil prices, there are no active forces driving up inflation at the moment: economic activity is not putting pressure on prices and the earlier imbalance between the wage and profit shares of national income has been largely corrected, i.e. the profits share has been restored. We might well say, in effect: "let's divide up the national income 'cake' as we do now, so that we all have the same share in real terms. But let's do it in an environment of price stability rather than one in which prices are rising at 6 per cent." That, no doubt, sounds rather fanciful - but the thought is no longer as fantastic as it would have seemed a short time ago. The burden of this talk is that the proper role for monetary policy goes beyond the simple rule: "when the economy is running too fast, tighten; when it is too slow, ease interest rates". Monetary policy can have a powerful role during the cycle, particularly in slowing an overheated economy. But it can make a lasting contribution when it helps to lower inflation. When the economy is running too fast, there is no conflict between the anti-inflation and anti-cyclical objectives of monetary policy. It is probably now, when the economy has slowed, that there is greater potential for getting the balance wrong. The temptation is to respond to the immediate problem - the cycle - and ignore the longer term task of getting inflation down. Much, clearly, hinges on getting the balance right over the next year.

r911003a_BOA

australia

fraser

Today I wish to talk about real interest rates. I do so mainly from an historical perspective, without intending to imply anything specific about the movement of interest rates over the months ahead. Nor am I intending to promote real interest rates as a new yardstick for the conduct of monetary policy; they are much too complex for that purpose. In fact, the whole topic raises a number of somewhat technical issues which we have been ruminating on in the Reserve Bank for some time. The simple message is that high real interest rates are part of the costs of combating high inflation; reducing inflation and inflationary expectations will reduce those costs. Viewed over long periods, the real rate of interest has been quite low on average. Studies in the United States, for example, put the average real interest rate since 1900 at about per cent. In Australia, the bond rate deflated by the CPI also averaged about per cent over this period. Actuaries usually assume a real rate of return on a diversified portfolio of about 4 per cent; this is consistent with rates of 1 to 2 per cent for fixed-interest securities, and rates somewhat above 4 per cent for riskier assets, such as equities and property. Two points to note about these long-term averages are: First, there is considerable variation in them. Graph 1 shows real long-term interest rates in Australia averaged over five-year periods since the beginning of the century. The variability is obvious. Real interest rates actually peaked in the Depression, when the price level was falling, and were most negative during the short-lived Korean War boom. I will say more about the recent - and more relevant - decades shortly. * Secondly, there are measurement problems involved in calculating real interest rates. In a purist approach, nominal interest rates would be deflated by inflationary expectations. These expectations, however, cannot be observed directly and we must use a proxy for them. The conventional approach is to deflate nominal rates by the rate of actual inflation over the preceding 12 months. This provides a reasonable approximation for short-term interest rates, given that inflation in the period immediately ahead is generally seen as an extrapolation of the recent past. It is less applicable, however, for longer-term rates; one alternative approach is to use the actual inflation rates recorded over the life of the asset. These points limit the scope for formulating firm rules about real interest rates for monetary policy purposes. Carefully interpreted, however, they can provide some useful information on economic behaviour. Real interest rates have varied widely over recent decades. Calculated in the conventional manner - that is, deflating the nominal interest rate by the rate of inflation over the previous in the 1960s, real interest rates were close to the long-term average of about per cent; in the 1970s, they fell sharply, and were negative for much of the decade; in the 1980s, they rose to very high levels. These observations apply broadly whether we look at short-term interest rates or long-term interest rates. show that the average experience of G7 countries has many similarities to that of Many factors influence real interest rates. The most obvious are demand and supply factors. Real rates could be expected to rise, for example, in periods when business investment surges, or savings fall sharply, or large budget deficits emerge. Those factors no doubt contribute to variations in real interest rates. But other influences are also involved. The thrust of this talk is that the interaction of monetary policy, inflation and inflationary expectations also exerts a major influence on real interest rates. This influence probably accounts for more of the variability in real interest rates than raw supply and demand factors, although in practice they all interact. The inflation factor, however, helps to explain why, at different times, people have lent at negative real interest rates and have been prepared to borrow at very high real interest rates. The two main props to this story are inflationary expectations and inflation/tax distortions. Each is addressed in turn. Why did people lend funds at very low - and often negative - real interest rates in the the benefit of hindsight, it seems surprising that even professional money managers should have bought bonds and debentures, and made fixed-rate mortgage loans during this period. We should not allow ourselves any feelings of superiority just because we have the benefit of hindsight. The fact is that many investors in the 1970s were the victims of an unanticipated rise in inflation. Having become accustomed to low inflation per cent over the decade), investors could not foresee the sharp jump in the early 1970s, with inflation spiralling to 18 per cent in 1974. Such increases were outside their range of experience. By 1976 they were still in a difficult position. By then they had a few years of very high inflation behind them, but what were they to expect for the future? Should they assume inflation would continue at its recent exceptionally rapid rate, or could they expect it to be brought under control and quickly return to the levels experienced in the 1960s? Many, apparently, thought the latter. One thing we have learnt over the years is that it takes a long time for inflationary expectations - and then business strategies - to adjust to changing circumstances. Two examples will illustrate this: subscriptions flooded in. The issue had to be closed early for fear that it would cause problems for the savings banks and building societies. Investors thought the per cent interest rate on offer was too good to be true - not just the mums and dads, but also many big players who were subscribing in units of $100,000. Inflation at the time was higher than per cent but the general expectation seemed to be that there would be a quick return to the more familiar rates of the 1960s. In the event, inflation declined only slowly and the real yield of ASB No.1 was pretty miserable - only 0.6 per cent per annum if held to maturity. (ii) Life offices in the 1970s engaged in a lot of long-term, fixed-interest lending, and frequently provided developers of commercial buildings or housing estates with mortgage finance. In the 1970s the developers did very well out of this borrowing as inflation pushed up property prices. The lenders, however, did very badly, with many loans in their portfolio earning interest rates much lower than they could earn through new lending. By the 1980s the big institutions had learnt their lesson and stopped providing fixed-term credit; in some cases they (and several finance companies) switched to providing equity through joint property ventures - financing, in retrospect, they should perhaps have been doing in the 1970s! As I say, these examples illustrate that: even professional investors can lose money through unanticipated changes in the rate of inflation; and, more importantly, it can take a long time for people to, firstly, adjust their inflationary expectations and, secondly, adjust their business strategies. Of course, other factors were at work during the 1970s. In particular, interest rate ceilings on bank deposits and the fact that the Government set the yields on its own debt introduced important rigidities. Nominal interest rates were slow to adjust upwards because such adjustments required politically unpopular government decisions. This slowness exacerbated inflationary pressures, although over time some adjustments were made. Without these ceilings, nominal interest rates would probably have risen more quickly, although we still would have seen negative real interest rates (as we did in most OECD countries, some of which had looser controls on interest rates than Australia). Interest rate ceilings, however, should not have prevented bigger players from making a positive real rate of return on their savings. Those who made $100,000 subscriptions to ASB No. 1 had choices beyond government bonds and bank deposits, including the purchase of equities or property. That many did not pursue those latter courses suggests that they expected to get a reasonable return from ASBs. Similarly, professional funds managers did not have to make mortgage loans or buy debentures, but many did so because they too were slow to accept the change in the inflationary environment. however, inflationary expectations adjusted upwards. This was kicked along throughout the world by further large increases in oil prices in 1979. For some countries, including the United States, inflation was higher in the early 1980s than it had been in the mid 1970s. By 1982, when the first bond tender was held in Australia, yields reached 16.6 per cent, which were high in real terms, however measured. Bond yields remained high for the rest of the decade, being generally within a 12 to 15 per cent range. Inflation by this time had declined well below its rate in the 1970s, averaging 7 to 8 per cent over the period in question. Yet real rates of interest remained high in the 1980s, whether calculated on a conventional or ex post basis. Why were real rates so high in the 1980s, when inflation itself was on a downward trend? The answer in part is in the mirror image of the 1970s experience. After that decade of very high inflation, in Australia and abroad, inflationary expectations adjusted upwards. (Inflation fell briefly to around 5 per cent in 1984, following a recession and a wage freeze, but inflationary expectations did not adjust In this climate of entrenched high inflationary expectations, it became difficult to find investors who were prepared to lend long term at fixed rates. The smell of burnt fingers in the 1970s lingered on. Even lenders whose inflationary expectations had begun to turn downwards still demanded a risk premium as insurance against a resurgence in inflation. High interest rates had to be offered to coax lenders out of the woodwork. In contrast to the 1970s, funds managers and others were now more interested in buying equities and property. While high inflationary expectations reduced the willingness to lend long term at fixed rates, they whetted the appetite for borrowing. Many assumed inflation would continue to whittle away the real value of their borrowings, and at the same time push up the value of acquired real assets. Borrowers were also very aware that they could write off the full borrowing costs against current income for tax purposes, even though the inflation component was implicitly a repayment of capital. In these ways, entrenched high inflationary expectations contributed to the asset price boom in the second half of the 1980s. They also help to explain the conundrum that very strong demand for credit could persist notwithstanding some very high real interest rates. After a time, of course, that demand could not be sustained, and high real interest rates eventually won out. But we were all surprised by how far real interest rates had to be pushed up, and how long they had to be kept there, to check the asset price boom and associated heavy demand for borrowed funds. The mechanics of a conventional tax system, as exists in all major countries, also contribute to high real interest rates in an inflation environment. This is because both the nominal and real component of interest are deductible for tax purposes. Consequently, the higher the inflation component of nominal interest rates, the higher the nominal rates have to be raised to achieve any given after-tax real interest rates. To the extent that it is the latter that matters for many borrowing decisions, the achievement of a given contractionary policy stance will require a higher before-tax real interest rate, the higher is the rate of inflation. In Australia in the late 1980s, there was little choice but to persevere with high real interest rates if inflation was to be tackled seriously. No one needs to be reminded that the effects of those high real interest rates have been far-reaching. Their effects, moreover, are not confined to domestic borrowing decisions. If high inflation countries have higher real interest rates as a consequence, then real exchange rates might also be pushed up as foreign investors are attracted by the high real interest rates. High inflation economies might actually go through periods of upward pressure on their exchange rates. We have seen this in a number of countries, including Australia in recent times. The United late eighties provide further examples, while Mechanism entrants, such as Spain, have exhibited the same characteristic. I observed earlier that most countries experienced generally low or negative real rates in the 1970s and generally high, positive rates in the 1980s. It seems clear that when the largely unanticipated lift in inflation occurred in the 1970s, the countries that experienced the highest rates of inflation tended to have the most negative real interest rates (Graphs 5 and 6). In other words, inflationary expectations Real interest rates in the 1990s has been a popular topic for discussion around the world. Much of the discussion has focussed on an anticipated world capital shortage which reflects projected demands for funds from eastern Europe, the Soviet Union and the Middle East, piled on top of the on-going and increasing demands from traditional developed and developing countries. Every decade, however, generates massive demands for capital, which are bound to outstrip the funds available. In the 1990s, as in earlier decades, the rationing will ultimately occur in the market place; proposals which do not generate acceptable rates of return will not go ahead (or, if they do, they do so at the expense of other, more productive projects). Our hunch is that it will be some years yet before projects in eastern Europe or the Soviet Union can jump the required hurdle rates of return in such numbers as to impose major additional demands on world capital markets. Australia must still compete with all comers for its share of the world's scarce capital; how it does that is largely outside the scope of today's talk. What happens to real interest rates in Australia in the 1990s, however, will depend had furthest to adjust and, while they were adjusting, real interest rates (as measured) were often significantly negative. Again, the 1980s were a mirror image of the 1970s. Although most countries achieved lower inflation rates in the 1980s than in the 1970s, they did so with varying degrees of success. Those countries that were least successful in reducing inflation tended to have higher real interest rates at the short end than at the short end that monetary policy directly does its work and monetary policy has had to work harder in the higher inflation countries. Australia, not surprisingly, is one of the observations in the top right portion of the scatter diagrams shown in Graphs 7 and 8. importantly on what happens to inflation and inflationary expectations. Given time, inflation gets incorporated into the structure of nominal interest rates, and lower inflation therefore allows lower nominal rates. The question is whether the relationship is one for one, or whether real interest rates are also affected. There is no straightforward answer to this question: for one thing, the stage of the cycle and the outlook for economic activity have to be taken into account, as well as inflation. The odds are, however, that if we succeed in lowering inflation, and creating expectations that it will stay down for the foreseeable future, then there is likely to be scope for real interest rates (as conventionally measured) also to be lower. As shown in Graph 2, short-term real rates have been declining in Australia over recent years although they remain relatively high. As the economy slowed and inflationary pressures receded, nominal interest rates were lowered while retaining the anti-inflationary stance of monetary policy. They were lowered further than the fall in inflation so that real interest rates also fell - which was appropriate, given the phase of the cycle. Even so, monetary policy has been generally tougher in the downward phase of this cycle than in previous cycles. The payoff has been sharply lower inflation and a lower level of inflationary expectations. The costs have been substantial in terms of lost production and unemployment, although those costs cannot be all attributed to tight monetary policy. There is, however, no alternative to the present monetary policy strategy of continuing to bear down on inflation while remaining alert to the need to encourage economic recovery. The timing of any further reductions in official interest rates will depend, as with earlier reductions, on developments in both inflation and economic activity. The latter, which has been weaker than generally expected, is forecast to recover moderately during 1991/92. Recent falls in interest rates will help the recovery but monetary policy can best help in delivering sustained economic growth by maintaining a low-inflationary environment. Given such an environment and further structural changes of the kinds that have been occurring over the past five years, we will be well placed to reap that economic growth. Fortunately, we have been doing much better on inflation than was generally expected and further gains are in prospect over the quarters ahead. This improved performance is gradually permeating the inflationary expectations of consumers, businesses, unions and financial markets. As we have seen in earlier decades, however, it can take some time for expectations about future inflation to be firmed up and incorporated into decision making. While inflationary expectations in Australia have been declining over the past year or so, strong residual fears remain in some quarters that inflation will bounce back. That is why lenders continue to build in a risk premium. It is also why the Reserve Bank - while prepared to initiate responsible reductions in interest rates ahead of the market - has been nonetheless cautious about lowering rates until there is evidence that inflationary expectations are continuing to decline. We continue to believe that we now have the opportunity to get inflation back to 1960s rates. We have said repeatedly that Australians should not fatalistically accept that we are a high inflation/high interest rate country. Indeed, over most of this century, Australia had one of the better inflation records of any country. If inflationary expectations can be moved to a permanently low level, we can have lower nominal interest rates, lower real interest rates, a more productive mix of investment and, in the longer run, stronger growth and higher real income.

r920314a_BOA

australia

fraser

I welcome this opportunity to talk about prospects for banks in Australia, a topic of possibly more than usual interest to many of you following the Government's recent decisions to further open up banking in this country. In part, of course, the prospects for banks are linked to the prospects for the economy generally. A strong economy will help to promote strong banks, just as a healthy banking system can help to foster a robust economy. What then are the prospects for Australia? In broad terms, we have several good reasons to be confident about Australia's economic prospects in the 1990s. One is that we are located in the most vibrant part of the world. In the 1980s, Asian economies grew about twice as fast as OECD economies. Some Asian countries may not be able to sustain the very high rates they recorded last decade, partly because their labour forces are forecast to grow less rapidly. Against that, the generally high savings and investment ratios in those countries, and their capacity to adopt new technologies, will ensure further exceptionally strong economic performances in the 1990s. Australia, increasingly, will be part of this performance. Already more than half of our total exports go to Asia; Singapore alone now takes more of our exports than the United Kingdom. We have opportunities to do great things in Asia but it is more than a five minute job. A second set of reasons is Australia's own resource and other endowments. Australia is one of literally only a handful of countries that can boast large food surpluses, an abundance of energy and other resources, modern infrastructure, a skilled and educated population, democratic institutions and a hospitable living environment. Thirdly, Australians are at last coming to terms with the challenges and opportunities inherent in their geographic location and resource endowments. This, for me, is the main reason for optimism about our economic future. Subtle changes in attitudes have permeated most sections of the community during the past decade. They are reflected in the growing internationalisation of the Australian economy, with a sharper focus on Asia; in greater competitiveness, including in manufactured exports; in genuine efforts to raise productivity through co-operative workplace negotiations; and in a general clamour for speedier micro-economic reforms. We still have detractors - those who hanker for old ways and those afflicted with an however, and notwithstanding the real shortcomings which remain, Australians generally are facing up to the need for on-going changes and are confidently making the necessary adaptations. We sell ourselves short if we fail to acknowledge how much has been accomplished, and how much momentum exists to push on and complete the job. Properly nurtured, these changes in attitudes will deliver a better economic future for Australia. Certainly, it is in our power to prove the pessimists wrong. The effects of many of these changes have been masked by the recession but they will become more apparent as recovery gets underway. That is now occurring, albeit sporadically. The housing and farm sectors are improving while stocks have been reduced to the point where future increases in spending will be reflected quickly in increases in production. The Government's recent economic package, together with earlier reductions in interest rates, will help to sustain a gradual recovery throughout 1992 - its gradualness being mainly a consequence of a slack world economy. As Australia's recovery gets underway, we expect to see on-going improvements in productivity and competitiveness, as well as the maintenance of relatively low inflation (about which I will say more later). Economic recovery, and the steadier property values that can be expected to accompany it, will provide a welcome boost to the banks. Although conditions remain difficult for many banks in Australia, there are some signs that the worst may be over. Non-performing loans, for example, appear to have flattened out at about 5 per cent of total banking assets in the second half of 1991. Several foreign banks have also issued improved results for 1991 compared with the preceding year. Even with a favourable macro-economic environment, however, the next few years will not be plain sailing for the banks: for many the debris from the late 1980s will take a long time to clear away. Fortunately, the capital position of banks in Australia is quite healthy. At the end of 1991, the consolidated capital ratio of the banking sector was around 10.4 per cent. This was 1 percentage point above the corresponding ratio in June 1990 and 2 percentage points above the minimum capital ratio of 8 per cent. All authorised banks operating in Australia have capital ratios in excess of that minimum; each of the four major banks has a ratio above 10 per cent. The general environment for banks in Australia seems certain to remain highly competitive. The banking landscape itself is already crowded and some new players could soon appear on the scene. As a group, the source of competition for banks is altering but it is unlikely to become any less intense. Over the past two decades, the main competitors were institutions engaged in "banking-type" business, such as building societies, merchant banks and finance companies. They were essentially off-shoots of regulation and their importance has declined following deregulation. In the years ahead, the main competitors are likely to be institutions linking businesses directly to the capital markets, and superannuation funds. In the 1980s, the assets of banks and superannuation funds both grew quickly. In the latter case, the main cause of the strong growth was not the inflow of new money, but the exceptionally high rates of return which funds were able to earn. This was largely a function of the coincidence of high real interest rates and high asset price inflation over much of the period - more so, perhaps, than the exercise of exceptional investment skills as such. In the 1990s, superannuation fund asset growth is likely to be more dependent on the inflow of new money (and the application of exceptional investment skills). Given the Government's encouragement of superannuation, large inflows are now on the cards. Banks, not surprisingly, are very interested in expanding their involvement in superannuation business. Given these various competitive pressures, the banks' already low profit margins are likely to remain under threat for some time to come. should banks practitioners, you know better than I what is required but the major focus clearly has to be on ways to restore profitability and rates of return, with all that that means for pricing services, cutting costs, changing bank structures, diversifying into other activities and so on. A good starting point would be to remember well the lessons so painfully learned in recent years. From our perspective, we would expect to see: more focus on profitability and rates of return, rather than on the size of the balance sheet or its rate of growth; a closer involvement of boards in strategic decisions and risk management of banks and their subsidiaries; more rigorous risk assessment and control procedures; less fixation with quick profits, which in the past was reflected, inter alia, in the way some institutions accounted for profits (relying excessively on up-front fees without amortisation) and in the way incentive packages for lending officers were structured; some rethinking of earlier attitudes towards off-shore expansion, particularly while banks' management and capital resources are already stretched; more vigilance by auditors; and greater efforts to raise the standing of banks in the community (through, for example, improvements in prudential standards, customer services and openness with the public). As guardian of the integrity of the banking system, the Reserve Bank has an important role in all this. We want to maintain the special status of banks but we do not want to create an exclusive club with fixed membership. That is an important reason for freeing up the entry of foreign banks. We want to see a competitive, efficient banking and financial system: that is the best guarantee of delivering quality, affordable services to customers. At the same time, we accept that, if it is working properly, competition will exert pressure on banks' profit margins and make it more difficult for less efficient banks to survive. Our task is to produce an acceptable balance between the benefits and risks of competition; between management's freedom of choice and stability of the system; between the rigid discipline of the market place and the flexibility of practical decision making. In general, our approach has been to encourage banks to behave prudently (through capital adequacy requirements, limits on large credit exposures and such devices), without recourse to heavy handed regulation or interference in individual banking decisions. We try to ensure that our requirements do not add excessively to the pressures on capital already occurring as a result of competitive forces. That will remain our approach, although certain procedures are being tightened in the light of experience - without, I trust, over-reacting to recent shortcomings. To this end, efforts are being made to upgrade the quality of information on banks' risks, problem loans and control systems, and to develop some in-house capacity to undertake limited on-site investigations. As noted earlier, banks are moving into the provision of life insurance, superannuation and other funds management services. As this diversification continues, banks will increasingly become part of financial conglomerates, with banks being the holding companies. trend towards conglomerates" raises some important supervisory issues for the Reserve Bank, particularly in protecting depositors with banks. These issues have to do with the way problems can flow from one part of a financial group to another, and with possible conflicts of interest among the various parts. We seek to minimise these problems by requiring funds management activities to be clearly separate from the banks themselves, if the banks are to avoid the need to hold capital against the relevant assets. Funds management activities must, for example, be conducted in subsidiaries, not by the banks themselves. There are also restrictions on the financial support which a bank may provide, as well as requirements for making clear to investors the separateness of the funds management vehicle from the bank. Similar principles apply in situations where banks form loose "alliance" arrangements with other financial institutions. As you know, the Prime Minister's the way for more foreign banks to operate in foreign banks will have the option to operate as branches, provided their business is restricted to wholesale activities; but any retail banking activities will be required to be conducted through locally incorporated subsidiaries; and the existing exemption which allows certain non-bank institutions to label themselves as "merchant banks" will be removed. The Reserve Bank also issued a statement on 26 February which outlined the general principles to be followed in implementing these new arrangements. Some particular issues are currently being considered and a further statement will be issued at the end of April. One obviously major issue to be resolved is the distinction between wholesale and retail banking operations. This is important because the Reserve Bank's powers under the Banking Act to assume management of a bank in the interests of depositors are unlikely to be enforceable in the case of a branch of a foreign bank. That is why retail banking activities will be required to be conducted through locally incorporated subsidiaries. Once the details of this and other issues are clarified, steps can be taken to draft amendments to the Banking Act to permit branch operations. At the same time, prospective applicants will also be better placed to consider their position, to do their sums, to consult with their home country supervisors and so on. Even in a crowded market a place will always exist for new entrants who can provide some additional competition or some niche service. It has been suggested, for example, that there is currently rather less competition in the small and medium sized business market than there is in the corporate area. As well as being able to satisfy our prudential requirements and being subject to appropriate supervision in the home country, we will expect foreign banks to make a worthwhile contribution to banking services in Australia, and not merely add to the number of banks. This will be an important consideration in assessing applications. We will not be looking for applicants to promise a full range of banking services, but we will expect them to plan a significant presence in Australia, and to add some depth and competition to local markets, especially in wholesale banking. In practice, any significant increase in competition at the retail level is more likely to come through a different route, such as the acquisition of an existing retail operation by a large foreign bank or the amalgamation of existing retail banks. One further point about foreign bank entry. Banks have always followed trade flows and as Australia's two-way commerce with the Asian region expands, so too will the scope for banking services. Our hope is that there will be opportunities for Australian banks to increase their activities in neighbouring countries on terms similar to those we are extending to their banks in Australia. I want to end with some observations on banking in a low inflationary environment. Sustained low inflation in the 1990s will be a new experience for many bankers and others in Australia. Strategies that were appropriate in an inflationary environment will need to be rethought. That process should be occurring already, and preparations made for this new environment. But first, can we be confident that inflation will stay down? How can we be sure it won't bounce back once the recession ends? The main reason is that the recent fall in inflation - to an underlying rate of 3 to per cent - reflects structural as well as cyclical factors. There are several points: Inflationary expectations, which remained stubbornly high through the 1970s and most of the 1980s, have fallen sharply. Whereas expectations of inflation fell to a low of 14 per cent in the mid-1970s recession and were around 10 per cent at their low point during the 1982/83 recession, the comparable figure now is 4 per cent. These lower expectations are working their way through the economy, including to areas previously dominated by expectations of continuing high inflation, such as the property market. People have been reminded that property prices and rents go down as well as up, and this is being reflected in their behaviour - gearing up for property acquisition, for example, has lost its earlier appeal. Bond yields, on the other hand, remain stubbornly high. Investors in this market appear to be slow to adjust to the changed inflationary outlook, just as they were slow to adjust to the rise in inflation in the 1970s. (ii) The period of sustained wage restraint predates the recession and this experience provides grounds for believing that Accord-type processes will help to contain inflation as recovery proceeds. The centralised component of wage increases has become a progressively smaller part of the total over recent years, thereby easing earlier concerns that national wage increases would put a floor under future inflation. The understanding reached between the Government and the ACTU that wage rises in Australia be consistent with holding inflation to that in major trading partners will further underpin the contribution which wages policy is making to relative price stability. (iii) Businesses in all sectors of the economy are now acutely aware of the need to control costs and raise productivity. One obvious sign of this has been the paring of staff numbers, a process which began before the recession set in. The short term consequences are clearly adverse but large gains in productivity can be expected as production picks up; these too will help to hold down price increases. It is usual for inflation to stay relatively low in the first year or two of recovery. This tendency will be reinforced on this occasion by the factors just mentioned, as well as by the determination of the authorities to hold on to the hard won gains on inflation - a determination, incidentally, which not all groups in the community exhibited when the going got tough. What will sustained lower inflation mean for the banks? This is another question best answered by the banks themselves. As noted earlier, they should be thinking through the implications and preparing for them. To jog that process along, we have tried to identify some possible implications. The main conclusion seems to be that bank balance sheets are likely to grow more slowly in the 1990s than they did in the 1980s. This is partly because of lower inflation but more importantly because the earlier unsustainably rapid growth will be wound back as a result of changes in the behaviour of borrowers and lenders in a low inflation world. The main components of these changes in behaviour include: On the borrowing side, lower inflation is likely to reduce the demand for debt. Less emphasis will be placed on purchasing existing assets for capital gains, and more on new income generating investments. Investors in property could start to view their investments in a manner similar to holders of a fixed interest investment i.e. to concentrate on the yield and allow for little in the way of capital gain. (ii) Lower inflation is likely to involve more equity and less debt than formerly. It will reduce the taxation attractions of debt and not erode debt servicing costs to the extent that high inflation does. Negative gearing should go out of favour. (iii) In a low inflation environment, investors are likely to take a longer term perspective. High inflation, and associated high interest rates bias investment decisions against long-lived projects because of the high discount rates applied to future returns. With low inflation, this bias should disappear. If investors think more in terms of long-lived projects, they may seek more long term funding. (iv) Low inflation should make interest bearing assets, such as bank deposits , more attractive to the majority of investors. This is because it will reduce the distortion caused by the interaction between inflation and the tax system. High inflation makes potential depositors very conscious of the tax bite because tax is levied on total interest income, including that part which compensates depositors for the erosion of the real value of their asset. Over time, as inflation falls, interest bearing assets such as bank deposits are likely to gain in attractiveness, relative to equity-type instruments and inflation hedges. (v) Sustained lower inflation can be expected to change the shape of the yield curve. In Australia, we have come to think of the downward sloping yield curve as the norm, and banks have developed cash management-type products to cater for those wishing to capitalise on high short term interest rates. Although downward sloping yield curves have dominated the landscape in Australia in the deregulated era, positive sloped yield curves have been the norm in a number of other countries, particularly those with relatively low A move to mainly upward sloping yield curves should increase the attractiveness of longer term deposits, relative to cash management-type accounts. (vi) If businesses are looking for more longer term fixed financing, they may, of course, go direct to the market for new issues of debt (particularly as lenders will also be looking for more longer term fixed interest assets). This could possibly lead to a revived domestic corporate bond market, with institutions such as superannuation funds holding a lot of the private long term bonds. Banks should per cent think about how they might respond to such competition; their experience in the bill market should be helpful in this regard. The implications for banking of sustained low inflation might appear rather speculative at this time but it is important to look ahead. It is always easier to simply react to issues when they arise, or to wait to see how others in the industry are behaving. As we have seen in the recent past, this is not good enough; the changes resulting from deregulation caught many in the industry napping, and there was a tendency to hold collectively to various nostrums that proved to be unwise. It is also easy to fall back on the view that the 1990s will be another decade of rapid changes, many of which are unforeseeable. This is no doubt correct, but we all know that those who best anticipate changes and react promptly and sensibly will perform best.

r920529a_BOA

australia

fraser

It is a pleasure to have this opportunity to address such an influential gathering. I am particularly pleased that Hans Tietmeyer and many other central bank colleagues are able to be here. I take this opportunity to tell you something about exchange rate movements in Australia over recent years and the Reserve Bank's role in that. "There is no sphere of human thought in which it is easier for a man to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange." I hope what I have to say goes beyond the superficial. I hope too that I shall manage to avoid the many perils that can beset central bankers who talk publicly about exchange rates. The foreign exchange market in Australia has developed rapidly in the period since the foreign exchange turnover now averages about US$30 billion a day, a little below the peak of 40 per cent of the turnover is against the Australian dollar. At the time of the 1989 BIS survey, the Australian foreign exchange market was the eighth largest in the world and the Australian dollar was the sixth most heavily traded currency. This relative prominence reflects several factors, including a time zone which spans the closure of New York and the opening of Tokyo, and well developed domestic markets in a resource rich economy, which provide good opportunities for international investors seeking to diversify their portfolios. The initial post-float years saw a good deal of volatility in the foreign exchange market and we had our share of cowboys. The market has since matured and volatility has declined. For some time the Australian dollar has been steadier against the US dollar than the experience of the main European currencies and the yen. In trade-weighted terms, volatility over recent years has been similar to that of other major currencies. Unlike foreign exchange traders, policy makers and others generally welcome reductions in volatility. We expect the Australian foreign exchange market to develop further and will be encouraging it to do so. The exchange rate plays an important role in the economy's adjustment to terms of trade and other external "shocks". The deeper and more mature the market becomes, the greater confidence we can all have in the exchange rate movements it produces. Economists usually think of the exchange rate as a price which keeps our balance with the rest of the world in some kind of equilibrium. Traditionally, the current account was put at the centre of thinking about the exchange rate, which was seen as being determined in markets for exports and imports. This view had its heyday in the days of fixed exchange rates and widespread restrictions on the international flow of capital. In these days of much greater capital mobility the relationship between the current account and the exchange rate is more complicated. In the short run, however, exchange rates are determined in financial markets, essentially by the portfolio decisions of international investors. This does not mean that the exchange rate can be permanently decoupled from its current account-based fundamentals; at the end of the day the fundamentals will always assert themselves. But it does mean that, in a world of mobile capital, countries might be able to sustain large current account deficits for longer than they could in the past, provided international investors remain confident about the conduct of domestic economic policies. It may also mean that views about what is a sustainable current account, and hence the exchange rate, will be more variable than in the past. Certainly, the importance of expectations in determining exchange rates has been heightened; portfolio managers will always try to anticipate changes in asset prices, political developments and many other variables in addition to the "fundamentals". This framework has been described as a "rope and anchor" theory of the exchange rate. The anchor is that, in the long run, the exchange rate has to move to a level consistent with a sustainable current account balance, and financial markets should be able to acquire some feel for that, however imprecisely. The rope which stops the exchange rate from drifting too far from that point is the pressure of market forces: significant departures of exchange rates from their expected long-run future values should not persist, because they would be wound in by profitable speculation. It is a neat analogy but two points should be emphasised: First, the anchor - the long-run equilibrium exchange rate - itself shifts in response to changes in the terms of trade and productivity trends (which means that market participants need to continually reassess their views about Secondly, the rope - the speculative process of the market - will provide a somewhat flimsy link to the anchor. Far from having their eyes firmly fixed on the long run, many investors are notoriously shortsighted and can be swept away by the psychology of the market. Against that background, a useful starting point in seeking to understand changes in the exchange rate is to distinguish between nominal and real exchange rates. It is intuitively obvious that if a country inflates much faster than its trading partners, its exchange rate will at some point have to depreciate to reflect this. Exchange rate movements can therefore be divided into two elements - one part which reflects inflation rate differentials, and one which reflects other, more fundamental factors. The focus here is on the second component: what determines the real exchange rate? For countries like Australia, changes in terms of trade are clearly important. Falls in the terms of trade, for example, reduce export income and put downward pressure on the exchange rate. Where falls in the terms of trade are perceived to be permanent and cause the real exchange rate to fall, this will set off an adjustment process which operates to discourage imports and encourage exports. In practice, fine judgments are involved in determining whether a change in the terms of trade is permanent or temporary. For present purposes, however, the point to note is that countries like Australia with volatile terms of trade can expect to have significant swings in their real exchange rates. productivity changes will also influence the real exchange rate in a fundamental - if very long term - way. A country which achieves an increase in relative productivity, for example, will benefit by seeing its real exchange rate appreciate over time, thereby enabling it to buy imports more cheaply. An important shorter term influence on the real exchange rate is the interest rate differential with other countries. Relatively high interest rates attract foreign capital, which puts upward pressure on the exchange rate. Of course, those higher interest rates will not be attractive to foreign investors if they are expected to be offset by currency depreciations. Consequently, and as a shorthand measure, the focus is usually on inflation adjusted (or real ) interest differentials. All this is necessarily imprecise in practice but the basic idea is simple enough: if a country maintains relatively high real interest rates, it will tend to have a higher real exchange rate. So much for the main factors which influence the exchange rate in theory: how has the $A behaved in practice? And how well has the market performed in delivering the "right" exchange rate - that rate which will help to keep the economy in reasonable internal and external balance? Perhaps the most constant factor over the past two decades has been the difference between Australia's inflation rate and that of As shown in Graph 1, when allowance is made for our past relatively high inflation rate, the fall in the real exchange rate is much less than in the nominal rate. On this measure, much of the potential improvement in competitiveness from falls in the nominal exchange rate in the past has been whittled away by a relatively poor performance on inflation. Even so, the real exchange rate has been subject to some large fluctuations. Changes in the terms of trade clearly have been important here, as can be seen from Graph 2. In particular, the sharp fall in the terms of trade in 1985 and 1986 - and the equally sharp recovery over 1987 and 1988 - were broadly mirrored by the real exchange rate. Not all this movement in the real rate, however, can be attributed to the terms of trade. (The fall in the terms of trade in the mid-1980s was about 15 per cent while the fall in the real TWI was about 30 per cent.) our trading partners. For most of the 1970s and 1980s, Australia's inflation exceeded the average of our trading partners. And the nominal exchange rate has followed a downward trend to compensate for this (see was worth US$1.12; today it is worth about index, the Australian dollar has fallen from 100 in 1970 to about 57 today. Another reason for the very large fall in the exchange rate in 1985 and 1986 was the decidedly bearish sentiment towards the $A at that time, in part reflecting a re-assessment of Australia's external position. General concerns as to whether the economy was on a sustainable path were crystallised in the then The role of interest rates is more difficult to disentangle, if only because there are various measures to consider (ie short versus long, nominal versus real). Changes in short term rates as a result of monetary policy actions can influence the exchange rate through their effects on both rates of return and expectations. At the longer end, interest rates are determined in the market and the linkages can run both ways. At times the exchange rate has moved up in response to large capital inflows pursuing attractive bond yields; at other times bond yields have risen on the back of a weakening exchange rate and expectations of higher inflation (as in January this year). In short, the relationship between interest rates and the exchange rate is two-way and causality can vary from episode to episode. Some observers have been surprised by the underlying strength of the $A since early 1990, given the substantial reductions in nominal interest rates which have occurred. The differentials in real interest rates, however, have narrowed by lesser amounts and in those terms there is less to be surprised about (see Summarising all this, the exchange rate over the post-float period seems to have responded in roughly the way the theory would suggest. Inflation differentials and terms of trade changes can explain much of what has happened, but interest rate differentials also have been important. At times the market has developed a life of its own, driven by expectations and sentiments which have sometimes caused the rate to overshoot (in both directions). What role does the exchange rate play in setting monetary policy in Australia? One of the main reasons for floating the $A in 1983 was to regain control over monetary policy after a period when foreign capital flows had, at times, frustrated attempts to exercise monetary control. Floating the currency has avoided the automatic importation of foreign inflation in the manner that had occurred in the first half of the 1970s (and, even more dramatically, during the Internationally, the thinking on links between monetary policy and exchange rates seems to be evolving in two directions. Some countries, like Australia, see virtue in retaining exchange rate flexibility, and using monetary policy to home in directly on domestic economic objectives. Other countries prefer to have a basically fixed exchange rate as an anchor for their inflation objective, and address their monetary policies to keeping their exchange rates stable. Most western European countries now have either a formal link to the Deutschemark through the strong informal link which keeps their exchange rates steady against ERM currencies. Their reasons for adopting this approach include the desire to promote European economic integration, to avoid exchange rate volatility, and to import German-style monetary discipline. Why does Australia not adopt a similar The short answer is that, given Australia's economic structure, the costs would be too great. As a country susceptible to highly volatile terms of trade, we need greater exchange rate flexibility. With a largely fixed exchange rate, a sharp fall in the terms of trade would be highly contractionary. The automatic exchange rate depreciation that tends to occur with a floating rate buffers those contractionary effects to some extent. vulnerable to changes in terms of trade, along composition of each country's imports differs substantially from the composition of its exports, opening the way for wide swings in relative prices to occur. (The mix of Australia's imports and exports is, of course, very different from that of Japan; a major change in oil prices, for example, would have opposite implications for the two countries.) The terms of trade of the ERM countries, on the other hand, tend to move in the same direction. So the broad strategy for Australia is clear enough. Whereas the ERM countries use the exchange rate as an anchor for their inflation objectives, and have to absorb the (relatively small) swings in their terms of trade, I believe Australia is better served by allowing the exchange rate to respond to the changes in the terms of trade and focussing monetary policy directly on containing inflation and supporting economic adjustment. With the exchange rate free to move, monetary policy can be set primarily having regard to where inflation and domestic activity are heading. Australia has not, since the float, subordinated monetary policy to hitting any exchange rate target. To have done so would have negated one of the main reasons for floating the currency. There have been episodes when the exchange rate has been a major consideration in setting monetary policy, most notably in 1985 and 1986. Even then, however, the main objective was to restrain the fall in the exchange rate so as to limit the inflationary consequences of excessive depreciation, not to target any particular exchange rate. Although not an objective in determining monetary policy in Australia, the exchange rate is affected by monetary policy settings. I noted earlier that real interest differentials can influence the exchange rate. Rising real interest rates throughout 1988 and 1989 no doubt influenced the exchange rate, although they were aimed squarely at hosing down an overheated domestic economy. This side effect of firm monetary policies on the exchange rate was criticised in the late 1980s on the grounds that the brunt of the adjustment was being borne by the traded goods sector. The exchange rate response to tight monetary policies, however, can be an important channel through which monetary policy operates: a higher exchange rate encourages an increased flow of imports which adds to the domestic supply of goods and restrains inflation. Even if it was possible to cut off this channel, it would not be desirable to do so. An extension of this criticism is the view that monetary policy should be adjusted to engineer a currency depreciation. This view is usually based on a belief that the current account deficit is unsustainably high or that we are accumulating an unsustainable foreign debt burden. Proponents of this view see a lower exchange rate as the panacea which would deliver faster growth and remove the external constraint. The American journalist H.L. Mencken might well have had this sort of argument in mind when he said that, for every complex problem, there is a solution that is neat, plausible and wrong. Putting to one side the issue of the Bank's ability to deliver any particular exchange rate target, this approach begs the question of whether Australia's real exchange rate is overvalued. There can be no definitive answer to this question but the framework outlined earlier is relevant. The exchange rate might be judged "about right" if it is consistent with reasonable prospects for achieving medium term internal and external balance - that is, with an acceptable rate of economic growth and a sustainable current account position. While precise answers are not possible, several points can be made to pessimists who assert that our present path is not sustainable: First, exports of goods and services have been remarkably strong over recent years, including manufacturing exports (see here but much of the growth is explained by new and concerted efforts to pursue export markets, and by the good fortune to be close to the fastest growing region of the world. Secondly, the interest burden on Australia's overseas borrowings has fallen substantially as interest rates have come down. This has been reinforced by the recent switch away from debt to equity in capital flows. Thirdly, Australian exporters can expect to reap substantial productivity benefits in the years ahead from recent and on-going structural changes in the labour market, the transport sector and elsewhere. Fourthly, the relative stability of the $A, notwithstanding the large reductions in official interest rates since early 1990, suggests that international investors retain their confidence that Australia is on a sustainable path. While these trends continue, it is difficult to substantiate the view that the current exchange rate is inconsistent with a sustainable adjustment path for the Australian economy. Certainly to manipulate the exchange rate through artificially low interest rates in search of improved competitiveness would be a fool's errand. Monetary policy is bringing inflation under control and this is its main contribution to improving competitiveness. The underlying inflation rate now is less than 3 per cent and, always subject to the proviso that appropriate policies are followed, we expect inflation to remain at low levels as the recovery gathers momentum. Competitiveness, moreover, is not only just about the "real" exchange rate. It depends on many other fundamental factors, mostly "micro-economic" in nature. Changes in these areas, which require actions by businesses and unions as well as governments, will do more to improve Australia's competitiveness than any monetary policy actions to force a lower nominal exchange rate. In normal circumstances, the market can be relied upon to deliver broadly the "right" exchange rate. But the market is not infallible. As we all know, it does have a tendency on occasions to over-react to news, and to be driven by expectations and sentiments which are not always well based. On occasions, the Reserve Bank will reach a different view from the market. This brings me to make a few observations on Reserve Bank intervention. Usually when the Bank intervenes, its aim is to restore order in market conditions. This might involve adding some two-way business when the market is tending to be very onesided, or dampening volatile movements in the rate. The aim is not to resist changes, but to try to ensure that adjustments are well based and reasonably orderly. Sharp changes in the exchange rate - for whatever reason - are not good for the economy. The market can become very unsettled at times, and particularly when major policy announcements are imminent and participants are trying to guess future policy changes. This was the case last January when, following changes in political leadership, the market took a highly pessimistic view of the Government's future attitude to fiscal policy and the exchange rate. Many players in the market were drawing inferences and making pronouncements which could not be substantiated on the basis of available information. In this situation, the Bank judged that the market was misreading the signs and should not be allowed to dictate the exchange rate outcome. At the time the exchange rate already had fallen by nearly 10 per cent in trade-weighted terms from its September 1991 peak; a further large fall would have threatened the progress being made on inflation and ruled out any additional monetary policy easings to support a still fragile recovery. The Bank backed its judgment with some solid intervention. In the event, sentiment in the market improved quickly once the Government's policies were clarified. The Bank then ceased its intervention. Only very occasionally has the Bank intervened to try to move the exchange rate towards what it judged to be a more sustainable level. These occasions have been rare because we can rarely be confident that the market has lost touch with the fundamentals. But three such occasions were 1991 when we judged that the exchange rate was overly strong, having regard to some of the "fundamentals". On the two latter occasions the intervention was co-ordinated with easings of monetary policy and supported by official comments that made clear our intentions. These efforts produced some useful, if limited, corrections. We have "tested" the strength of market pressures on many occasions and we will undoubtedly do so again. There may also be times when - as in January this year - we think the market has got it wrong, and some intervention will again be considered appropriate. We operate in the market both to meet the needs of our clients - notably the Commonwealth Government - and on our own account. The foreign currency needs of clients provide a natural base on which the Bank can structure its market operations and, in practice, operations on behalf of clients and those on our own account tend to merge. As already indicated, we operate on both sides of the market, although the emphasis shifts from time to time. In the early post-float period, there were few market operations and the Bank met the Government's foreign currency needs from its foreign exchange reserves. This changed rapidly in 1985 and 1986 when, with the $A under severe downward pressure, substantial sales of foreign currency were made. overwhelmingly a net buyer of foreign buying was only partly offset by the heavy sales of foreign currency in January 1992. To the extent that the Bank's operations have been an influence on the exchange rate over this period, they have been to resist upward pressures on the $A. This is contrary to a frequently heard complaint that the Bank has been acting to hold up the currency. After its heavy selling of foreign currency last January, some people asserted that the taxpayers' money. Such views are, in every sense, wrong. The Bank's balance sheet comprises Australian dollar assets and foreign currency assets. When the Bank intervenes, it is simply replacing assets denominated in one currency for assets denominated in another; its balance sheet is unchanged. Rather than costing the taxpayers money, the Bank's foreign exchange operations have produced significant profits. We estimate that the Bank's intervention has generated realised trading profits over the post-float period as a valuation profits attributable to the Australian dollar's depreciation over the period. These profits are incidental to the intervention which the Bank conducts in pursuit of its general policy objectives. I mention them only because they are one test of whether intervention has helped to stabilise the exchange rate. Our experience suggests it has. A central bank which is successful in reducing exchange rate volatility would, on average, be buying when the rate was low and selling when the rate was high. Such a strategy would, over time, also be profitable. At the very least, it suggests that the Bank has not sought to defend the indefensible.

r920817a_BOA

australia

fraser

As a long-time fan of Don Sanders, I am delighted to be participating in this tribute to the Reserve Bank Board, and on the Commonwealth Bank Board, after he was appointed Managing Director of the latter taken a more than passing interest in his commercial banking activities. Our close contact over recent years has brought home to me just how good a choice Don was to head up the Commonwealth Bank. His cautious but firm hand was precisely what the Commonwealth Bank needed at that point in its history. Whenever you debate an issue with Don you are always uncomfortably aware that he has come to his position after deep deliberation, and will defend it stoutly. His intellectual rigour and integrity, and his effective management style, lay behind the exceptionally solid performance of the Commonwealth Bank under his leadership. The two perspectives of my talk are not , as the title might possibly suggest, the rules orientated and discretionary approaches to monetary policy. they are perspectives on monetary policy from the vantage points of someone who has been a practitioner in both the Treasury and the Bank. They are personal observations; I know some of my colleagues - past and current - will not share a number of them. The title carries an implication that there are two different perspectives. I am acutely aware of certain suggestions that there should be two different perspectives. Some critics who professed to see nothing politically sinister about my own appointment, for example, nonetheless saw something intrinsically wrong in a Secretary to the Treasury being appointed Governor of the That seems a peculiarly Australian notion. Many central bankers around the world have Treasury backgrounds, including the current Governors of central banks in France, the The President-elect of the Bundesbank is also governorship is rotated between the Bank of and the of (Curiously, the traffic is all one-way; commercial banking, it seems, is a popular destination with many ex-central bankers.) Unless you believe in leopards changing their spots, international practice suggests that the perspectives are not intrinsically - or irreconcilably - different. By virtue of their ex officio positions on the Board of the Reserve Bank, and their Department's legitimate involvement in their overseas counterparts) do acquire a familiarity with the objectives and operations of central banks. They also acquire an intimate understanding of wider economic policy and political decision making processes which, potentially, could enhance a central bank's effectiveness: despite occasional suggestions to the contrary, no central bank operates in a political vacuum. That, however, is to anticipate some observations I will come to shortly. The immediate point is simply that appointments such as my own should be judged on the basis of the all-round talents of the individuals concerned, not on the presumption that the perspectives are - or should be - so different as to be irreconcilable. Few people span the full term of Don Sanders' involvement in monetary matters. My talk will focus mainly on the past decade. This is the period I know best, being privileged to have served as Treasury Secretary for five years, and as Governor for the past three years: in this audience I must capitalise on any comparative advantage I might have! But it does mean passing over some apparently epic contests between Governors and Secretaries. By my time, legendary spectacles of a couple of giants doing battle before the crowd had given way to relatively tame discussions among "equals". Be that as it may, I count myself fortunate to have had first class working relationships with Bob Johnston, Treasury, and again with Chris Higgins and Tony Cole when I moved to the other side of the table. Another reason for concentrating on the past decade is that monetary policy instruments - and the associated institutional arrangements - in that period were quite different from earlier periods. Until the early 1980s, monetary policy was exercised through a variety of instruments - such as interest rate ceilings, the setting of bond rates, variations in the Statutory Reserve Deposit Ratio, lending controls, monetary targets, pegged exchange rates - and the Treasurer and Treasury were very much involved in their use. "Deregulation" and other changes have seen these controls abandoned to the point where short term interest rates are now virtually the only monetary policy instrument. With these changes has come much greater autonomy for the Bank. In particular, decision making has shifted from committees in Canberra to financial markets which are influenced by the Bank's operations. The introduction of bond tenders to fully fund budget deficits in 1982, and the floating of the currency in 1983, were two especially notable changes. Another sign of this shift was that the M3 projection, the watchword for monetary policy changes between 1976 and 1984 and reserved for promulgation in the Treasurer's budget speeches, was dropped in Given such changes, it is only to be expected that the perspectives on monetary policy in the recent period would be very different - from both vantage points - from what they were in earlier periods. But what about differences between the Bank and the Treasury within particular periods, and especially the past decade? There are obviously some differences. To begin with, the Bank is established under an Act of Parliament, with a Board of Directors, its own charter, specific procedures for consultation and the resolution of possible disputes with the Treasurer, and so on. This Act affords a degree of clarity and comfort to Governors that is not available to Secretaries. The legal separateness of the Bank is enhanced by its distance from Canberra. Close physical proximity to the foreign exchange and domestic money markets in which the Bank operates is vital, and I see in the Bank an intimacy with the markets that would be impossible for a Canberra-based Treasury to replicate even if it tried to - which it sensibly never has. The Bank is closer to the markets but Treasury is closer to Parliament House. It is sometimes inferred from this that Treasury is more susceptible to political pressures, and more preoccupied with day-to-day events to the detriment of longer run trends, than a ("properly independent") central bank would be. In my experience, such inferences are incorrect; senior officers of the Treasury, almost to a fault, have always called the shots as they have seen them, whatever the political pressures. And the "longer run", or a "medium term framework", has been an integral part of Treasury thinking for as long as I can remember. Quite a lot has been written lately about the the enjoys a high degree of independence and I recall that others in a position to know the facts have rejected all assertions that the Bank has been pressured into taking "political" decisions. It puzzles me that some people seem to equate independence with conflict, consultation with subservience, and (at least until recently) concern for growth with wimpishness. In the institutional setting that has existed since the mid 1980s, monetary policy is a much more "hands on" experience for the Bank than it could ever be for the Treasury. With that goes a heightened awareness that monetary policy actions and utterances by the Bank are being shadowed more closely by the markets, the media and others than is the case with the Treasury. The need for extra care in this situation is obvious, the more so when it has to be accommodated with an equally compelling need for the Bank to say more about monetary policy issues in the interests of raising public understanding of them. As important as some of these differences are, they say little about perspectives of monetary policy. Before exploring that issue in the context of the past decade, I want to look briefly at some changes in perspectives on the role of monetary policy over a longer period. These serve to remind us how policies and their intellectual underpinnings change; they suggest also that the main differences in perspectives reflect not so much institutional factors as new sets of circumstances and frameworks of thought. At the beginning of the 1960s, when Don was settling back into the Department of the Bank after some study at the LSE and a year at the Bank of England, and I had just joined the Public Service, stabilising the cycle was the economic fashion. Inflation was a concern, even in this Keynesian world, and to combat it policy relied heavily on demand management. Fiscal policy was seen by most economists as the preferred instrument for that purpose. Monetary policy was seen as an adjunct to fiscal policy, but doubts remained about its potency; in "liquidity traps", for example, easing monetary policy could be like "pushing on a piece of string". There was no presumption that monetary policy might have a comparative advantage in controlling inflation. Both monetary policy and fiscal policy influenced demand and, then, inflation. Some confidence existed that the cycle could be controlled and that if inflation reared its head, it could be handled by a short sharp shock of the 1960/61 variety. The view that fiscal policy played the dominant role in affecting economic activity and controlling inflation was reflected by Heinz Arndt at the time. Writing in 1960 on the control of inflation through fiscal policy, "If aggregate spending is excessive, there will be inflation ... one way in which governments can control the level of aggregate spending is through budget policy ..." But he was careful to note the importance also of other policies: "The efficacy of fiscal policy depends in considerable measure on the simultaneous application of disinflationary monetary and wages policy. Unless monetary restraints are effective, much of the impact of fiscal policy on consumption may be dissipated through increased resort to consumer credit." The Keynesian framework of policy was a framework for both unemployment and inflation. to the intellectual underpinning of such frameworks usually come not from an abstract rethinking of the theory, but from the arrival of some inconvenient facts which cannot be explained in terms of the old theory. The inconvenient facts which arrived in the early 1970s were the conjunction of high inflation and high unemployment. Inflation was not simply a matter of the economy growing too fast: prices could rise even if there was slack in the economy. This problem was widespread, with inflation rising sharply in major OECD countries from the beginning of the 1970s revive the role of monetary policy and elevate it from just another instrument for influencing aggregate demand to a more central and specialised role in controlling inflation. In leading the revival of the old Quantity Theory, Friedman emphasised that money and prices were closely linked, and that increases in the money supply would lead mainly to higher prices, with no long term increase in real activity. This provided a much sharper focus on what caused prices to rise. It had the policy implication that governments can and should control the money supply in order to avoid inflation; in its extreme form, it implied that monetary policy should be put on auto pilot. Australia did not go that far but a form of monetary targeting was introduced in 1976. A close link with fiscal policy remained, however, because the budget position fed directly into money formation, which was at the heart of the monetary analysis of the time. This and the sale of government bonds to the non-bank public were seen as central to monetary policy. In Statement No. 2 in the "The Budget is clearly a central policy instrument, both in its own right and in its contribution to the achievement of the objectives of monetary policy ... unless the growth of monetary aggregates can be reduced consistently over a run of years, there can be no real prospect of winding back the rate of inflation." And a little further on: "Appropriate fiscal and monetary policies are twin imperatives for reducing less than wholehearted endorsement of monetarism appears to have been shared by the Bank. Responding to the monetarist debate in the Campbell Committee context in mid 1982, Don "Some of you may find anything short of wholehearted embrace of a monetarist rule disappointing; what I see as real The emergence of significantly higher inflation and the traumas of the first OPEC oil price shock undermined the demand orientated Keynesian framework and cleared the way for a different strand of theory to emerge - one which had its origins in the classical idea of "money neutrality". It was to complexities should not be read as antipathy to monetarism and all its works. The philosophy is fundamental to efforts to come to grips with inflation. But it can be unwise to rely too heavily on a monetarist policy." Committee did not get more closely wedded to these (monetarist) philosophies. I do not think that a monetary rule can tame the authorities .... We practitioners have always felt that fiscal outcomes, as well as money, matter." By the mid 1980s, even the cautious endorsement which most central banks around the world had given to monetarism - what Charles Goodhart has called "pragmatic monetarism" - was being inconvenienced by the facts. To be useful for policy,a stable relationship between money and prices was a critical pre-requisite; this did not prove to be the case in many countries, including was abandoned in early 1985. As Treasury noted in Statement No. 2 later that year: "The analytical integrity of simple monetary targeting rests on the existence of a stable relationship between the chosen aggregate and the ultimate policy objectives. That is no longer the case at The breakdown is illustrated in Graph 2. Others in this audience are better equipped to discuss Treasury and Bank perspectives on monetary policy over the past thirty years. I suspect, however, that while the perspectives changed over time, there was a good deal of common ground between the two institutions at any particular point in time. That is, their views were shaped primarily by changing circumstances and intellectual frameworks, not by their particular vantage points; as the world changed and old views were found wanting, the "mainstream" view changed in both institutions. Certainly, in the period since the mid 1980s, a large degree of unanimity has existed between Canberra and Sydney on the role and objectives of monetary policy. If there was a difference in perspective in this latter period, it was a preference on the part of the Bank for relatively more of the burden of adjustment to be borne by fiscal policy and, from the Treasury side, a preference for monetary policy to shoulder relatively more of the load. Some of this flavour is contained in Don Sanders' comments to the Campbell Committee which I quoted earlier, and it percolated through some of the advice going forward to the Government from the Bank and Treasury during this period. It is perhaps inherent in every institution to prefer that the more unpalatable medicine be administered by another. Of greater policy significance around this time was the emergence of a fairly common view that fiscal policy should be seen more as a vehicle for medium term structural change of the public sector than as an instrument for blown out to 7 per cent of GDP, and that in itself had limited the room to use fiscal policy for counter-cyclical purposes. The primary objective of the new emphasis was to reduce the structural deficit and the size of the public sector over time, mainly through restraint on government expenditures. It was in keeping with the prevailing international orthodoxy. But one consequence was to push more of the burden of inflation control and counter-cyclical stabilisation onto monetary policy. We all recognise the limitations of macro fine-tuning but policy makers cannot tune all their instruments to just the long run. With the benefit of hindsight, it might be argued that the reluctance to use fiscal policy more vigorously for counter-cyclical purposes in both the upswing and downswing phases of the recent cycle had the effect of over -burdening monetary policy. In contrast to the "stagflation" of the 1970s, the 1980s saw long periods of lower inflation and stronger growth. Australia shared in this improved but variable performance. Australia, for example, recorded more sustained growth in employment in the 1980s than any other OECD country, but generally higher inflation. I believe there was also much greater attention to "social reforms" in Australia during this period than was embodied in, for example, Reaganomics or Thatcherism. (One's view of the relative merits of these different thrusts depends ultimately, of course, on one's view of the world more generally.) The 1980s were challenging years for monetary policy. episode which illustrates this was the easing of monetary policy in 1987, which has been credited by some people with causing the boom at the end of the decade. In hindsight, it can be argued that the easing went too far, and so made some contribution to the boom. But the story is more complicated than that. First, some easing was required: interest rates were very 1987 those levels could no longer be justified, given that activity had plateaued, inflation had peaked and the earlier weakness of the exchange rate had been reversed. Secondly, international and domestic conditions outside the influence of monetary policy were such that activity was bound to accelerate. The strong world economy saw Australia's terms of trade rise by about 25 per cent from the low point in 1986 and such rises have always been expansionary in the past (and inflationary, although on this occasion - see Graph 4 - inflation continued to edge down, in contrast to what was occurring in most countries). Domestically, a higher profit share (facilitated by wage restraint), and a more competitive exchange rate, were associated with a very bullish trend in business confidence and investment. In short, monetary policy contributed to but did not cause the boom. There are, of course, other episodes, the essence of which will be familiar to members of this audience. Critics have argued, for example, that policy should not have been tightened as much as it was in 1988/89; that policy should have been tightened earlier, before the upswing gathered too much momentum; and, after the inevitable recession, that policy should have been eased sooner and faster. I mention these criticisms not to debate their merits: again with the benefit of hindsight, some mistakes were obviously made, although at the time I recall few people arguing that the tightening in 1988/89 had gone too far, and even fewer suggesting that the monetary easings which commenced in January 1990 should have been started earlier or pushed harder. What these and other episodes serve to indicate is that business cycles have a momentum of their own, and that other factors besides monetary policy bear upon booms, recessions, recoveries and inflation. I have talked mainly about monetary policy in the context of inflation, with growth in activity and employment attracting less attention. This accords broadly with the priorities which, I believe, central banks and Treasuries traditionally assign to these objectives. Indeed, in my observation, those priorities are ingrained in the cultures of both the Reserve Bank and the Treasury (and of their counterparts in most other countries). There is an important if subtle point here. It is that more attention should be paid to growth, and to sustaining that with low inflation, not that less attention should be paid to inflation. In a world of limited natural constituencies for low inflation, central banks and Treasuries will be obliged to always give a high priority to inflation. But a broader focus (together with better forecasts!) would help to achieve a better balance of the risks inherent in policy adjustments. I trust those comments can be made without arousing suspicions of being or going soft on inflation. It should be obvious from the performance of monetary policy over recent years that there is no basis for such suspicions. Australia now has one of the lowest rates of inflation in the world. Inflation has come down faster than everyone expected, but it is not just the recession, or a fluke, that has caused it to decline. Policy has been important, and the costs substantial. Price expectations, which are now seen as occupying a central role in the inflationary process, have been cracked; given this, together with continued policy vigilance, there is no reason why the current underlying inflation rate of 2 to 3 per cent cannot be sustained. In the 1980s, it was common for economists to assign specialised roles to particular policy instruments, and to attach priority rankings to inflation, growth and other objectives. Life would be a lot easier for policy advisers if it was as simple as that! Reality, in my view, requires a broader view than that, including greater acceptance of the following two propositions: monetary policy on its own will not deliver sustained low inflation in Australia; and growth and jobs, as well as inflation, are important objectives. Practitioners generally take some comfort from having a full case of policy instruments to draw upon, whether the problem is inflation, growth, jobs or whatever. demonstrates that the accessibility and effectiveness of particular instruments will vary with the circumstances of individual situations, including the phase of the business and budget cycles. Monetary policy today is more focused on inflation control - that is where its comparative advantage is seen to lie - but that does not mean we have a single objective. Monetary policy cannot ignore activity and the cycle, especially if (as seems likely) fiscal policy must maintain a predominantly medium term horizon for some time to come. We now have a more precise view of the role of fiscal and monetary policy in relation to inflation than was current in the 1960s. Few people today would see fiscal policy as the critical policy instrument in controlling inflation. That said, the thrust of the earlier analysis still seems to be correct:that excess demand can be an important cause of inflation and all macro policy instruments should be used to combat that problem when it occurs. But controlling inflation at least cost also requires judicious recourse to other available policy instruments. Tariff reductions, better transport, and practically everything that comes under the tag of micro reform has to be included here. So does the Accord, which I believe has been a substantial contributor to the low rate of inflation we now see in Australia: the Accord processes are not perfect but that is the nature of compromise and human affairs generally. It is a pragmatic approach but I see nothing wrong in following what is most likely to work in the real world. In my view, careful co-ordination of all policy instruments is more likely to deliver sustained lower inflation at acceptable cost in Australia than is, for example, relying on monetary policy to sustain a low inflation target. inflation has come down and unemployment has risen, more emphasis has come, understandably, to be placed on growth and jobs. How should the authorities respond? One response is to say that we have never had a single-minded fixation with price stability. That, clearly, has been the situation in recent years. In each of the thirteen announced reductions in cash rates since the Government and the Bank) have acknowledged the importance of trends in both inflation and activity in those decisions. It is not as if there is any great mystery about how to bring about low or even zero inflation; the more relevant question is how to achieve a sustainable balance between low inflation and high productivity growth. How can we put policy content into this? Monetary policy cannot, by itself, awaken the animal spirits which drive business investment. Nor can it, with any precision, keep them in check when they are running fast. What policy can do is to lean against these forces during the cycle, and over the medium term help to set the framework within which businesses will make decisions conducive to growth and employment. Price stability is one important element of this framework, as it facilitates sensible and rational investment decisions. At the same time, while it might be inconvenient to some, the fact has to be recognised that low inflation is not an end in itself and will not, in itself, be sufficient to ensure growth and bring down unemployment. There are many other elements in the framework, including those which come under the general rubric of micro reform. It is worth remembering that the good pace of growth between 1983 and 1990 followed action to bring the budget deficit and real wages back into kilter; those changes contributed to the business confidence which drove the growth (in its later stages, too It is an old dilemma, but it needs to be resolved afresh in its current setting; we do not want the 1990s to become a decade of low inflation and low growth.

r930331a_BOA

australia

fraser

I have been looking forward to this opportunity to speak to ABE. For one thing, business economists tend to be practical and pragmatic people who are interested in policies which actually work, rather than theoretical or ideological prescriptions. Perhaps this is because they have to 'sell' their advice to their boards and clients, and bear a measure of responsibility for the quality of that product. In these respects, they are akin to practical central bankers! With the election settled, now is also an opportune time to revisit some aspects of the Reserve Bank's monetary policy role. Some views of this role became rather foggy in the hothouse political atmosphere of the recent past. Demisting might make the path of monetary policy easier for business economists (and others) to follow in the years ahead. First, a few comments on the economy. At around 11 per cent, unemployment is understandably the main focus of current discussion. The magnitude of that problem reflects the conjunction of unusually strong cyclical and structural forces. After contracting in 1990/91, the economy has been growing at a modest 2 to 3 per cent, which is not fast enough to reduce unemployment. The effects of the recession have been compounded by longer-term structural changes in the labour market. To help sustain profits, and to become more competitive, businesses everywhere have been vigorously cutting their costs - and especially their labour costs. This cost cutting, together with associated efforts to raise productivity, has real pluses for the economy longer term, but it involves immediate job losses. As we get more perspective on the economic history of the late 1980s and early 1990s, we may find that the record is better than it appears from the current perspective, close to the low point in the cycle. Certainly, many structural and attitudinal changes have occurred which augur well for Australia's future prosperity. These include: microeconomic reforms, extending across the public and private sectors, and penetrating the product, capital and labour markets. The emergence of a more competitive economy consequent upon Australia's increasing integration with the outside world - import volumes increased from 15 per cent of GDP in 1986 to over 18 per cent in 1992, while export volumes rose from 15 per cent to almost 20 per cent. This increased focus on export markets is no passing fashion, to be dropped when domestic demand picks up: it reflects a fundamental change of attitude towards exporting, particularly to the fast growing Asian economies. Inflation and inflationary expectations have fallen to low levels. The 'headline' rate of 0.3 per cent in the past year is among the lowest in the world, while the underlying rate of around 2 per cent matches that of the traditionally low inflation countries. In these (and other) ways, the economic structure and mindset of the nation are changing. The benefits of these changes will become more apparent as the recovery accelerates, as will the opportunities they 'Whoever exploits structural trends is almost certain to succeed.' The two main constraints on faster growth at present are slack business investment and the global recession. As a share of GDP, business investment is at its lowest level in decades, depressed by surplus capacity (including empty office space), asset price falls and debt burdens. With time, these negatives will fade and more businesses will start expanding and investing again. Recoveries traditionally have been primed by higher commodity prices and export demand but that external stimulus has been missing on this occasion. Time, too, will lift that constraint. OECD countries as a bloc are forecast to grow a little faster in 1993 - perhaps by about 2 per cent, compared with around per cent last year. Faster growth in the United States should offset continuing weakness in Japan and Germany. Fortunately for Australia, the sustained rapid growth of most of the Asian economies (other than Japan) is cushioning the effects of the global recession - these countries now account for about one third of our total exports. Australia's growth rate should pick up gradually during the course of 1993. It will be aided by the fiscal stimulus now in the pipeline, and by the recent depreciation of the $A which, in TWI terms, is about 12 per cent below its we have been doing better than our competitors in the inflation stakes, the fall would be a couple of percentage points more than this.) I expect the economy to be growing at an annual rate of about 4 per cent by the end of 1993. Growth of at least that order is needed over a sustained period to provide jobs for all those people who want them. Jobless growth is inadequate growth. A good blend of economic policies is important. Most policies have both short and long-term effects which can pull in different directions. Ideally, policies at this time should address both the short-term cyclical problem of excess capacity and enhance the longer-term growth potential of the economy. I want to talk about some of the issues involved here from the perspective of a central banker - whose primary focus is, of course, monetary policy. Like central banks everywhere, the Reserve Bank attaches a high priority to price stability. Our role as guardians of low inflation is important in part because there is no strong, natural lobby for it in Australia. The high inflation rates of earlier years were lamented widely, but our re-entry to the low inflation club has not brought out large numbers of cheering fans. Hopefully, more support will develop in time as, for example, low inflation is seen to assist businesses to make sound investment decisions in more competitive export sectors; as workers see the creation of new and more sustainable jobs; and as savers come to appreciate that while low inflation means lower interest earnings it also means greater protection of their savings from the insidious tax that high inflation is. The appropriate degree of price stability to aim for is a matter of judgment. My own view is that if the rate of inflation in underlying terms could be held to an average of 2 to 3 per cent over a period of years, that would be a good outcome. Such a rate would be unlikely to materially affect business and consumer decisions, and it would avoid the unnecessary costs entailed in pursuing a lower rate. Achieving and maintaining low inflation does involve some costs. This is true of most structural changes - including, for example, lower tariffs and increases in competition more generally; wage restraint; and changes in taxes and other fiscal measures. And it is true of monetary policy, which plays the crucial role of anchoring prices and price expectations in the medium term. Changes in interest rates can have immediate 'announcement' effects, including via the exchange rate, but monetary policy works to reduce inflation mainly through its lagged effect on domestic demand. By increasing the amount of slack in the economy, monetary policy affects the behaviour of price and wage setters and in that way impacts on inflation and inflationary expectations. It follows from this that monetary policy has implications for activity as well as prices, and that central banks should have regard to both. Most do, although not always as explicitly as in the case of the Reserve Bank of Australia. Over the past three years, monetary policy has been exercised with an eye to both inflation and activity. Interest rates have been eased progressively on the back of signs that inflation and inflationary expectations were falling, and that activity and employment were slowing. It is true that over this period the signs in respect of both objectives were pointing in the same direction, i.e. in favour of progressive easings. Nonetheless, attention did remain focussed on both objectives: if the concern had been about activity levels only, for example, monetary policy may well have been eased less cautiously. The exchange rate was not a dominant consideration in monetary policy deliberations during most of this period, although it has assumed more prominence in recent months. Again, this reflects a concern for both objectives: a further sharp depreciation of the $A, coming on top of the earlier falls, would have posed risks for inflation and, through its effects on general confidence levels, for activity also. In simple terms, monetary policy decisions reflect judgments about how best to sustain reasonable price stability without unreasonably constraining activity. These judgments have regard to the circumstances at the time - the extent to which inflation is out of control, for example, or the jobs situation is deteriorating. Earlier in the cycle, the task was to steer a course that would deliver lower inflation while minimising the inevitable costs in terms of output and employment. The task now is to hold the gains on inflation while releasing the brake on activity. To assess the extent to which monetary policy is acting as a brake on the economy requires a careful monitoring of a large number of activity and financial indicators. In practice, policy making is more complex than this. Inflation and activity are buffeted constantly by 'shocks' which push the economy off track; the indicators often give conflicting signals; and monetary policy operates imprecisely and with lags. Retaining some room to manoeuvre in the implementation of monetary policy is therefore important. One lesson that has been hammered home to me over the years is that policy flexibility is the best defence against shocks of various kinds (including major forecasting errors!). It is a simple lesson but, in economics as in other fields, the simple lessons are often the last to be learned. Partly for this reason, I am rather wary of inflation targets. A case for targets can be made where inflation is out of control and no credible anti-inflation policy is in place. In those circumstances, a target which the authorities were seen to be totally committed to could help to establish credibility and thereby push down price expectations. Even in these circumstances, however, the evidence suggests that price expectations are shifted more by actions than by words. To my knowledge, no country has reduced its inflation by incantation, rather than by creating some slack in the economy. My reading of the evidence is that Australia reduced inflation at least as effectively (in terms of the trade-off between inflation and lost output) as countries like New Zealand, which have an inflation target. (I note in passing that inflation was also reduced about as effectively as in the celebrated 'Volcker disinflation' in the An inflation target of the narrow '0 to 2 per cent' variety would, I believe, do us more harm than good. In particular, such targets are apt to bias policy responses to shocks which impinge on prices. Such shocks are probably best absorbed by changes in both prices and activity but if the authorities are bound to a narrow inflation target then virtually all of the shock has to impact on activity. We are often reminded that activity cannot be fine-tuned. Fine-tuning prices is at least as difficult and attempts to do so are likely to adversely affect other macro-economic goals. Much has been said about Reserve Bank 'independence' over the past few years and, more recently, about the 'accountability'. A high degree of independence and insulation from day-to-day political pressures is important for a central bank. It is a way of reducing the risks that monetary policy might be misused for short-term political purposes. That is why central bank independence is an important element of a good macro-economic framework. Unfortunately, much of the public debate on this issue has been rendered sterile by gladiatorial notions of independence - as something to be displayed like a warrior's shield, raised in constant battle with the government of the day. Nowhere do such romantic notions ring true. I have said many times that the Reserve Bank does, in fact, have a high degree of independence. We can and do pursue our statutory responsibilities without political interference. But we seek to do this in close consultation with the government - to exercise independence with consultation . This accords with the linkages which exist between monetary and other policies, and with the realities of decision making processes in most comparable countries. Co-operation and consultation are not the same as subservience. As in all joint ventures, success relies on the goodwill of the participants. Should this not be forthcoming, and major disagreements were to develop concerning the conduct of monetary policy, then the dispute resolution procedures outlined in the would be activated. Those procedures, however, have never been used. (Indeed, it is ironic that the advocacy over recent years of greater independence for the Reserve Bank essentially as a means of focussing monetary policy on lower inflation - has coincided with a period when inflation has fallen to its lowest level in a generation, although monetary policy cannot claim all the credit for that.) Recent talk of greater accountability of the Bank is a potentially more fruitful issue for discussion. It at least carries with it the inference that the Bank is independent and has something to be accountable for! Yet it is not always clear what people have in mind when they talk about accountability, or what is driving suggestions that the Bank should be 'more' accountable. expect to have independence without accountability. In simple terms, the entrusts the Bank with certain responsibilities and the Bank should be held accountable to the Parliament and the public at large for its actions in pursuit of those responsibilities. The Bank should be required to explain what it is doing and why: such accountability is part and parcel of good governance. In recognition of the high degree of independence which we have, and have exercised over recent years, we have put a lot more resources into explaining our actions. This is true not only of changes in monetary policy - which have been the subject of public announcements since January 1990 - but also of the Bank's responsibilities for supervision and its other important but less glamorous activities like banking, registry and currency services. Senior bank officers are very accessible and spend a good deal of time talking, publicly and privately, on all aspects of the Bank's operations. Efforts also are continuing to incorporate additional 'accountability' information in the Bank's Annual Report, which is tabled in the opportunity has existed for the House Administration to quiz the Bank on issues raised by its Annual Report. That opportunity but the meeting was attended by only three Committee members (admittedly, there were some competing attractions that day). It is sometimes suggested that the Governor should be required to appear before appropriate Parliamentary Committees a couple of times a year, in much the same way that the Chairman of the Federal Reserve, for example, is required to appear before Congressional Committees. I have no difficulty with suggestions of that kind, provided they were treated as serious exercises in accountability (as distinct from exercises in political point-scoring, or lobbying for a particular monetary policy). Indeed, on several occasions over the past few years I would have welcomed such an opportunity to respond to a number of unfounded criticisms levelled at the Bank, sometimes from privileged positions. will continue to provide more information about the Bank in statements, speeches and Annual Reports. For me, the main constraint - apart from the confidentiality of some of the information that we collect - is the need to ensure that the Bank's decision making processes are not impaired. Some important issues are involved here. Many people would no doubt like to know who said what on particular policy issues in Board Room discussions - that is the stuff of conflict so beloved by media commentators in Australia. It can provide good copy for stories on, for example, perceived divisions between the Bank and the Government, and even within the Bank. But would it improve the decision making process? I think not. It might be seen by some as old-fashioned but, in my view, policy decision making processes usually work best when conducted through private, rather than public, channels. Bank Board members, for example, can - and do - debate policy options, but they should - and do - rally behind the position that is eventually reached by the Board and enunciated by the Chairman. This process is important for efficient decision making and that, in my view, should be the paramount consideration. It follows that suggestions that the Bank release detailed minutes of its deliberations hold few attractions. I say 'detailed' minutes because the key policy decisions of the Reserve Bank Board are already communicated to the public in press statements in a way that does not occur in, for example, the US (where the directive adopted by the Federal Open Market Committee is released shortly after the next meeting - a lag of about six weeks). Apart from their potential to fuel 'conflict' stories, and to burn up enormous amounts of energy, the preparation and publication of detailed minutes which reported individual members' positions would run a real risk of impairing the Bank's decision making. The human temptation would be for Board members to have at least one eye to the public perception of their involvement. It would risk making performers out of participants. Accountability might be enhanced in the sense of being able, retrospectively, to publicly 'nail' or praise particular Board members, but the decision making process would suffer. I mentioned earlier that no path to price stability was costless. These costs, however, could be diminished to the extent that other policies are supportive of monetary policy. Wages pressures, for example, have been critical influences at times. In the mid-1970s, wage demands fuelled the inflationary process and distorted factor shares. On the other hand, wage restraint in the late 1980s (achieved in part through was important in preventing inflation from escalating in the boom conditions of 1988 and At this time, wages pose no threat to inflation but the time will come when there is much less slack in the labour market than exists at present. Wages policy would then be called upon to help avoid another round of competing claims for increased shares of the national cake; the success or failure of that policy would have a bearing on the appropriate stance of monetary policy. What happens to fiscal policy is also relevant in this context. Fiscal policy has been in the headlines recently and I want to take this opportunity to elaborate on some brief comments I made recently. At times monetary and fiscal policy can reinforce one another, while at other times monetary policy can be called upon to 'offset' or counter-balance fiscal policy. If, for instance, the economy was running close to capacity and fiscal policy was still imparting a stimulus, then monetary policy - with its eye on inflation would have to try to offset this. That is not the situation we face in Australia at present. With the economy growing only slowly, and with plenty of slack in evidence, now is not the time to implement a vigorous deficit reduction campaign. But while the present degree of fiscal stimulus might be broadly appropriate, we do need to be able to pull back as the economy recovers. The problem, as we see it, is further down the track. There are two aspects, cyclical and structural. cyclical concern is that, when business investment does recover and this feeds through to faster growth in spending, capacity constraints will begin to appear, putting pressure on inflation. To help avoid this, the extra fiscal stimulus injected during the slack period should be withdrawn. In part, this will happen automatically through the operation of so-called 'automatic stabilisers': as the economy grows, tax revenues rise and expenditure on unemployment benefits falls. Economic growth can have a powerful effect on the deficit but more than that is likely to be required to wind back the extra discretionary expenditure provided during the downturn. In addition to this cyclical concern, there is the matter of the structural deficit. Structural deficits are not intrinsically inflationary; the US has run a significant structural deficit throughout the 1980s while maintaining a good record on inflation, while the experience of OECD countries generally suggests there is no clear relationship between deficits and inflation. The concerns about large structural deficits are of three kinds. First, there are arguments about resource allocation - that continuing structural deficits can be justified only if the return on the budget spending is very high and will benefit future generations, who have to foot the bill. Some government expenditures do, no doubt, have very high returns and raise the longer-term production potential of the economy. I simply observe here, however, that the case has not been made to justify continuing structural deficits on this ground. A second argument against large on-going deficits is that governments can be tempted to resort to the printing presses to finance them and this will push up inflation. This seems to have been a common enough experience in some developing countries, and it was an issue in Australia in the 1970s. Since the mid 1980s, however, budget deficits in Australia have been fully funded by tenders of securities at market determined rates. The third and substantive concern comes by way of the external sector. Because we are linked with outside capital markets, an ongoing structural budget deficit need not 'crowd out' business investment or other desirable domestic expenditures. Instead, the extra expenditure is likely to be reflected in a larger current account deficit. This is not to say that the linkage is one for one: the experience of the 1980s refuted the rigorous version of the 'twin deficits' theory. But there is a link between the budget deficit and the external deficit. The external deficit averaged around 5 per cent of GDP during the 1980s. It is now about per cent but it could widen again as the economy grows faster. While a significant deficit can be sustained for quite some time (as was demonstrated in the 1980s), sooner or later it has to be wound back if we are to maintain the confidence of international investors. Whether we like it or not, the reality is that even perceptions of large on-going budget deficits and borrowing requirements risk major instability in financial markets, which is in noone's interests. We have had several reminders over the past year of how such perceptions, which were not always well founded, have destabilised both bond and foreign exchange markets. Winding back the dependence on foreign savings - which is effectively what the current account deficit reflects - requires an improvement in the nation's private savings (through, for example, more superannuation) is important but it seems inevitable that the major contribution will have to come from the public sector reducing its demands on savings to fund its deficits. I repeat that the fiscal task is not to withdraw immediately the short-term stimulus, but to address the longer-term problem. This requires longer-term solutions and the planning for these needs to start now. As one of the foot soldiers in the late 1980s campaigns, I know that it is, in the words of the Duke of Wellington, a matter of 'hard pounding'. It takes time and, in practice, plans need to be put in place before the pressures emerge. It is, therefore, reassuring to hear the Treasurer reiterate a couple of days ago that planning is underway. Tensions can arise for both monetary and fiscal policy between what they can do to help smooth the cycle, and their longer-term objectives. That is one reason for seeking to coordinate these (and other) policies as much as possible. So far as monetary policy is concerned, various institutional and operational changes have been suggested with the aim of preserving the longer-term objective of price stability in the face of pressing short-term cyclical concerns. We do not believe that narrow targets - whether in the form of a monetary aggregate, the exchange rate, or an inflation number - provide the answer. But nor does ad hoc policy making. We think we have struck a reasonable mix - a flexible approach which gives a high priority to low inflation over the medium term, while recognising that policy also has to take account of what is happening to jobs and activity in the near term. Inflation is now running at low levels and the authorities have reiterated their determination to retain those gains as the economy picks up. We believe we have the institutional and operational structure in Australia to back that resolve.

r930520a_BOA

australia

fraser

Economic growth is usually viewed from a short-term perspective but it is long-term growth that has been the basis of wealth and power for nation states throughout history. It is the basis also of the additional jobs and higher living standards that we all desire today. Most economists are happy enough, I think, to be labelled 'pro-growth'. They do argue, however, about the priority to be attached to economic growth and, of course, about the policies necessary to sustain it. The intensity of those arguments increases as growth rates decline. I would like to offer some general observations on Australia's long-term growth performance and prospects. I will touch upon some policy issues, particularly those related to human capital. A generation ago the task of sustaining an acceptable rate of economic growth in a country like Australia seemed straightforward. Leaving aside the occasional poor year, the 1950s and 1960s were good years by current policy standards, with real GDP growing by over 4 per cent per annum, inflation about 3 per cent and unemployment under 2 per cent. Current account deficits and budget deficits were intermittent distractions, rather than constant challenges (see Graph 1 By the mid 1950s, unemployment had long ceased to be a problem and there was a confidence that rapid economic growth and full employment would be sustained. This was rooted in catch-up post-war development and nurtured by the Keynesian belief that governments would come to the rescue with 'anti-cyclical' fiscal and monetary policies, should the economy falter. Such confidence is apparent, for example, in the Treasury's Survey of the Australian Economy for 1958, the year I enrolled at the in the series of literary precursors to Budget Statement No. 2, noted that on-going growth 'provides a sustaining force of undoubted strength'. It went on: 'That is a great lesson from the post-war period. All through those years, the Australian economy has been borne along on a strong, persistent urge to grow which has enabled it to surmount adversities, whether of external or of internal origin. At times it has thrust ahead too fast; at other times it has faltered a little; but its underlying strength has not abated. In this thrust we have found a most effective safeguard against the deep recessions of activity which, in pre-war times, led to heavy unemployment and curtailment of growth and which, once they had developed, stubbornly resisted efforts at revival.' Many prominent economists shared this confidence, some going so far as to proclaim that the business cycle was 'obsolete'. Arthur Okun reflected the mood of the 1960s when he said that 'recessions are now generally considered to be fundamentally preventable, like airplane crashes and unlike hurricanes'. As Mark Twain might have observed, that news was 'premature'. History has demonstrated that the business cycle everywhere is very much alive and kicking. And while appeals to governments to 'do something' in difficult times have not diminished, the public today is probably less confident than previously about a government's capacity to prevent damaging swings in the business cycle. The 1970s marked the break in sentiment. The average growth rate was lower (around 3 per cent compared with over 4 per cent), consumer prices rose at double digit annual rates (11 per cent, on average), and average unemployment rose to 5 per cent. External shocks, including two dramatic oil price jumps, were partly responsible for this deterioration, but homegrown problems also contributed, especially the massive blowouts in wages and in the budget deficit that occurred in the mid 1970s. In the 1980s, performance was mixed. Growth averaged about 3 per cent. A good deal of policy effort went into correcting the imbalances which emerged in the 1970s, with some notable successes. Wage increases, for example, were brought under control through the Accord process and inflation declined to an average rate of about 8 per cent; inflation has since declined to rates which no longer cast a threatening shadow over our economic prospects. In addition, persistent budget deficits gave way to a succession of budget surpluses late in the decade. On the other hand, some new imbalances emerged, including large increases in business and national indebtedness, while unemployment drifted higher. These are the problems of the 1990s. In particular, for a variety of reasons - domestic and external, cyclical and structural - the Australian economy is not growing fast enough to provide jobs for all who want them. That is the major economic, social and political challenge for today and, probably, for the next several years. One point should be emphasised here because it is germane to Australia's post-war economic performance, to the nature of the current unemployment problem, and to possible solutions to that problem. That point is Australia's relatively poor productivity performance. While our post-war growth has generally mirrored that of OECD countries, our workforce has grown faster than most. As a result, comparisons on a per capita basis show Australia in a less favourable light - we have slipped from fifth rung on the OECD ladder of per capita incomes in 1950, to tenth in 1970 and to fourteenth in 1990 (see Academic thinking on what determines economic growth has changed since my undergraduate days in Armidale. Growth theory then was still in its infancy. We were acquainted with the Harrod-Domar growth models, which emphasised the need for sustained savings and investment if output and employment were to grow continuously. All that seemed reasonable, but the rigid relationships postulated in the models for savings, investment and growth pointed to the unpleasant conclusion that economies could experience prolonged periods of unemployment. In the mid 1950s, against the background of the US economy growing with full employment but little inflation, Robert Solow and others (including Trevor Swan at the ANU) took issue with the idea that savings determined the rate of growth. The crux of their argument was that as society acquired more and more equipment, the marginal return to additional investment would diminish and, after a point, the incentives to save and accumulate more equipment would disappear. In short, market mechanisms would come into play which would substantially reduce the instability inherent in Despite its fame at the time, Solow's theory did not really tell us what determined longrun economic growth. Solow's own calculations suggested that a large part of growth in per capita output came from unexplained 'technological progress'. Edward Denison and others attempted to 'account' for this unexplained component, but interest in growth theory waned for a time, before being rekindled in the 1980s. The so-called 'new' growth theory comes back to investment as the key ingredient for growth, but the traditional concept of capital has been generalised to include human capital - that is, investment in education, training and More recently, in an effort to improve their competitiveness, Australian enterprises in both the public and private sectors have been doing a lot of cost cutting, much of it through labour shedding. This will increase productivity and profitability in the future. In the meanwhile, however, it is creating substantial frictional unemployment at a time of high cyclical unemployment. With productivity growth of perhaps 2 per cent, and labour force growth of about 1 per cent, the economy clearly needs to grow a good deal faster than the current 2 to 3 per cent to sustain substantial reductions in unemployment. As well as helping with unemployment, faster, well-based economic growth would help also with our budget deficit and national savings problems. How to bring about that growth is the question. related activities. By playing up the technology and productivity spinoffs 'embodied' in investment, new growth theory largely unhitches the constraint of diminishing marginal returns to capital. Perhaps most of all, it highlights the contribution of human capital to the production process. Studies suggest that investment in human capital leads to increased investment in physical capital. With more education and training, people adapt more effectively to new technologies, thereby raising productivity and economic growth. Spinoffs can occur where, for example, increased investment in one group of workers raises the productivity of other workers. These ideas are hardly new. What modern growth theory does is formalise them and promote human capital as an important determinant of economic growth. It also gives formal support for what policy people like to believe is true, namely that there is a role for carefully crafted government policies in promoting long-term growth. Because the social returns from spending on education, training and R&D can exceed the private returns, a respectable case can be mounted for government intervention aimed at enhancing these activities. The success of several Asian nations which have stressed education has also sharpened the focus on human capital. In the United States, George Bush dubbed himself 'the education president', while Bill Clinton made his mark in Arkansas with his education reforms. In Australia, the phrase 'the clever country' is now part of the vernacular, even if our performance is still catching up with the rhetoric. The numbers are not easy to interpret, but total R&D spending in Australia as a share of GDP is among the lowest of OECD countries relatively rapidly, from its low base. Moreover, in activities where Australia is among the world's leaders - for example, in agriculture, mining and horse racing - our research efforts are impressive by international standards. In education too, major changes have occurred. Today, 77 per cent of Australian school children are going on to complete Year 12. Only ten years ago, the figure was 36 per cent. The accumulation of human capital is seen also in the increase in numbers undertaking post-secondary school education. In 1958, the total number of students enrolled in bachelor degrees accounted for less than 5 per cent of the population aged 20 to 24; today, the comparable figure is 25 per cent. In 1969, less than 20 per cent of the Australian workforce held some form of post-secondary qualification; by 1992, the proportion had increased to 42 per cent. The Vernon Committee estimated that the proportion of 15 to 19 year olds undergoing full-time education in Australia in 1958 was about one-third that of the United States and half that of Canada. Today, we have almost In part, these improvements reflect the increased resources devoted to most education and training activities, including at the tertiary level. In the early 1960s, total government spending on education was around 3 per cent of GDP. This share rose to about 6 per cent in the late 1970s, before slipping slightly to around 5 per cent in the late 1980s; it is now This renewed interest in Australia (and elsewhere) in upgrading the nation's human capital reflects a number of factors, including new growth theory and the demonstration effects already mentioned. Ultimately, however, it is related to the search for new jobs and higher living standards in a changed and more testing world environment. (There may also be a realisation that the quality of at least part of the nation's human capital could well deteriorate if high unemployment were to persist for a prolonged period.) Australia's changing relations with the rest of the world have many profound implications. In 1958, commodity exports, mostly of rural origin, accounted for 75 per cent of total exports, and we had a policy of developing manufacturing industry behind a high tariff wall. Our large natural resource endowments, the protection from foreign competition, and a rather compartmentalised world economy meant that, for a time, high and growing incomes could be achieved without trying too hard to improve our human capital. In short, we did not have to be particularly clever to enjoy high living standards. All this has changed. The world now is more integrated, or 'globalised'. It is a world of many more players, including several others rich in natural resources. Above all, it is a more competitive world. Of the usual factors of production, capital and technology are now extremely mobile. But even land and labour are mobile these days, in the sense that businesses can be located almost anywhere in the world to take advantage of lower costs and/or higher skills. In these currents if you don't swim strongly, you sink. Fortunately, Australians are now coming to terms with this reality. As the 'rents' from agriculture and mining have declined, we have recognised that a protected, inefficient manufacturing sector is a luxury we can no longer afford. Tariffs are now coming down and Australian industry is more exposed to competition from international best practice. Too many people wring their hands over Australia's future. They wonder how we can possibly compete with many Asian countries where wages are a fraction of those paid in Australia. The truth is that we cannot compete in low-technology, labour-intensive industries. But it is also true that we do not want to compete in those industries. We want industries that are world-competitive because our labour is high quality, not because our labour is cheap. Thousands of German, American and Japanese companies are very competitive in world markets despite high wages. The same is true of some Australian companies but can be true of many more; enhancing human capital helps to raise both real wages and competitiveness. Industry is responding to the challenge. Commodities still make up 65 per cent of our exports but manufactured goods and tourism are increasingly important. It is not well appreciated that exports of manufactured goods have increased by 15 to 20 per cent in each of the last five years. And the push is continuing. Last week, for example, ran a series of articles with headlines like ' manufacturing revolution ', ' Smart gadgets from the clever country ', and ' The best earners are the brainy industries '. The message of these and other stories is the same: Australia is gradually, but surely, turning itself into a clever country and exporting its clever ideas to the world. We are developing leading edge technologies in industries like aerospace, scientific equipment and telecommunications. The transformation is assisted by Australia being, for the first time in its history, geographically close to the world's fastest-growing markets. Almost one-third of our exports are now consigned to Asian countries other than Japan (which takes another third). In a world of highly mobile capital and technology, the greatest rewards will go to countries with flexible, highly skilled workforces. Australia can be in the vanguard here, with effective human capital policies. Modern growth theory implies that governments have an important role in all this but it is not specific as to what that role should be. I leave others who are expert in these matters to determine the 'right' structure of education and training for Australia - one that stresses the quality of the outputs, rather than the volume of inputs or throughputs. What seems clear, however, is that the notion of lifetime employment which was taken for granted a generation ago is no longer appropriate; more relevant today is the notion of lifetime employability. This suggests the need for more emphasis on developing broadbased and transferable skills at all levels of education - skills that will assist Australians to problem-solve, innovate and co-operate. Another general requirement is to assist people to move to activities that are world-competitive and away from those that are not. This has many facets, including further freeing up of the labour market, a strong commitment to retraining, and on-going micro reform. A well-educated and trained workforce will not realise its potential if, for example, our transport and communications networks are second rate. In today's global economy, two of the most important assets that a country has are its people and its infrastructure. Australia has, I believe, a very bright longerterm future. This should not be obscured by the current preoccupation with the cycle and the modest nature of the recovery to date. We clearly need to grow faster than we are over a sustained period to see unemployment subside. Policy can enhance or undermine our long-term growth: policy choices today, however, appear more complex and less clear cut than in the past. That is why I suggested late last year that the Government consider preparing a White Paper designed to get a better handle on specific policies conducive to sustained economic and employment growth. Macro-economic policies have a role to play in creating a steady environment for long-term growth, particularly in delivering low inflation and moderating inevitable business fluctuations. They are doing their stuff: several discretionary fiscal measures, including increases in spending programs and taxation incentives for business investment, have been taken to support the automatic stabilisers. Interest rates have been wound down progressively over the past two and a half years. These measures have been appropriate. Because the Government took the tough decisions to produce budget surpluses when the economy was strong, it was able to use fiscal policy to help the economy out of recession. Interest rates have come down as inflation has fallen. But there are limits to how far macro-economic policies can be pushed to assist the recovery before they begin to threaten long-term growth prospects. An important reason why the current recovery is so sluggish is that the usual external stimulus from higher commodity prices and external demand has been missing on this occasion. Much of the industrial world is still in recession, and likely to pick up only gradually. It will recover but we will have to be patient so far as the arrival of any major external stimulus is concerned. That does not mean we should simply sit on our hands in the meanwhile. Over the past decade, the structure and ethos of the Australian economy have been quietly transformed in many ways which will help to underpin long-term growth in a competitive, global economy - not the least of which is the return to low inflation and inflationary expectations. But more remains to be done and we should be pressing on urgently with that unfinished work, including further improvements to our human capital. The future will belong to those who are highly motivated, have a global focus and are well-trained. In outlook and practice we are becoming a smarter nation, but we need more innovation and management and labour skills, and more 'brainy industries' and 'smart gadgets'. Theory and common sense tell us that success requires concerted action on the part of governments, businesses, unions and many others, including universities.

r930804a_BOA

australia

fraser

Vision' is not one of my favourite words: it can have surrealist overtones. But all policy makers and advisers should have - and implicitly do have - a view or vision of their world. Many have at least two: a view of the world as they see it now and another, Walter Mitty-kind-of-view, of how the world would look if policy makers everywhere were as smart as they are. In between lie the 'pragmatic' visions - those that are attainable, that actually work. The CEDA vision, in my view, falls into the latter category. I could not endorse all its detail, but I share its broad thrust and its major think, accept readily a vision of their country characterised, inter alia , by: rising standards of living, sustained by faster economic and employment growth than we now have, and the low rates of inflation we currently have; genuine equal opportunity in all its guises so that, whatever their origins, all Australians receive a 'fair go'; and a social and physical environment which reinforces these fundamental tenets. Substantive differences can be expected to arise over how best to pursue even a shared vision - over the preferred policy mix and its speed of implementation. Too often, selfserving ideology and misrepresentation gets in the way of objective assessments of contemporary economic policy and strategy. This initiative by CEDA, and Mr Argy's clear exposition of the issues, affords a very welcome opportunity to take a fresh look; it deserves to be supported. Of course, it is not just the decisions of domestic policy makers that determine how many goals we kick. What happens internationally is also very important to a country like Australia. Play in the wider arena has been bogged down over recent years. We see that in, for example, dismal growth rates around the world and in the failure of action to match the rhetoric in the GATT trade negotiations, which keep going into extra time. The apparent decline in relevance of multilateral bodies like GATT and the IMF highlights the lack of effective institutional arrangements for co-ordinating policies in ways which actively promote a faster growing world economy. The recent breakdown of the illustrates the problems of international policy co-ordination, although the broader growth implications of the demise of that mechanism have still to unfold. For the moment, we rely heavily on meetings of leaders of small groups of major countries. But whether that group is the G3 or the G5 or the G7, recent performances have been unremarkable. I suspect that this is because all the major players are so beset by their own problems that none is able to exercise authoritative leadership - which serves to illustrate the point about getting your own house in order before seeking to reform others. Australians have to accept the world much as it is. We too, however, need to keep our house in order, both to perform as well as we can whatever the prevailing circumstances, and to respond positively to changes in those circumstances. In retrospect, we can always see how things might have been done differently and better, but policy makers do not have the luxury of reformulations and reruns. In any event, I agree with Fred Argy's comment that: 'We achieved much in the 1980s, before the onset of the devastating recession. It showed that we can be a nation of achievers. What we need now is confidence in ourselves and a greater sense of national purpose.' I believe these things are coming together, albeit slowly, and the benefits will emerge more clearly as the pall of world recession is lifted. Now is not the time for visions of despair or for banal bleatings about 'leadership' every time an inconvenient problem arises. It is the time for everyone to be getting on with things. For the Reserve Bank, this means helping, through banking and monetary policies, to make Australia work better. The Bank has specific responsibilities for the banking system, as well as some more general responsibilities for the financial system as a whole. Actual performances in these sectors in Australia in the second half of the 1980s were clearly less than ideal, as they were in a number of other countries which embarked upon rapid financial deregulation. But whatever the precise reasons for those shortcomings - and it is simplistic and inaccurate to lay the blame for the recession solely at the feet of the banks and monetary policy - the banking system has withstood the tempests reasonably well. The stock of banks' non-performing loans, for example, declined from a peak equivalent to 6 per cent of total assets in to 4 per cent in June 1993. At the latter date, the average risk-weighted capital ratio was close to 11 per cent, its highest recorded level and well above the 8 per cent minimum. On average, bank spreads - the difference between what depositors are paid and borrowers are charged - appear to have remained steady over recent years. As the health of the banking system continues to mend, it can be expected to become more effective in mobilising savings and supporting investment. It can be expected also to become more innovative and responsive to customers' needs. Behind these expectations is the knowledge that the forces necessary for their realisation are already a very competitive banking environment, which is compelling improvements in efficiency; growing transparency of bank dealings flowing from, for example, greater disclosure requirements and, when it is in will promote fair dealing on both sides of the counter); and on-going advances in technology, especially in the payments system. These considerations of competitiveness, efficiency, transparency and innovativeness are lauded in the CEDA study as hallmarks of reform in all markets, not just the market for financial services. They will weigh heavily in the Bank's on-going deliberations on banking/financial sector issues, including attainment of the 'right' balance between freedoms and intrusions in prudential supervision; the future role of banks in mobilising and allocating savings through, for example, superannuation and funds management; and closer relationships with small and medium-sized businesses. These businesses are emerging as major sources of new jobs and exports and are in the spotlight more than ever before. It is unclear, however, just how significant reported problems in gaining access to bank finance are in impeding the sector's expansion, relative to other factors such as access to equity capital and deficiencies in management and Panel, which has been established by the Reserve Bank and which will hold its first meeting later this month, should help to shed some additional light on this question. What is clear is that, by and large, the banks have responded positively to the Reserve Bank's calls to the banks not to overlook business borrowers. Since those calls were first made in late 1991, banks' business indicator rates have fallen by at least as much as their housing loan rates. Within the business sector, reductions on average appear to have been spread fairly evenly across large and small customers. Perhaps the major long-run contribution a central bank can make to growth is to help to keep inflation low. The CEDA vision rightly emphasises this pre-condition for the delivery of faster, sustained growth. Today I want to talk not about the cyclical swings in activity and prices - which have implications for monetary policy - but about longer-run trends which are shaped in important ways by the prevailing rate of inflation. Without being fanatical about it, the Reserve Bank attaches a high priority to keeping inflation under control. I have observed before that we do not have a strong natural antiinflation constituency in Australia. Partly for that reason, we have to keep harping on the costs of high inflation. These include: changes in the distribution of income and wealth. Higher prices across the board cannot really enrich the nation; instead, they generate gains for those able to take advantage of inflation (particularly of asset prices) at the expense of others. Those gains and losses alter income distributions in ways that most people would not vote for if given the choice; inefficiencies in economic decision making. Most aspects of our institutional framework - eg for taxes, laws, financial arrangements - assume stable prices. Adjustments can, and are, made to take account of rising prices, but these are costly and incomplete in practice; shortening of time horizons. This impedes capital accumulation, which is a key part of raising living standards. The empty office blocks in our cities clearly testify to the inflationary mentality of earlier times, which pushed activity into speculative ventures at the expense of investment in more productive activities. Ideally, we would like (to pick up Alan Greenspan's definition of practical price stability) to see inflation kept low enough so as not to bias behaviour in these costly ways. Putting numbers on that definition is a matter of judgment. Mr Argy has suggested a range of 2 to 4 per cent. My own view is that if the average rate of underlying inflation could be held to 2 to 3 per cent over time, we would meet our test. That is the standard which countries often seen as benchmarks have achieved - and which we ourselves achieved in the 1950s and 1960s. Our recent performance, too, is up to this standard. The CPI published last week showed that prices rose by 0.4 per cent in the June quarter and by 1.9 per cent over the past year. This latest reading confirmed the picture of low inflation evident for several years now. Over the three years to June 1993, inflation as measured by the CPI averaged around 2 per cent a year; the last three-year period to show such a low inflation rate was in the early For policy purposes, what we are most interested in is the core or 'underlying' rate of inflation which abstracts from transitory or special influences to better reflect demand and supply conditions in the economy. There is no unique measure of this: our approach is to study a wide range of price indicators, and reach a judgment about the trends. The measures which we routinely consider are listed in Table 1. The most important measures are based on the CPI, but adjusted to exclude items such as mortgage interest and consumer credit charges (which are conceptually inappropriate in a measure of inflation for monetary policy purposes), and items subject to temporary influences (such as petrol and fresh fruit and vegetables). Rises in government taxes and charges, which have had a significant impact over the past year, should also be excluded, given that they reflect administrative decisions rather than demand/supply pressures. After adjustments for such factors, most measures suggest an underlying rate of consumer price inflation of around 2 per cent over the past year. This result is still affected by import price rises flowing from the exchange rate depreciation, although this effect (so far) has been smaller than generally anticipated. Measures of producer prices are more disparate but, overall, are running at generally low rates. Given that we have had a depreciation in the exchange rate of close to 20 per cent over the past two years, underlying inflation of around 2 per cent is a pretty good performance. The challenge is to maintain this performance. Looking ahead, the published or 'headline' rate of inflation could rise in the second half of 1993, as the effects of higher import prices continue to come through, albeit slowly. Ideally, inflation in an ongoing sense would remain close to present rates of around 2 per cent: the rises in import prices (and government taxes) have to pass through but, once they have been digested, the measured inflation rate would fall back. Can we be confident that the effects of higher import prices and government taxes will be a once-off lift in the price level, and not the beginnings of a new spiral? The key here is whether the initial price rises generate second-round effects, through wage and other cost increases. Such outcomes cannot be ruled out entirely, but the chances of 'quarantining' the effects of the higher import prices and taxes look good. Wage growth, which is perhaps the best test of the strength of our grip on inflation, has been quite restrained, with ordinary-time earnings rising by less than 2 per cent over the past year. Given current levels of unemployment and excess capacity, any second-round effects of import prices and taxes through the wage channel are likely to be fairly muted. In brief, underlying inflation should remain in a 2 to 3 per cent range over the next year. That was an important consideration behind the decision last Friday to reduce interest rates by a further half per cent. That decision, incidentally, had little to do directly with the current account statistics. Such statistics are relevant mainly for what they might say about the strength of domestic demand, which bears upon the price outlook, and for the short-term effects they might have on financial markets, which can sometimes be relevant to the timing of policy announcements. All along, however, the focus of monetary policy has been on domestic price and activity objectives, not the structural balance of payments problem; that problem is not amenable to monetary policy solutions but needs to be (and is being) tackled by the kinds of policies listed for earlier sessions of this conference. Strong international competitiveness is part of the solution but no country has ever depreciated its way to prosperity. What about the longer term? Here the critical factor is inflationary expectations. I do not mean a narrow economist's definition, but rather the whole way of thinking about inflation in business, government and the community generally. In the 1970s and much of the 1980s this had developed to the point where most people assumed high inflation would continue, and behaved accordingly. Happily, this mentality has been breaking down over recent years. Our actual performance on inflation has been a big factor, as has the effect of sharp falls in asset prices. The recession and subdued pace of the recovery have reinforced those factors. That, however, is not the whole of the story: the recession in 1982/83 was accompanied by a big fall in inflation, but it had virtually no effect on expectations. That made it harder to maintain low inflation once activity picked up. This time, expectations have fallen dramatically. A recent NAB survey indicated that nearly 80 per cent of respondents expect inflation to stay below 4 per cent during the rest of the 1990s. In bond markets, yields on 10 year bonds are now at their lowest levels for two decades. The clear public commitment by the authorities (the Government and the Bank) to maintaining low inflation over the medium term appears to have been an important factor in turning around expectations. That said, the inflationary mentality is not dead. We still hear stories, for example, of companies adopting target rates of return on capital which appear to embody an inflation 'premium' which was part of the 1970s and 1980s, but no longer fits the 1990s. Companies understandably seek to maximise their returns to shareholders, but any failure to properly allow for likely lower rates of future inflation impedes investment, to the detriment of growth in the economy - and perhaps also to the detriment of shareholders' returns. Some retirees, too, show signs of inflation 'illusion', in that they believe their living standards are now being squeezed as interest rates come down. At least part of this, however, reflects the winding back of inflation, with a corresponding reduction in the inflation premium built into nominal interest rates, which in earlier years was being consumed - ie retirees were effectively running down their real capital, often without realising it. As the process of adjusting to lower inflation proceeds, the economy should be able to grow faster in a sustainable way. If wage negotiations, for example, were to build in current low expected price increases - of the order of 2 to 3 per cent - that kind of behaviour would clearly produce better national outcomes than if larger increases (not backed by genuine productivity gains) were pursued and granted, only to be followed by a tightening of policy. Sustained low inflation and stable financial conditions will help to make Australia more competitive. They are important for faster growth but other ingredients also are important. As these come together and businesses marshal the confidence to take advantage of them, we will see a pick-up in investment - and we will be on the way to boosting living standards over the remainder of the 1990s.

r930921a_BOA

australia

fraser

I welcome this opportunity to mention some developments in Australia of likely interest to Japanese institutional investors. At the end of the day, you will reach your own judgments about whether or not to invest in Australia; it is in all our interests, however, that those judgments be based on current data, not outdated perceptions. Australia traditionally calls upon overseas capital to augment its domestic savings and help finance its investment spending. Using the current account deficit as a rough measure of the national savings gap, we presently require net capital inflow of about terms we have to pay for that capital - that is, the interest rates and exchange rates which apply - depend ultimately on our attractiveness to overseas investors. Japan, of course, runs large current account surpluses and every month has some relatively small part of that investment comes to Australia but it represents about 20 per cent of all foreign investment in Australia. Until recently, government bond holdings have accounted for a large proportion of Japanese investment in Australia. This serves to highlight the particular importance of interest rates and exchange rates to Japanese investors. Curiously, unlike their American and British counterparts, Japanese investors have shown relatively little interest in equity investment in Australia, especially portfolio equity investment. The lack of interest in equity is perhaps attributable to earlier unfavourable perceptions of Australia's economic performance. If so, those perceptions are in need of updating. As Graph 1 shows, share prices in Australia have risen strongly over the past year; this mainly reflects lower long-term interest rates, and good profit results and prospects. As for government bonds, Japanese investors have done nicely from their investments in Australia over the years. This can be seen from Graph 2, which compares the cumulative returns, in yen, from investments in government bonds in several countries since 1985. Over this period, high coupons and large $A capital gains from falling yields have more than outweighed what, at times, have been unfavourable currency movements. The exchange rate of the $A to the yen was fairly steady in a range of 90-110 over the six years to mid-1992. Since then, the $A has depreciated by 28 per cent against the yen; this is a large fall but it is not out of line with the falls in some other currencies against the yen over this period. Central bankers are not in the business of proffering forecasts of interest rates or exchange rates. I want instead to review recent movements in these rates, as a focus for discussing economic developments and policies which can have implications for future rate movements. My bottom line is that the economic structure of Australia is changing in ways which should be viewed positively by overseas investors. Monetary policy in Australia was tightened in 1988 and 1989, before being eased progressively. As shown in Graph 3, the tightening and the easing both occurred somewhat earlier than in Japan (and most overnight interest rates in Australia have fallen from 18 per cent to 4 per cent. Over the same period, yields on 10 year government bonds have almost halved, from around 13 per cent to around 6 per cent. Similar movements have occurred in Japan but they have been less marked; as a result, interest rates in the two countries are much closer than they have been in a long time. what determines the attractiveness of Australia for Japanese (and other) investors is the return on investments, whatever form those investments take. Many factors enter this equation but interest rates and exchange rates are always prominent, both in themselves and as proxies for broader economic and political trends. One reason for this is that Australia's inflation rate is back in line with that in Japan and other traditionally low inflation countries. This can be seen in Graph 4; it is a major change compared with the 1970s and 1980s, when Australia was seen as a high inflation country. That perception is now clearly outdated. We are confident that inflation will be held in check as the economy picks up. While some 'one-off ' factors are likely to push the published (or 'headline') rate to 3 per cent or a little higher over the next year, we believe the 'underlying' rate will be held around 2 to 3 per cent. This belief reflects several factors, not least being the determination of the Reserve Bank and the Government to see that Australia stays in the low inflation league. They will be assisted in that endeavour by several developments: First, expectations of future inflation have fallen as actual inflation has fallen, and these lower expectations are being factored into price and wage setting behaviour. Secondly, Australia has become more closely integrated with the international economy, and more exposed to international competitive forces; this is imposing extra discipline on wage and price setters. Thirdly, even before the recent recession and the jump in unemployment to around 11 per cent, changes in wages policy were leading to more moderate wage increases and closer linkages to productivity improvements - as the black line in Graph 5 shows, the increases in earnings have been modest for several years (Graph 5 also shows, incidentally, the sustained decline in the number of industrial disputes in Australia; this is another feature of the changing economic landscape). The reductions in official interest rates over the past three and a half years have been mainly in response to domestic developments - specifically, to evidence of declining inflation and sluggish economic recovery. Over the last year or so, the exchange rate has become more significant in the consideration of interest rate changes, mainly because of the potential inflationary consequences of an on-going slump in the $A. The earlier monetary policy environment is now changing. In particular, the level of economic activity is looking a little stronger, the 'headline' (but not the 'underlying') rate of inflation is set to rise, and the exchange rate is lower. All this suggests that the long phase of reductions in short-term interest rates is coming to an end. It also brings me to the question of the exchange rate, which is likely to be of more than passing interest to this audience. $A has depreciated by about 20 per cent over the past two years. Against the yen, it has fallen by over 30 per cent; most of this fall occurred over the past year when, as noted earlier, other currencies too have fallen sharply against the yen. How should this fall be viewed? Stepping back from day-to-day market gyrations, I see it as having a large cyclical component, with the potential for some reversal. Australia's export base is being steadily broadened but rural and resource commodities still account for two-thirds of total exports of goods and services (compared with over 70 per cent 10 years ago). It is not surprising, therefore, that our currency tends to move broadly in line with commodity prices, which in turn tend to mirror cyclical swings in the world economy. The close relationship between commodity prices and the trade weighted $A can be seen in Graph 6. In the second half of the 1980s, when world industrial production and commodity prices were generally strong, the $A too was generally strong; so far in the 1990s, when industrial production in OECD countries has declined and commodity prices have fallen, the $A has drifted down. any particular exchange rate: we have recognised that in a weak world economic environment it was logical for a commodity exporting country like Australia to have a lower exchange rate. What we have sought to do is to counter large and sudden movements which appear to be triggered more by market rumours than fundamental factors and which, unchecked, could threaten inflation and other policy objectives. That continues to be the Bank's approach. To date, we have achieved our objectives with intervention but, if necessary, we would also use interest rates. How quickly the world economy recovers is obviously very important for Australia, and for the $A. Most commentators remain gloomy about the outlook, although growth in 1994 is generally expected to be somewhat better than in 1993. How much better will depend in part on policy action (or inaction) in larger economies like Japan and Germany to achieve faster growth. Eventually, the world economy will pick up and, as that occurs, the $A also can be expected to recover somewhat. If history is any guide, that recovery could be quite strong. The Australian economy is growing at about to 3 per cent, which is better than most OECD countries. We need to grow faster than that but it is difficult to do so in the middle of a world recession. Policy makers in Australia cannot accelerate the world recovery. What they can do is to get their own house in order so that Australia can exploit both the limited market opportunities that presently exist, and the greater opportunities that will come with the eventual turnabout in the world economy. process of renovating and strengthening the Australian economy so that it better withstands commodity price and other shocks in the future, has been underway for some time. It is far from completed but good progress is being made. That story, regrettably, is not understood as fully as it deserves to be - either inside or outside the country. I would like, therefore, to emphasise some key points. It is well known that the Reserve Bank has intervened heavily in the foreign exchange market on occasions over recent years. In intervening, we have not sought to hold The central theme is a major improvement in Australia's international competitiveness. Several factors stand out here. One is our low inflation and another is the 20 per cent two years. The fact that Australia's inflation performance has at least matched that of our trading partners means that the large nominal depreciation is being translated into an equally large real depreciation. The improvement in competitiveness, however, goes much deeper than the recent depreciation of the $A. It is also being built on important structural changes in all sectors of the economy. I have mentioned already developments in the labour market that are leading to more moderate, productivity-based wage increases. In other markets too, major changes are occurring - in the markets for goods, and for banking, telecommunications, transport and other services, including government services. In some areas, changes need to be pursued further and with greater urgency but our competitiveness is being enhanced. That is why I believe Australia will remain competitive even when the $A moves up on the back of stronger world growth and commodity prices. The changes are on-going and mutually reinforcing. They reflect deep-seated changes in attitudes and aspirations in all sections of the community. Above all, they reflect a growing realisation that Australia must be internationally competitive if it is to prosper in today's world. They are real changes with profound implications for Australia, although their significance is lost on those whose vision is clouded by short-term preoccupations. Already there is indisputable evidence that these structural changes are creating a more open and competitive Australian economy. The greater openness is well illustrated by the sharp rise in both exports and imports relative to national output. We can see this in Graph 7; the left hand panel of that graph shows that exports, for example, now represent 20 per cent of output, compared with about 13 per cent a decade ago. In a fortunate conjuncture of events, the increased openness of the Australian economy has coincided with the rapid growth and industrialisation of the Asian region. This historic change in the pattern of world production and trade has underscored a major relative shift in Australian export markets from hand panel of Graph 7 shows this shift; over 60 per cent of our merchandise exports now go to Japan and other countries in Asia. These domestic and international structural changes are altering the composition of Australia's exports. Graph 8 illustrates the point made earlier about the dominance of commodity based exports. At the same time, however, tourism, education and other services have grown rapidly while the most striking feature has been the growth in exports of high value-added manufactured goods; these have grown (in volume terms) at an average annual rate of 14 per cent over the past seven years and now account for more than 15 per cent of total exports. It is worth mentioning, incidentally, that this growth has occurred against the background of a substantial reduction in tariff and other assistance available to the manufacturing sector; the effective rate of assistance has fallen from about 22 per cent in 1984 to less than 15 per cent in 1991. It is continuing to fall. For the moment, investment growth is the notable absentee in Australia's economic recovery. This is partly because of the weak domestic and international demand, and partly because of the focus by businesses on restructuring their balance sheets. As in other countries, many firms in Australia borrowed extensively to acquire assets in the late 1980s and have been obliged to reduce their balance sheets and unwind their debt. Everywhere this balance sheet restructuring is taking much longer than had been expected, but businesses in Australia appear to be further along the road than in most countries. With business profits recovering strongly and share prices rising, the funding conditions for a recovery in private investment are improving. Banks in Australia also are over their worst problems and able to respond to stronger demand for business credit when it emerges. In particular, non-performing loans, which impose heavy burdens on banks, have been declining. Graph 9 shows that banks' total non-performing loans declined from a peak of 5.9 per cent of total assets in March also that the average risk-weighted capital ratio of Australian banks reached 10.9 per cent in June, with all banks well above the 8 per cent minimum requirement. In summary, then, I believe the Australian economy is changing in ways which are adding flexibility and strength, and preparing the ground for solid and sustainable future growth. As always, there are some constraints on growth. For Australia, these ultimately come down to external constraints in the form of the current account deficit and foreign debt. The current account deficit in 1993/94 is forecast to be about 4 per cent of GDP, compared with an average of 5 per cent in the 1980s, and the 2 to 3 per cent range characteristic of the 1950s and 1960s. One consequence of running large on-going current account deficits is that we have to borrow heavily overseas to finance them. This generates a growing external debt, which has to be serviced. If the overseas borrowings are invested wisely, and return at least their servicing costs, this is not a major concern. That has not always been the case in the past but, overall, servicing foreign debt has not been an unmanageable problem for Australia. While the net foreign debt has been rising (to almost shows that debt service ratios have fallen significantly in recent years (mainly as a consequence of falling domestic and international interest rates). High foreign debt levels do, however, make us vulnerable to major swings in investor sentiment, for whatever reason. If foreign investors were to become disenchanted with Australia to the point of ceasing to lend, the policy options would be both limited and unpleasant. For this reason, the current account deficit needs ultimately to be lowered relative to GDP. There are two sides to this. One is that we need to sell more to the world - which is why current efforts to make Australian industry more competitive cannot be relaxed. Secondly, large current account deficits imply a heavy dependence on foreign savings. Over time, we need to reduce the vulnerability associated with large current account deficits by raising our national savings. That is why implementation of the budget deficit reduction program is so important. Reductions in the budget deficit - and the generation of budget surpluses - are the surest and quickest means of increasing national savings. The Budget now before the Parliament acknowledges and addresses these linkages; it provides for the budget deficit to be reduced from a cyclical peak of around 4 per cent of GDP in 1993/94 to around The important linkages between the budget deficit and other policy objectives are not universally understood and politicking over particular budget measures tends to divert attention from them. A lot of criticism recently has been directed at selected tax increases, even though some revenue enhancing measures are inevitable if the deficit is to be lowered over time. The Budget will be debated further in the Parliament over coming weeks. The Government, which achieved four successive budget surpluses in the late 1980s, knows how important it is for the deficit to be wound back over the medium term. It is committed to its program and is confident it will be implemented. I trust that Japanese institutions will continue to take a keen interest in Australia, and seek out the investment opportunities which exist. In assessing whether now is the time to be investing more in Australia, I would suggest that you take extra care to distinguish cyclical changes from structural changes. In my view, the structure of the Australian economy is changing in ways which will create favourable investment opportunities for those prepared to see and seize them. At the end of the day you will, as I said earlier, make your own judgments on these matters; I hope my comments today will help you to make better informed judgments.

r931110a_BOA

australia

fraser

"Australia, like other countries, has a number of economic problems. Too often the media focuses on (...TRUNCATED)