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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 the negatives, and downplays the good progress which, I believe, is being made on several fronts. Today I want to suggest ten reasons for confidence about Australia's future - both in sustaining the nascent recovery, and in meeting the challenges of a competitive world. These reasons reflect changes wrought over the past decade - changes which are often not appreciated, and which are (and need to be) on-going. It is clear that steady, if unspectacular, economic recovery is underway in Australia. Over the past two years, real GDP has grown by about 5 per cent, with the main contributions coming from consumer and government spending, and from housing (see The economy is currently growing at an annual rate of about 3 per cent. This compares favourably with most OECD countries but Australia needs to grow faster, on a sustained basis, to wind back unemployment. That faster growth is attainable but it requires a number of things to happen, including pick-ups in the world economy and business investment, and on-going economic policies which build on past measures to boost national savings and international competitiveness. The immediate outlook is bleak in parts but the world economy will recover eventually. The United States is exhibiting a stronger tone but Germany and Japan are six to twelve months away from showing any significant growth. As a group, the industrial countries are forecast to grow by a little over 2 per cent in 1994; this suggests a very modest improvement compared with the past three years when growth averaged 1 per cent. As the developed countries pick up, commodity prices can be expected to recover also, notwithstanding the current over-supply of certain commodities. This connection between growth in industrial countries and commodity prices is well understood - it is one of the main mechanisms through which events in the industrial world have an impact on Australia. What is less well understood is the connection between Australia and the newly industrialising countries of Asia. These countries now account for almost 35 per cent of Australia's exports, compared with little more than 10 per cent 20 years ago (see Graph 2). Over the same period, the share of total exports represented by European countries has declined from 20 per cent to 12 per cent. (The share of foreign investment in Australia attributable to European countries has also declined sharply - from around 40 per cent in 1980 to around 25 per cent at The strong performances of many Asian economies have lifted the growth rate in Australia's major trading partners a good percentage point above that for the OECD group of countries over recent years. Although some slowing in China appears inevitable in the near term, the extra impetus to Australia's exports from sustained, rapid growth in this region should continue. The prospects for that other necessary ingredient for faster growth - business investment - are also improving. Reflecting the cash flow benefits of lower interest rates and cost cutting programs, company profits are now comparable with the levels reached prior to the strong surge in investment in the second half of the 1980s. To date, the improved cash flows and increased equity raisings have been directed mainly towards restructuring balance sheets and reducing corporate gearing. This process now appears to have largely run its course and, with more businesses operating profitably and confidence gradually returning, the focus is switching to plans to increase spending on Credit to the business sector has not grown during the past 2 years but the banks generally are now better placed to respond to demands for credit when they emerge. Their profitability has been improved by cost cutting measures and by a steady decline in non-performing loans and new provisions for bad loans. Their capital positions are strong, with the average capital ratio for all banks approaching 11 per cent at the end of June, well above the 8 per cent minimum (see Confidence is quite important for business investors. They need to be confident that increased output can be sold. They need to be confident also that economic policy will remain broadly on track. Uncertainties of the kind raised recently over aspects of the budget, Mabo and new industrial relations legislation will arise from time to time. These do affect adversely perceptions about Australia. As much as businesses might like to put them to one side, and get on with the main game, that is difficult when real or perceived changes in the rules of the game are involved. Such concerns, however, are likely to be assuaged to the extent that policy 'fundamentals' are on the right track - and expected to stay there. Fortunately, the 'fundamentals' generally are on track, which augurs well for the future. Chief among these is our lower rate of inflation. Australia is into its third year of 'underlying' inflation of around 2 per cent - the best performance since the early 1960s, and one of the best in the world (see Graph 5). The 'headline' or published rate is expected to rise a little over coming quarters as increases in government taxes and charges show up, along with the impact of the depreciation of the $A on prices of imported goods. But, provided these effects are contained, and second-round increases in prices and wages are avoided, the 'underlying' rate of inflation can be held around 2 to 3 per cent. Our confidence on this issue reflects several the 'authorities' (meaning the Government and the central bank) are determined to hang on to low inflation; our greater integration into the world economy, particularly Asia, together with on-going reductions in tariffs, will exert powerful international competitive pressure on domestic prices and wages; and largely reflecting these pressures, attitudes are changing with, for example, greater emphasis on increases in productivity, and greater acceptance of lower future inflation in price and wage setting behaviour. Wage increases have been quite moderate made an important contribution to lowering inflation. That contribution needs to continue, through even closer linkages to productivity and further attention to freeing up restrictive work and management practices. Rigid positions by one or more parties result in larger job losses in firms having to cut costs to survive than would be necessary if the parties were more flexible. many of the stereotypes about Australia. These trends provide a basis for confidence about the future. The decline in inflation and inflationary expectations over recent years has allowed nominal interest rates to fall to historically low short-term interest rates (the ones determined by the authorities) have declined from 18 per cent to under 5 per cent. As the recovery gathers momentum, there will be a natural desire for workers to share in the better profits. That is a legitimate aspiration, and negotiated increases based around continuing improvements in productivity and workplace flexibility provide a mechanism for both paying higher wages and containing costs. In this way, growth can be kept going for longer, absorbing more of the unemployed (including the long term unemployed) and generating more wealth. That situation is obviously to be preferred to a reversion to the bitterness and confrontation of the past, which is counterproductive for all - bringing a fall in profits, employment and, ultimately, incomes. The containment of labour costs and lower industrial disputation reflected in Graph 6 are both well kept secrets, which are counter to In 'real' terms, short and long-term interest rates in Australia are currently in about the middle of the range of OECD countries (see As well as improving the cash flows of both households and businesses, lower interest rates have led to some portfolio adjustments, with the stock market being the main beneficiary. Share prices have risen by over one-third so far in 1993. Lower rates of inflation also need to be taken into account when evaluating rates of return and payback benchmarks for investment projects. Some companies appear to be evaluating investment opportunities using criteria more appropriate to the high inflation era of the 1970s and 1980s than the present. In that era, short payback periods, and assets whose capital values appreciated quickly (such as property), were the order of the day. Today, longer-term investment in genuinely productive areas is more competitive and we can expect to see more of it as the changed inflation outlook is factored into investment decisions. A sixth reason for being confident about Australia's economic future is that labour productivity is growing again, after pausing in the second half of the 1980s (see Graph 9). Indeed, allowing for strong productivity gains in several areas such as finance and the public sector - where low or zero productivity growth is effectively assumed - the true picture is probably even better than the graph suggests. This productivity growth is helping to moderate labour costs, and to maintain low inflation and export competitiveness. Over the longer run, rising productivity means rising standards of living. Further improvements can be made. I mentioned earlier how genuine enterprise bargaining over work conditions can help to raise private sector productivity. In the government sector too there is scope to use the capital stock more effectively by reducing overmanning and removing monopoly privileges. This is now happening in several areas, including electricity generation, airlines, telecommunications, banking and infrastructure development. It is another well kept secret, but the ratio of government debt to GDP in Australia is one of the lowest in the world (see Graph 10). Australia's good showing in this graph, which covers all levels of government, owes much to the four successive years of budget surpluses recorded by the Commonwealth Government in the late 1980s. It explains why Australia has had more room than most countries for some fiscal manoeuvering - that is, room to allow, responsibly, the budget deficit to run up in the past couple of years to assist economic recovery. The government debt ratio is rising again because of anti-cyclical fiscal measures in Maintaining our good position requires that budget deficits at all levels of government be wound back as the recovery proceeds. That is why the passage of the latest Commonwealth budget was very important. That budget provided, for the first time, a package of measures to reduce the deficit over the medium term - from close to 4 per cent specific measures proposed to achieve that result - and, indeed, the appropriateness of the 1 per cent deficit target for 1996/97 and its underlying assumptions - can be debated but few would question the need to substantially wind back the deficit as the economy picks up. Reducing the budget deficit is the quickest and surest way to achieve a significant improvement in our national savings. This, in turn, will help to reduce our heavy call on foreign savings which has been reflected in large current account deficits and rising foreign debt. This is my ninth reason why we should have confidence in Australia's economic future. In simple terms, the best way for Australia to grow faster and escape the external constraints of large current account deficits and rising foreign debt is through increased exports. Resources are now being shifted to the export sector, encouraged by our proximity to the rapidly growing countries of Asia. The composition of our exports also is changing. Rural and resource based exports still dominate, but exports of elaborately transformed manufactures and services (notably tourism) have grown rapidly in recent (which include manufactures that are not elaborately transformed), manufactures comprise a bigger share of exports than rural products. What is not generally recognised is that these adjustments have been underway for several years and are now having a discernible impact on the current account. The trend improvement in the trade balance since the early 1980s is evident in Graph 13. In trend terms, the current account deficit has stabilised over this period, following the trend increase during the 1970s and early 1980s. These adjustments will need to be pursued to further lower the current account deficit. The problem with large on-going current account deficits is that they keep adding up our foreign debt. Australia's net foreign debt stands at about 43 per cent of GDP, which is comparable with, for example, Canada and well below that of New Zealand. The private sector accounts for 63 per cent of Australia's foreign debt, with government businesses accounting for another 16 per cent; the general government sector accounts for only a relatively small part (20 per cent). The level of foreign debt does matter but it should be kept in perspective. Debt has to be serviced and we would be vulnerable if, because of shocks of one kind or another, servicing threatened to become an unmanageable burden. It has not in the past. In fact, while foreign debt has continued to accumulate, our ability to service that debt has improved over recent years. Aided mainly by falling interest rates at home and abroad, debt service payments as a proportion of export income have fallen from 21 per cent This is my tenth reason. That we are now very competitive has to be a major plus for the future. Sustained low inflation and ongoing productivity gains will help to hold the competitive edge conferred by the 20 per cent fall in the exchange rate over the past two years. In real terms, our exchange rate is low by recent gains are unlikely to be frittered away by renewed domestic inflation. Unit labour costs in Australia are 30 to 40 per cent lower, relative to our key trading partners, than they were a decade ago, and 50 per cent lower than at the worst point in the mid 1970s. I have talked today mainly about facts and specific data that could be illustrated with a graph. I conclude with a more nebulous idea - that the most important change, and the most important reason for optimism about Australia, is an attitudinal shift. No longer do manufacturers, for example, look to tariff protection to shelter them from overseas competition or domestic cost pressures. No longer do Australian workers assume that they can achieve wage levels without regard for overseas conditions and competition. Employers and employees are coming to grips with the reality of competing in international markets and, to do this, 'world best practice' is becoming the watchword. The attitudinal change is not total, nor has it always been translated fully into practice. But the transformation is well underway and there is no notion of turning back. Despite a sharp downturn and protracted recovery, the longer term measures to create a more competitive economy have continued unabated. Australians are ready to step forward and meet the challenge of greater internationalisation - they are understanding that in the short term it is painful, but in the longer term essential.

r931124a_BOA

australia

fraser

This is my fifth appearance at a CEDA AGM dinner, and perhaps the regulars among you are beginning to feel the onset of fatigue. For my own part, I see no end of topics that could be discussed in this forum. At past meetings I have talked about a variety of policy matters, with a particular focus on monetary policy - inflation and other objectives, independence of the Reserve Bank and all that. Last year, teeing off CEDA's commendable efforts to define a vision for Australia, I talked about aspects of longer-term economic growth. I noted the obvious point that government policy is itself an important factor of production in the growth process. I suggested also that perhaps it was time, being almost 50 years since publication of the in Australia', to have a similar paper on growth and related issues. That suggestion was not picked up, although the Government is working towards a White Paper on unemployment, our major economic and social problem. No one questions that government policies can have a mighty impact, for good or ill, on production and employment. Indeed, the value added (or subtracted) by government policies helps to explain why some countries perform better (or worse) than others. Other things are never equal but, if they were, the best performers would be countries with clear, certain and consistent economic policies. Delivering such policies is easier said than done. A common complaint these days is that policy and its accompanying legislation in many areas - taxation, superannuation and Mabo to name three - are excessively complex and confusing. Perhaps part of the confusion is manufactured, out of either deliberate intent or negligent ignorance. I suspect the larger part, however, is inherent in the very process of trying to deliver the clarity and certainty in legislation that everyone clamours for - the harder governments try to do this, the more complex the legislation is likely to be. I do not see any real solution to this problem. An outbreak of enlightened national consensus building on major economic and social issues would help but the prospects for that, unfortunately, look forlorn. Governments could, no doubt, help to reduce confusion, if not complexity, by trying harder to explain the intent and rationale of their policy changes. At the end of the day, however, some businesses (not always the same ones) will have to find their way through - or 'live with' - particular policies and pieces of legislation they might wish did not exist. For businesses generally, the most critical requirement, in my view, is that there be reasonable certainty and consistency on the policy 'fundamentals'. I believe that has been the case in Australia, by and large, for some time now. Macroeconomic policies have been consistently supportive of stronger economic and employment growth, while mindful of preserving the gains on inflation. We are now seeing results. Most indicators are suggesting a pick-up in what has been a modest rate of recovery, perhaps to about 3 per cent. Consumer spending - led by 'durables' - and housing investment have been important contributors to the recovery. These sectors have responded, albeit gradually, to the easings in monetary policy, which have seen short-term interest rates fall from 18 per cent to under 5 per cent since January 1990. The other major contributor to the recovery has been government spending. This has increased in part as an automatic response to rising unemployment, and in part as a result of deliberate government spending decisions. With the economy picking up, the scope for further major stimulation through monetary and fiscal policies is diminishing. The same constraints do not apply to micro-economic policies. Over the past decade, many measures have been taken to free up labour and capital markets, to lower tariffs and to otherwise increase competition in the markets for goods and services. As a result of these and other changes, Australia's international competitiveness has improved by about one-third over the past decade. But there is still further to travel. As those who operate at the front line know, staying competitive means staying on the treadmill of reform. We like to see ourselves as part of Asia these days - and rightly so, given that 60 per cent of Australia's exports go to countries in the region. Holding our place in this company requires that we stay in touch with the rapid pace of change in many Asian countries. Indeed, these days we face fierce competition for investment not only from Asia, but also from 'emerging' countries Government policies are obviously important but they are not the end of the story. Businesses and others have to be on the job too, seeking out and following up the opportunities flowing from our improved fundamentals. Nowhere is this more critical than in the case of business investment. Investments which earn a good return advance the prosperity of shareholders and citizens alike; as well as rewarding investors, they generate jobs and raise real wages. So far in the present recovery, aggregate business investment has been a conspicuous offices and other buildings consequent upon the earlier over-investment explains why non-residential construction has been exceptionally weak. But, investment in plant and equipment also has been weak (see preoccupation of borrowers with debt reduction have been important factors here. Some uncertainties remain. In particular, growth, while picking up, is still relatively slow, and major structural problems in Japan and Europe dim the prospects of any marked acceleration in the near future. Nonetheless, the conditions for stronger investment are falling gradually into place. In business balance sheets have been improving and the debt burden has become less onerous (see Graphs 3 and business profitability has improved, particularly after interest payments, which have declined on the back of reduced business confidence has revived as the recovery has broadened and share prices have risen, lowering the cost of equity capital; and sustained low inflation will help, over time, to remove a major element of uncertainty and encourage lenders to lend longer. Reflecting these improvements, investment in plant and equipment has started to pick up. In real terms, it rose by almost 6 per cent in 1992/93. Figures released today point to a further 4 per cent increase in the September quarter, to a level 9 per cent higher than a year earlier. Companies in the private and public sectors are working their existing capital harder - which is a good thing - but, over time, substantial new investment will be needed to accommodate stronger growth in output and employment. Internally generated funds are the main source of investment capital but banks provide the lion's share (around two-thirds) of the external borrowing of businesses. Banks, therefore, are significant players in business investment. The financial system as a whole can be expected to adapt to meet the financing needs of higher levels of investment. Financing has not been a problem in the past; indeed, the large stock of vacant office blocks and shops testifies to a surplus, rather than a shortage, of funding. But no individual institution is guaranteed its place in the financial sector. The 1990s are bringing a different set of challenges, but the need for adaptation is no less than it was with deregulation in the 1980s. I mention just two changes that will require some adaptation by banks and other financial institutions. First, much of the investment in the 1980s was funded from overseas -- in, for example, the US and Euro-bond markets. The counterparts of these large capital inflows were large current account deficits, which averaged around 5 per cent of GDP in the 1980s. We expect to see those deficits reduced significantly over the years ahead as domestic savings recover. National savings will be enhanced by the projected reduction in the budget deficit, and by increased private saving through superannuation. Secondly, banks and others will have to continue to adapt to the heightened yield sensitivity of lenders. The days when depositors would leave money with banks at low or zero rates of interest are gone. All that changed in the 1980s, when savers became accustomed to high nominal interest rates. As inflation has come down and nominal interest rates have fallen, savers have been searching around for higher yields. The move of 'the little people' into equities is one example of this change. Institutions which in the past enjoyed substantial low interest funding have had to adapt to this new world. To date, the relatively higher funding costs have tended to be passed on to borrowers in higher loan interest rates. In the years ahead, as the benefits of cost cutting programs become more apparent, we would expect to see some reductions in bank interest spreads - which, averaged across the four majors, have not changed much in recent Some commentators believe banks are destined to shrink, if not disappear. Last year, magazine, for example, posed the question: 'does banking have a future?'. Its answer was that 'it does not take a visionary to imagine a world without banking'. Such a view is clearly not based on some banks' recent difficulties. If it was, it could be largely dismissed, given the good progress which banks (both here and in some other countries) have made in working off the burden of non-performing loans. This process accounts for much of the recent improvement in bank profitability. At the same time that non-performing loans have been falling, Australian banks generally have continued to build up their capital ratios. view instead contends that continued technological innovation, closer integration of national financial markets and increasing competition will erode the preeminent position of banks, and continue to blur the distinction between banks, other financial institutions and securities markets. One strand to this argument is that banks will find it increasingly costly to raise funds as households shift out of bank deposits into other assets. Another, is that a greater volume of lending will be done through the securities markets directly (and indirectly through securitising certain assets off bank balance These arguments raise many issues which I can only touch upon here. In the end, how the banks themselves adapt to change will also help to determine their future. On the liabilities side of the balance sheet, bank deposits have several attractions for individuals which will help banks to retain their core role. They are at the low end of the risk spectrum and they are highly liquid. For many individuals, bank deposits are the main asset in which they hold their financial wealth; deposits at banks still represent about 30 per cent of household financial assets. Banks also provide payments services. The growing share of assets held in life offices and superannuation funds is sometimes pointed to as evidence of the declining importance of banks. At least to this time, however, the growth in assets held in superannuation funds reflects mainly reinvestment of the high earnings of the 1980s, rather than higher contributions from individuals. That is, to date it does not reflect deliberate action by people to shift more of their assets into superannuation funds and away from banks and other intermediaries. That said, superannuation funds seem likely to become a larger part of the financial sector as the Superannuation Guarantee Levy rises. I support this push for greater saving for retirement but it does imply a significant reshaping of how wealth is held in the community, with superannuation assets likely to grow relative to other financial assets. This raises the prospect that savings will in the future be channelled away from bank deposits into superannuation funds. People are unlikely to hold as much as they would otherwise in other forms of wealth (deposits, government securities, equity and perhaps housing) when they are forced to save more through superannuation funds. On the other hand, banks will continue to play a role in directing funds to various end users. Someone will have to perform that role - a role which is likely to grow if Australia is to fund a larger proportion of its investment through enlarged domestic savings. Banks might be able to securitise some assets or issue liabilities that are held by superannuation funds. The process need not, therefore, imply a smaller role for banks in absolute terms: they may have a smaller share of the financial sector, but the sector would be larger. So far as banks' business lending is concerned (my main focus tonight), it is true that some borrowers are obtaining funds outside the banking system. Large firms with good credit ratings, for example, are increasingly raising funds directly in the securities markets. Some firms appear able to raise funds more cheaply than banks themselves. (In addition, in some countries, securitisation has tended to take home mortgages and some other good quality assets off bank balance sheets.) Even in the United States, however, where these developments are most advanced, they clearly have not rendered banks obsolete. One area where banks (and especially domestic banks) have an opportunity to enhance their role is in financing small and medium businesses. These businesses are an important part of our growing economy. So far in the recovery, virtually all the growth in employment has come from businesses which employ fewer than 20 people. Over the years ahead, small and medium sized businesses are seen as major sources of jobs and exports. For this to occur, a number of things need to happen, of which one - but only one - is that these businesses have reasonable access to finance. Banks are the logical provider of funds to relatively small firms not able to tap financial markets in their own name (either by issuing debentures or equity), and generally not sufficiently well known to borrow directly from large wholesale financial institutions. Even if large firms do increasingly look after themselves, this will still leave a potentially huge business customer base for banks. The essential characteristic of lending to smaller firms is that a large amount of information specific to the firm is required to help assess the creditworthiness of the borrower. Among financial institutions, the banks are best placed to build up this information. It is the sort of information bank managers might acquire, not only through the routine management of their customers' lending and deposit accounts, but also through the often subjective judgements which good managers can make - the knowledge which managers get from visiting businesses to 'kick the tyres' and from close contact with their local business community. Gathering and processing this information is the heart of successful intermediation. The problems are also prodigious, which probably explains why many bankers are less enthusiastic than I might appear to be. First and foremost is the cost of assembling sufficient information to assess the borrower's proposal. This cost can be as great for a small loan as for a large loan and it ultimately has to be met by borrowers. The high failure rate for small business loans compounds the problem; if, say, 2 per cent of such loans fail, banks need a margin of this order on all their loans before allowing for the other costs involved. In these circumstances, it is hardly surprising that, in practice, banks tend to trade off the costs of gathering information against the provision of security. That is understandable, but better information could also broaden the base for lending to small and medium sized businesses. I believe that banks generally are keen to lend more to small businesses where they can be reasonably confident of getting their money back. Many have introduced relatively attractive packages for such borrowers. At the same time, many banks also acknowledge the need for more skilled staff and extra training to handle small and medium business borrowers. All this takes time but I would like to see it given a higher priority. Banks were slow to adapt their risk assessment and management skills to the changes wrought by deregulation in the 1980s. They need to move more quickly now to master the art of credit assessment for small and medium businesses so that they are prepared for the pick-up in demand for credit from these businesses when it comes. More generally, any action which reduces the heavy information gathering costs would be a step forward. To this end, the Reserve Bank is looking closely at the work being undertaken by several groups to streamline the information banks require from small businesses. Incidentally, the high costs of gathering information to support what are traditional bank lending activities suggest that most banks would encounter even more severe problems in making equity investments. Perhaps more to the point, those bankers who are interested in this possibility tend to focus on larger, rather than smaller, businesses (most of the latter, for their part, are not keen for banks - or other institutions - to own a slice of them). While the level of business investment remains quite low, recent trends are encouraging. It appears that we are getting closer to finding this 'missing link', which is so important for sustaining growth in employment and living standards over the years ahead. The banks have a special role in the investment process, helping to identify high return projects and to channel funds to them. They could further develop this role by greater funding of such projects by small and medium firms. Their main comparative advantage lies in gathering information about those firms which are not large enough to raise money in their own names. By honing their skills on the asset side of their balance sheets, the banks can maintain and increase their role in the evolving financial sector. If they do not exploit their comparative advantage, we can expect pressure for other (and perhaps new) institutions to fill this role. The Economist article mentioned earlier make a worthy motto', and that banks which pursue these goals 'will prosper and grow'. As always, the trick for the banks is to strike an appropriate balance. Too much ingenuity could result in more bad lending. But too much prudence could see customers shift their business elsewhere.

r940330a_BOA

australia

fraser

It is a pleasure to be with you again today. It is almost a year to the day since I last spoke to you. At that time, I said that I enjoyed speaking with business economists because they tended to be 'practical and pragmatic people who are interested in policies which actually work, rather than theoretical or ideological prescriptions'. I could have added, I trust, that they are also less prone than some in the financial markets to fear economic growth - less inclined to anticipate, Pavlovian-like, runaway inflation at the first whiff of stronger growth. A lot has happened since I was last with you, most of it good. A year ago, I said: '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.' That turned out to be one of my better forecasts! At the time, I recall, it was seen as a trifle optimistic. The recovery was still finding its feet: growth was a modest 2 to 3 per cent, unemployment was still rising, firms were still deferring investment, and the OECD world was still stalled. My relative optimism sprang from a belief that Australia's 'fundamentals' were coming together. Company profits were rising strongly, as were exports. Inflation and inflationary expectations had fallen to low levels. Micro-economic reforms were changing attitudes and practices in many sectors of the economy. The main thing missing was confidence; that arrived in the latter part of 1993, and growth accelerated. The present 4 per cent growth rate could go a little higher in the year ahead, with signs of strengthening in several areas of previous weakness. Employment has risen strongly by 150,000 or about 2 per cent - since last August, and unemployment has begun to decline. By underpinning consumer spending, this will help to make growth more selfsustaining. Judging by the forward indicators, business investment is set to surge over the next year or so. This is what we would expect, given rising sales and confidence, and better company profits and balance sheets. It is also what we need to boost the nation's capital stock and productive capacity. Faster growth, to this time, has not caused any acceleration in inflation. If anything, inflation has continued to come in below expectations. The balance of payments also has been doing better than expected, despite faster domestic growth and a generally difficult world environment. In the first seven months of 1993/94, the current account deficit has been running at an annual rate of $16 billion, compared with the Budget forecast of $18 billion. So far, then, so good: the broad policy strategy adhered to consistently over several years is now delivering visible results. It makes sense to stay with a strategy which is working, although there is always room for improvement. The task now is to sustain strong growth. That is the best way - indeed, the only way to ensure that permanent jobs are available for people who want them and, in that and in other ways, to raise living standards across the community. Growth which creates jobs and improves living standards for ordinary Australians is what makes sometimes painful economic changes socially, and therefore politically, acceptable. Today I would like to offer some observations on managing strong and sustainable growth. I do so from a Reserve Bank perspective, so that 'sustainable' growth is synonymous with 'low inflation' growth. As any central banker will tell you, low inflation helps to facilitate growth by holding down interest rates and encouraging longer-term investment in productive assets. The measure of success now being enjoyed is no cause to lose sight of the job still to be done. Most prominent, of course, is the unconscionably high level of unemployment, especially among young people. At a time when various remedies are currently being prescribed for this problem, I would like to reiterate a few common-sense points: everything, but it is essential to getting unemployment down. * The trend slowing in the growth rate since the mid-1970s is an important reason why unemployment now is higher than 20 years ago. In my view, the surest way to provide jobs for the great bulk of those who want them, including people unemployed for long periods, is through sustained higher growth. * Business economists know this but those who blithely support increasing the regulatory and taxation burden on businesses, or who advocate a reallocation of existing jobs and incomes through work sharing and early retirement schemes, do need to be reminded. * Others who see current unemployment entirely in structural terms, and advance the simple solution of cutting wages, are also wide of the mark; part is structural but much is cyclical. * Even with sustained growth, however, the problem will take years to solve; in the strongest years of the late 1980s, the unemployment rate fell only by about one percentage point a year. (ii) Sustained growth is the key but well targeted measures can help longterm unemployed people. * Evidence on the effectiveness of labour market programs is not strong either way, so it would be unwise to be dogmatic here. * Training and other programs which enhance the employability (or 'job of the long-term unemployed are likely to be helpful, particularly in the context of a growing economy. Apart from their social spinoffs, such programs - if they are successful - increase the supply of labour and lift the economy's potential growth rate. * The qualification that has to be heeded, of course, is that their benefits not be negated by the adverse effects of any new measures necessary to fund them. unemployment should extend to the appropriateness or otherwise of existing support programs for the unemployed. * This raises emotional issues but it is a legitimate area for review in circumstances where consideration is being given to major new expenditures to assist people genuinely seeking employment and where strong growth will be creating more job opportunities for those who want them. At the broadest level, what is needed most is not so much a 'jobs compact' but a 'growth compact' - a view on the part of policy makers, businesses, unions and opinion leaders that strong and sustainable growth is a desirable objective, backed by a commitment to pursue it. Labour market programs are really an appendage to this - to help it happen, to help those who have been missing out to come on board. For the next year or two, strong growth (4 to 5 per cent) with modest inflation (2 to 3 per cent) seems within reasonable reach. Can this combination be achieved over the rest of the decade? I think it can, but it is no easy task; it will require good policies, as well as a little luck. In particular, the inflation and external constraints which have checked growth in the past have to be pushed back. Unless this happens, the recovery will run into problems early in the upswing which are likely to necessitate tighter policies, leading to lower production and employment. On our recent performance, we should be positive about the outlook for inflation. As measured by the CPI, inflation has averaged around 2 per cent per annum over the past four years. In underlying terms, it is currently about 2 per cent. Yet doubts persist that low inflation can be maintained as growth quickens. This scepticism has resurfaced recently in financial markets, as part of a worldwide reaction to a small, well timed and well telegraphed lift in the US Federal funds rate, and to perceptions that US inflation is on the rise. The extrapolation of these concerns to Australia is difficult to defend. To do so is to rely on some very simple and questionable rules linking growth and inflation. The experience of the past 30 years is that any number of combinations of inflation and for example, high growth rode in tandem with low inflation, while the 1970s was a decade of low growth and high inflation. The 1980s saw somewhat better growth but only a mediocre performance on inflation. These outcomes were influenced by the environment at the time, and within each period there was some cyclical variation in inflation. But the basic point remains that strong growth should not, automatically, evoke fears of higher inflation. Several reasons can be advanced for expecting low inflation to be maintained in Australia, even with stronger growth: One reason is the starting point. It is easier to maintain low inflation if inflation and inflationary expectations are low to begin with. Underlying inflation has held around 2 per cent for several years now, despite some factors which might have been expected to push it higher. The sharp fall in the Australian dollar last year, for example, risked blowing us off course (as it did in the mid-1980s), but we withstood that storm quite well. The dollar has since recovered part of last year's fall. (ii) Another reason is our highly competitive environment. Tariff reductions and closer integration with world markets will continue to exert powerful competitive pressures on Australia's trading sectors. At the same time, on-going microeconomic reforms are making for a more efficient non-traded goods sector sectors today, attitudes towards cutting costs and raising productivity are streets ahead of what they were ten, or even five, years ago. (iii) A third reason is the considerable slack still in the economy. This is most evident, of course, in the labour market and parts of the property market. Many firms also are still working well below their capacity limits but this gap is likely to close somewhat over the next year or so. That is why an early spurt in capacity expanding business investment is so important. What happens to wage costs is critical. The wage breakouts of the 1970s and early 1980s caused inflation to rise sharply, and output and employment to contract. Those events took many years to correct and were extremely damaging to the long-term prosperity of which occurred in the wage and profit shares of national income in the 1970s, and its correction during the 1980s.) Fortunately, a whole new approach to wage setting has evolved over the past decade, driven by some quite profound changes in attitudes and institutions. It is now more widely appreciated that living standards can only be raised by improving productivity, and that wage increases in excess of productivity increases are more likely than not to result in declining profits, investment and jobs. These changes have helped to deliver an extended The evolution of the wage fixing system is, by necessity, changing the way we think about wages. In the days of a more centralised system, the focus was on achieving aggregate wage outcomes which were consistent with broad economic objectives, taking some account of the competing interests of those at the bargaining table. While that system achieved considerable success during the late 1980s, we are now moving to a system which, appropriately in my view, places greater period of wage moderation, including in the late 1980s when the labour market was quite tight. This has continued into the 1990s, partly under the influence of high unemployment, but also through the good sense of the main emphasis on a culture of productivity enhancement in the workplace, and changes in wage relativities. This is a major step forward. As the role of the centralised arbiter recedes, however, the question arises of how to ensure that the multiplicity of settlements does not result in unacceptable cost pressures or additional unemployment. The question is further complicated because the consequences of any particular settlement are more difficult to judge under the new arrangements; the extent to which individual settlements are based on genuine productivity changes, for example, will be uncertain in many cases. The overall test we must apply is ultimately the 'bottom line' one: is low inflation being maintained? That cannot be known with much certainty before the event, of course. It is, therefore, important that wage and price setting processes occur in an environment where low expected inflation is a key assumption. The Reserve Bank has to do what it can to condition acceptance of this assumption, especially by making sure everyone understands the rules of the game. The cardinal rule is that the authorities will act decisively, when necessary, to keep inflation under control. This does not mean that minor fluctuations in headline inflation rates should elicit draconian responses which threaten to plunge the economy into recession for the sake of taking a fraction of a point off the CPI. It does mean, however, that developments which are fundamentally at odds with holding inflation at around 2 to 3 per cent over a run of years will bring forth an appropriate monetary policy response. Those involved in setting wages and prices (ie. business executives as well as union officials) should plan on this basis, and not build wage or price claims on expectations of higher inflation. Similarly, company boards should not maintain inappropriately high hurdle rates of return for investments because of expectations of higher inflation. Current wage developments pass the test of being consistent with continued low inflation. In underlying terms, wages appear to be rising by about 3 per cent per annum. With trend productivity growth of close to 2 per cent, these figures do not pose a serious threat to inflation at this time. Looking ahead, growth in unit labour costs should remain moderate as the economy grows faster and the pool of unemployed grows smaller. The structural changes which have been occurring - including the move to enterprise bargaining, productivity improvements and internationalisation of the economy - are conducive to that outcome. Beyond that, it is up to all the parties involved to behave sensibly. This is not to say that wages cannot grow (or that they should be cut across the board, which is what some people appear to have in mind when they speak of greater wage 'flexibility'). Most people are in favour of upgrading the skills and pay of workers in return for greater productivity. But the logic of more flexible wage setting arrangements has to be allowed to work: wage increases should be related to genuine productivity gains and should reward the workers responsible, not be translated into generalised increases. The longer wage moderation is sustained, the longer monetary policy can remain supportive of growth - and hence jobs. On the other hand, if there were to be a return to the adversarial and cost increasing mentality of the past, the consequences for inflation would not be something that monetary policy could ignore. I cannot believe, however, that anyone genuinely committed to economic and social progress in Australia would wish to see a reversion to the earlier era. If we have learned anything over the past couple of decades, it is that restrictive monetary and fiscal policies cannot, on their own, deliver wage and price restraint without also creating intolerably high unemployment. Without effective wage setting procedures and institutions, based broadly on trust and fairness, we stand little chance of achieving the twin goals of low inflation and low unemployment. Everyone needs to realise this, and to spare no effort to make enterprise bargaining work. The other potentially important constraint is the 'external' constraint. By this we do not mean the old idea, emanating from the world of fixed exchange rates and limited capital mobility, that growth faster than our trading partners leads to a flood of imports and a payments crisis which brings on contractionary policies. (These old ideas have a habit of hanging around long after their useby dates, perpetuating the myth that Australia is more prone to boom/bust occurrences than most countries.) Nor do we mean that current account deficits as such are disasters. Some of the more simplistic comments we hear about 'every month another billion dollars in debt' imply that Australians are getting poorer month by month. That is untrue; our net wealth has increased roughly three-fold over the past decade. A current account deficit essentially means that part of our investment is being funded by foreign saving; that means we are not as wealthy as we would be if we had been able to fund it all ourselves, but it does not mean we are poorer. By tapping foreign capital, we can take advantage of more investment opportunities to boost our wealth. The real issue is how well we use the foreign capital, and how vulnerable our reliance on it makes us in a volatile financial world. The external constraint emerges because, simply, there are qualifications to the 'consenting adults' view of the world in which deficits do not matter. If there are doubts about the viability of overseas funded investments, these could give rise to concerns about the sustainability of the debt burden. It might be argued that we should not worry too much on this score because sharp-pencilled investors would not undertake investments that could not meet the associated debt repayments. Unfortunately, that is not always the case, as the over-building of office blocks in the 1980s testifies. A heavy reliance on foreign savings also means that we are more susceptible to potentially abrupt swings in financial market sentiment. If markets were to doubt our ongoing capacity to service foreign debt, and were to unload Australian assets, they could probably enforce a sharp and costly economic adjustment. It is in this sense that there is still an external constraint. If the current account deficit widens too quickly during the expansion phase of the cycle, and creditors lose confidence in the conduct of our affairs, sharp changes in market sentiment could bring on measures to cut short the recovery. It is for policy to try to pre-empt that possibility. Now is an opportune time to be thinking about this, given the likely pressures on national savings to fund a big expansion in investment over the years ahead. The more of this investment that can be funded from national savings the less we will have to call upon foreign savings, and the better our chances of fending off the external constraint. National savings are affected by developments in both the private and public sectors. Private saving is affected by the cycle but, in trend terms, has been fairly steady over inflation and (over time) the Superannuation Guarantee Charge could add to private saving, but it is difficult to be prescriptive about measures to boost private savings. The situation is clearer with public sector saving. This is where most of the long-term deterioration in national savings has occurred. It is also where dissaving during the recent recession has been most pronounced when, appropriately in the circumstances, the budget deficit was allowed to expand. With the recovery gathering momentum, however, it is just as appropriate now to be winding in the budget deficit. This argument can be sustained without recourse to the idea of 'twin deficits' - the notion, popular in the 1980s, that higher public saving is reflected commensurately in a lower current account deficit. That particular debating tool appears to have backfired, to the extent that it has generated the counterargument we hear today that higher public saving did not deliver a lower current account deficit in the 1980s so it will not work now. This is all too simplistic. What is true (by definition) is that the aggregate of the private sector's spending balance (ie the excess of its investment over its saving) and the public sector's spending balance (ie its budget deficit) is always equal to the current account deficit. The linkage between the public sector deficit and the current account deficit, however, is more tenuous because the private sector balance can also change. This is what happened in the late 1980s when business investment boomed, spurred by high profits, better terms of trade, rapid bank lending and rising asset prices. In effect, the increases in public sector savings stemming from budget surpluses were offset by increases in private sector investment, rather than by reductions in current account deficits (foreign savings). That does not mean, of course, that the policy of public sector restraint was misguided. On the contrary, it was entirely appropriate, and the current account deficit would have been much worse if it had not occurred. In addition, the budget surpluses that were generated later allowed scope for a responsible expansion of government spending during the recession: fiscal discipline during the good years allowed some latitude when things were less good. Many countries today do not enjoy the latitude we have had in recent years. The situation today is quite simple. We need a big lift in business investment, and we think it is coming. We should fund as much as possible of this from domestic saving. We could continue to draw heavily on foreign saving for a time - that is, run higher current account deficits - but ultimately there are limits to how far this is feasible. Without more domestic saving, these limits would probably be reached before we had all the investment we needed. By increasing our own saving efforts, and in particular public sector saving, we can push out the external constraint to sustainable growth. Fiscal policy is moving in the right direction. The federal government's goal of reducing the budget deficit to around 1 per cent of GDP by 1996/97 is a useful benchmark, but given the present outlook, the case is for doing more, rather than less. Calls to use any higher revenues flowing from a stronger economy - the so-called 'growth dividend' - to boost spending rather than reduce the deficit are misguided in my view. For a start, while growth is looking stronger than was expected last August, inflation will be lower than was assumed and windfall revenues are likely to be fewer than is commonly anticipated. More importantly, effective management of the recovery requires not just relying upon cyclical adjustments to the budget numbers. It also requires the progressive unwinding of the discretionary fiscal stimulus of the last few years, to provide more room for increased business investment. Two further points can be made in the context of the external constraint. The first is to underline the earlier emphasis on the quality of investment. If we are to argue in favour of containing government demands for credit and resources to 'make room' for private investment, we have also to be sure we get the right kind of investment, and not repeat the mistakes of the late 1980s. That does not appear to be a major issue at this time. To date, the modest recovery in business investment has been concentrated in plant and equipment (see Graph 5), and that is likely to be the case for some time - partly because no early resumption of new investment in office blocks is in sight, and partly because low inflation and a more chastened financial system should favour longer-term productive investments ahead of speculative investments. terms), and manufactured goods no less than 16 per cent per annum. As the world economy gradually picks up, we can expect to see some improvement in Australia's terms of trade, and some upward pressure on the $A (but probably less than in the late 1980s, given that Australia's inflation and interest rates now are more in line with those of other major countries). This should not do any lasting damage to our competitiveness. We understand that a sustained exchange rate appreciation has implications for the ability of our exporters to compete. We have no wish to see an overvalued (or undervalued) exchange rate as a persistent situation. Intervention can help at times, and we will continue to use that tool (in both directions) when we judge the rate to be departing substantially from the 'fundamentals'. But there is little the Bank can or should do through intervention or in other ways to prevent well-based and sustained moves in the exchange rate. At the end of the day, our international competitiveness depends on our productivity performance relative to other countries, not on attempts to engineer particular exchange rate outcomes. This is another way of saying that we need on-going micro-economic reform so that Australia can, at least, keep up with the growth in productivity and innovation occurring in other countries. Progress is being made in several areas but no end of challenges remain. Many require a concerted, national approach. If 'co-operative federalism' and competition policy can be carried beyond the rhetoric, we could expect to see substantial productivity gains in transport, power generation and many other activities in the years ahead. What are the implications of all this for monetary policy? It is quite clear to everyone now that the policy environment has altered. The recovery The second point concerns our competitiveness, which is relevant to the other side of the current account coin, our trade performance. As a nation, we need to save more and we need to remain internationally competitive. Staying competitive will obviously help to keep the current account deficit manageable. On simple measures, Australia is now roughly 30 per cent more competitive than it was a decade ago. Much of this reflects the decline in the nominal exchange rate but other factors have contributed - in particular, the fact that for some time our inflation rate has been lower than that of many of our competitors. The big structural fall in the exchange rate occurred in 1985 and 1986, when the TWI fell by about 40 per cent (from 82.5 in Since that time, the exchange rate has fluctuated within a moderate range around an average TWI of 57. Over that period, exports have grown strongly, with total exports averaging 7 per cent per annum (in volume has reached the point where policies must focus on managing the growth phase of the cycle - keeping it balanced and sustainable, seeking to deliver both low unemployment and low inflation. Present policy settings are broadly appropriate for an economy where growth is picking up, without significant pressures on inflation. As the cycle matures, and confidence and borrowing and spending rise further, we can expect to reach a point where these settings will begin to look too accommodating. At that point, and notwithstanding good policies in the meanwhile, short-term interest rates may well need to rise to help keep growth at sustainable rates. In many respects, our broad approach is similar to that of the US Fed, including the belief that monetary policy should be tightened before inflation rises to unacceptable Federal Reserve waits until actual inflation worsens before taking counter measures, it would have waited far too long.' Although parallels can be drawn between the Australian and US situations, some important differences must also be noted. First, official short-term interest rates in the US were much lower than ours to start with and, two Fed adjustments on, they are still significantly lower. Secondly, the US recession was milder than ours and its recovery thus far has brought it closer to full capacity constraints; unemployment, for example, has fallen to within less than a percentage point of what is generally regarded as the US 'full employment' level. So while we have a similar approach to the US, we have a different starting position. This means that while upward adjustments in interest rates will probably be required in due course, the time to begin that adjustment is still some way off. To emphasise the main point once more, we have little to fear from stronger growth as such. The financial markets might take fright from more vigorous growth but that seems to me to reflect an erroneous view that stronger growth will automatically generate 1970s style inflation. Ultimately, it is the host of other businesses which produce the bulk of the community's income and wealth, and they need growth and a stable inflationary environment in which to expand. Good policy making has to have regard to those broader economic and social considerations. (Perpetual sedation of the economy is hardly in the financial community's own best interests anyway, because any prolonged period of poor economic performance will eventually elicit policy responses which are likely to be detrimental to the financial We expect strong growth to continue but we cannot assume it. We have to remain alert to potential constraints of the kind mentioned in this talk. At the end of the day, the role of monetary policy in helping to manage the recovery will depend on the behaviour of all the main players, including businesses, workers and governments. To the extent that sufficient business investment is forthcoming to avoid any early onset of physical capacity constraints, that will help in deferring the onset of tighter monetary policies. Sustained wage and price moderation, and progressive reductions in the budget deficit, will have similar effects. Through sensible behaviour in these areas the potential inflation and external constraints can be held at bay, and monetary policy can remain generally supportive of growth and employment - lower interest rates can be sustained longer. If, however, shortcomings in one or more of these areas were to threaten to push underlying inflation noticeably above the 2 to 3 per cent range, corrective action would have to be implemented. After a 20-year struggle to regain the low inflation key to sustained growth, it would be irresponsible to lose it now.

r940512a_BOA

australia

fraser

The rural sector is less significant in the overall economy now than in the days when I was growing up in Junee. Forty years ago, farm output represented around 20 per cent of Australia's GDP and contributed over 80 per cent of exports. Today, it accounts for less than 5 per cent of total output but still generates about a quarter of Australia's exports. These bland figures, however, say nothing about the enormous growth in farm productivity over the decades. And they say nothing of the contribution which farming communities, forged in the flames of fickle seasons and overseas markets, have made to the Australian ethos. Happily, after the setbacks of recent years, things are now starting to look better than they have for some time. The world economy is showing signs of more life and this is helping commodity prices, including some farm commodities. The recent GATT deal should, over time, boost rural incomes, as the major countries open up their markets and cut back their subsidies. The expanding middle classes in Asia hold the promise of a ready market for suppliers of high quality foodstuffs - and geography is, for once, on our side. All this you know better than I do. I plan to stick to matters closest to my own turf - matters like bank finance, interest rates and exchange rates, and how they relate to farmers and others in the real economy. I trust my remarks will not be seen as an exercise in what is sometimes disparagingly referred to as 'jawboning' - the notion that people (and markets) can be talked into behaving in ways which are contrary to their perceived self interests. The success rate with such exercises is probably close to zero, particularly when the message flies in the face of fundamental factors. My aim is more to shed some clearer light on the 'fundamentals' which enter into monetary policy decisions, in the hope that this will contribute to a better understanding of the issues and to better outcomes in various areas. Deregulation of Australia's banking system has made it more competitive and boosted the range of products available. This has been to the benefit of depositors, as well as borrowers. It has not meant open slather for the banks; deregulation has been accompanied by a framework of prudential oversight which has been strengthened over recent years. Credit outstanding to businesses of all kinds has been falling for the past three years. Some suggest this is because banks have restricted their lending to businesses, especially small businesses; bankers, on the other hand, point to a dearth of sound lending proposals. Others have suggested that a good volume of lending is actually occurring but is not yet showing up in loans outstanding because of large writeoffs and repayments. I suspect the truth comprises elements of all these explanations. The Reserve Bank has been endeavouring to get a better handle on lending to 'small businesses'. (We include farmers in this category, although lending to farmers - who are often asset rich but income poor - has its special problems.) An initial progress report was presented in the April edition of the . In general, our data confirm findings from other sources that lack of access to bank lending has not been a major problem for most small businesses in recent times. Our surveys, however, have also confirmed that working relationships between banks and their customers leave a lot to be desired. Many small businesses believe, for example, that loans officers often are not in their positions long enough to get to know their customers, or their customers to know them. Interestingly, this is a greater problem for metropolitan businesses than it is for rural businesses. Perhaps the better personal relationships rural people have with their bankers owe something to the greater efforts made by banks to employ specialists in country branches who have an understanding of farming, as well as banking. Issues such as cash flow lending, bricks and mortar security and documentation requirements often make for tensions in the relationship. Sometimes unreal expectations are displayed on one side, and excessive caution and insensitivity on the other. These are real problems and it is good to see banks and others taking steps to tackle them. Last week's White Paper also included some measures aimed at improving communications between banks and their customers. Business demand for credit is expected to grow in the period ahead as new investment in plant and equipment builds up. We believe that banks are both well placed and keen to respond to this demand. Over the past year, many banks have introduced new products to attract small and medium-sized business customers; some of these offer low interest rates capped for several years, and some waive the usual customer risk margins which would normally be added to base rates in determining interest charges. In this context, questions have been asked about the current rapid rate of lending to housing. Is it occurring at the expense of lending to business (including farmers and other small businesses)? Is it a threat to Several points can be made in response to such questions: the housing sector has rebounded in a traditional and helpful way during the current economic cycle, providing a good boost to demand when the recovery was slow to get underway; we would not wish, however, to see housing overheat to the point where it might ignite asset price inflation and spread into higher inflationary expectations generally; so far, there is little evidence of any strong or generalised rises in house prices but that situation could not be sustained if lending for housing were to continue to grow at its current rate of over 20 per cent; and so far also, the banks' focus on housing has not been a major problem because of the subdued demand for business loans, but it could become more of an issue as business investment gathers momentum. It is against this background that the Bank has talked to the banks and pointed out to them - not 'jawboned' or 'threatened' them - that the cause of sustained growth would be assisted if housing lending were to slow as business lending increased. To the extent that does not occur, and lending for housing continued to grow at a pace which threatened to push up house prices and inflationary expectations, or aggregate credit growth threatened to become excessive, the Bank would have to take those considerations into account in framing monetary policy. I turn now to interest rates, and look first at long-term rates. These are determined in the market place, and are less influenced by the authorities than short-term rates (to which I will come shortly). As everyone knows, long-term bond yields have moved up sharply in most countries over recent months, keying off rises in the US. The increases in Australia have been greater than in other countries, with ten-year yields rising by 2 to 2 percentage points since early interest rates had come to an end. In short, faster economic growth was seen as leading inevitably to higher future inflation - and hence higher interest rates. As markets often do, they reflected these concerns about the future in financial prices today, even though there is no evidence yet of heightened inflationary pressures (in the US or They might also have seen the projected stronger world economy, combined with continuing large budget deficits in major countries, as increasing the demand for capital and leading to higher real interest rates. With so much surplus capacity in the world economy, however, those kinds of global pressures seem to be some way off. In addition to these concerns, part of the momentum behind the recent rises in US bond yields appears to have come from large speculative players selling into a falling market. Some so-called 'hedge funds' were caught with leveraged long positions in bonds and when prices moved against them they were forced to cut their losses, driving prices down further. In this respect, the short-term dynamics of the bond market have resembled what we have seen in share markets in periods of panic, with holders seeking to sell at every opportunity. (Many farmers will know the sinking feeling that comes with having to sell into falling Given the dominance of the US capital market, and its strong linkages to other markets in a world where capital moves freely, the pressures in US bond markets were bound to flow through to other markets. When US portfolio managers decide to reduce their bond holdings, they tend to reduce their holdings of foreign bonds, as well as US bonds. Bond markets outside the US, aware of the linkages, are quick to follow the US lead. The flow-on effects appear to have been accentuated in Australia's case by parallel perceptions of mounting inflationary pressures with faster growth, and by specific concerns about the White Paper and the Budget. This basically reflects scepticism about the ability of the authorities to keep inflation under control over the years ahead. The decision by the Federal Reserve on February to increase US short-term interest rates by 0.25 percentage points was the trigger. The Fed has followed with two further increases, gradually tightening its previously accommodative monetary policy. Although these increases hardly came as surprises, their arrival caused markets to re-assess the outlook for growth and inflation in the US, and to conclude that the extended period of falling As I have said before, I believe that scepticism to be unjustified, and I will say more about this in a moment. But first, a word about the implications of the movements which have occurred to date. Higher long-term bond rates mean, of course, higher borrowing costs for governments with budget deficits to finance. They also mean higher interest costs for private borrowers in countries like the US and Germany where more borrowing is done in long-term capital markets. While this flow-on to lending rates may be helpful in slowing the strong US economy, it will be distinctly unhelpful (assuming it is sustained) in countries like Germany, where recovery is just beginning and unemployment is still rising. Australia is relatively well placed to absorb the effects of the recent rises in bond yields. The great bulk of banks' business and housing lending is at variable rates, which are based on short-term interest rates, and these have not moved. On the other hand, the weaker share market will make new equity raisings more difficult, while market confidence has taken a bit of a knock. Confidence in the community generally, however, remains strong and the 'real economy' should continue on its way, despite the ructions in financial markets. What does the rise in long-term bond yields mean for monetary policy in Australia? Does it mean an automatic rise in short-term rates? The short answer to the second question is 'no'. Monetary policy has to be determined essentially on the basis of Australian conditions. Overseas developments are not irrelevant, but their significance comes through their implications for the domestic economy. They could be quite significant if, for example, there were to be large rises in interest rates offshore which threatened to cause the $A to depreciate to the point where it might undermine continued low inflation. In the present episode, the exchange rate has not come under that sort of pressure. I mentioned earlier that I thought domestic bond markets, in keying off US developments, had over-reacted relative to actual conditions in Australia. Certainly, the extent of the rises in bond yields in Australia over recent months cannot be explained by any objective evidence of higher inflationary expectations. The recent March quarter CPI confirmed that underlying inflation remained around 2 per cent (where it has been for more than two years now) and most forecasters retain a medium-term prospect of continuing relatively low inflation. In the past, we have ourselves looked to yield curves for possible clues to inflationary expectations. On this occasion, however, when there is little evidence from other sources to corroborate what they are suggesting, we have to discount them as an indicator of future movements in inflation (and monetary At this point, I would like to outline our monetary policy framework in a little more detail. We start with an economy that is in good shape, with real growth of 4 per cent or more, and underlying inflation of 2 per cent. The task is to sustain solid growth with low inflation. The recession has been a factor in producing the good inflation numbers in Australia, just as it has in virtually every other country with low inflation, and the task will become more demanding as the economy moves into the cyclical upswing. With good policies and sensible behaviour, however, we believe inflation can be held in check as the economy grows. Those sceptics who take their cues from past experiences should look to the 1960s, and not just the 1970s or 1980s. We see advantages in having reasonable flexibility to adjust policies to changes in economic conditions, rather than being precommitted to certain actions, as we would be, for example, if we had a narrow and precise inflation target. We have said several times, however, that we would like to hold the underlying rate to around 2 to 3 per cent over the medium term. Our favourable starting position will be helpful in achieving that, as will the on-going effects of many of the cultural, institutional and structural changes of the past decade. In particular, price setters - and, by extension, wage setters - are exposed to more powerful competitive forces now than ever before. These are coming from reductions in tariffs and the need to get into export markets to expand production, and from various microeconomic reforms which are helping to shake up the non-traded goods sector (including government services). Looking ahead, much will depend on how events unfold and how policy responds. Our focus is on monetary policy but other policies have to play their part. In particular, fiscal policy has to do its bit to keep total demands on resources under control while providing scope for business investment to expand. Given the lags before it affects the economy, monetary policy has to be forward looking. And it has to be adjusted before significant inflationary pressures actually emerge. Against this background, the Bank is continually assessing indicators of potential pressures on inflation a year or two ahead. For the moment, the indicators are generally favourable. Capacity utilisation is picking up but it is still well short of levels which, on past experience, could be described as 'full'. Labour costs continue to grow by around 3 per cent, which is consistent with relatively low inflation being maintained. High levels of unemployment should keep the lid on general wage pressures in the near term, and enterprise bargaining provides the framework for securing productivity offsets to wage rises. The exchange rate, which threatened to be a concern during 1993, has traded more firmly of late, and import prices today show no net change compared with a year ago. Growth in the money and credit aggregates is not suggestive of any problems of excessive financial activity or incipient inflation; these readings lack precision but credit growth of around 7 per cent (six months to March at an annual rate) is not out of line with current trends in the economy. In brief, we expect inflation to remain at levels consistent with our medium-term objectives over the next year or so. Given that, and current interest rate settings, we see no pressing need to be tightening policy and raising short-term rates at this time. At some stage, the recovery can be expected to reach a point where higher short-term interest rates will be needed to contain inflation and keep growth on a sustainable path. At that time, appropriate action will be taken. Barring major unforeseen 'shocks', however, we judge that time is still some way off. I do not need to sell the benefits of low inflation to this audience. The importance to the whole economy of holding rises in prices and wage costs around the 2 to 3 per cent mark (rather than the much larger numbers of the past) has grown as the proportion of our production sold in overseas markets has increased. Today, about $1 in every $5 of national income is earned in very competitive international markets; for farmers, it is $3 in every $4. I have referred in passing to the exchange rate. I am aware that this has been a bone of contention with farmers on occasions and I would like to go over some issues in a little detail. The exchange rate was floated in 1983 not because of any great belief in the perfection of market solutions, but because the managed rate alternative had become unworkable. Floating means that the exchange rate is determined by the interplay of demand and supply - forces which farmers understand better than most. Over the medium term, the market tends to reflect so-called 'fundamental' factors, but over shorter terms other factors can sometimes over-ride the fundamentals, and send confusing signals to investors and producers. In thinking about the factors affecting the exchange rate, it is useful to look first at inflation. Countries with relatively high rates of inflation are likely to see their currencies depreciate, to compensate for their higher costs relative to the rest of the world. Adjusting the nominal exchange rate for our relative inflation performance provides a measure of the 'real' exchange rate, which is what matters for exporters. Graph 2 shows that this inflation differential explains the large trend fall in our nominal exchange rate, but it does not explain swings in the real rate. matters can form and change quite quickly, and cause volatile exchange rate movements when they do. In our judgment, the broad sweep of the exchange rate since the mid 1980s is explainable in terms of fundamental factors, such as inflation and interest rate differentials, terms of trade, current account deficits and foreign debt accumulation. This is not to say exchange rates always move in ways we find easy to explain, or that a 'hands off' policy is always appropriate. The exchange rate can be susceptible to sharp changes in market sentiment, which are not always soundly based. In some episodes, speculative flows have moved the exchange rate - in both directions - well away from levels which we judged to be consistent with the fundamentals. In mid 1990, for example, when the rate was clearly overvalued, given that Australia was slipping into recession, interest differentials were moving against us, and the terms of trade were falling. In September 1993, when the rate fell to a low of back of concerns about whether or not the Budget would pass the Senate, it was clearly undervalued. On those (and other) occasions, when we judged that the rate had moved well away from the 'fundamentals', the Bank has intervened. We have, then, been on both sides of the market, selling Australian dollars when the rate was judged to be too high, and buying them when it looked too weak. We have not, however, targetted any particular exchange rate, nor do we believe it would be sensible to try to do so. Our experience suggests that intervention can be effective when it is directed towards returning the rate to a level more in line with long-term fundamentals. Although not an objective as such, the Bank's intervention, overall, has been profitable - which is consistent with it performing a stabilising role. It is generally understood today that international competitiveness cannot be sustained through artificially depreciating the exchange rate: any short-term advantage will Movements in the real rate reflect developments in both the current account and the capital account of the balance of payments. The current account is influenced by cyclical swings (in both Australia and the world economy), and by structural factors (such as trade protection policies in both Australia and overseas). Trends in productivity and in commodity prices are obviously important; countries with relatively high rates of productivity growth tend to have stronger current accounts and appreciating currencies. Rising commodity prices tend to exert upward pressure on the exchange rate, and vice versa. Some of these factors like relative productivity performance exert their influence only slowly. Other factors, which operate mainly through the capital account, have a more immediate influence. These are mostly financial in nature, and reflect expectations about interest rates, share prices and exchange rates. We all know that expectations about such be lost sooner or later through higher domestic inflation. What the exchange rate giveth, high inflation taketh away! That is why keeping inflation under control and accelerating microeconomic reforms are so critical. Better industrial relations, continuing wage restraint, lower tariffs, financial deregulation, industry restructuring, trade links with Asia, and progressive work and business attitudes are what improves productivity and competitiveness, not attempts to artificially depress the exchange rate. Over most of the past decade, the trade weighted index has fluctuated around a level of about 57, somewhat above its present level particularly of manufactured goods - have increased dramatically. This suggests that businesses have been competitive at this sort of exchange rate and remain so. It suggests also that exporters have found ways of coping with recurrent bouts of exchange rate volatility. As to interest rates, Australia is a little behind the US in the recovery phase so that differentials could move against Australia for a time, as US authorities continue to tighten monetary policy. This factor apart, interest differentials on Australian dollar assets will reflect many factors which are impossible to predict. What we can be more confident about is that inflation in Australia will remain comparable with that in our major trading partners, and so, therefore, should interest rates. This suggests that interest differentials are unlikely to produce anything like the same incentive for capital inflow that they did in the late 1980s. The Reserve Bank is not in the business of trying to predict the net effect of these and other influences on the exchange rate. But we can be sure that the rate will move about, as it is supposed to in a floating regime. It has remained fairly steady over recent months, notwithstanding problems in the bond markets, and the Bank has not intervened in any significant way since last September. We are happy with that situation. If, however, the rate does 'overshoot' in a major way - in either direction - we stand ready to intervene. As I said earlier, intervention can sometimes help, but the bottom line, realistically, is that potentially disruptive, short-term capital flows are something we have to live with. They cannot be 'regulated away': we have to play with the cards that are dealt. The main contribution the Bank can make to promoting greater stability is through a monetary policy which keeps inflation in check, while supporting reasonable economic growth. Low inflation facilitates low interest rates, which are more conducive to long-term investment and less prone to attracting the sort of capital that chases financial market volatility and high short-term gains. Beyond that, the best response to excessive reliance on foreign capital (whether short or long-term) is to reduce our calls on it. This, as everyone knows, requires a better domestic savings effort, which comes back unfailingly to more private and, especially, public saving. On the latter, Tuesday's Budget papers provide Over the months ahead, the main influences on the exchange rate are likely to be commodity prices and interest differentials. With the outlook for the international economy looking a little brighter, the tentative improvements in commodity prices we have seen since last September should move further in Australia's favour. This could exert some upward influence on the exchange rate. some reassurance. They show, for example, that budget outlays as a proportion of GDP are projected to decline continuously over the next four years; this story holds when the proceeds of asset sales are excluded. The Budget papers also show that the deficit is now projected to be a little under 1 per cent in 1996/97, and to virtually disappear the following year. That is a comforting mediumterm benchmark - especially compared with the more modest goals which many other countries are aiming for. But there can be no certainty that this projected medium-term path will match exactly the dictates of macroeconomic policy and debt management as the economic cycle rolls on. In the past, the Government has demonstrated a preparedness to take tough fiscal decisions, and I would expect the Government to display the same resolve in the future, if that should be necessary.

r940523a_BOA

australia

fraser

As supervisor of the banks, the Reserve Bank has been likened to the shepherd tending his flock. Keeping the flock intact over the past decade, after the regulatory fences came down, has had its moments. A couple have wandered off, and a couple have lost more than their tails. But no carcasses litter the landscape. Indeed, the flock today is looking stronger and healthier than it has for some time, although still requiring careful husbandry. Today I plan to focus on a few topical subjects, namely lending for housing and for small businesses, and the vexed issue of bank interest margins. I do so from a perspective which embraces both prudential supervision and macroeconomic policy. If there is a single theme, it is that while we have quite a lot of competition in our banking system, we could benefit from more - even if, at times, there is the appearance of having too much of a good Banks are the major source of debt finance for both households and businesses, accounting for about three-quarters and two-thirds respectively of all debt finance provided to those sectors. Healthy banks, able and keen to lend, help make for a healthy economy. Happily, our system is in better shape now than it was a few years ago: non-performing loans of the banks (ie. loans on which full interest payments are not expected or are overdue 90 days) now represent, on average, about 2 per cent of assets, compared with a peak of 6 per the average capital ratio across the banking system is close to 12 per cent, well above the 8 per cent minimum requirement mainly because of reduced provisions for bad debts and lower operating costs. Good and sustained profits are one sign of a healthy bank and, consequently, profitability is an important focus for supervisors (and depositors). It is by no means the only focus, however; as well as being profitable, the Reserve Bank looks to the banks, to the extent these things are reconcilable, to be efficient intermediaries, and to be responsive to the needs of the economy and the community. Given their improving health, the banks are well placed to finance a growing economy. They are also, I believe, keen to do this. In March 1994, total credit extended by banks to the private sector was about 7 per cent higher than a year earlier, its highest growth rate for three years. Looking behind this growth in total credit, we see that it has occurred almost entirely in two years, banks' housing loans outstanding have grown by 19 per cent per annum. Building societies and other non-bank institutions also have expanded their lending into this competitive market. Over the year to total housing lending has grown by about 21 per cent, following an increase of 18 per cent in the preceding year. Some people have suggested that the banks' appetite for housing loans has been whetted by the concessional risk weight applied to housing in the capital adequacy arrangements. These arrangements, which have been in operation since 1988, require banks to hold capital equivalent to 4 per cent of their housing loans, but 8 per cent in respect of most of their other loans. In other words, loans secured by residential mortgages can be funded by 4 per cent capital and 96 per cent deposits, whereas ordinary loans require 8 per cent capital and 92 per cent deposits. This advantage, however, is not all that large - it is estimated to be worth about half of one percentage point on the average housing loan interest rate (calculated as 4 per cent of the difference between the cost of capital and the cost of deposits). The lower weight, moreover, can be justified by the banks' extremely low default experience with housing loans. The main factor driving the recent strong growth in housing lending is not this regulatory device but the best level of housing affordability in almost a decade - in part, reflecting the lowest nominal housing interest rate since 1974. The associated increase in housing activity has been a normal and helpful part of our cyclical recovery. To this time at least, there are few signs of the industry overheating, or of large, widespread rises in house prices. But we can have too much of a good thing, and we are looking to housing lending to slow down. As we have said before, we would be concerned if lending for housing were to go on growing at 20 per cent. These concerns are macroeconomic rather than prudential, although the latter are not entirely irrelevant. The banks do need, for example, to keep to prudent loan to valuation ratios in their housing lending. Even then, problems could still arise in individual cases - particularly for borrowers - if circumstances were to change in unexpected ways. Those user-friendly computers which feature so prominently in bank advertisements would seem an ideal vehicle for borrowers to explore the full range of contingencies - to check what their repayments would be in the event of, say, higher interest rates. The macroeconomic concern, of course, is that if this lending were to continue to grow at recent rates it would risk sharp rises in house prices and a return of asset price expectations of the kind last seen in the late 1980s. That situation has not been reached - indeed, housing lending and dwelling investment are both showing some signs of flattening out, albeit at high levels. Developments in these areas are being monitored closely. Not all lending secured against houses is for the purchase or extension of those houses. Increasingly, banks are allowing - even enticing - consumers to borrow for other purposes as well, with the advantage of relatively lower home loan interest rates. What should we make of a situation where loans for almost any consumption purpose can be included in home loans? Again, prudential and macroeconomic policy issues are involved. From the latter perspective, it would be perverse if these products were to result in more of the nation's savings being channelled into consumption when the emphasis should be on marshalling those savings for the expected - and necessary - lift in business investment. It is not clear that significant diversion is occurring at this time, but the situation is being watched. From a prudential perspective, this lending - again within limits - need not be a cause of concern, given the good track record of loans secured against housing and the relatively light debt burdens of Australian households (see Graph 3). Rather, it can be seen as an illustration of how competition among the banks can benefit the man in the street, enabling low interest housing borrowing to be substituted for higher interest credit card or personal loan borrowing. What is 'within limits' is a matter of judgment. Current debt ratios appear comfortable enough, with debt service payments equivalent to around 8 per cent of household income, compared with levels of 6 per cent in the 1970s and 10 per cent in the 1980s. Some increase, therefore, will hardly be fatal but, again, we need to avoid making too much of a good thing. Households might feel comfortable with current ratios but in some cases this will be because current interest rates, however, cannot be assumed to remain at these levels. At some point in the business cycle, they are likely to go higher. Moreover, wage rises, which in the past have tended to ease the burden of housing repayments over time, will be much smaller in a low inflation world. It would be imprudent, for borrowers and lenders alike, not to allow for such developments. Borrowers must take individual responsibility for their decisions, and they should be mindful of the consequences of changed circumstances on increased levels of indebtedness; the fall in house prices and the rise in unemployment in the recent recession in the UK illustrate the problems that can befall over-indebted households. As to the banks, we certainly expect them to be alert to the risks of changing circumstances, and to take them into account when lending to customers, as envisaged in the Code of Banking Practice. And they need to be careful not to push their new products to the point where historically low default rates on housing loans start to creep up. Some of you might be wondering whether the Reserve Bank should do more. How far the Bank should go in stripping banks and households of the responsibility for their actions is a tricky question. We know from experience that banks and their customers will make some mistakes, which the Bank could not stop even if it tried. Given our deregulated framework, we believe the best course is for the Bank, in its on-going oversight of the banks, to do what it can to heighten awareness of the risks banks and their customers might be running. If, notwithstanding this, some go too close to the edge and fall over, this will be unfortunate - and the shepherd will, no doubt, be blamed! As noted earlier, total business credit has declined somewhat from the peak levels of three years ago. This experience appears to be common to both large and small businesses. Over this period, firms have relied heavily on internally generated cash flows and new equity raisings to meet their funding needs. Those funds have been used mostly to repay debt, rather than to finance new investment. It is this lack of interest in undertaking new investment, rather than a lack of interest on the part of banks, which probably explains much of the fall in business lending (although the preoccupations and cautions bred of the late 1980s excesses and subsequent recession were no doubt important contributory factors). The scene is set for business investment to bounce back. Profits are good, and while business surveys are not yet indicating any general pressure on physical capacity, rising domestic - and, prospectively, international - activity will change this. We have also moved into a new, low inflation environment - something which, I trust, firms have noticed and are factoring into their calculations of the nominal return they require from their investments. The sooner business investment moves up, the more confident we can be that premature capacity shortages will not frustrate sustained jobs growth with low inflation. Business demand for bank credit can be expected to rise as investment rises. Bank finance is especially important for small and medium firms which cannot go to capital markets for funds. The Reserve Bank has made no secret of its wish for banks to become more involved in lending to such businesses. Not only are they major generators of exports and jobs, but also they are natural customers of the banks. Again, we point these things out to the banks and we urge them to switch some of their energies from housing to small businesses but we stop short, in our deregulated environment, of directing them to lend in particular volumes. A popular perception is that small businesses are being constrained by availability of bank finance. Anecdotes abound but hard data are scarce. We are, however, now getting a better feel for small business lending, following the establishment of an advisory panel, the introduction of a new statistical collection, and the commissioning of two surveys of small businesses. Some of our findings were published in the for April. (That article is to be reproduced, I understand, in the AIB's journal in June.) In brief, our findings suggest that access to bank credit is not a major obstacle to the expansion of most small and medium businesses. This is in line with indications from other surveys. Although small businesses have a number of criticisms of banks, and the general view is often expressed that banks are unwilling to lend, relatively few small businesses are actually refused finance. Some are refused, of course, but this has always been the case, and always will be. Small businesses pay more on average for a bank loan than larger businesses, but the difference does not seem to be disproportionate to the greater risks and administrative costs associated with such lending. I am happy to observe that many banks are now making greater efforts to market loans to the small and medium sized business sector. Over the past year or so, more banks have been positioning themselves in this market and offering special deals. I would like to think that this is at least partly in response to Reserve Bank encouragement, and to the decision to pay a market rate of interest on the NonCallable Deposits (NCDs) held by the banks with the Reserve Bank. Whatever the reasons, many banks now offer discounted rates on special deals for new investment by small businesses. Generally speaking, a discount of 1 - 2 percentage points is offered on the variable rates normally charged to business customers. One smaller bank is offering a business loan, secured by residential real estate, at the same rate of interest that home borrowers pay, with no added customer risk margins. Although not all that significant in the overall scheme of things, it illustrates the interest which smaller banks are now taking in lending to this sector and the competition they can provide here (as they have in housing). The working relationships between banks and their customers also appear to be improving gradually, from the dismal depths reached during the recession. Some tension, however, is inherent in the relationship. Security is a case in point. Some borrowers complain that banks always want too much security. At the same time, there are some borrowers who would prefer to keep their equity out of the business and leave the bank to carry most of the risk. In a survey commissioned recently by the Reserve Bank, over 70 per cent of metropolitan small businesses believed banks insisted on too much security but relatively few reported they had been refused a loan in the past year because of insufficient security (or any other reason for that matter). In this and other areas where problems have more to do with perceptions than realities, banks could do their own cause no end of good by being clearer and more sensitive in their dealings and communications with their small business (and other) customers. I believe there is a desire on the part of banks to lift their game and, in time, the training and information programs now underway should deliver better results. I turn now to the issue of bank interest rate margins - the difference between the interest rates at which banks borrow and the rates at which they lend. This issue has been around for some time. It first rose to prominence in mid 1990, shortly after official interest rates had begun to fall. Claims were made at the time that banks were not passing on to borrowers the benefits of lower official rates but were instead increasing their margins and profits to help cover their mistakes in the late 1980s. Like a good shepherd, we investigated these claims. Our findings have been reported on a number of occasions, including in a special article in the May 1992 edition of the Bank's , and in its recent Annual Reports. The first task was to clear up some of the confusion about the concept. Many commentators viewed the margin simply as the gap between an individual loan rate, such as a business indicator rate, and an individual deposit rate, such as the overnight cash rate. Such measures can sometimes shed light on the size of the margin seemingly attached to individual products, but they do not do justice to the complexity of overall trends and broader issues in margins. Single measures cannot, for example, capture the substantial changes which have occurred over time in the composition of banks' loans and deposits. To give one illustration, since 1981 banks' low cost deposits have declined from over 50 per cent of total deposits to 15 per cent (Graph 5); this means that, at any given structure of interest rates, the banks have to pay a higher average cost for their funds now than they did in earlier periods. Rather than look at single measures, we believe it is more valid - when assessing the impact of interest rate movements on bank profits - to look at measures of average margins across all loans and deposits. This has been the focus of the Bank's work on margins. If we look at the difference between the average interest rate the four majors have earned on all their loans (including non-accrual loans) and the average interest rate they have paid on all their deposits, we see that there has been no significant change in the margin over the past four years; it has been quite steady at around 4 percentage points. This is the 'net' interest margin (or 'spread') shown in Graph 6. If we want to see the effect of the growth in non-accrual loans, we can add in the estimated interest forgone by the banks on such loans. This gives the 'gross' interest margin (or 'spread'), also shown in Graph 6; its level is a little higher but it shows much the same trend as the net interest margin. Looked at another way, the banks have not reduced the average cost of their deposits by as much as the reduction in official interest rates, because of competition for funds and the greater interest awareness of depositors these days. The average lending rates of the banks, however, have fallen in line with the fall in their average cost of funds. To the extent that the full reduction in official rates has not been passed on to borrowers, it has gone to depositors, not to the banks in higher margins. To say that banks have not increased their profits by increasing their margins is neither to endorse current margins, nor to suggest that they are immutable. Indeed, we have said several times that we expect margins to decline over time, as competition within the banking sector heats up further. More recently, the debate has shifted away from trends in margins over time to levels of margins: specifically, are the margins of Australian banks too high? They might be, but that is not something that is easily established, and certainly not from the data currently available on international comparisons of margins. The two most quoted sources of international comparisons in the Australian debate have been the OECD and Salomon Brothers, the US investment bank. For what they are worth, both sources suggest margins in Australia are roughly on a par with those in the US and UK but higher than those in Japan, Germany and Switzerland. The data, however, are not worth very much: the basic problem with both sources is that they do not compare like with like. The Salomon Brothers data relate to a small number of banks in several countries, but the banks are hardly comparable. The US 'money centre' banks (such as Citibank and Bankers Trust) and the large Japanese 'city banks', bear little resemblance to the four 'majors' shown for Australia. The OECD covers more banks and includes data for different sub-groups of bank, but the standardisation problem remains; the OECD acknowledges this and urges caution in using its data for comparative purposes. Meaningful comparisons require that Australian banks be compared with broadly similar banks in other countries. This is not done at present. It makes no sense to compare the margins of the Australian majors, which are predominantly retail banks operating large branch networks and offering a wide range of household and business products, with very large banks in other countries, which are predominantly wholesale banks servicing mainly professional money and securities markets. The latter banks will, inherently, deliver slimmer margins than the Australian banks. Personally, I doubt whether, even with considerable research, we will ever produce entirely satisfactory international data on bank margins. Given the interest in the topic, however, and the shortcomings in the existing data, we indicated to the House of time ago that we would try to compile some comparable data. To this end, we are currently assembling data on a selection of banks in the two continental European countries which are closest to the Australian majors in terms of size, product mix, branch structure, regulatory environment, and so on. We will be looking not only at margins - which relate to only part of a bank's activities - but also at broader measures of profitability and efficiency. We hope to be in a position to include some results We will have to await the completion of that work to assess the usefulness of the results. But we do not need international data to ask questions about whether the performance of Australian banks can be improved and existing margins lowered. As indicated earlier, we expect margins in Australia to narrow over time as banks compete more vigorously for business, and for the deposits to fund them. In our view, effective competition among banks is the best way to ensure 'acceptable' levels of bank margins, profits and efficiency - 'acceptability' being defined not in terms of rankings with other countries, but in terms of the amount of competition and other changes which we, as a community, are prepared to accept to see lower margins in our banks. I will conclude with some additional comments which might help to make clearer what I have in mind here. If the margin on a particular bank product is perceived to be on the 'fat' side, competitive pressures should trim that back over time. So long as there is effective competition, other players will enter the market for the fat margin products and compete down the margin. Housing lending is an area where many observers believe margins err on the generous side, and competition does seem to have stepped up in this area - not only in the special deals being offered by different banks but also through the entry of non-banks (such as GIO and, Mutual venture) into this market. is, therefore, essential to keeping downward pressure on margins. Our banks are already quite competitive and, with the problems of the early 1990s now largely behind them, should become even more so in the future. We have a large number of banks and there are no special barriers to entry, although the restrictions sometimes imposed on sales of existing institutions do not always give top billing to considerations of competitiveness. The arrival of foreign banks in the mid-1980s served to increase competition in Australian banking, and the further liberalisation of policy in 1992 will, at the margin, work in the same direction; so far, six new banking authorities have been issued. (iii) Competition in the real world, however, seldom works in the manner described in the textbooks. There it is assumed that customers will actively play their part, and be prepared to shop around and switch their business if necessary. If they do shop around, they are likely to discover that they can get better deals on particular products from different banks. But in practice many borrowers are reluctant to shop around for a number of reasons, including inertia and the convenience of current 'packaged' services (comprising housing loan, cheque account, credit cards and so on), reluctance to try nontraditional sources of funds, and the actual or perceived costs of switching some or all transactions from one bank to another. To the extent that customers do not shop around for individual products, however, the competitive pressure on banks is reduced. (iv) Associated with this last point is the extensive cross-subsidisation of different groups of services and customers which still exists in Australian banking. Many customers, for example, pay few charges for most of their transactions, provided they maintain a relatively small minimum transaction account balance. Competition should, over time, lead some banks to undercut others on the products that are very profitable (the source of the cross-subsidies), while not offering the products that are unprofitable; for the reasons mentioned, however, this tends to be a slow process. But as it proceeds, banks will have to move to full cost pricing by making greater use of fees for services; if they do not move in this direction, they risk losing market share in profitable products, and increasing it in unprofitable ones. While some bank products will become cheaper, the rise in charges for others could be substantial; these will not be accepted quietly by most bank customers, but they do seem to be an inevitable consequence of more vigorous competition among the banks. At present, to the extent that costs of some services are not recouped directly from the users of those services, they are being recouped indirectly in other ways - some borrowers pay more while some depositors receive less than would otherwise be the case. In other words, margins are higher than they would otherwise be. (v) The efficiency of the banking system in delivering its services is also important. The more efficient the banks are, the easier it will be for them to maintain good profits and lower margins. Banks have taken many steps in recent years to cut costs and in other ways become more efficient, and the effects are now beginning to show up in their bottom lines. Banks can, no doubt, be made more efficient still but many of the avenues for achieving this (such as further branch closures and staff reductions) will not be popular. These, then, are some of the questions and constraints that need to be considered when we talk about bank margins. We are looking at them, along with the banks and a lot of others. The whole subject is clearly more complicated than might be inferred from international comparisons, even if those were not seriously flawed. It is, moreover, one where community expectations appear to be pulling in a number of directions at the one time. Everyone would like to see lower costs and margins, but not everyone is as keen to see the service fees, branch closures, staff reductions and other changes necessary to bring them about. Those changes must, however, be part of the process.

r940713a_BOA

australia

fraser

Australia since I spoke at the corresponding BZW seminar last September, most of it good. The best news is that the Australian economy is now growing quite strongly and that inflation is under control. I suspect you know this already; these days economic news - good and bad - travels quickly. Indeed, in London a few weeks ago I spoke to several groups of funds managers with investments in Australia and I made a point of asking them what it was that concerned them most about Australia. With only slight exaggeration, the common answer can be summarised as 'too much good news'! Today it is not so much a matter of whether the news about Australia is good or bad (as it was a year ago), but rather what all the 'good' news means. The short answer is that it can mean different things to different people. For investors in Australian bonds, for example, it appears to raise some doubts about our ability to manage the good times without recurring boom and bust conditions. Others will see the same things differently. For businesses (large and small), for example, it means the best economic outlook in decades. Confidence and profitability are at record levels, and businesses of all kinds are poised to take advantage of the projected world recovery. For unemployed workers - and while the numbers are declining, 10 per cent of the workforce is still unemployed - it means the best chance in a long time of finding a job. Sustained economic growth is inherently the best cure for the economic and social ills of high unemployment. Governments - and central banks - have to weigh up the interests and aspirations of all groups in the community in coming to judgments about economic policy. It is my view that, properly managed, current trends can deliver a long period of strong, noninflationary growth. I will return to some particular aspects of this management task later in my talk. But first I should enlarge on what is happening in the 'real' economy: it is those developments which ultimately determine the returns to everyone who lives, works and invests in In terms of output, the Australian economy bottomed in mid-1991 and has been recovering since then. It has been a fairly gradual recovery but the pace has quickened recently, to a very respectable rate of 4 to 5 per cent. It has been a fairly traditional recovery, being led by consumer spending, housing investment and public spending. It is a recovery with many quality features. In particular, productivity appears to be growing strongly, while export volumes - notwithstanding the slack world economy - have increased by more than 20 per cent over the past three years. Inflation has averaged less than 2 per cent a year through the recovery. I find it hard to accept that 4 to 5 per cent growth and 2 per cent inflation, which we now are experiencing, is 'too much good news'. That growth rate is above what can be sustained long term, but it is sustainable for a time because we started with considerable spare capacity. This is being taken up at a measured pace; it has taken three years for output to rise 10 per cent above its trough in this recovery, compared with only a year and a half in the early 1980s recovery. with the where unemployment (at 6 per cent) is close to its effective floor, Australia has no real pressures on labour supplies. We do, however, need a pick-up in business investment soon to head off possible physical capacity constraints a year or two out. In the meanwhile, businesses are using their existing plant more efficiently, and a lot more output is being squeezed out of it. The scene is set for a strong recovery in business investment. Sales are rising, company profits are the highest they have been for 25 years, and cash flows are strong. Moreover, banks in Australia, which are now returning to better levels of profitability and have an average capital ratio of 12 per cent, are well placed to assist. All business surveys point to the high levels of confidence and investment intentions. Timing is always difficult to predict but a large increase in investment in new plant and equipment is anticipated over the year ahead. This is not expected to cause aggregate demand to grow too strongly; even with a substantial increase in business investment, the overall pace of growth is forecast to remain secret, however, that we would like to see the on-going strength in housing lending ease off as business credit picks up. The two major perceived threats to keeping Australia on the narrow path of sustained growth are blowouts in the current account and inflation. How real are these threats? Australia has always run a significant current account deficit, that being, in effect, the channel through which we have drawn on foreign savings to help finance our development. The 'brooding pessimism' about Australia's external sector resurfaced in the 1980s, when the deficit averaged close to 5 per cent of GDP, about double the long-term average. The underlying situation, however, has shown some improvement since the Asian economies, which are now the destination for almost two-thirds of Australia's total exports. Last year, the current account deficit represented about 3 per cent of GDP. It is forecast to increase a little in 1994/95, mainly for cyclical reasons. Strong domestic growth will add to the demand for imports, especially of capital equipment. Rises in interest rates will also add to debt service costs. On the other hand, stronger world growth should bring some offsets through higher export volumes and prices. Seen in terms of an excess of investment over domestic savings, a structural change in the current account deficit requires a counterpart change in the domestic savings/ investment imbalance. All I want to say about this important issue today is that policy makers understand the need to increase domestic savings. To that effect, steps have been taken to encourage private savings, particularly through compulsory superannuation arrangements, and (what is quantitatively more important) to raise public savings through reductions in the budget deficit. By international standards, Australia's budget deficit is not high. This year, it is estimated to be about 3 per cent of GDP, or about half the average for member countries Government, moreover, is committed to reduce its budget deficit to under 1 per cent of GDP by 1996/97. I am hopeful that it will be able to do better than that, and I am encouraged in this view by recent comments by the Treasurer that, if necessary, additional measures will be taken to reduce the deficit. Such comments are comforting to a central banker because, when the time comes to pull on the reins to keep the economy on a sustainable path, it is helpful for fiscal - as well as monetary - policy to be involved. However it is viewed, the current account deficit should not be a major constraint over the years ahead. At the same time, there is still some unfinished business for Australia in this area. the mid-1980s when the balance on goods and services balance needs to be held around zero (or better) to stabilise the foreign debt to GDP The current account deficit can be viewed from two perspectives. One focuses on export and import performances, and the other on the national savings/investment balance. As to the former, imports and exports have both increased relative to GDP as Australia has become more integrated with the rest of the world. The strong export story which I outlined last year, built around the strength of manufacturing and service exports, remains true today. In part, it reflects the expansion of A more serious threat, in the eyes of some people, is a blowout on inflation. Seen in historical perspective, it is wrong to view Australia as a chronically inflation-prone the Korean War but that passed quickly, to be followed by roughly two decades of low average inflation and good growth. This record was broken in the 1970s by oil and commodity price shocks, exacerbated by policy shortcomings. In the 1980s, progress in winding back inflation was interrupted by the 35 per cent depreciation of the $A in the middle of the decade. Yet, in the years of strong growth in the late 1980s (before the onset of recession), Australia's rate of inflation had begun to ease back. other times (as in the 1970s and early 1980s) it served to spread wage pressures throughout the economy. It also provided few linkages between wage outcomes and enterprise level productivity, and hence little incentive for employers and employees to negotiate 'win/win' changes to work practices. With the shift from centralised increases towards enterprise based adjustments, the earlier linkages have been broken and wage increases are coming to depend more on the productivity performance of individual enterprises. The new system is still evolving, and it has had its teething troubles. It does not eliminate the dangers of excessive wage claims, but it does embody the prospect of a less inflation-prone wages system. This prospect is enhanced by the concern for price and cost competitiveness which now pervades all businesses (including government enterprises) in Australia. In part, it reflects the greater exposure of the economy to international competition, along with associated attitudinal changes. One catalyst was the reduction in protection from imports, which has been halved over the last decade. Another is the mobility of investment and production processes, which has concentrated the minds of all the parties with an interest in attracting and keeping businesses in Australia. Global linkages also have brought improved practices, such as benchmarking. These structural and attitudinal changes can be seen in Australia's better macro productivity performance during the recovery. They are encapsulated also in what has been described as 'the renaissance of manufacturing': over the past year, that sector's output rose by 10 per cent; productivity rose by 8 per cent; and exports increased by 20 per cent. The bottom line of all this is that wage increases have been relatively modest in Australia for some time now. Increases in earnings have averaged 3 per cent per annum over the past three years. Some additional pressures can be expected as the recovery consolidates, but the slack in the labour market, lower inflationary expectations, and the changes mentioned earlier (in exposure Why are our prospects for maintaining low inflation better now than in the 1970s and 1980s? The short answer is that the two main culprits in the past - excessive wage outcomes and exchange rate problems - are now seen as less threatening. Under Australia's earlier centralised wage system, wage increases in one sector tended to pass quickly to other sectors. That system helped to deliver substantial wage restraint during the second half of the 1980s but at to international competition, in the wages system, and in attitudes), suggest that a serious blowout is unlikely. This leaves the other major potential threat of a severe and sustained currency depreciation. As noted earlier, the 35 per cent depreciation of the $A in the mid-1980s was accompanied by a sharp rise in inflation Around the time of the corresponding seminar last September, the Australian dollar reached a low in trade-weighted terms of 47.1, bringing the fall over the preceding two years to about 20 per cent. Such a fall, if it had been sustained, might have brought some unwanted inflationary pressures through higher import prices - which helps to explain why the Reserve Bank intervened heavily in the foreign exchange market at the time, and also considered raising interest rates to support the exchange rate. In the event, part of this fall was reversed fairly quickly, with the tradeweighted index appreciating by about 14 per cent between the end of September 1993 and quite firm since then, notwithstanding the turbulence in international bond markets improve further on the back of the projected recovery in world industrial output in 1994 and 1995. Australia's export base has diversified over recent years but commodities still comprise more than 60 per cent of the total, and we tend to benefit more than most countries from higher commodity prices. Looking ahead then, neither wages nor the exchange rate appears likely to be a major source of unwinding of the substantial gains made on inflation in recent years. I would add two further reasons for confidence about the inflation outlook. The first is that our starting point is the best we have had for two decades, both in terms of actual inflation and inflationary expectations. The second is the policy commitment to keep inflation in the 2 to 3 per cent range, which we equate with reasonable price stability. It seems that more than three successive years of sub-2 per cent inflation is necessary to reestablish Australia's credentials as a low inflation country, but those who doubt our policy resolve run the risk of missing an important watershed. Some of you might be thinking that my assessment of the outlook for inflation in Australia is at odds with recent assessments by bond markets. It is, at least to the extent that those latter assessments continue to see Australia as an inflation-prone country. But I think the general issues here are more complex than such comparisons suggest. Long-term bond yields everywhere have risen over the past six months, but the rise in Australia has been greater than elsewhere country specific factors have been at work. The move by the US Fed to raise interest rates in early February (and subsequently) appears to have been the trigger for yields to rise globally. It is as though bond holders suddenly realised that, with strong growth occurring in the US and gathering signs of recovery in Germany The Reserve Bank is not in the business of forecasting exchange rates, but the odds are that the pressures over the next year or so are more likely to be upwards than downwards. The likelihood is that commodity prices will and elsewhere, the outlook had changed: with stronger world activity would come additional pressures on inflation, and increased demands for capital. will be slow to tighten monetary policy in response to such developments. The message from financial markets on interest rates seems to be that we should 'act, and act now'. Some people have interpreted the absence of any policy response as some attempt to 'stare the market down', and to prove that no interest rate increase is necessary. That is not the way we see it. We have a firm commitment to price stability and we accept the need for interest rates to be adjusted during the cycle in a forward looking way. It is clear that the economy now is growing rather more strongly than it was a year ago, when interest rates were still being reduced to encourage the recovery. The interest rate settings appropriate to those circumstances, however, will not remain appropriate as the recovery consolidates. But the economy is not about to burst out of its current 4 to 5 per cent growth range, and there are few signs that wage or other cost increases are accelerating. Indeed, there is every reason to believe that current growth and inflation rates will be sustained in 1994/95; given the lags involved, the policy tightening, when it comes, will help to sustain strong, non-inflationary growth over a longer period. All this has been stated repeatedly, and for some time, by both the Reserve Bank and the Government. There has been a clear commitment that policy would be tightened when this was judged necessary to keep the economy on a sustainable path, and to deliver the durable recovery needed to get unemployment back to acceptable levels. Seen in terms of this framework, I suspect there is more common ground between the markets and the authorities than has been acknowledged. Apart from the obvious point that the authorities must take a much broader view of economic developments than the Compared with the much more subdued outlook a year earlier, it therefore made sense for this improved outlook to be accompanied by some rise in interest rates. Whether that improvement was sufficiently dramatic to explain the sea-change in sentiment that occurred, particularly in the absence of any signs of accelerating inflation, are matters which economists can debate. But they are not matters which bond holders pause to debate in the frenzy of a falling market! Faced with large scale uncertainty, the general reaction (especially in highly leveraged markets) is to pull back - to go short - and this is what we have seen. Modern communications and market linkages ensured that the uncertainty and selling spread quickly to all markets. If something like this explains what has happened globally, what explains the larger than average increases in Australia (where 10-year bond yields have risen more than 300 basis points since their low points in January this year)? The factors usually mentioned are Australia's already fast rate of growth, and the prospect that rising commodity prices would stimulate Australia more than most countries, pushing the growth rate even higher. There seems also to be a view that the authorities markets, it largely comes down to a matter of judgment about timing. As to that, I think the markets have been too ready to believe the worst on inflation. Moreover, while no country which relies as heavily on foreign capital as Australia does can ignore what the markets are saying, the authorities naturally prefer to take policy actions on the basis of factors affecting their own domestic economy. I have said, on a number of occasions, that interest rates will have to rise as the recovery should doubt this resolve.

r940817a_BOA

australia

fraser

It will be ten years next month since the Government invited banks around the world to express an interest in acquiring an Australian banking authority. That process led to the first wave of foreign banks in the mid 1980s; it was to be followed by the second wave - a 'wavette' really - which is now occurring. I would like to offer a few observations on the operations of foreign banks in Australia. That decision ten years ago was quite a brave one. The Bank of China had been the last foreign bank to get in under the wire, opening a branch in Sydney in 1942. During the intervening period of more than forty years, it was bipartisan policy to exclude foreign banks from operating as banks in The change was one of a string of quite brave decisions at that time, their boldness little diminished by the ring of inevitability surrounding many of them. This was the era when Australia was at last emerging from its insular, protectionist pouch, and beginning to find its feet in a big and competitive world. The financial sector was leading the way in this process; exchange controls had been lifted and the exchange rate floated, and controls on interest rates on both loans and deposits were being removed. Foreign banks, of course, were not without some influence in Australia before this time. As early as the 1960s, many had established operations in Australia as what are now known as merchant banks. By 1974, 60 per cent of the paid-up capital of such institutions was owned by overseas banks. Today, the assets of merchant banks owned by foreign banks total $38 billion, while the assets of authorised foreign banks are somewhat larger at $47 billion. Taken together, foreign banks and foreign bank owned merchant banks account for around 16 per cent of the Australian assets of all financial intermediaries operating in this country. The main spin-offs from foreign bank entry were seen as increased competition (with the new players introducing leading edge banking services and techniques) and improved access to international capital markets. By and large, these potential benefits have been realised. Australia now has a very competitive, internationally integrated banking system. The threat of competition itself was sufficient to stir the domestic banks to considerable activity, even before the foreign banks arrived. There could have been few doubts in the minds of Australian corporates and 'entrepreneurs' in the late 1980s about the spur to competition which came with the foreign banks. During this period, domestic and foreign banks were falling over themselves as they chased prospective customers. Throughout the second half of the 1980s, business credit was easily the fastest growing component of total credit, expanding by close to 25 per cent per annum. We all know now how unsound the fruit of much of that borrowing frenzy was. Without seeking to apportion blame in that episode, I think it is legitimate to question whether any sustained rapid growth in lending - be it business credit in the late 1980s and housing credit in more recent years - is driven entirely by demand factors. There is always a suspicion that part reflects commission-driven efforts of eager salespeople operating in a fully deregulated environment. The possibility of deregulation going too far or too fast was not among the (mainly xenophobic) arguments against admitting foreign banks which were canvassed before the supporters of deregulation will concede that there can be too much of a good thing, and that additional prudential supervision, for example, might be necessary to retain the benefits of a competitive financial system, or that unfettered financial market activity might sometimes need to be checked in the interests of broader economic and social objectives. I think these views are more respectable today than they were a decade ago. At the time foreign bank entry was being debated, the issue of economies of scale figured prominently - on both sides. Foreign banks were seen innately as having economies of scale which would make them immediately competitive with major Australian banks. The downside was that these potential cost advantages might be so large as to render the foreign banks too competitive for the locals. In the event, the major Australian banks had to work hard but they successfully defended their retail businesses. The experience of the past decade confirms that winning over a critical mass of retail customers in a foreign country is an extraordinarily difficult - if not impossible - task. For most banks, the only real prospect would be to buy that critical mass, through the purchase of a significant Australian retail bank. Various strategies and market niches have been explored by foreign banks, with some spectacular successes (e.g. in funds management and corporate advice), and some equally spectacular failures (e.g. in retail banking). The relative contributions of the foreign banks to the foreign exchange market, the derivatives market and funds management are much greater than their share of Australian assets of financial intermediaries would suggest. So much for a quick look at the past. At the present time, the environment - for domestic and foreign banks alike - is more settled than it has been for a decade. This, of course, is cheering to a central banker, because a strong banking system contributes to a strong economy, as well as being more resistant to prudential problems. The capital positions of the banks - the first buffer against unpleasant shocks - are robust. The average capital ratio for the Australian banking system in June 1994 was close to 12 per cent, compared with 11 per cent a year earlier, and well above the 8 per cent minimum requirement. Foreign banks operating in Australia made losses equivalent to around one-third of their equity base in 1990, but the support of parent banks and changes in strategies and scales of operation have been such that their average capital ratio is now around 15 per cent, well above that for the The Reserve Bank's new guidelines for the public reporting of bad loans becomes effective next month. Somewhat ironically, if nonetheless happily, this problem has diminished dramatically while the measurement questions were being resolved. For the banking system as a whole, non-performing loans, as currently measured, have declined from a peak of close to $30 billion in March 1992, to $23 billion in As a percentage of assets, the fall has been from a peak of close to 6 per cent to 2.3 per cent in June 1994. The new and more rigorous definitions to apply from September are likely to generate slightly higher numbers than the current definitions, but the underlying downward trend will remain. For foreign banks, the improvement in loan quality has been particularly pronounced. Our regular consultations with individual banks are now punctuated by reports of office blocks, hotels and other previously unwanted assets moving off the books of banks to new owners. The non-performing loans of the foreign banks peaked much earlier and at much higher levels than they did for local banks, reaching close to 12 per cent of assets in late 1990, three times the average for the system as a whole at that time. By late 1992, the ratio was back in line with the system average and, at just over 2 per cent, it is now a little under the was only possible with the help of some very understanding parents. the door to additional foreign banks to operate as authorised banks in Australia, and the option of branch banking status was made available (including to foreign banks already operating here as subsidiaries). The first wave of foreign banks was restricted to subsidiaries, so that, inter alia , they would be subject to Australian law and prudential standards, and operate on the same footing as domestic banks. From a supervisory perspective, locally incorporated banks, with their own capital in Australia, were seen to be preferable to branches which, for all intents and purposes, were indistinguishable from the parent foreign banks. As with the change in the mid 1980s, the latest move was motivated fundamentally by a desire to increase competition in the banking sector. On this occasion, however, the expectations as to where that competition might occur were somewhat more limited. Although the policy changes provided for more retail orientated banks to be opened as subsidiaries, experience suggested that any increased competition was likely to be concentrated in treasury activities and corporate lending, rather than in retail or comprehensive banking services. It was recognised at the outset that the competitive bonus from this change was likely to be modest. We accepted the argument by foreign banks that the benefits of operating with the capital resources and ratings of their parents would permit branches to perform more competitively than subsidiaries (which were required to hold capital in their own name, and to operate under certain other constraints). Some additional foreign bank branches might, therefore, sharpen competition in the non-retail sector but the gains were likely to be marginal rather than spectacular. Even those potential gains would depend very much on the value added by the new branches. That is why the granting of additional authorities was made conditional upon, inter alia , branches adding depth to an existing market or developing new niche markets. In other words, we expect prospective applicants to be in a position to add something of significance and permanence to the Australian market. We do not see much point in handing out banking authorities to institutions to book business on behalf of overseas offices, or to sell head office products, or to do what they might already be doing in Australia as merchant banks. Fine judgments will sometimes be required about what is and is not acceptable in particular cases. I can perhaps give one indication of our general thinking by reference to the tendency in recent times for foreign banks (and some non-bank foreign exchange dealers) to locate parts of their administrative and trading activities offshore. While we might prefer otherwise, we have acquiesced in decisions which involve transactions originating in Australia being processed through computer houses in offshore relatively relaxed about this because such activities are routine and involve no significant risks for Australia, and we recognise that there may well be important economies of scale for the banks concerned. Of more significance have been the decisions of some institutions to centralise parts of their foreign exchange trading - mainly third currency business - in other countries of the region, and to close that part of their Australian operations, even though a good and profitable business might have been built up here. Such decisions have been disappointing to us, and they have diminished the Australian market, but again we have accepted them as the considered commercial judgments of the foreign banks concerned. Nevertheless, some of these decisions are perplexing, given Australia's very competitive cost structure and skills base these days. The cost of office space in Sydney, for example, appears to be about a quarter the cost in Hong Kong and Tokyo, and below that in Singapore. If current tendencies towards regionalisation by banks were simply a response to commercial considerations, it would not be unreasonable to expect some of this activity to be coming Australia's way, as it is in certain other areas. Where we have drawn the line on proposed relocations of activities to regional headquarters is on what we see as essential elements of the banking process, such as settlements. This is an issue of risk control. Australian managements must be responsible unambiguously for a branch's entire Australian operations, and be able to report directly to the Reserve Bank on those operations. If parts of a bank's Australian operations were to be rolled into operations located elsewhere, the lines of responsibility would become very difficult to disentangle. For this reason, the Reserve Bank has not approved proposals to relocate the settlements function of foreign branches (or foreign exchange dealers). Any approach to move the administration of other essential aspects of Australian branches' business would be treated similarly. Eight banking authorities have been issued under the 1992 guidelines, including three which received authorisation as locally incorporated subsidiaries during the 1985 number of other banks are at various stages of processing. As everyone knows now, taxation issues have delayed and complicated the applications of more than a few branch aspirants. They have also complicated matters for the Reserve Bank. This is a little ironic, because I well recall that taxation issues were not raised in any prominent way at the time foreign banks were making the case for branch status, in the leadup to the revised policy statement in February 1992. If taxation issues were in the minds of any of the advocates at the time, it must have been presumed that they would somehow be resolved along the way. The major taxation issue has been interest withholding tax. Interest derived by nonresidents is subject to Australian withholding tax, to the extent that the interest is an expense of an Australian business. An exception to this general rule arises under Section 128F of the , which provides for an exemption from IWT for interest on borrowings raised outside Australia by Australian resident companies by means of public or widely spread issues of securities. For some banks, it has transpired that these arrangements can disadvantage branches vis-a-vis subsidiaries. A lot of lobbying for the removal of IWT followed this discovery. For the Government, it was a question of weighing up the potential loss of significant amounts of revenue against the facilitation of additional foreign bank branches. In June 1993, the Government announced that it would, in effect, exempt half of the interest on intra-bank borrowings from IWT; the legislation to implement this change is currently before the The Reserve Bank requires that, unless there are good reasons to the contrary, foreign banks operating in Australia through branches should conduct the bulk of their financial intermediation through the branch. This requirement also has come up hard against the IWT issue and the Bank, too, has compromised in the interests of facilitating the entry of more branches and more competition in Australian banking. that it would accept access to Section 128F funding from abroad as a sufficient reason for intermediation business to be undertaken within a non-bank subsidiary, rather than in the branch. In the resultant model, the branch would conduct foreign exchange and other business which does not require much funding while a non-bank subsidiary would conduct most of the lending using Section 128F exempt (and, therefore, lower cost) funding. From the point of view of a prudential supervisor, such bank/non-bank hybrids are very much compromise solutions. Still the lobbying goes on. Some of this is directed towards the complete removal of IWT. This is essentially a matter for the Bank considered the earlier decision to exempt half of the interest on intra-bank borrowings from IWT as a reasonable compromise in the circumstances; given that, and given my oftstated desire to see the budget deficit reduction program accelerated if possible, I am hardly in a good position to support complete abolition of IWT (and the loss of several hundred million dollars of revenue) at this time. As to suggestions that the Reserve Bank should allow other forms of offshore borrowings borrowings) and intermediation to be conducted indefinitely in a non-bank subsidiary, rather than in the branch, I have to say that we remain to be persuaded. If a branch is to be established, it does not make a lot of sense to me to be constantly relaxing the 'bulk of intermediation' test to get around taxation and regulatory difficulties in particular countries so that more business in Australia can be done outside the branch in the non-bank subsidiary. There is no cut-off time for foreign banks to decide whether they can benefit themselves and Australia as authorised branches, and to apply for branch status. My own hunch is that the present steady line of enquiry from foreign banks interested in setting up branches in Australia will continue. This hunch is based on the belief that, over time, the benefits of Australia's comparatively lower costs and its integration with the Asian region will become more compelling. Foreign banks have been important players in Australia's derivatives markets, and branches in particular are likely to concentrate their business in treasury products, including derivatives. This audience will understand that, properly used, derivatives can help to improve the management of risk. But they can also increase exposure to risk, either deliberately in the case of position taking for speculative purposes, or inadvertently through a lack of understanding of sometimes complex products. The Reserve Bank is seeking to assure itself that banks are properly managing the risks involved. Banks already are required to hold capital against the credit risks involved in derivatives, and you will be aware of the Basle Committee proposals for market risks (including those from derivatives) also to be included in the capital framework. Although foreign branches will not have to hold capital in Australia, they will be caught up in the global capital calculations of their parents. In addition to holding capital as a buffer against possible losses, banks need sound systems to measure and control the risks associated with derivatives. In this connection, the Basle Committee has stressed the importance of: effective oversight of risks by a bank's board and senior management; adequate measurement, monitoring and limitation of risk; and thorough audit and control procedures. The Reserve Bank's own survey of risk management practices of Australian banks suggests that banks generally have made good progress in developing their systems to a generally high standard. But there will always be scope for improvements, and as well as continuing to monitor developments in this area, we are planning visits to banks to discuss their derivatives activities; a particular focus will be the possible use of banks' own systems for the calculation of required capital to be held against market risks. I am pleased to acknowledge that the banks have readily co-operated with us in similar visits in the past, and I trust that this co-operative spirit will continue. Finally, a few words on the role of independent directors on the boards of banks, be they foreign or domestic. It is the ultimate responsibility of the board of a bank to see that the bank operates in a sound and prudent manner. A board may delegate authority to senior management for the bank's day-to-day operations, but it should bring an independent and questioning approach to the management of a bank. As a general principle, we believe that is more likely to occur where a majority of the directors and the chairman are independent of management (i.e. are nonexecutive directors). In addition to their responsibilities to shareholders, bank directors have a responsibility to depositors. Where banks are operating as subsidiaries of foreign banks, we are prepared to accept that executives of the overseas banks can act as non-executive directors of the Australian subsidiary. Our preference, however, is that at least two directors should be independent of the shareholder bank. Such a requirement was included in a draft guideline which we circulated earlier this year for comment. It elicited some sharp responses, principally from foreign banks who argued that directors of a subsidiary cannot have a view independent of its global entity. It was also argued that it would be unfair to independent directors to put them in such a position. Those arguments do not, in my view, give sufficient weight to the fact that an Australian subsidiary is a separate bank in its own right, and not a branch of the overseas parent. The policy of a subsidiary will necessarily be set by the overseas parent, but it is reasonable that there be some independent minds on the board prepared to speak up, should it be necessary, for the interests of the local depositors. While the independent directors will usually be in the minority and can be outvoted, in extreme cases they may well take more radical steps, such as resigning and explaining their positions to the central bank. I see nothing wrong in that situation.

r940926a_BOA

australia

fraser

I am honoured to have the opportunity to address this year's Conference of Economists. Economists have long had a substantial influence on public debate and public policy. We should not be surprised by that. Keynes observed almost 60 years ago that: '... the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. ... I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.' Monetary policy is one area where the gradual encroachment of ideas has left its mark. Views about the role of monetary policy have evolved over several decades in response to the arguments of economists and the lessons of experience. They are still evolving and there is no unanimity. My own views, which I offer from the perspective of a policy maker, are in part encapsulated in the topic of my talk, 'The Art of Monetary Policy'. However one sees economics in the round, monetary policy is definitely an art, not a science. I start with the goals of monetary policy. What can monetary policy do? One thing most economists can agree on is that monetary policy should be concerned primarily with 'price stability'. That term can be defined in different ways, but low inflation is the primary goal of central banks everywhere. Monetary policy is widely seen as the main key to low inflation, although some locks also need other keys. This audience does not have to be reminded that economies work better when prices are relatively stable, and consumers, investors and savers are spared the effort of having to adapt to ever changing price levels. A second possible role for monetary policy- that of helping to smooth the business cycle - is more controversial. Some economists argue that monetary policy has no effect on output. Others, on a different tack, argue that attempts to smooth the cycle with monetary policy will prove counter-productive. The notion that monetary policy has no effect on output can only be a throwback to textbook constructs of self correcting forces which keep the economy in some kind of equilibrium - including, in their modern guise, perfect foresight and rational expectations. It is clearly wrong over any time horizon relevant to policy makers. Changes in monetary policy might not do much to raise the economy's 'long-term' growth potential, but they certainly affect output and employment over the course of the business cycle. Some economists concede that monetary policy can influence both prices and output, but worry that one objective will be pursued at the expense of the other. The mechanical formulation of this argument is that one instrument cannot achieve two objectives. But multiple objectives are routinely pursued - and satisfactorily met - in all walks of life. The issue, therefore, should not be settled by any mechanistic dismissal of the possibility. History, on my reading, demonstrates that consistency of goals is attainable, although I recognise that conflicts can occur and that policy must sometimes give priority to one objective. The validity of this view can be illustrated with the help of the distinction between disturbances (or 'shocks') on the demand side and those on the supply side. In the case of a demand shock, which might cause the economy to run too fast, the appropriate monetary policy response is to raise interest rates to slow activity and combat inflation. There is no intrinsic conflict here between the two objectives (although actual policy making still requires some fine judgments and depends on imprecise instruments, leaving ample room for mistakes). In the case of a supply shock, the monetary authorities have the same fine judgments to make but the situation is quite different. A supply shock, for example a major oil price increase, will reduce both actual and potential output, as well as raising prices. If policy were to respond simply by stimulating the economy in an attempt to return to the initial output level, its main effect would be to ratchet up the inflation rate. In this situation, monetary policy should give priority to price stability (and rely on structural policies to restore potential output). Australia has encountered shocks of both kinds over the post-war period. In the 1950s and 1960s, they were mainly on the demand side and, broadly speaking, keeping inflation low and moderating the business cycle were one and the same task for policy makers. Inflation was seen as a product of excess demand so that smoothing the cycle helped to deliver price stability. The outcomes on both objectives were generally satisfactory, although policy makers were sometimes reluctant to slow down the economy when things were famous dictum that it is the job of central bankers 'to take away the punch bowl just when the party gets going' is an early recognition of the need for monetary policy to be forward looking - and perhaps a reminder that acting in a timely fashion is not always easy. In the 1970s, the problems were more on the supply side, with the price of oil quadrupling and wages exploding. As noted a moment ago, such shocks do bring the two goals into conflict in the short run, because they simultaneously raise prices and lower both actual and potential output. Experience suggests that the authorities, both here and overseas, often have been reluctant to take the tough measures necessary to lower inflation in an economy already weakened by the shock. During the 1980s, policy in Australia sought to restore the earlier balance and consistency of output and price objectives, with some success. The past decade also has seen more focus on the 'medium' term and on structural change, and less on smoothing the cycle. Over this period, fiscal policy came to be framed increasingly in a medium-term framework, leaving cyclical stabilisation largely to monetary policy. Today, a significant body of opinion holds that not much can be done about the cycle, and that fiscal policy should aim for structural balance, while monetary policy should address price stability. This kind of instrument assignment commands a wide degree of academic acceptance, as well as a fair amount of rhetorical support among practitioners. My reading of recent macroeconomic policy actions around the world, however, suggests that policy makers have not totally foresaken the cycle when setting monetary or fiscal policies. Nor should they. Policy makers cannot eradicate the business cycle but, notwithstanding their less than complete success in the past, they can help to moderate its amplitude. Having one, rather than two, specific objectives does not remove the difficult decisions which lie at the heart of good monetary policy. In responding to demand shocks, the authorities will want to take account of the level and path of real income and demand. There is always a question of how rapidly or how gradually policy should be eased or tightened in seeking to return to the desired path. For supply shocks, all monetary authorities are in the same position, with the same invidious decisions to be made about the desirable speed of winding back the offending price increases, and the same constraint of lower potential output. Indeed, apart from possible 'credibility bonuses' (of which I will say more later), monetary policy everywhere operates to lower inflation essentially by creating slack in the economy. It follows that monetary policy, even when primacy is given to price stability, should keep one eye on the consequences for output and employment. In practice most central bankers are interested in real activity (whatever their charters might say), both for its own sake and as an indicator of future inflation. prescribes multiple objectives for the Bank. It is required to have regard to activity and employment, as well as to price stability. Personally, I am quite comfortable with those multiple objectives. That should not be taken to suggest softness or wimpishness about inflation, or to imply a belief in permanent trade-offs between inflation and unemployment. I think it is regrettable that central banks with an attachment to more than one objective are often treated with suspicion so far as their commitment to low inflation is concerned. They are sometimes portrayed as misguided adherents to defunct Phillips curve notions that unemployment can be reduced permanently by tolerating higher and higher rates of inflation. For the record, the Reserve Bank does not carry around any model of a usable Phillips curve in its kit-bag. We do not believe that more than a quart can be had from a quart pot, or that an economy can run sustainably beyond its resource capacity. We do, however, believe that monetary policy influences the course of the cycle and, handled with skill, that influence is beneficial. We do, then, seek to have regard, in pursuing a low rate of inflation through the cycle, to the consequences of our actions for activity and employment, as well as for inflation. Some of you might be thinking that this treatment of what is a fairly simple and straightforward point is rather laboured. Perhaps it is, but many commentators - including some practitioners - do forget it, or pretend that it does not exist. It is apparent from what has been said already that monetary policy makers have many questions to try to resolve. What, for example, is the nature of a particular 'shock'? What is the outlook for inflation? What stage of the cycle is the economy at? What is the 'natural rate' of unemployment? What are safe 'speed limits'? What is the impact of other policy settings? None of these questions has an easy answer. All involve judgments and we know that judgments are fallible. That fact has led to the search for 'rules', or 'intermediate targets', to guide monetary policy, as an alternative to relying on the judgments of central bankers and Treasurers. In the eyes of some people, governments in particular are seen to be prone to predictable temptations which impart an inflationary bias to policy making. On this view, the best outcome for inflation (and output) is achieved only when the authorities lash themselves - Odysseus-like - to the mast of an inflexible rule. But are rules the answer? Are they likely to deliver more acceptable outcomes for Australia? In my view, the answer to both questions is a clear 'no'. collapsed relationship. What matters is whether it is possible to identify before the event a set of regularities of sufficient centrality and robustness to provide the qualitative and quantitative basis for sound policy making.' As I have said, we have not been able to identify such 'regularities' before the event. The experience of the preceding 30 years proved to be of little value in foreseeing the extent to which financial deregulation would affect linkages between money and income. Unrelenting changes in financial markets and structures seem likely to render any on-going search for useful links unproductive. I should be clear about where this conclusion takes us. Monetary and credit aggregates may still contain useful material, including corroborative information about turning points in nominal demand, or about structural developments (such as changes in debt levels in particular sectors). We continue to scrutinise them in that light; we do not believe, however, that they can be elevated to the status of an intermediate target for monetary policy. The other prominent 'rule' is to peg the exchange rate to the currency of a low inflation current model, with Germany playing the anchor role. This arrangement appears to have been helpful to a number of European countries, providing them with the discipline they needed to lower their inflation rates. In recent years, the ERM has been shaken by the 'shock' of German reunification, and at times overwhelmed by massive speculative flows of capital. Some participating central banks, in attempting to defend fixed parities, have found themselves kicking own goals in expensive games with speculators. These experiences have resulted in the departure from the ERM of some countries which did not want to go on directing their monetary policies largely to managing exchange rates, and in much wider intervention bands within the ERM. Australia knows something about the problems that can be caused by shocks, having The main rules that have been suggested to guide monetary policy are monetary targets and exchange rates fixed to a low inflation 'anchor' country. The idea of giving monetary policy the sole task of achieving a set rate of growth of a monetary aggregate dates from the old Quantity Theory of Money, which was revived by Milton Friedman in a famous paper in 1948. At some time in their recent history, most industrial countries, including Australia, have taken this idea seriously and have used money supply targets to guide policy. Several European countries, including Germany, still maintain a certain attachment to monetary publishes a monetary target, but this appears to be more an on-going obligation under a law passed in 1978 than an integral part of current policy making.) For many countries, any relationship between money (however defined) and nominal income which might have existed in earlier times was rendered an increasingly unreliable guide for policy by the financial deregulation of the 1980s. In Australia, the practice of setting a growth rate 'projection' of the monetary aggregate M3 was abandoned Bank, both at that time and subsequently, pointed to the fragility and instability of empirical relationships between money and income in Australia. Some economists who continue to investigate these relationships purport to find, in the haystack of the statistics, the needle of a stable money-income relationship. But ex post 'stability' is not good enough. Harvard economist, Benjamin Friedman, made this point well when he said: '... the question is not whether a sufficiently clever econometrician, surveying the wreckage after the fact, can devise some new specification, or invent some new variable, capable of restoring order to a experienced several violent movements in its terms of trade over the decades. Given this, it would be unwise to tie the Australian dollar to the currency of any low inflation country which was not exposed to similar shocks. Graph 1 illustrates why. It shows the inflation outcome in the aftermath of three large rises in the terms of trade since the Second World War. In the first two episodes, in the days when Australia had a fixed exchange rate, rising terms of trade were followed by sharp rises in domestic inflation. In the more recent episode, with a floating exchange rate regime, that outcome was not repeated. As I mentioned earlier, our aim is to maintain price stability while doing what we can to smooth the business cycle. Alan Greenspan has defined price stability in terms such that 'expected changes in the average price level are small enough and gradual enough so that they do not materially enter business and household financial decisions'. This is a practical definition, although putting numbers to it still requires judgment. Economists can advance various reasons why policy should aim for a small positive number, rather than a zero rate of inflation. For one thing, should reductions in real wages be necessary, these are more likely to be achievable through modest rises in prices than through falls in money wages. Again, current measures of inflation, because they do not adjust fully for improvements in quality and new products, tend to be biased upwards. In our judgment, underlying inflation of around 2 to 3 per cent is a reasonable goal for monetary policy. These figures, incidentally, are not intended to define a (narrow) range; rather, they are indicative of where we would like to see the average rate over a run of years. Such a rate would meet Greenspan's test, and minimise the costs of inflation. It is similar to the informal goals of the US Federal Reserve and the Bundesbank, and not dramatically different from the more formal targets in the Our focus is very much on the 'underlying' rate of inflation. This, conceptually, is a measure of the trend in the general price level which reflects the broad balance between aggregate demand and supply in the economy. That trend, rather than the published (or 'headline') rate which can be affected by 'special' factors, is what matters for monetary policy purposes. Unfortunately, there is no single and unambiguous measure of underlying inflation, which is perhaps a drawback in promoting public acceptance of the concept. Our preferred approach is to monitor different measures of underlying inflation and reach an informed judgment on the basis of all those measures. As a minimum, however, the effects of changes in interest rates Of course, the exchange rate regime was not the only difference across these episodes. In the late 1980s, for example, the Accord processes also helped to keep inflation in check. But the capacity of the floating exchange rate to respond to terms of trade changes - with the currency tending to appreciate when international commodity prices rise - is an important shock absorber for the Australian economy. In summary, in my view, neither a monetary target nor an exchange rate target has any appeal as a guide for Australian monetary policy. In these circumstances, a good deal obviously swings on the judgment and competence of the Reserve Bank in seeking to keep inflation under control. This leads me to say a little more about the Bank's approach. should be removed when trying to assess underlying inflation for policy purposes. However it is quantified, the goal itself has to be pursued in a forward looking way. If policy waits until inflation actually rises, it will respond too late. This means relying to some extent on forecasts of inflation. In preparing our forecasts, we study the forces which drive inflation, including the macro demand/supply balance, capacity utilisation and the labour market, financial aggregates, wages, and price expectations. We then come to a judgment about the inflation outlook, and the balance of risks from a policy perspective. Forecasting, as everyone knows, is a hazardous and imperfect process. But there is no getting away from the need for it. To borrow once more from Benjamin Friedman: 'Making decisions and taking action in a setting driven by the unknown and the unknowable are a large part of what the making of monetary policy is all about.' This apparent lack of rigour will disappoint some people, particularly those looking for a simple rule. But it is no use having a compass if there is no reliable magnetic north. Instead, we have to consider all the evidence and make informed judgments about the likely effects of monetary policy actions on the economy. We obviously hope those judgments are close to the mark, although even good calls will overshoot or undershoot to some extent. As Alan Blinder has said, small errors will, in the eyes of history, be seen as bull's-eyes. The quality of the Bank's judgments on monetary policy will reflect, in part, the experience and competence of its officers. But it will also reflect the broader framework in which monetary policy operates. It is to that framework that I now turn. The first observation is that monetary policy does not operate in a vacuum. (The corollary is that monetary policy alone cannot deliver low inflation in an acceptable way.) Its contribution to price stability and smoothing the business cycle will be enhanced if other policies are working towards broadly similar goals. In many countries, where spending has been unrestrained and deficits have accumulated over many years, fiscal policy has become largely unusable for counter-cyclical purposes. This is not true, however, of Australia where, after four successive budget surpluses in the late 1980s, the Government has been able, responsibly, to run deficits to help the economy out of the recession. The Government is committed to a substantial winding back of the budget deficit over the years ahead. With growth now firmly established and private investment kicking in strongly, my hope is that the Government will try harder to better its current deficit reduction plans. That will not avoid the need for interest rate adjustments but, to the extent that it helped to manage demand pressures in the economy, it would be relevant to the setting of monetary policy. (Incidentally, while it would be reasonable to presume that firmer fiscal policy would be helpful in this regard, that help is not guaranteed - as we saw in the late 1980s, when reductions in the budget deficit were accompanied by stronger growth in private sector activity, putting additional pressure on monetary policy.) More critically, better progress in reducing projected budget deficits would boost national savings and help to alleviate the current account constraint. Australia needs, over time, to lessen its dependence on foreign savings and reduce its vulnerability to destabilising changes in market sentiment towards it (which, of course, have implications for monetary policy). How wage and price setters behave is also very important. Monetary policy would be assisted if these players were convinced that underlying inflation would be held around 2 to 3 per cent, and acted accordingly in coming to their decisions. If that were to occur, and if wage rises were linked to genuine improvements in productivity, price rises would be moderate, as would interest rate rises. That is a very simple and straightforward message which, like all good news messages, cannot be repeated too often. On the other hand, a free-for-all in wage and price setting which threatened a major outbreak of inflation would have to be countered by much larger rises in interest rates, notwithstanding possible consequences for activity and employment. To do otherwise would set up Australia for an early replay of the painful experiences which accompanied the recent reduction in inflation. This is one aspect of the issue of the credibility of monetary policy, which is talked about a good deal these days. Usually the issue arises in the context of the authorities' perceived (lack of) credibility with the financial markets. Having credibility in that quarter is important to all central banks, not least in countries like Australia which have sizeable budget and current account deficits to fund. But that is not the only relevant quarter; as I have just noted, credibility with wage and price setters would help to control inflation. Then there is the issue of the Bank's credibility in terms of its obligation to the broader community to do what it can to sustain economic activity and employment. In theory, the more credible a central bank's anti-inflation credentials, the less it will have to actually tighten monetary policy and pursue its objective through the creation of wasteful slack in the economy. It has some intuitive appeal, although the theory is not always borne out in practice: everywhere, it seems, actions count for more than words. What is clear is that credibility cannot be legislated for, nor can it be established quickly. Australia's performance over the past three years is quite impressive, with an average underlying rate of inflation of around establish a much longer track record of low inflation to exorcise the memories of high inflation in the 1970s and 1980s. In particular, we will need to sustain low rates of inflation through the upswing of the current cycle to build real credibility. That is what we are about. I want to come now to an aspect of the institutional framework in which monetary policy is conducted, namely the issue of central bank independence. It is relevant to the conduct of monetary policy in Australia, if only because some commentators persist in their mistaken beliefs that the Reserve Bank is not independent and that can flow over to broader perceptions of the Bank's antiinflation credentials and credibility. 'Independence' is not a precise term, and it is helpful to draw a distinction between goal independence and instrument independence . No central bank has absolute goal independence, that is, the unconstrained ability to choose and change its objectives. Nor should it, in my view. The practical question is how explicit, precise and immutable is the remit given to the central bank by the political process. It can be very specific (as in New Zealand, where the central bank has been given the sole objective to keep inflation within a 0 to 2 per cent band), or quite broad (as in Australia, where 'stability of the currency' and 'the maintenance of full employment' are As noted earlier, I am quite comfortable with the Reserve Bank's broad, multiple objectives. For me, they encompass the various real life concerns of macroeconomic policy makers, and they have in them a degree of flexibility that befits policy making in an uncertain world. At the same time, however, they do require alertness against possible conflicts and policy prevarication that can lead to, for example, a reluctance to remove the punch bowl. independence concerns the extent to which a central bank has the freedom and discretion to implement the goals of monetary policy. A central bank that is required to maintain a fixed exchange rate, or to finance the government's budget deficit, has limited instrument independence. On this measure, the Reserve Bank has become increasingly independent over the past decade, partly because of major regulatory changes, such as the introduction of a tender system for treasury notes and bonds and the floating of the currency. These changes have enhanced the capacity of monetary policy to control inflation independently of the Government's fiscal position, and independently of inflation in the rest of the world. This capacity has been further enhanced by a change in operating procedures, which has seen public announcements of every change in the official cash rate - the key policy interest rate - since policy are now transparent and clear, avoiding the scope for confusion which existed in earlier times when changes in rates were not accompanied by official commentary. In terms of freedom and discretion to change the cash rate when that is deemed appropriate, the Bank has effective independence. It has not, as some commentators like to imagine, been pressured to adjust (or not adjust) interest rates for political motives. The initiative and basic carriage of changes in the cash rate rest with the Bank. As part of this process, we consult with the Treasurer and his department. That is required by the but it also makes good practical sense for the Bank and the Government to sing much the same tune when interest rates are being adjusted. The basic approach I have described was followed in the lead-up to last month's decision to raise the cash rate by threequarters of a percentage point. The effects of that increase are now being monitored, as part of our on-going assessment of the various indicators bearing upon the outlook for activity and inflation. Judgments are being made about the appropriateness of current policy settings all the time. Others in the economy are doing similar things and reaching their own, and sometimes different, judgments. A case in point is the bond market, where yields on Australian bonds have risen sharply over the past six months or so. This has sprung in part from concerns about inflation in the United States, but the amplification of those concerns in their transmission to Australia implies an adverse judgment about the outlook for inflation in our economy which we do not share. While we foresee some upward pressure on inflation as the recovery continues, we expect policy and other developments to prevent a return to the high levels we have experienced in previous upswings. This is not a matter of 'taking on the market', but of different parties coming to different judgments. No-one is infallible. The natural tendency in some quarters is to assume that the authorities will get things wrong (as they do sometimes), but to forget that markets also can get things wrong; they failed, for example, to pick both the big rise in inflation in the late 1970s, and the big falls in the early 1980s and early 1990s (see We do look closely at swings in the financial markets and the various explanations that are advanced for them. From what I have said about the Bank's approach, it should be clear that any differences between our judgments and the markets' judgments can occur not only because our inflation forecasts might differ, but also because our basic objectives are much broader than the markets', and our horizons are much longer. At the end of the day, the Bank has to come to its own judgments, and be prepared to back those judgments. That is the art of monetary policy. The Bank's commitment to low inflation does not stem from a belief that conquering inflation is more important than combating unemployment. Rather, it comes from a belief that combating unemployment by allowing inflation to rise would simply return us to a world we have taken great pains to leave. It would be an admission of failure. In the final analysis, achieving low inflation while doing what we can to smooth the business cycle provides the best possible environment for investment, growth and employment. It is what the art of monetary policy is all about.

r941123a_BOA

australia

fraser

The issue of central bank independence has generated considerable debate all over the world in recent years. We are all familiar with the much publicised reforms to the Reserve element in the European Monetary Union is the formation of an independent supranational central bank. Many of the 'transitional economies' of eastern Europe also have adopted reforms aimed at making their central banks more independent. In what is something of a rarity these days, the issue has attracted attention from both practitioners and academic economists. The issue is as old as central banking itself, having been debated on and off over the past couple of hundred years. The hallmarks of independence - namely, autonomy from the government and non-financing of budgets - were identified clearly by David Ricardo in a paper on the establishment of a national bank 'It is said that Government could not be safely entrusted with the power of issuing paper money; that it would most certainly abuse it ... There would, I confess, be great danger of this if Government - that is to say, the Ministers - were themselves to be entrusted with the power of issuing paper money. But I propose to place this trust in the hands of Commissioners, not removable from their official situation but by a vote of one or both Houses of Parliament. I propose also to prevent all intercourse between these Commissioners and Ministers, by forbidding any species of money transactions between them. The Commissioners should never, on any pretense, lend money to Government, nor in the slightest degree be under its control or influence ... If Government wanted money, it should be obliged to raise it in the legitimate way; by taxing the people; by the issue and sale of exchequer bills; by funded loans; or by borrowing from any of the numerous banks which might exist in the country; but in no case should it be allowed to borrow from those who have the power of creating money.' Earlier this century, Keynes expressed his thoughts on central bank independence while testifying before the 1913 Royal Commission into an Indian central bank. The ideal central bank, he said, 'would combine ultimate government responsibility with a high degree of dayto-day independence for the authorities of the bank'. He added that it would be desirable 'to preserve unimpaired authority in the executive officers of the bank, whose duty it would be to take a broad and not always commercial view of policy'. There has always been some kind of a relationship between central banks and governments. Given that central banks are created by government legislation and derive their powers from such legislation, they cannot be completely separate from the government. The debate today is about the appropriate degree of separation. Is this renewed interest in central bank independence just another passing fashion? I think not. Rather, it is a reflection of history and the changed policy environment. In part it reflects the worldwide surge of inflation in the 1970s and the onset of the new phenomenon of 'stagflation'. In part also it is a recognition that the anchors which held prices stable in earlier eras - first the gold standard, then the Bretton Woods system - had come adrift and something else had to be put in their place. Central bank independence has emerged in that search for a new anchor. The earlier arrangements had imposed an international discipline on countries but when they passed into history, the responsibility for maintaining price stability reverted to national authorities. New ways had to be found, in the conflicting priorities of national policy making, to anchor prices against inherent swells in inflationary pressures. Today I would like to canvass some aspects of this mammoth topic from a practitioner's perspective. To this end, I want to consider five broad questions: Why is central bank independence an important issue? What is central bank independence? Does increased central bank independence lead to lower inflation? Does prudential supervision compromise independence? and What does accountability mean? None of these questions has a straightforward answer. Different models of central banks exist and work. This is, I believe, in keeping with the different historical origins of central banks, and the different environments in which they have evolved, sometimes propelled along more by accidental factors than by the deliberate intent of legislators or central bankers. Most central banks these days pursue a number of functions but the emphasis here is on monetary policy; this is the function which, since the 1970s, has been the focus of the debate about the independence of central banks. Why is central bank independence an important issue? The brief answer to this question is that price stability is generally considered a good thing, and that an independent central bank can help to achieve it. I do not need to dwell on the desirability of price stability. Economies work better if investment and wage decisions are not confused and thwarted by high inflation. Some people see price stability as an anchor not only for the economy, but also for society at large. Price stability, however, is not the natural order of things in a modern economy. Apart from higher oil prices and other 'shocks', there are two particular threats which bear upon the issue of central bank the tendency for policy makers and politicians to push the economy to run faster and further than its capacity limits allow; and the temptation that governments have to incur budget deficits and fund these by borrowings from the central bank. Let us examine these two sources of inflationary pressure more closely. It is understandable that policy makers and politicians (in part in response to public pressure) should wish to squeeze as much growth as possible out of the economy - to run it a bit faster and a bit further than its capacity limits allow. In the jargon, there is a tendency to exploit the short-run trade-off between output and inflation. Even economies which have few spare resources can grow at rates above their long-term capacity limits for a time. Although it may take some time to show up, higher inflation will be the inevitable result. Cynics blame this inflation bias on the political process, claiming that politicians have short time horizons, stretching only as far as the next election. According to this view, we end up on the treadmill of a political business cycle, where interest rates are eased prior to an election to generate strong growth around election time, and the inflation does not surface until after the election. After the election, interest rates are raised, thereby perpetuating a boom/bust cycle. In this story, even politicians who understand that there is no long-term trade-off between inflation and economic activity are drawn irresistibly to the short-term trade-off. Independent and longsighted central bankers are needed to rescue politicians from this temptation. I am less cynical about politicians generally, but I nonetheless think there is an inherent bias in policy making which pushes policy makers towards a trade-off point which is soft on inflation. We can warn that economies cannot continue to operate above long-term capacity but no-one knows with any confidence just where those limits are or what the 'natural' rate of unemployment is. Nor do they know precisely where the economy is in the cycle, or what in-built momentum it is generating. And they do not know the length of the lags between policy changes and their impact on growth and inflation. In short, as all practitioners know, policy is determined and implemented under conditions of great uncertainty. It is this uncertainty - rather than any cynical exploitation of the short-run inflation/output trade-off - which can inject an inflationary bias into the policy making process. In conditions of uncertainty, policy makers may believe that the economy can run just a little longer at a fast pace, or go a little further. They may be reluctant to take away the punchbowl just when the party gets going - that unpopular task which the Governor of the US Martin, said was the duty of central bankers. The other source of inflationary pressure is the obligation some central banks have to fund their governments' budgets. There is a fundamental conflict between independence and an obligation to finance the budget deficit - a conflict which, generally, is resolved at the expense of price stability. I do not need to labour the potential dangers of this channel. (Here we are entitled to be cynical about governments which survive by printing money when they could not survive by other means.) It has been the major cause of high inflation and hyperinflation in a number of countries over the years. It was responsible for the hyperinflation of Indonesia in the 1960s, before the balanced budget rule was introduced in 1966. It is contributing to current inflationary problems in several former Soviet Union and eastern European countries. The examples are numerous, and the lesson is clear: unless a central bank is protected from the need to fund budget deficits, price stability rests more in the hands of the budgetary authorities, than the central bank. In short, sound money cannot be maintained without a sound fiscal system. So much for the problem. What can be done? To be able to do their job of keeping inflation under control, central banks have to be able to say 'no' to governments when that objective is threatened. This is why the notion of central bank independence is so important. What is central bank independence? In principle, the answer to the first threat is relatively straightforward - give central banks a charter which includes a strong commitment to price stability, and the freedom to pursue it. This does involve the government in setting the goals, but that is the way it should be: central banks cannot expect to determine the goals they should pursue, but they should have adequate scope to pursue the goals that have been set. In the jargon, they should not have goal independence but they should have instrument independence . That is clear enough in principle, but it has been interpreted differently in practice, resulting in different approaches by central banks. The Bundesbank is directed simply to 'safeguard the currency'. The Reserve Bank of New Zealand has the very specific goal of pursuing an inflation target between zero and 2 per cent. In Australia, the specifies stability of the currency and maintenance of full employment as the central bank's objectives. In the United States, the requires the Federal Reserve to conduct monetary policy to promote the goals of 'maximum employment, stable prices, and moderate long-term interest rates'. Very broadly, three approaches to goal setting can be identified. One is to give the central bank a single goal of price stability. A second is to give the bank an intermediate target - such as an exchange rate fixed to the currency of a strong anti-inflation country, or specific targets for the rate of growth of a particular money aggregate. A third approach is for the government to set multiple goals, which include price stability. Each approach has its drawbacks. A single goal of price stability could prove unduly constraining if unforeseen circumstances were to warrant the central bank giving more weight to things other than the simple inflation target. (In those circumstances, of course, the government could always change the goal.) targets embellished in 'rules') imply a somewhat mechanical and automatic approach to monetary policy: if the exchange rate is under downward pressure, tighten policy; or if M3 or some other category of money is growing above the target, again the response would be to tighten. (This is, of course, to oversimplify; even if a central bank were to respond within the dictates of the rules, it has still to exercise its judgment as to how fast it should seek to get back on target.) For some countries, intermediate targets have provided a valuable compass for monetary policy settings, adding to the credibility of the central bank in the process. The role of the fixed exchange rate in Hong Kong in recent years is one example. Many European countries also have found it useful to commit themselves to maintaining a more or less fixed exchange rate with the German mark. In the years following the breakdown of the Bretton Woods arrangements, most central banks experimented with intermediate targets of one kind or another. Some, as just noted, still have them. But for many countries (including my own), they proved unsatisfactory, either because any relationship that might have existed between monetary aggregates and nominal GDP broke down with the onset of financial deregulation, or because maintaining a fixed exchange rate was not a sensible policy option. A potential danger with all intermediate targets is that they can require policy adjustments inconsistent with ultimate objectives. A slavishly pursued monetary target could result in either inflation or deflation; a monetary policy directed at a fixed exchange rate could prove too tough or too soft (and may ultimately prove unsustainable, as several European countries found with the ERM in 1992). In short, having a target other than the ultimate objective might help to anchor monetary policy, but the authorities have to be sure that the intermediate target is the correct one. The third approach is to require the central bank to give a high priority to price stability while also having regard to other objectives, such as growth and employment. In this case, the priority attached to fighting inflation at any point in time will depend a good deal on the make-up of the Board of the bank and its Governor, and some people (particularly those who rank price stability above all else) will say that this leaves too much to chance. The charter of the Reserve Bank of Australia comes within this third category. It is one which I am comfortable with. We have a very clear commitment to keeping inflation under control, but that is not formulated in a way which restricts flexibility in the exercise of monetary policy. To my way of thinking, the flexibility of this approach suits the complexity and uncertainty of the real world better than simple, single goals. In one sense, central banks with multiple goals have more independence, because they have extra dimensions on which they must make decisions. Some would say that this gives the central bank more scope for making mistakes and for downgrading the priority of price stability. But this need not be the outcome. An independent central bank has no inherent reason to misuse the short-term trade-off, provided the bank has a clear commitment to pursuing price stability. In Australia's case, this commitment is reinforced by the self-imposed discipline of keeping underlying inflation to around 2 to 3 per cent through the cycle. Independence is vital to good policy making where the central bank has multiple goals but, given that independence, there is nothing inherently inconsistent in pursuing multiple goals. As to the threat of inflation which arises when central banks are required to fund government budgets, the simple answer is to remove that requirement - which is easier said than done in the countries concerned. Although Ricardo drew attention to this problem 170 years ago, it is only in recent decades that central banks have moved towards positions where they can say 'no' to funding budget deficits (and other development objectives) which are at odds with good macro management. The longer term answer is to be found in building domestic bond markets and financial intermediaries which will be able to shoulder these funding tasks. Does increased central bank independence lead to lower inflation? This question has been the focus of a number of studies of the relationship between central bank independence and inflation. The usual approach has been to create an index of central bank independence (based largely on elements in the relevant legislation which the authors consider to be proxies for independence), and to compare that with the inflation performances of the countries sampled. These studies show that countries with (legally) more independent central banks tend to have lower inflation (see graph for one central bank independence is not associated with a lower rate of economic growth. At face value, this suggests that central bank independence is in the nature of a 'free lunch': increasing the independence of the central bank delivers lower inflation which, in the long run, is not at the expense of lower economic growth. As with all 'free lunches', I think this is too good to be true. Most rankings of central banks by legal independence which I have seen do not capture the full complexity of the issue, and some are downright misleading. To list a couple of points: legal independence, which is what the empirical studies seek to measure, can be very different from practical independence. In Australia, the legislation provides that in the event of a dispute over monetary policy, the government can override the Reserve Bank by tabling its objections before both houses of parliament. While this is the legal position (which scores a negative on the index of independence), such a situation has never arisen in practice; and indexes of legal independence cannot capture the role of personalities (such as Minister) who fill in the operational gaps in the relevant legislation. Nor can they capture the changing policy-making environment. For example, the greater reliance on market-based policies (rather than controls) in Australia over the past decade has significantly enhanced the degree of independence of the Reserve Bank, without any change in the Bank's charter. An important point here is that the correlations reflect a presumption - wrongly - that central banks and monetary policies are the only influences on inflation. Fiscal, wages and other policies are important too - which is why, incidentally, I put a considerable premium on effective consultation and policy coordination between the central bank and the government. Monetary policy needs to be properly co-ordinated with other economic policies; the prospects for price stability are are close allies in that battle. Other 'third factors' might also lie behind some correlations. The low inflation record of Germany and the independence of the Bundesbank, for example, are both related to the inflation aversion of the German people, following the experience of hyperinflation in the 1920s. We should, then, be wary about drawing too firm conclusions from the findings of these sorts of studies. It is a big jump from their findings to the conclusion that every country needs or can have a Bundesbank. The Bank of Japan is usually rated as having a low level of independence, but Japan has an excellent inflation record. There are no universal rules. We can all learn from what other central banks have done, but each country must establish the legal framework for its central bank, and allow for its evolution, in ways which best fit that country's own history and institutions. Does prudential supervision compromise independence? Prudential supervision of the banking system is a formal core function of most central banks, but not all. (In Germany, for example, the central bank does not have formal supervisory responsibility.) This is another illustration of the point that there are different approaches to tasks. It is sometimes argued that central banks with responsibilities for bank supervision will be inhibited in conducting an independent monetary policy because of those responsibilities. In circumstances where monetary policy should be tightened, the central bank might hesitate, so the argument goes, because of a concern about the effects on one or more banks. I think this and other arguments for separation of the two functions are overdrawn. During several years when conditions have been difficult for some banks, it does not seem to me that there has been a conflict between monetary policy and prudential supervision. In practice, it seems natural that a central bank will always consider the effects of its actions on the financial system as a whole. Moreover, if an individual bank should find itself in distress it will almost certainly require remedial action which is different in kind from that which could be afforded through deferment of monetary policy action. Tensions will sometimes arise whether the supervisory agency is within the central bank or external to it; in my mind, there is something to be said for internalising these tensions. More positively, coming from a central bank which performs both functions, I am aware of some 'synergies'. Much of the information we gather on the financial system in our role as supervisor assists us in our consideration of monetary policy, given that the banking system is a major transmission mechanism of central bank actions. We get a good feel, for example, for the extent to which any slackness in credit growth is concentrated on the demand or supply sides, as well as for the strengths of the different sectoral (e.g. housing and business) demands for credit. This and other information about the system could always be obtained from another agency - as it is by non-supervising central banks - but its internalisation can be both convenient and efficient. What does accountability mean? As interest in central bank independence has increased, so too has interest in central bank accountability - which is understandable, given that they are closely related. As a central bank becomes more independent, it needs to be more accountable for its actions. Accountability, however, is a broad concept: to whom should a central bank be accountable, and for what? The focus is mainly on policy accountability. In general, central banks should be accountable for achieving the goals specified for them in their charters, and they should be accountable to the parliament, as representatives of the public. Other bodies - such as the media and the financial markets - will also take it upon themselves to pass judgments upon monetary policy; they are entitled to do that, but we must remember that their judgments will usually reflect narrower perspectives, and shorter time horizons, than those of the central bank. Central banks should be accountable in terms of their charters, but they can express their accountability in different ways. In New Zealand, the Governor reports on progress in achieving the government's very specific inflation target. In the United States, the Chairman of the Federal Reserve is obliged by the to testify before Congress several times a year. In the United Kingdom, the Bank of England now publishes a Quarterly Inflation Report as part of its endeavours to be more accountable. the usual practices of regular public speeches, quarterly articles and annual reports, and testimony before parliament. In addition, and unlike some other central banks, it issues relatively detailed press statements at the time of each change in interest rates, both to announce the change and to explain the reasons for it. This serves to increase the transparency of the monetary policy process and helps to avoid confusion in the market place. More generally, by reducing the mystique surrounding the process and clarifying the central bank's role in it, this transparency serves not only to increase accountability but also independence. Central banks should be accountable also for the sometimes substantial staff and financial resources which are entrusted to responsible for its own budget, which gives the Bank financial independence from the government. It also heightens the need for the Bank to account publicly for its budgetary and financial operations. To this end, our reporting includes data on trends in staff numbers and productivity performances, as well as on the returns the Bank earns from its management of the country's international reserves and from its intervention in the foreign exchange market. What can we conclude about central bank independence? A number of points can be drawn from the foregoing discussion: (1) Central bank independence is a major policy issue today, largely because of the on-going search for an institutional framework that will help monetary policy to deliver low inflation over the medium term. It can be seen as part of the lineage of the gold standard of the late 19th century, the Bretton Woods system of the early post-war era, and the monetary targeting of the 1970s. (2) 'Independence' in this context means the freedom of central banks to pursue monetary policies which are not dictated by political considerations. It does not preclude Ministers from commenting on monetary policies, and it does not preclude central banks from consulting with the government on monetary and other policies. In practice, varying degrees of independence have been exercised through a variety of approaches. Some of these constrain the central bank's room for manoeuvre by providing a single final objective or a single intermediate target, while others provide more flexibility to central banks to respond to uncertainty. Different approaches can and do work. (3) Increased central bank independence does not necessarily lead to lower inflation. This is because monetary policies, on their own, cannot guarantee to deliver lower inflation without unacceptable costs in terms of lost output and jobs. Fiscal and wages policies have an important bearing on inflation outcomes, and these need to be compatible with an anti-inflation monetary policy. (4) Legislated independence will not necessarily deliver practical independence, but any action that limits the ability of governments to finance their budgets from central banks is likely to enhance effective independence. (5) 'Credibility' is helpful to central banks in implementing monetary policy and a pre-condition for this is that the central bank be perceived to be independent and free from political interference. Beyond that, however, credibility has to be earned, essentially through the consistent demonstration over a long period of the bank's determination to achieve its goals. (6) If central banks are to be independent of the government, then they must be accountable for their actions. Not only is this proper in a well run society, but public accountability can help to preserve the independence of central banks. Provided the decisions of central banks are competent to begin with, and are transparent and understood by the public, there will be less opportunity for political interference. (7) The competence of central banks and the personalities of their Governors, and of Treasurers and other Ministers, are obviously important, whatever the precise legislative framework. In this regard, central bank independence can be likened to a game of cricket. The legal framework that central banks operate in is important, as the rules of the game are important in cricket. What matters most to the outcome of the game, however, is the performance of the players on the field.

r941129a_BOA

australia

fraser

This is the sixth opportunity I have had to address CEDA's AGM as Governor; for me it has been a long and happy association with Tonight I would like to stand back from the daily occurrences which excite the media and financial markets to observe some longer-term trends which, ultimately, determine standards of living in this country. I think we have come a long way over the past decade, but the road stretches ever onward. If we are smart enough to make the right policy turns, we will enjoy rising prosperity along the way. in Australia rose by about one-third over the decade to 1993/94. This represents an average growth rate of just over 3 per cent per annum the combined effects of increases in the number of people in work, and rises in the productivity of that workforce. Australia's growth over the decade is on a par with the average for OECD countries, although we have relied relatively more on increases in employment to hold up our performance; our average productivity growth countries as a group have been comprehensively outpointed. The recent recession, of course, pulled down Australia's average growth rate (as did recessions in other developed economies). Our last recession has been described as the worst recession in 60 years. In fact, it was broadly comparable in severity with the early 1980s recession. The fall in GDP (excluding the farm per cent) was somewhat smaller than that which occurred in the early 1980s recession was initially slower this time around. ( GDP fell by 1.8 per cent in the early 1990s and by 4.1 per cent in the early 1980s, the latter figure in part reflecting the effects of drought on the farm sector.) In terms of unemployment, rather than output, the early 1990s slowdown looks more severe, but there is not a lot in it. From a low of 5.8 per cent at the end of 1989, the unemployment rate rose to a peak of 11.2 per cent three years later. In the earlier episode, the unemployment rate increased from 5.4 per cent in June 1981 to episode is comparable with the depression of the 1930s, when unemployment reached close to 20 per cent of the workforce. A point to remember about the rise in unemployment in the early 1990s is that it was exacerbated by unprecedented labour shedding. In both the public and private sectors, the pennies dropped that businesses had to reduce their costs and become more competitive, or risk going under. This labour shedding has helped Australia's longer-term competitiveness, but the short-term consequences for employment were severe. I will return to the problem of unemployment later in this talk. But first, a few comments on two other problems. On one of these, a good measure of success has been achieved; on the other, despite some progress, we are still a long way from declaring victory. The area of success is, of course, inflation: economies work better with stable prices. How many of you envisaged in the early 1980s that Australia would be back in the low inflation Increases in the consumer price index have averaged 1.6 per cent over the past three years; in underlying terms - our preferred measure - the average has been a touch over 2 per cent. The economic downturn in the early 1990s contributed to this inflation performance, but that could not have been the only factor. After all, we have now had three years of growth - and quite robust growth at that over the latter half of the period. Lower tariffs, deregulated financial and communications services, enterprise bargaining and other changes to boost competitiveness also have played a part. So too has monetary policy, which has focussed clearly on lower inflation; this has helped to lessen the inflationary mentality which has pervaded the community for so long (although that battle is not yet won). As I noted earlier, we have paid quite a price, in terms of lost production and jobs, to get lower inflation. For that reason alone, we should not countenance attempts by any group now to subvert that benefit. What are the prospects for keeping inflation in Australia under control? The financial markets are pessimistic, to judge from the sharp upward trend in bond yields through most of 1994. No-one is sure just what is driving bond yields higher in Australia (or elsewhere for that matter) but various factors are mentioned. These include the assignment of large risk premia to bonds and predictions of world capital shortages, as well as worries about future inflation. Factors of the former kind might well be valid, but they tell us little or nothing about inflationary pressures in Australia. To the extent that the higher bond yields reflect concerns about future inflation, they have to be sourced not in current trends but in Australia's more distant track record. And, it has to be conceded, we have not done particularly well in the past in combining strong growth with low inflation. In my book, however, that past track record is likely to be a poor guide to future performance. This is not to deny the possibility that inflation could rise in Australia. The main risk to inflation is the pressure of demand on capacity, which is often reflected first in wage increases. Excluding the farm sector, the Australian economy is currently growing at an annual rate of the order of 5 to 6 per cent; at anything like this rate, such spare capacity as still exists will soon be taken up. In other words, the current rate of spending in the economy cannot be sustained over an extended period without generating higher inflation (and imports). It was to help bring about more sustainable rates of spending that official interest rates were raised by a total of percentage points in August and October. Similar pressures on capacity are emerging in several other countries, as growth in those countries picks up. This is being reflected in higher commodity and other material prices, which are themselves potential sources of inflationary pressures. In Australia, this avenue of 'imported' inflation is moderated to some extent by the floating exchange rate: higher commodity prices tend to push up the $A which, in turn, helps to hold down import prices. How successful we are in bettering our past track record will depend critically on labour market developments. The past decade has been characterised by sustained wage restraint, which has contributed substantially to both low inflation and strong employment growth. At the same time, real wages have still managed to show increases; on average, they have risen by around 1 per cent per annum over the past five years (and by a little more in after-tax terms). Looking ahead, productivity bargaining provides a vehicle for employees to share in the fruits of economic growth. As with other systems, however, any tendency for wages to run substantially ahead of productivity will, ultimately, diminish the harvest. Today, the parties directly involved have a greater responsibility than ever before to see that no major wage outbreak occurs. That really would be a wrong turn down a very dangerous road: once a wage breakout has occurred, it becomes largely a matter of where the 'damage' is sustained - in higher unemployment or higher inflation (or both). As capacity utilisation rises and the labour market tightens, some increase in overall wage pressures can be expected over the next year. Recent rumblings in particular sectors of industry appear to portend some large wage increases, with uncertain productivity offsets. Like others, we are watching these developments closely. While we see no reason for panic, the Bank and the Government have made it clear that they would not sit on their hands if excessive wage and price pressures were to develop. One disturbing aspect of the current wage negotiating environment is the argument that the effects of higher interest rates should be offset by increases in wages. This argument might be a handy hook on which to base claims that were already surfacing at the time interest rates rose. That does not mean, however, that the argument has any real validity. Indeed, with a little reflection, it is easy to see why following this argument would be self-defeating. No-one can responsibly promise to maintain stable interest rates over time. Interest rates are an instrument for managing the economy and as such they are inevitably adjusted over time, rising and falling through the business cycle. Increases in interest rates are intended to restrain the growth in spending, including in particular household spending. To the extent that wage earners try to offset that impact through higher wage claims, this simply means that interest rates would need to rise even further to contain inflation, ultimately undermining the capacity of employers to sustain output and jobs in the process. On the other hand, what we can responsibly promise wage earners and others is that early and appropriate adjustments of interest rates will result in lower interest rates over the course of the cycle than would otherwise occur. One further comment on wages and itself to 'work to wage outcomes which are consistent with Australia maintaining an inflation rate comparable with those of our major trading partners'. This has been an important symbolic demonstration of the antiinflation resolve of the Accord process. But is it quite the right standard for today? Inflation in our trading partners is probably averaging 3 to 4 per cent (pushed up by China and pulled down by Japan). The 'best practice' inflation standard, however, is more like the 2 to 3 per cent average for OECD countries (where wage restraint, which has been a central element in lowering inflation in these countries, seems set to continue). A reasonable benchmark for wage and salary rises in Australia, consistent with both the commitment to 2 to 3 per cent underlying inflation and the productivity based enterprise bargaining arrangements, would be for rises to be no more than 2 to 3 per cent plus any genuine productivity increases. General adherence to such a 'norm' would help to hold inflation around the 2 to 3 per cent mark, while providing for higher (and lower) wage increases in some sectors. The second problem I want to discuss is one on which some progress was made in the past decade but which is still there. This is the current account deficit. Evidence that the long-term balance of payments has been responding in a broadly appropriate way is suggested in Graph 3. The balance on goods and services has moved towards surplus over the past decade, and this trend has largely offset the rise in debt service payments. This longer-term improvement in the trade account reflects, inter alia , strong growth of manufacturing and tourism exports, both associated in part with greater access to These developments demonstrate that appropriate long-term adjustments can be made. At present, the deficit is once more expanding cyclically around the trend, as it has in the past. Everyone now expects the current account deficit in 1994/95 to be a good deal higher than the $18 billion (or 4 per cent of GDP) forecast at budget time. This is partly for 'special' and unpredictable factors, such as the effects of drought on rural exports (adding perhaps as much as $1.5 billion to the deficit), and the impact of higher world interest rates on debt service payments (adding perhaps a similar amount). It is partly also because of faster-thanexpected growth in all categories of imports, which is another indicator that domestic demand is running faster than earlier forecast. The drought apart, these are basically cyclical influences. They raise important questions for the management of the economic cycle, but that is not my concern tonight. The more important question is the longer-run trend in the current account. It is in this sense that the problem remains before us. Is a current account deficit equivalent to per cent of GDP, which was the average over the 1980s, optimal - or even sustainable - in the longer term? There is a spectrum of opinion about this. One view is that accessing foreign savings to fund domestic investment is a perfectly sensible course to follow, provided the returns from doing so are sufficiently high. Another view is that even small current account deficits somehow indicate a structural problem which has to be addressed. I prefer some middle ground. I believe there is a case for accepting an on-going deficit of modest proportions, but it is more likely to be 3 per cent of GDP, rather than 4 or 5 per cent. That is not a target so much as a judgment about what is comfortably sustainable over the long term. It seems to me unlikely that we can continue indefinitely to absorb world savings at the high rate we have over the past decade. Australia does not have the highest debt ratio among developed countries, but we are clearly in the top half of current account deficits of 5 or 6 per cent of GDP would not be conducive to improving our external debt position. In fact, they would worsen it, increasing our vulnerability to the vagaries of sentiment in international financial markets - something which many people already find unsettling when it starts to go against Australia. Coping with the legacy of foreign debt built up over the past 15 years requires that our trade accounts be in at least modest surplus for a sustained period. That means, in the parlance of the production and spending sides of the economy, improving our productivity. Wage costs are obviously important here but so too are other factors, including management and other skills, infrastructure efficiencies, and government regulations. The closer we get to 'best practice' in these areas, the more investors will locate and produce here, making use of our talents and resources, for sales into global markets. From the perspective of the saving and investment sides of the economy, the required adjustment involves greater national saving (unless we want to invest less, which I doubt). My views on the part which lower budget deficits can play in improving national savings are well known. Tonight, I would just add two rather obvious points. First, we cannot rely on faster economic growth to close the budget gap. As noted earlier, the economy is already growing at a faster rate than is sustainable over the medium term, so a further acceleration is out of the question. At some stage, slower growth than now will need to be factored in. In any event, Per cent of GDP to the extent that rapid growth reduces the budget deficit faster, it is also likely to be associated with stronger investment spending in the private sector, which adds to the calls on national saving. Secondly, I think it is time we faced up to the fact that attempting to manage the budget without the capacity to vary taxes is not a winning strategy. There are always areas where government spending can be trimmed but possible tax increases should not be ruled out. In current circumstances, where aggregate spending is in danger of overstepping the crease, there should be no presumption that only public spending needs to be restrained. Tax increases (like interest rate increases) can help to manage private spending through the cycle. More generally, people who talk about substantially lower budget deficits but who are not prepared to contemplate increases in taxes do not deserve to be taken seriously. The bottom line on deficits - both current account and budget - is ultimately a matter of sovereignty. If, in the globally competitive market place, we want to enter the next century with a greater measure of control over our own destiny as a nation, economically as well as politically, we need to lift our efforts both at being productive and innovative, and at saving. I want to end with some observations on the complex problem of unemployment - which, at more than 9 per cent, remains a blight on the policy landscape. As an institution charged to pursue price stability and 'full employment', we obviously feel some sensitivity on the latter score at this time. About a year ago, the Bank made a submission to the Committee on Employment Opportunities in which we made two fairly simple, but important, points. The first was that much of the then unemployment rate of about 11 per cent was cyclical - i.e. it reflected the weak demand for labour - and could be expected to decline as economic activity recovered. That has been happening, and the 2 percentage points fall in the unemployment rate over the past year exceeds anything recorded in the 1980s recovery. In absolute terms, the number of people unemployed fell by 160,000 over the past year, of whom about one-third were people who had been unemployed for a year or more. This experience indicates the potency of strong economic growth in lowering the unemployment rate, including that for longterm unemployed people. But it takes time. This is why, of course, we are so keen to see the economy stay on a sustainable growth path, and for real wages not to run ahead of productivity increases. The second important point in our submission was to acknowledge that there is a large 'structural' core of unemployment, which mainly has to do with problems on the supply side of the labour market, and which policies aimed at stimulating demand cannot do much about. This has led to the notion of a 'natural' rate of unemployment, or what economists have called the Non-Accelerating Inflation Rate of Unemployment, or the NAIRU - either way, a terrible mouthful. In simple terms, it is a minimum unemployment rate below which the economy cannot operate for any sustained period without generating wage pressures and pushing up inflation. No-one knows precisely what this minimum rate is, but different researchers have suggested a range of 6 to 8 per cent for Australia, with most estimates towards the top of this range. Estimates for some European countries tend to be higher still, at 8 to 9 per cent; for the United States, it is generally thought to be around 6 per cent. It is a fuzzy concept and of limited practical value. But the idea that there is a hard core of unemployment which is very difficult to reduce, and that this has risen over time, seems to be borne out by the long-term trend in the unemployment rate. Unemployment in Australia reached around 3 per cent in the recession of the early 1960s, and successive peaks have tended to be higher, peaking at 10.4 per cent in the recession of the early 1980s. It took a run of good years of solid growth in the mid-1980s to lower this peak to just under 6 per cent at the end of 1989. Many factors bear upon the extent of structural unemployment in an economy, including the degree to which wages are responsive to labour market conditions, the effect of welfare safety nets on incentives to work, as well as social mores, attitudes to work and leisure and so on. In considering what might be done to reduce structural unemployment, it is interesting to compare the approach of the United States on the one hand, and that of many European countries on the other. The United States has a minimalist welfare safety net but considerable wage flexibility; this combination has produced the relatively low natural rate of unemployment mentioned earlier. The United States is one of few countries where the trend rate of unemployment today is not too different from what it was 20 years ago. On the other hand, many working Americans are paid wages which, in real terms, are lower today than they were 10 or 15 years ago, and inequalities among wage earners have widened. These trends, together with the limited support available for unemployed Americans, are understandably substantial sources of worrying social tensions. In Europe, labour markets tend to be much more inflexible but welfare safety nets tend to be much more generous. This combination has produced trend levels of unemployment and natural rates of unemployment which are much higher than they were 20 years ago. Indeed, double digit unemployment appears to be commonly expected to be a routine feature of European life for the rest of this decade. Neither of these approaches is particularly attractive to me. Greater labour market flexibility which results in low market wages for some (mostly unskilled) workers and widening income inequalities does not have much to commend it. Nor does the more 'caring' approach, if the main result of its generous welfare support arrangements is persistently high levels of unemployment and all the economic and social consequences of that. Again, the best place to be is somewhere in the middle, which Australia is. We have less flexibility but more generous support arrangements than in the United States, and more flexibility than many European countries but broadly similar support systems. That said, however, our current arrangements could not be said to strike an ideal balance among such objectives as wage flexibility, incentives to work, skill upgrades and welfare support: there is always scope for improvements in at least some of these areas. To its credit, the Government has not given up on structural unemployment as an unsolvable problem. It has not said that the best we can expect to do in future is reduce unemployment to 7 or 8 per cent. Rather, it has responded to the challenge with training and other programs estimated to cost $6.5 billion over the next few years. In principle, training and work experience programs have to be steps in the right direction, given that it is mainly unskilled and inexperienced people who bear the brunt of rising unemployment (and of relatively low wages in the United States). This problem is likely to grow as technology makes skilled people more valuable, and unskilled people increasingly redundant. Training programs are, however, quite expensive and the results in some countries have been mixed. If they work, of course, they will more than pay for themselves by allowing a bigger economy and enhancing budget revenues (not to mention the social gains). As always, a lot will hinge on their implementation. At the same time, people need to be motivated to make training programs work, and to get off the welfare system. There is an obligation on the part of the unemployed to take advantage of the programs and to accept reasonable job offers, with penalties (such as the loss and/or limitation of benefits) for refusing offers. As I understand them, the Government's programs are mindful of both the incentives and budgetary cost aspects. Hopefully, these will have come into even sharper focus over the past year, as the economy has gathered momentum, job vacancies have reached record levels and signs of wage pressures have started to emerge. The Reserve Bank too has a continuing obligation to do what it can to promote sustainable employment. We have not given up either, and I do not see any need to change the Bank's charter, although all of us obviously have to rethink what we mean by 'full employment'. But we should not accept 7 or 8 per cent as the 'full employment' or 'natural' rate of unemployment: there is something very unnatural about such a rate, not to mention the criminal waste of resources involved. A good deal of progress has been made over the past decade in adjusting to some harsh realities of life in a competitive world. In the process, we have left behind the old, unsustainable ways of earlier times. At the same time, we have managed to retain the basic attributes of a fair and decent society. But we have not yet reached a sustainable long-run position. Completing what has been described by some as an historic transformation will test our reserves of tolerance and ingenuity. Mostly, it will take a good deal of plain commonsense. Many hazards will have to be negotiated over the coming years, most of which will be beyond our capacity to anticipate. Unlike some others perhaps, I have enough confidence in the virtues of our basic system - our economic and political institutions, and the good sense of Australians - to be optimistic about our ability to make the right turns.

r941214a_BOA

australia

fraser

It is a pleasure to take part in today's Conference. My brief is to tell you a little about our experience with the development of financial markets in Australia, and to draw out aspects of that experience which might be of interest to other countries in the region. After more than a decade of restructuring, Australia's financial system today is about as deregulated as any system is likely to become. Generally speaking, we are satisfied with the system that has evolved, although the process was not always as smooth as we might have expected or wished. We can all learn something from each other's experiences, but there are no universal models which all countries should follow. Each country has its unique economic structure, stage of development and culture, and these will influence the depth and speed of financial reform. In any event, it would be unwise of me to push the Australian model in this audience, given the obvious success of countries represented here in funding sustained, robust economic growth; along with most OECD countries, Australia looks enviously at the high levels of savings and investment which characterise economies in this region (see Graph 1). Financial markets perform various functions which, conducted efficiently, help to boost economic growth and living standards. Their is to bring together borrowers and lenders in ways that best allocate a nation's financial resources. To do this, they must provide savers with adequate real returns, while satisfying their liquidity and risk preferences; they must also allocate funds to a wide spectrum of borrowers at prices which accurately reflect the riskiness of projects. To these ends, the financial system comprises different types of institutions and markets, each fulfilling specialised roles which reflect its particular comparative advantage. Banks and similar institutions tend to the bulk of lending to small and medium sized borrowers whose credit worthiness requires a good deal of information to assess. They are the conduits through which the funds of many small savers are transferred to borrowers who cannot raise money directly. That is their comparative advantage, and I expect banks to continue to perform this role for a long time to come. Capital markets, on the other hand, allow borrowers (both public and private), whose credit worthiness is more easily assessable, to obtain funds , without the involvement of an intermediary. At their most basic, capital markets consist mainly of markets for debt and equity but, as sophistication grows, they expand to provide deep and liquid secondary markets, and to encompass other financial products, such as derivatives. When I talk about the financial system, I will generally have in mind both banks and capital markets. Since the late 1970s, Australia has moved from having a narrow, tightly regulated financial system to an open, market-based system. The transformation occurred in several stages; there was no 'Big Bang', but the pace of change did accelerate in the first half of the 1980s. Various catalysts were involved. In some respects, the main driving force was simply that the regulated system was breaking down under the weight of its own restrictions and distortions. Another contributing factor was a shift in the intellectual climate, away from the view that the financial system was an instrument of government policy toward a more libertarian view that economic objectives would be better served by allowing market forces greater sway. This shift was promoted by the Campbell Committee, which conducted a major review of the Australian financial system in the early 1980s. In the early post-war period, the Australian financial system was highly regulated and dominated by banks engaged in traditional intermediation. Interest rates on bank deposits and loans were set by the authorities. The operations of banks were also subject to lending guidelines. Interest rates on government debt, too, were set by the authorities, and there were 'captive market' arrangements under which banks and other institutions were required to hold minimum amounts of government debt. The exchange rate was fixed for much of this period; from the mid 1970s, it was set daily by the authorities. An extensive range of exchange controls was in place. These arrangements worked well enough during the fairly tranquil 1950s and 1960s. By the mid 1970s, however, the regulations on the banks were causing them to lose market share to other, unregulated institutions, such as merchant banks and building societies (see Graph 2). As the banks' share of intermediation contracted - from about 80 per cent to about 55 per cent - the rationale of the regulations was undermined. For one thing, monetary policy became increasingly difficult when the controls under-pinning it applied to a shrinking part of the financial system. To counter these problems and assist banks to compete with non banks, interest rates on some bank deposits were deregulated in the mid 1970s. This process continued gradually over the following 10 years until all controls on bank interest rates and lending had been removed. As banks gained the freedom to set their own interest rates, their share of intermediation business recovered steadily (see Graph 2). Once bank interest rates were free to move, it became increasingly untenable to maintain managed rates on government debt. Interest rates on government debt were, therefore, deregulated in the late 1970s and early 1980s, as the authorities moved to a tender system for issuing government securities. This allowed the Government to fully fund its requirements in the market place, without recourse to central bank financing (and all the adverse consequences for monetary growth associated with that kind of financing). As such, it helped to make the central bank and monetary policy more independent. As a result of these changes, interest rates were free to move but the exchange rate was not. One consequence was that pressures in the economy were reflected in a lot of volatility in interest rates but not much in the exchange rate. Perhaps more importantly, the huge flows of capital into and out of the country made it very difficult to control financial conditions. The next logical steps in the process, therefore, were to float the exchange rate, and to dismantle exchange controls. These changes occurred in December 1983. The floating rate regime, I believe, has served the Australian economy well over the past decade. As well as bringing a powerful discipline to bear on domestic policy making, it has helped in managing the big swings in the terms of trade to which Australia is subject. By the end of 1983, then, most interest rates and the exchange rate were free of restrictions and effectively determined in the market place. Although the main changes were concentrated in a relatively short period, it would be incorrect to infer that the whole process unfolded in accordance with a planned script. There were elements of that but responses to particular 'shocks' also played a part (as, for example, with the float). It might not be ideal but sometimes opportunities to implement reforms will arise unexpectedly, and it is a matter of being prepared to seize those opportunities at the time. One area where the authorities deliberately proceeded gradually was in relation to the entry of foreign banks. To promote increased competition in the banking sector, 16 major foreign banks were invited in the mid 1980s to establish operations in Australia. At that time they were required to establish as subsidiaries, and to offer a wide range of banking services. Their entry certainly contributed to a more competitive banking system in Australia - way beyond what their 10 per cent share of the market might suggest. That competition, however, was to lead to many unwise lending decisions and some very large losses for domestic and foreign banks alike. Two years ago, the policy on foreign banks was liberalised to the point where any foreign bank which can satisfy Reserve Bank requirements can expect to get a banking authority. If they wish, new entrants (and the foreign banks established earlier as subsidiaries) can choose to operate as a branch. Since this policy change, 11 authorities have been granted to foreign banks to operate as branches, including three to former subsidiaries; two authorities have been granted to foreign banks to operate as subsidiaries. The banks today count for nearly 80 per cent of financial intermediation, which is similar to the levels of 30 years ago. Over time, however, the intermediation process has become less important as a source of financing in the economy overall, with corporates switching more to direct financing and households channelling more of their savings into pension and other managed funds, rather than bank deposits. Intermediated finance (through banks and other deposit taking institutions) has declined from about 72 per cent of total finance in 1980 to about in 1994 (see Graph 3), with a corresponding increase in direct funding in capital markets. In recent years, equity funding has satisfied nearly three-quarters of the corporate sector's external financing needs, and debt the remaining quarter. This is in marked contrast to the 1980s when the corporate sector substantially increased its gearing, mostly through the banking system, either directly as loans or indirectly through short-term bank bills. There has been little development of a longer-term corporate debt market in Australia. Various reasons have been suggested for this, including the persistence, until recently, of relatively high rates of inflation in Australia, which reduced the incentive to issue and hold longer-term securities. Perhaps of most importance, however, has been the ability of many of Australia's largest firms to raise funds at competitive rates in Euro and other overseas markets, helped by the development of active markets in cross currency and interest rate swaps. In other words, it makes sense for many countries to tap into existing international markets, rather than trying to develop all elements of capital markets within their own borders - particularly given the high costs in terms of skilled manpower and other resources involved in establishing some capital markets. Over the past decade, partly as a by-product of deregulation, and partly as a result of ongoing financial innovation and global integration, financial markets in Australia have expanded rapidly in size and sophistication. Some figures on average daily turnovers are shown in Table 1. Not all of this growth in turnover could be described as totally beneficial. At times, speculation has led to some over-trading, which has caused problems, including for policy makers. Overall, however, the growth in turnover mainly reflects the greater ability of markets to channel funds into productive areas, and to transfer risk to those most willing to bear it. Complaints that deregulated markets lead to excessive volatility in financial prices are heard most often in Australia in relation to the exchange rate. It is true that the exchange rate was more volatile for a number of years immediately after the currency was floated. In more recent years, however, it has exhibited rather less volatility. The flipside to the increase in volatility in the exchange rate is the decrease in volatility in interest rates (see To the extent that asset prices have become more volatile, the greater availability of hedging instruments now on offer - a direct consequence of deregulation - assists companies and individuals to handle the associated risks more effectively. Overall, the financial services available to the Australian community are now more varied, and delivered more efficiently, than was the case before deregulation. We are now through the transitional period and we have no wish to return to the regulated system; deregulation has delivered benefits to customers, provided opportunities for new entrants, and compelled existing players to lift their game. As I noted at the outset, we should be wary about seeking to transfer particular approaches and experiences from one country to other countries. There is no single approach which is suitable for every country. Different models exist - and work - and it is for each country to select the approach which best suits its unique circumstances and stage of development. A floating exchange rate regime, for example, suits Australia's economic structure and has been a plus in terms of macro-economic management, but it will not necessarily suit other countries. This general point is well underlined by the observation that, with the exception of Singapore and Hong Kong, many countries in the region have achieved their impressive economic performances without the benefit of competitive and well developed financial markets. Their high levels of saving and investment are testimony to the existence of efficient arrangements, but these tend to be more informal or government directed than markets in major industrial countries. As these countries develop and industrialise, they will discover that, like Australia, they have no option but to free up their financial markets. Indeed, properly conducted, that process itself can help to sustain high levels of economic activity. Based on Australia's experience, I would draw five general lessons: With the benefit of hindsight, however, it is apparent that especially rigorous discipline is required if the excesses that can flow from fierce competition among deregulated banks are to be avoided. In particular, if we were to have our time over again, we would have to try harder to ensure that the banks, their customers and their supervisors were better prepared for financial deregulation, especially in terms of their information and risk management systems. The safeguards which supervisors need to impose to reduce the chances of damaging financial collapses increase, rather than diminish, as deregulation increases but, at the end of the day, these safeguards are no substitute for the rigorous credit control mechanisms and mature lending policies which only prudent bank and other capital market managements can provide.

r950330a_BOA

australia

fraser

Once again it is a pleasure to have this opportunity to speak to members of the ABE. I believe - I hope correctly - that business economists share our interest in seeking out practical policy responses to our problems. Today, I would like to offer some comments on current economic trends and their implications for policy. They will have a familiar ring to many of you. Looking back for a moment, by most measures 1994 was a very good year for the despite the drought, GDP appears to have grown by 5 to 6 per cent; employment increased by over 280,000 or per cent; unemployment declined by 130,000, including a fall of more than 60,000 in the number of long-term unemployed; the unemployment rate fell by percentage points to a touch under 9 per cent; business investment at last took off, increasing by over 20 per cent in real terms; business profits increased by around 10 per cent, and the profit share of national income continued to hover around its historical levels; and underlying inflation remained around 2 per cent. The combination of rapid growth and low inflation was most welcome, leading as it did to a sharp reduction in unemployment. It was only possible, however, because we had considerable spare capacity to begin with. As that capacity is taken up, it is natural - and necessary - for the growth rate to slow. That is now happening. Yet, despite these trends, there appear to be popular concerns that all is not well - that we are in danger of lapsing into our old boom/bust ways, when a spurt in growth caused both inflation and the current account to career out of control. These are legitimate concerns for policy makers at this time but I believe - more than some others perhaps - they will be managed satisfactorily. That management has begun already, with interest rates being raised on three occasions late last year. Those largely pre-emptive rises have helped to settle the exuberance of consumers and home buyers which, six months ago, was threatening to bubble over. That, of course, was the purpose of the interest rate rises. To make further inroads into unemployment, we need sustained economic growth, not an inflationary 'dash'. Since the recovery commenced in mid 1991, real GDP has grown by close to 15 per cent; employment is up by around 500,000 per cent) since its low point in mid 1993. This recovery would not last, however, if total spending were to continue to grow at anything like the 8 per cent recorded in the year to the September quarter: that would lead inevitably to major inflation and current account worries, followed by higher interest rates and unemployment. Sentiment generally is now less exuberant and - assuming it stays that way - this should help to slow the growth in spending during 1995. So far, the most visible slowing has occurred in the housing sector, and this probably owes more to the maturity of the housing cycle than it does to the relatively modest increase in mortgage rates since last August (less than two percentage points for most mortgage borrowers). For more than two years now, dwelling commencements have been running well ahead of underlying demand, presaging a fairly pronounced correction which still has some way to go. How quickly the pace of growth slows will have important implications for inflation down the track and, therefore, for monetary policy. Growth does appear to be slowing but - with the notable exception of housing - most sectors are continuing to grow quite strongly, at least to this time. How much of a slowdown should we be looking for? We can only make informed guesses about these things, but the notion of the long-term potential (or underlying) growth rate provides a couple of clues. This is the highest rate at which the economy can grow without running into inflation and current account constraints. No-one knows exactly what Australia's longrun potential growth rate is. Some commentators put it around 3 per cent. This seems too pessimistic to me, particularly given signs that productivity is on the rise. After stagnating for several years, investment is now growing again and adding to the nation's capital stock. Anecdotal and other information also point to better productivity performances; in the 1980s, output per hour worked grew at an annual rate of just over 1 per cent but in the past five years it has risen by around too early to conclude that this is a permanent improvement, but the structural changes of the past decade must have raised efficiency in many sectors of the economy. Traditionally, potential growth rates have been viewed as a function of two main components - namely, productivity growth and workforce growth. Over coming years, Australia's workforce is projected to grow by nearly 2 per cent per annum. Predicting labour productivity growth is more difficult, as I have just noted, but with the right focus we should be able to maintain a rate around 2 per cent per annum. On these assumptions, a long-term potential growth rate of around 4 per cent would not seem an unreasonable aspiration for Australia. You should not infer from these remarks that the Reserve Bank has a 'growth target'. We do not. Apart from the hypothetical nature of such targets, we recognise, more than most I suspect, that policy cannot be calibrated to achieve and hold any predetermined growth rate. Instead, what we have is a view about how fast the economy can grow over time without being blown off course by inflation or other pressures. It cannot be a fixed view. If, because of surplus capacity or better long-term productivity performances, a faster growth rate was consistent with maintaining low inflation, we would be more than happy to accommodate that growth. Similarly, if pressures on resources were such that maintaining low inflation required slower growth, then monetary policy has to contribute to that outcome. If, over the medium term, the prospects for growth consistent with low inflation were judged to be inadequate in terms of employment or other objectives, then the focus should be on structural and competition policies aimed at boosting productivity and exerting more discipline on price and wage setters, not on trying to run the economy faster than its inherent capacity. For present purposes, however, the key point is that if the sustainable growth rate is not 3 per cent, it is not 5 or 6 per cent either. Some slowing from recent growth rates is, therefore, needed. This is occurring but it is not clear, at this time, by how much. As you know, the Reserve Bank has a major responsibility to keep inflation low. But we must also take account of the impact of our actions on output and employment over the policy time horizon. So we spend a lot of time monitoring the various indicators, weighing up the risks for inflation and growth of policy miscalculations, and coming to what are often on-balance judgments. Currently, views about such things as the outlook for the world economy, the duration of the drought, and the shape of the forthcoming budget must also be factored into policy deliberations. There is nothing new about that process, which is ongoing. What I would like to emphasise is that should additional data and/or particular developments lead the Bank to a judgment that more (or less) needs to be done on monetary policy, we would follow through on that judgment, irrespective of any overlapping election or budget timetable. This should be more widely appreciated than it appears to be at present. I will say a little more about fiscal policy later, but it follows from what I have just said that while a 'good' budget could have implications for monetary policy, it would not necessarily obviate the need for further interest rate action. Some of these issues - and the challenges they pose for business decision makers as well as for policy makers - will become clearer as we look more closely at the pressures building on inflation and the current account. The Reserve Bank's objective is to hold underlying inflation to an average of 2 to 3 per cent over a run of years. This would, in our view, lead to better investment and saving decisions than would occur in an environment of higher inflation. The 2 to 3 per cent objective was never a narrow band in which we believed inflation must, or necessarily can, be maintained at all times and in all circumstances. That would be too narrow and too constraining a target, given the cyclical and other influences on inflation. Rather, the '2 to 3 per cent' specified an inflation rate we would aim for over the medium term: success would be reflected in an average inflation rate of '2 point something'. An alternative objective which has been suggested for Australia is that we maintain an inflation rate comparable with the average of our major trading partners. This formulation provides a useful reminder of our growing exposure to global markets and the importance of international competitiveness. On the other hand, it downplays domestic considerations. We pursue price stability because our economy will operate better with low inflation, and the average of our major trading partners may not always provide the 'best practice' standard. If some of our trading partners happen to run inflation rates that are clearly too high (such as China's 20 per cent plus rate), that does not mean Australia also should run high inflation rates; our lowinflation objective should not be hostage to policy makers in other countries. The Bank's objective is expressed in terms of underlying inflation, which is less volatile than the inflation rate measured by the overall averaged less than 2 per cent per annum over the past three and a half years, but increased by 2 per cent over the year to the December quarter. We expect this measure to jump sharply when the figure for the year to the March quarter is released in a few weeks time, and to hover around 4 to 5 per cent during 1995. This jump will largely reflect the flowthrough of the rises in official interest rates which occurred last year; to give an indication of the magnitudes involved, a one percentage point increase in mortgage and personal loan rates is estimated to boost the CPI directly by between 0.6 and 0.8 of a percentage point. We are, then, about to observe a graphic demonstration of how the usual CPI measure of inflation can depart from - and be an inappropriate guide to - the 'underlying' rate. For macro-economic policy purposes, what matters is the underlying rate, that is, the rate of increase in prices which reflects the balance between supply and demand pressures in the economy, after the effects of any policy measures designed to change that balance have been excluded. That is why we have focussed on the underlying rate as (now) published by the Statistician (and based on longstanding Treasury methodology). It has been our focus during the period when the underlying rate was above the overall CPI rate; it will, of course, continue to be our focus during the year ahead when it is expected to be somewhat below the overall rate. Whether others are similarly focussed over this period will be an interesting test of the maturity of our economic commentators. Underlying inflation was running at about 2 per cent in the year to the December quarter. We expect this to rise over the quarters ahead, and to exceed 3 per cent during the course of 1995. Several factors lie behind this forecast, including the absorption of spare capacity, an upward drift in wage rises, and increases in some commodity and materials prices. Were it to persist, the recent decline in the exchange rate would be another contributing factor. The prospect of underlying inflation exceeding 3 per cent is not, in itself, a cause for alarm. The natural dynamics of inflation over the course of the business cycle can be expected to generate some pressures on the upswing. It does not represent any weakening of our resolve to maintain low inflation. Nor does it mean that inflation is going off-track over the medium term. It would be a different story if underlying inflation above 3 per cent was set to become entrenched. But that is not the situation, and it is the aim of policy to avoid that situation. To that end, interest rates were raised a total of 2.75 percentage points last year while underlying inflation was still at 2 per cent. Monetary policy remains committed to the 2 to 3 per cent objective and, if necessary, will be adjusted to deal with departures from that objective. Because labour costs tend to dominate total production costs, the most critical determinant of the future path of underlying inflation will be the size of wage and salary increases. Over the past year, the growth in ordinary-time earnings has quickened a little, rate of increase, together with current rates of productivity growth and profit margins, is broadly consistent with underlying inflation of 2 to 3 per cent. That situation, however, is quite tight; it has no room for further slippage, or for any slowing from current rates of productivity growth. I think some commentators assume too readily that there will be major slippage on wages. The past couple of decades have demonstrated clearly that wage restraint delivers strong jobs growth, and vice versa: that lesson has not gone unheeded. Moreover, attitudes and institutional arrangements are very different today. Having to compete in global markets and to contend with tariff reductions and other structural changes helps to concentrate many minds on the importance of wage restraint. And, despite on-going wrangles over some aspects, the enterprise bargaining arrangements do appear to be delivering better wage outcomes than the previous centralised system. Monetary policy - in conjunction with these other policies - also plays a role in shaping an environment conducive to continued price and wage restraint. More people now understand that low inflation comes at too high a cost to be given up at the first whiff of trouble. To make much the same point in different words, it would be a terrible indictment of everyone involved - policy makers, employees and employers - if serious wage pressures were to break out while unemployment remained around 9 per cent. That would imply that the the United States, where the economy has been growing strongly for several years and the unemployment rate has slipped below per cent, wage increases have remained around 3 per cent, at least to this time. Comparisons with other countries are seldom straightforward, and different approaches to social safety nets complicate comparisons of our natural rate of unemployment with that in the United States. But the basic point is clear: Australia needs to be able to reduce its unemployment well below current rates without triggering higher inflation. One argument which has been used recently to justify higher wage claims is that workers should be compensated for increases in mortgage interest rates (and in taxes for that matter). I can well understand the desire of employees to offset the effects of higher mortgage interest rates on their disposable incomes. But that does not make the argument correct: its logic is that interest rates (and taxes) should not be raised because such increases would cause a wages surge and higher inflation. Accepting that logic would lead either to policy gridlock, or to the sort of showdown between policy and labour markets which would leave everyone a loser. If higher interest rates were to lead to larger wage outcomes, inflationary pressures could be expected to intensify, in the short run. But higher labour costs would increase business costs and squeeze profits. That would be bad for investment and jobs. If employers passed on the higher wage costs, prices would move higher, necessitating further interest rate rises - again with adverse effects on employment. The simple fact is that when spending (especially private and public consumption spending) is growing at too fast a pace - as it has been - then that spending needs to be curbed through policy tightenings of one kind or another. Seeking to protect incomes and spending from the effects of such measures will only increase the pressure for even more policy tightening, with even higher costs in terms of lost jobs. This should be remembered as the effects of past interest rate rises flow through the Consumer Price Index over the next couple of quarters. I should explain, as an important footnote to this discussion on wages, that I talk of 'wage' restraint as a shorthand for restraint on wages and salaries across the board, including the salaries of managers and executives. The latter appear to have been rising somewhat faster than wages. Whatever the realities of life in an international market for executives, another reality of life is that most ordinary people notice the example set by their bosses. If executives pay themselves increases that are out of line with the increases paid to their employees, they can hardly complain if this is noticed and provokes higher wage claims. The other major storm cloud to be negotiated is the rising current account deficit. You will recall the Treasurer indicated at the end of January that the current account deficit in 1994/95 was likely to reach $26 billion (or per cent of GDP), compared with the budget time forecast of $18 billion (4 per cent). Several factors are responsible for this increase of $8 billion. The effects of the drought on rural exports are estimated to have contributed about $1.4 billion. Exports of cereals have been the hardest hit, with the wheat crop only half that of last year. With a return to more normal seasonal conditions, rural exports should rebound solidly in The much faster-than-forecast growth in domestic spending appears to have absorbed some manufactured goods that might otherwise have found their way to export markets. In the second half of 1994, growth in exports of elaborately transformed manufactured goods slowed sharply, after a number of years of strong growth. To the extent that this apparent diversion to domestic markets reflects the recent strength of domestic demand, it should be reversed as the pace of growth slows. The main cyclical influence on the current account deficit, however, has been on the imports side. Here, the faster growth in domestic spending is estimated to have contributed about $5 billion of the $8 billion increase. Over the second half of 1994, imports of capital goods were 37 per cent higher than in the corresponding period a year earlier; imports of intermediate and consumption goods both rose by about 15 per cent over the same period. The surge in investment spending is to be welcomed, and will expand our capacity to boost future output and exports. In the absence of a pick-up in domestic saving, however, this investment surge translates into an increase in the current account deficit. Finally, higher world interest rates, leading to higher net debt service payments, have also contributed to the higher current account deficit, adding about $1 billion to the budget time forecast. In summary, the increase in the forecast 1994/95 current account deficit can be explained in terms of the strength of the cyclical upswing, and fluctuations in seasonal conditions and world interest rates. Behind those explanations, however, lies a more fundamental causation, namely the persistent imbalance between saving and investment: as a nation, we spend far more than we earn. If we were to adjust the present estimates for the effects of weather and world interest rates (over which we have no control), and to assume more normal investment and growth rates, we would still be left with a current account deficit equivalent to around 4 per cent of GDP. This is the structural dimension of our current account problem. It is perhaps best illustrated by the fact that net service payments on foreign liabilities have risen to the point where they alone now represent I have said before that, while there can be no precision in these matters, we could all feel a lot more comfortable if the average current account deficit over the business cycle was somewhat lower. A deficit which averaged around 3 per cent, for example, would stabilise the ratio of net foreign liabilities to GDP around current levels. So long as we remain so dependent on foreign savings, for which we must compete in international capital markets, we will remain vulnerable to adverse swings in market sentiment. The most obvious vulnerability is our exposure to a sharply falling exchange rate. We know from past experience that the markets can sometimes turn sharply against Australia and the $A, not always for wellbased reasons. Downward pressure on the exchange rate, if it were to persist, would add to inflationary pressures, and force the authorities into tough policy measures. The best counter here, of course, is to pursue fundamentally sound policies as a matter of course. The necessary thrust of those policies seems straightforward enough. The cyclical dimension of the current account problem will be assisted by measures to remove excess demand pressures. In addition, we need, over time, to run a significant surplus on the balance of trade in goods and services - to spend less than we produce - which means increasing our national savings (to address the structural The budget has a role to play on both fronts. First, by restraining private and/or public spending, it can help to slow economic growth to a more sustainable rate, thereby easing pressures on both inflation and the current account. The extent of the budget deficit reduction, and the manner in which it is achieved, are obviously important here. I would add only that, given the stage of the economic cycle, the next budget should, on macro-economic grounds, be moving much closer towards balance. Viewed in these terms, a 'good' budget could be seen as easing the pressure for possible further monetary policy tightenings. That is true. But even a 'good' budget would not necessarily rule out further interest rate adjustments. For one thing, we could not be sure that such a budget would cause the economy to slow sufficiently, particularly given the favourable effects it could have on confidence generally. The implications for monetary policy of a 'bad' budget are, however, rather clearer. As for reversing the decline in national saving (and reducing our dependence on foreign saving), the broad options are well understood. Greater provision for personal retirement is probably the main means of raising, over time, the level of private saving. It is in the area of public-sector saving, however, that the largest trend decline has occurred (see Graph 4) and where, in the short term, the greatest scope exists to boost national saving - through the reduction and elimination of budget deficits. On the basis of current Government projections, the budget deficit would decline from 2.7 per cent of GDP in 1994/95 to a represent an improvement in national saving of about three percentage points in two years. I am confident that the Government will deliver an improvement of at least this order. It is good that jobs are being created in large The Reserve Bank is interested in job creation, not just because it is part of our charter but, more fundamentally, because that is the main route to higher living standards for ordinary Australians. But it has to be sustained job creation. This means solid growth sustained over a lengthy period, without the recovery self-destructing or having to be aborted prematurely in a surge of inflation or current account pressures. Monetary policy was tightened in 1994 to help achieve a rate of growth consistent with low inflation and, until this objective is assured, further tightening has to remain on the agenda. The forthcoming budget also has a role to play in moderating inflationary pressures and, more importantly, in helping to lift longer-term national saving.

r950613a_BOA

australia

fraser

Some people, when they meet a medical practitioner, like to regale the doctor with their current ailments, and seek insights into possible remedies. The corresponding occupational hazard for central bankers is to be interrogated about the outlook for interest rates and exchange rates. I suspect that the two burning questions on the minds of many people here today are: What is the outlook for interest rates in I understand this focus, particularly on the part of participants from the financial sector. But such questions do reflect a desire to take short cuts: they slide over a string of questions about more fundamental economic trends and policies. They reflect, too, a preoccupation with the short term - with possible changes over the next month or quarter, rather than the longer time horizons of more stable investors, and certainly of policy makers. Today, I want to concentrate on the fundamental factors that influence interest and exchange rates in Australia. These should be the proper focus of a central banker - and perhaps of some others as well. These are what will determine living standards and returns on investments in Australia. I have no direct answers to give you on those two burning questions, but I can give you a reading on the underlying trends and policies which will help to determine, inter alia , what happens to interest and exchange rates. I begin by reminding you that economic recovery in Australia commenced in mid 1991, rather earlier than in the UK and most other OECD countries. Since that time, growth has been higher, and inflation has been lower, than in most OECD countries. We can look back over 1994 in particular with some satisfaction: GDP grew by 5 to 6 per cent; expenditure grew even more strongly, underpinned by a welcome surge in business investment, which rose by about 25 per cent; employment increased by 3 per cent and unemployment fell sharply (it is now per cent); productivity continued to grow at an annual rate of about 2 per cent, well above the average in the 1980s; and for the third year in a row, underlying inflation remained at 2 per cent. Even so, the past year has not been a totally worry-free period for policy makers. Demand and cost pressures have emerged, raising questions about the outlook for inflation. The current account deficit also has increased to uncomfortably high levels. I will return often to these two concerns during the course of this talk. For the moment, I note that the forecasts released last month with the budget suggest that growth, while slowing, will be sustained at a respectable rate in 1995/96 (3 per cent); that inflation, while rising, will be contained within manageable bounds; and that a modest start will be made towards unwinding the current account deficit. If it eventuates, this would add up to a good outcome. Interest rates are the key prices in financial markets, and monetary policy operates through interest rates. Our normal response to questions about the outlook for interest rates - that 'it all depends' - might therefore seem a bit lame. It depends, first of all, on which interest rates we are talking about. It is true that some interest rates - at the very short end of the yield curve - are controlled by the central bank, so that we should, at least superficially, be able to say what will happen to these rates. Even here, however, changes reflect judgments about current and prospective trends in domestic activity and inflation, as well as overseas events. And, like other mortals, central bankers are limited in their ability to see into the future. Further out along the maturity spectrum, the direct influence of the central bank on interest rates diminishes. Longer-term rates reflect world real interest rates (which, in turn, reflect demands for capital and other factors); inflation expectations; and risk and uncertainty premia, which can vary greatly with the market psychology of the moment. , of course, the actions of the monetary authorities are relevant to longerterm rates. In a small country like Australia, we have to take world real interest rates as given, but our domestic policies do affect inflation expectations and the risk and uncertainty premia. In particular, the stronger the market's belief that the authorities will keep inflation down, the lower long-term interest rates are likely to be. Interest rates charged to borrowers and paid to depositors are subject to some additional influences as well. The extent of competition among financial institutions, for example, means that lending rates and margins can move, to some degree, independently of monetary policy actions. Over the past year, bank lending and deposit rates in Australia have risen by less than the rise in official shortterm rates. Long rates We can see these various influences at work during the past 18 months. At the long end, the sharp rise in rates began well before our monetary policy started to tighten in August 1994. The trigger for this in Australia, as in most other countries, was the rise in bond yields in the US in early 1994. The close linkage between US and Australian bond markets is not always explainable in terms of observable facts, but it has been real nonetheless. Although they followed similar trends, bond yields in Australia in 1994 rose more than in most countries. This reflected scepticism about our ability to sustain recent low rates of inflation and concerns that we might revert to our earlier, less flattering performances. Most other countries with poor histories of inflation during the 1970s and 1980s also experienced relatively large rises in bond yields in 1994. Given the historically low levels to which they had fallen in most countries by the end of 1993, some rise in world bond yields was on the cards. The sharp rises which occurred in 1994, however, suggested an over-reaction by investors to the perceived inflation risks posed by the pick-up in economic activity. The fact that inflation has remained subdued in most countries, including Australia, supports this view. The substantial falls in bond yields over recent months suggest that market participants themselves have come to a similar view. Since their peak in late 1994, yields on Australian 10-year bonds have fallen by 175 basis points to under 9 per cent. In Australia, the bond market has also benefited from the tightening in fiscal policy announced in the May budget. This has eased pressures on the bond market, partly on the grounds that its overall contractionary effect will help to contain inflationary pressures, but mainly because it presages a marked reduction in the Government's own demand for funds. The bond issue program is likely to be no more than $4 billion in 1995/96, compared with about $20 billion in 1994/95. Short rates So much for long rates, where recent experience reminds us just how closely linked we are with overseas financial markets. But it also reminds us that we need to follow credible policies of our own. Credibility is not earned by pious statements of intent, nor by monetary policy alone, but by getting the settings of all policies right and sticking to them. In my view, good progress is being made on the domestic policy front. In the second half of 1994, when it was emerging that the recovery had a good head of steam, the authorities raised short-term interest rates, even though inflation was still low (2 per cent or less) and unemployment was still high (over 9 per cent). Overnight interest rates were raised almost 3 percentage points in three steps, to 7.5 per cent. These rises are achieving their objectives: they are helping to deliver a sustainable rate of growth in output and employment, while keeping inflation under control. Future changes in monetary policy will be motivated by the same objectives. The notion that concerns for activity and employment should be part of the Reserve Bank's duty statement is somewhat controversial these days. It should not be. Monetary policy might not be able to do much to raise an economy's long-term growth rate but there is little doubt that it affects output and employment over the course of the business cycle. Indeed, monetary policy operates to lower inflation largely through its influence on the real economy. Helping to keep output and employment on a sustainable growth path, therefore, is not just consistent with low inflation, it is part and parcel of its achievement. With the economy and employment still growing at a good clip, our main focus at the moment is on keeping inflation in check. Price stability is not a pillar of dogma to be pursued for its own sake. Rather, experience demonstrates that economies work better when prices are relatively stable - when consumers and investors are more inclined to behave in ways conducive to sustaining growth and employment. Central banks express their inflation objectives in different ways: ours is to hold underlying inflation to an average of 2 to 3 per cent over a run of years. It is a firm and clear commitment. It has been endorsed by the government. Our formulation allows for the likelihood of some cyclical variation in inflation, but it does not provide for any structural pick-up. In other words, we can accept inflation above 2 to 3 per cent on occasions, provided the necessary policy adjustments are being made to bring it back to that rate within a reasonable period of time. We will judge ourselves successful if underlying inflation is held to '2 point something' over the course of the economic cycle. The pre-emptive tightenings of monetary policy in the second half of 1994 were designed to put policies in place before inflation actually picked up. It is now 10 months since the initial tightening and underlying inflation is still around 2 per cent. But we expect that it will pick up over the year ahead. The main sources of potential pressure are: overly strong levels of demand putting pressure on capacity and resources; and cost pressures coming from higher input prices, rising wages or a falling exchange rate. We are keeping a close watch on these areas, as well as on inflation expectations, which can affect price setting and wage bargaining behaviour. Short-term interest rates are set with each of these pressure points in mind. The pace of economic growth is clearly important but so too are the other potential threats. For the moment, monetary policy is, I believe, hitting its targets. Demand pressures The pace of growth in demand had to slow from last year's rapid rate to help keep inflation under control. There is no doubt that the economy has slowed, but by how much is less clear. The evidence is mixed. Over recent months, surveys of business and consumer sentiment have generally revealed a more restrained outlook for economic activity, and some indicators have weakened. On the other hand, employment, imports and personal credit have continued to grow quite strongly. The slowdown that is occurring reflects in part the working out of the dwelling and stock cycles, both of which are expected to detract from growth during 1995/96. But policy is also contributing, led by the monetary policy tightenings in the second half of 1994 and supported by the modest fiscal contraction - equivalent to 0.7 per cent of GDP - provided for in the budget for 1995/96. Real GDP grew by about 3 per cent in the year to the March quarter, and by less than that over the past six months. This suggests a significant slowing which, if sustained, would help to relieve pressure on inflation and the current account. As always, there are risks in the year ahead and economies rarely grow as smoothly as forecasts imply they will. Two notable areas of uncertainty at this time are the drought and when it might break, and the pace of growth in the world economy, especially in Japan and the United States. Business and consumer sentiment is another unpredictable factor which can shift quite quickly on the back of changes in expectations about interest rates and other developments. It is part of a prudent central banker's makeup, if not to worry about these things, to at least understand that they can change quickly and turn out differently from what has been forecast. This caution seems well based at present when there is more than usual uncertainty about the course of future demand pressures, but rather less about future cost pressures. Cost pressures Even if activity continues to slow to a more comfortable pace, cost pressures will need to be watched closely. Problems could come from one or more sources, including higher input prices, further upward drift in wages, and sustained exchange rate depreciation. Prices of some metals and other materials have been rising, but wages and the exchange rate - the two Achilles heels of Australian inflation in the past - are the main areas to watch. Pressures currently in the pipeline suggest that the 2 to 3 per cent inflation objective is in some danger of being exceeded during the year ahead. Over the past year, growth in ordinary time earnings has moved up to between 4 and 5 per cent (from 3 per cent in 1993/94) while productivity growth has been about 2 per cent. These kinds of numbers remain broadly consistent with the 2 to 3 per cent inflation objective, but this position would be undermined if wages were to grow any more rapidly. It should not be assumed that further slippage on wages will occur. One reason for optimism is that we have now had a decade of relative wage restraint, and most businesses and employees understand that this has delivered good outcomes for all parties. Employment has grown strongly, profitability has increased and inflation has come down. This experience has changed the attitudes of many Australians and is helping to build a community consensus in favour of responsible wage outcomes and low inflation. Wage restraint has been underpinned also by changes in wage setting institutional arrangements. One such change is the Accord process, which has given rise to an on-going series of understandings between the Government and the trade union movement. Accord Mark VIII is currently being negotiated, and all the indications are that the unions remain committed to reaching wage outcomes consistent with continuing low inflation. Another change is the shift to enterprise bargaining, which now covers approximately 40 per cent of the workforce and is spreading. Compared with earlier centralised arrangements, enterprise bargaining focuses the attention of employers and employees on productivity, and makes it harder for wage rises in one sector to 'flow on' to other sectors. This new focus on wage moderation and productivity improvement through more flexible work and management practices has been reinforced by other changes. Tariff reductions, deregulation and other measures to open up markets mean that large wage increases cannot easily be passed on to consumers: a welcome discipline is now being imposed on wage setters on both sides of the negotiating table. These are profound changes. Provided they can be sustained - and there is no reason to believe otherwise - they augur well for keeping inflation under control. The big test will be whether wage increases over the next year or so can be contained to around the current rate of 4 to 5 per cent, in circumstances where employment growth is expected to remain strong. The other potential near-term threat to inflation is the exchange rate. Depreciation, if sustained, is bad for inflation because it raises the prices of imported goods and materials directly, and reduces the competitive discipline on domestic producers; sustained appreciation has the opposite effects. In trade-weighted terms, the $A appreciated by over 10 per cent during 1994 but this has been whittled away during the first half of 1995. The pass-through of exchange rate changes to consumer prices usually takes a year or more, and depends on a number of factors, including expectations about future movements, and the strength of demand in the economy. If the recent fall in the Australian dollar was to be sustained, producers and retailers could be expected to pass on a large part of the increase in import prices to consumers, resulting in unwelcome upward pressure on prices over the next year or two of the order of around of a percentage point. On the other hand, if the recent fall is unwound over the months ahead, any such effects are likely to be small. The conclusion I would lead you to draw from all this is that there can be no certainty about the timing or direction of the next move in official interest rates in current circumstances. Any change will be dependent on judgments based on the flow of data about trends in activity, capacity utilisation, prices, wages, exchange rates, overseas developments and other factors. Movements in one particular area are unlikely to be definitive: all relevant pressure points have to be assessed. Monetary policy should be adjusted when those judgments - reached in the light of the twin objectives noted earlier - require it. Ideally, it should be adjusted pre-emptively - in either direction - but not prematurely. The short answer to our second burning question - what is likely to happen to the Australian dollar? - is that, perhaps more so than with interest rates, we cannot confidently predict how the exchange rate will behave. Over the years, academic economists and market practitioners have invested heavily in the search for a philosopher's stone of the financial markets: a model that accurately predicts exchange rates. None exists. Many people make predictions but no-one has succeeded in developing a model with any worthwhile predictive power, at least so far as month-to-month or quarter-to-quarter movements are concerned. This is hardly surprising, given that foreign exchange markets are driven largely by expectations of future events, including policy developments. The only consistent and reliable finding that has emerged from all this investment is that, over the long run, exchange rates adjust to reflect differences in inflation and productivity growth among countries. Over shorter periods, other factors like interest rates and market perceptions about policies enter the equation but these effects are especially difficult to quantify. Notwithstanding these problems, many market participants appear to view the Australian dollar as one of the more predictable exchange rates. This is partly because they see it as a 'commodity currency', which rises when commodity prices rise, and vice versa. This kind of relationship has been evident over the past decade, although the precise linkage is unclear. Commodities still account for 60 per cent of Australia's exports (compared with over 70 per cent 10 years ago), but the fluctuations in export receipts resulting from changes in commodity prices are not sufficiently large, by themselves, to explain fully the swings we have seen in the Australian dollar. Part of the explanation appears to be that many overseas investors and funds managers have a model in their minds that Australian investments are a good buy when commodity prices are rising; they act on this model and their actions tend to become self-fulfilling so far as the Australian dollar is concerned. Whatever the mechanism, the rise in the Australian dollar during 1994 owed a good deal to signs of rising world industrial activity, which lifted many commodity prices. In 1995, slowing economic activity in the US and continued weakness in Japan have halted this lift and, in some cases, led to falls. Another market perception of the Australian dollar is that of a 'dollar bloc currency'. At times, movements in the Australian dollar do seem to be driven largely by movements in the US dollar; some of the recent weakness in the Australian dollar appears to have fed off weakness in the US dollar. Again, there is no apparent strong rationale for expecting the Australian dollar to follow the US dollar, beyond the fact that (as now) the economic cycles in Australia and the US are often closely synchronised. There are, of course, no institutional linkages between the Australian dollar and the US dollar, in the way that there are between the German mark and many other European currencies. Although there are times when these market perceptions of the Australian dollar as a commodity currency or 'dollar bloc' currency might help to explain day-to-day fluctuations, they cannot explain longer-term movements. The perceptions themselves are not all that soundly based; Australia's economy and export base are diversifying, and its economic ties are increasingly with the Asian region. Here, as in some other areas, market perceptions are lagging behind realities. Over the longer term, the important influences on the exchange rate will be our performance in containing inflation, improving productivity and raising national saving. In short, in the conduct of economic policy generally. I have said already that I believe good progress is being made on the policy front. The episode of higher than average inflation of the 1970s and 1980s is now behind us, and our productivity performance has picked up. But the policy front keeps moving - and we have to move with it. This leads me to concerns about Australia's current account deficit, which appear to figure prominently in market perceptions of the Australian dollar. Large current account deficits certainly raise the level of market nervousness about the exchange rate. We saw this in early 1995 when the Treasurer indicated that Australia was facing a current account deficit equivalent to almost 6 per cent of GDP. This caused international investors to question the adequacy of domestic economic policies, and contributed significantly to the subsequent decline in the exchange rate. In part, the blowout in the 1994/95 current account deficit reflects several special factors. Exports of wheat and some other farm products, for example, have been decimated by the drought. At the same time, imports have been boosted by burgeoning domestic spending, especially business investment; capital goods imports rose 20 per cent in the 10 months to April 1995. While these seasonal and cyclical factors can be expected to reverse themselves, the fact remains that Australia's structural, or underlying, current account deficit deteriorated in the early 1980s and has not recovered; it averaged around 2 per cent of GDP in the 1960s and 1970s, but has averaged 4 per cent in the 1980s and 1990s. This change is not, in my view, a reflection of our current international competitiveness. Most of the deterioration occurred in the late 1970s and early 1980s. Since that time, the Australian economy has been transformed: it is now more open and competitive than ever before. Over the past decade, for example: the share of trade (imports and exports) in GDP has risen from about 30 per cent to about 40 per cent; the share of merchandise exports destined for the fast growing Asian market has grown from 53 per cent to 67 per cent; and exports of manufactured goods have grown at an average rate of 17 per cent per annum and now represent 23 per cent of total merchandise exports. More fundamentally, the current account deterioration reflects an increased reliance on foreign saving to help fund our investment. This long-term dependence on foreign saving has led to an accumulation of foreign liabilities. But we are coping with these. Net foreign debt, for example, was equivalent to 37 per cent of GDP in March 1995, down from a peak of 43 per cent in September 1993, and below the levels of countries such as Debt service payments in the year to March were equivalent to 11 per cent of total export earnings, compared with a peak of 21 per cent Although manageable, our on-going dependence on foreign saving does leave us exposed to wild swings in market sentiment against things Australian. Whether they are well based or not (and often they are not), such swings make for greater exchange rate volatility, as well as higher interest rate premia on borrowings. In short, there are some risks in a continuing heavy reliance on foreign capital inflows; certainly, the implications for policy of investors losing confidence in the economy are very sobering. I believe these risks are now better understood by both the authorities and the community more generally. It is understood, for example, that, given our on-going need to access volatile financial markets, we have additional pressures on us to pursue sound macro policies and structural reforms. And, I am pleased to say, there is a growing appreciation that the best counter of all to this exposure is to reduce our dependence on foreign saving. Herein lies the real significance of the Government's recent budget. It tackles the current account problem at its source, namely Australia's persistent national saving/ investment imbalance. It contains measures to significantly lift national saving over the years ahead through better public and private sector saving efforts. Both sectors have contributed to the secular decline in national saving during the past two decades, with the public sector contributing the bulk of the decline. (As with the current account deterioration, much of the structural decline in national saving occurred in the period from the mid 1970s to the early 1980s.) Public saving Four surpluses in a row were achieved in the late 1980s before the budget moved into deficit, with the onset of the recession of the early 1990s. The budget provides for a small surplus in 1995/96, which is projected to grow in the three following years. Part of the improvement next year reflects the effects of asset sales and some other special transactions, which the Government has been quite upfront about. Adjusting for these transactions (as we should from a national saving perspective), the 'underlying' budget deficit is projected to decline from about 3 per cent of GDP this year, to about 1 per cent in 1995/96. On the same basis, the budget would be in virtual balance in 1996/97, and in surplus thereafter. This represents substantial progress by international standards. The US, which is ahead of most countries in deficit reduction plans, is hoping to balance its budget by the turn of the century. By the more relevant standards of the stage of the economic cycle in Australia and the extent of our current account problem, it is less impressive - but still very welcome progress. Private saving The budget also announced a major initiative to promote private saving. It will operate through an extension of the superannuation scheme which is designed to encourage employees to save more for their retirement. Measures already are in place to require employers to pay a portion of employees' earnings into superannuation funds; this portion is being increased progressively to 9 per cent per annum by From July 1997, these arrangements will be extended to include contributions by employees, building up to 3 per cent per annum. The Government has also undertaken to pay amounts roughly equivalent to these contributions into a superannuation fund on behalf of employees (and self-employed people). All up, it is envisaged that, by 2002, most employees will have about 15 per cent of their earnings going into a retirement fund each year. How should we rate these various budgetary It is always possible to argue that more should have been done, but we should also evaluate objectively the measures that have been adopted. Given the starting point, it was always going to take more than one year to eliminate the budget deficit in underlying terms. Real progress has been made and we now have a credible medium-term orientation of fiscal policy. Notwithstanding that progress, I suspect that some further hard pounding lies ahead, particularly in keeping the lid on new spending commitments and in better targeting programs to genuinely needy recipients. Assuming they are properly implemented (with, for example, effective preservation provisions and protections against 'double dipping'), the superannuation changes will, in time, deliver higher living standards for many Australians in retirement, as well as making a substantial medium-term structural improvement in national saving. Taken together, the projected movement to budget surpluses and increased private retirement saving represent a major boost to national saving. It will help to fund the higher levels of investment needed for continued growth, with less reliance on foreign saving. I have said previously that life would be more comfortable for all of us if the current account deficit were to average around 3 per cent of GDP over the next decade, compared with the 4 per cent average of the 1980s and early 1990s. There are too many uncertainties to make confident long-term projections but the recent budget measures, properly followed through, do make that more comfortable state a real prospect. To the extent it occurs, it will ease our exposure to external shocks and debt servicing burdens; that should be a plus for many things, including the Australian dollar. Today I have focused on the fundamental factors and policies which help to determine interest and exchange rate outcomes in Australia. Monetary policy impinges on both, but fiscal and other policies also are clearly important. Success should be judged not in terms of achieving a particular outcome for either interest rates or exchange rates, but rather in terms of economic activity, jobs and inflation. In the main, monetary (and other) policies have to be based on judgments about prospects for growth and inflation a year or so ahead. These, rather than the often volatile swings in market sentiment, are what determine interest rates and exchange rates in all but the very short term.

r950711a_BOA

australia

fraser

Since the economy began to recover in mid 1991, real GDP has increased by about 15 per cent. Over the four-year period, this implies an average growth rate of between 3 and 4 per cent. Growth of a similar order is forecast for 1995/96. In other words, so far in this recovery phase we are looking at five years of growth averaging between 3 and 4 per cent - a rate which most commentators would put at the upper limit of Australia's long-run potential. Discerning listeners among you will know that, even allowing for some 'catch-up', five years of 3 to 4 per cent growth has a different ring to it - and certainly a truer ring - than hollow sounding throwaways, like 'five minutes of sunshine'. For another illustration of the fixation which many people have with the short term, cast your minds back over the various predictions that have been made about interest rates during the past six months. Some commentators criticised the rise in official interest rates last December - the third increase in the second half of 1994 - but most acknowledged that it was necessary. The common view among the pundits in the early months of 1995, however, was that further Frankly, I have been at a bit of a loss to know what I might talk to you about today. For one thing, I am unfamiliar with the Taproom Club, although the knowledge that it is comprised exclusively of media people is reason enough to be wary, whatever I might talk about. A brewery also seems to be involved, although there are no real surprises in that. (It presumably explains the name of the Club!) The fact that I had talked at some length about the Australian economy in London only a month ago added to my predicament. Nothing has occurred in the intervening weeks to alter the overall assessment presented in that talk. Indeed, it would have been remarkable if it had, given that economic circumstances rarely change in fundamental ways from one month to another. Certainly, policy makers must reach their decisions on the basis of longer-term trends, and not seek to adjust policy every time a 'good' or 'bad' figure appears. Unfortunately, not all commentators and would-be policy makers are capable of taking in this wider panorama. I will give you a few examples, and in the process make some observations on recent developments. and possibly substantial rises were still to come. These views owed something to the very strong growth shown in the national accounts data for the September quarter. As signs of slowing in the economy began to appear, expectations in the markets and elsewhere moved from further tightenings to possible easings. Then, about two weeks ago, in the wake of the current account number for May, many commentators swung back to the view that the next move in official interest rates would be up. Now, following the action last week by the Federal Reserve to reduce official interest rates in the US, expectations of interest rate reductions have begun to resurface. Some commentators who were earlier predicting substantial interest rate increases before the end of 1995 are now forecasting reductions. People are, of course, free to express their views, and to change their views. My point is that policy makers have less freedom in this regard - they must take longer-term views than most people in markets, the media and politics appear able or willing to take. And, as far as possible, they must base their judgments on hard data, rather than wishful thinking. We would be in real trouble - in real 'stop-go' territory - if those responsible for monetary policy decisions allowed themselves to be persuaded to follow even a fraction of the short-term swings in sentiment we see in financial markets (and elsewhere). It is clear that growth in the Australian economy is slowing down. For the moment, this seems to be occurring broadly as policy makers intended. According to the national accounts, non-farm growth slowed from an annual rate of 7 per cent in the six months to the September quarter, to a more sustainable annual rate of 3 per cent in the six months to the March quarter. Unfortunately, policy cannot slow the economy to some precise, desired growth path and then keep it to that path: the internal dynamics of economies and the lags before policy changes take effect almost guarantee some bumpiness, as distinct from a perfectly smooth ride. What is not clear at this time is the extent or likely duration of the slowdown which has been occurring. It is possible, for example, that the economy could slow further for a quarter or two. If it did, this need not be a cause for alarm. To the extent that any such pause in growth reflected the working off of excess holdings of stocks, for example, it would be temporary, and not in itself a reason to ease monetary policy. In London last month, I noted that recent indicators of economic activity in Australia were giving mixed signals, and that there were risks both ways on growth. New information, as it became available, would help to firm up the probabilities attached to these risks. I ' ... that there can be no certainty about the timing or direction of the next move in official interest rates in current circumstances. Any change will be dependent on judgments based on the flow of data about trends in activity, capacity utilisation, prices, wages, exchange rates, overseas developments and other factors.' That remains the situation as I see it. Last week's decision by the Fed to reduce official interest rates by 25 basis points is a relevant 'overseas development', to be taken on board in our on-going assessments. It is a small move, yet it is a good move, to the extent that it helps to 'cushion' the economic slowdown in the US. Any move of that kind, and the similar move by the Japanese authorities on Friday, which was even more pressing, has to be good news for Australia. It does not, however, have any immediate implications for official interest rates in Australia. There is no mechanical linkage between movements in US official interest rates and movements here. Domestic considerations are very much to the fore in our deliberations on monetary policy. To this time at least, growth in Australia appears to be holding up better than in the US. In the US, retail trade has been flat for much of this year, and employment has been falling over the past three months. Both these indicators have continued to grow strongly in Australia, as have imports. On inflation, while our actual performance over recent years is better than that of the US, our outlook is less secure, given the pressures already in the pipeline from a variety of sources, including the weak exchange rate. These domestic factors argue for holding the line on official interest rates in Australia for the time being. We also have a large current account problem. That problem is not a primary objective of monetary policy but, in circumstances where the exchange rate is so clearly being driven by concerns about the current account deficit, it has to be factored in. I have discussed the problem of our current account many times but a couple of points are worth repeating, particularly in the wake of reactions to the figure for May. That was obviously a big figure but it did not warrant the near hysterical reactions it evoked in certain quarters. Many of those reactions too can be sheeted home to short-termism - to an unwarranted focus on one month's figure. You do not have to be a student of economic statistics to know that monthly figures of the current account deficit (more so than most other indicators) have a lot of 'noise' in them: they can bounce wildly from month to month for a variety of reasons. The Statistician routinely issues public warnings to this effect. He also pointed out last week that, in respect of more than half the monthly figures published over the past decade, 'irregular' factors (as distinct from the trend and seasonal factors) have accounted for 80 per cent or more of the month-to-month movements. Monthly fluctuations, therefore, can hardly be seen as signalling new trends. In hosing down some of the more extreme reactions to the latest current account number, I do not want to appear to diminish the problem. The current account is the one area of the economy where not a lot of progress has been made over the past decade and a half. That is disappointing. But the need to tackle more vigorously the underlying source of the problem - namely, an insufficiency of national savings - is now widely recognised. And it is now occurring, if a little belatedly. I have suggested several times that life would be more comfortable for us if the current account deficit were to average around 3 per cent of GDP over a run of years - compared with the average of 4 per cent in the 1980s and 1990s. This would greatly reduce our vulnerability to sometimes fickle changes in sentiment in financial markets. Provided they are followed through appropriately, the measures announced in the last budget to move to surpluses and to raise private savings through increased provisions for superannuation will help to make that 3 per cent a realistic prospect. In short, I think policy is on the right track so far as the current account problem is concerned, but it will be a long journey. We will have to be patient. We will have to be on guard too to fend off the hawkers of nonexistent short-term fixes along the way. And we should not get too excited by monthly numbers, including those which happen to bounce in a favourable way. Like the recent move by the Fed, the May current account figure has no immediate implications for monetary policy. What seems somewhat ironic to me is that one event which completely overshadows both the May current account deficit and the Fed's move in terms of its implications for Australia's economic future has passed by with relatively little acknowledgment. I am referring, of course, to Accord VIII. People in financial markets do not appear to give much thought to the Accord, perhaps because incomes policies do not feature prominently in other countries' economic armouries these days. Or, if they do think about it, they tend to dismiss it as being incompatible with their view of the way 'market' economies should work. Some other commentators seem intent on maintaining the scepticism they have displayed from the outset - notwithstanding that, in the Accord process, Australia has had an incomes policy for more than a decade which actually works. It has contributed, significantly in my view, to sustained moderation in wage increases, and to engineering a more productivityfocussed industrial relations culture, without Darwinian consequences for the weaker members of the workforce. As in the past, the growth in wages in the years ahead will have a major bearing on how successful we are in keeping inflation under control. More specifically, it will be critical in helping to keep underlying inflation at 2 to 3 per cent, and in ensuring that any breaches of this objective that might occur are temporary. To my knowledge, Australia is the only country where a union movement has formally committed itself to pursuing wage increases which are consistent with delivering the central bank's inflation objective. I am afraid that what started out as some brief observations on recent developments has turned out to be rather longer than I had envisaged. It leaves little time to pursue some other aspects which I had planned to explore when I accepted your invitation. In the time remaining, I can give you just an inkling of a couple of these. One relates to the move towards a so-called 'cashless society'. For most of us, that too is proving to be a long journey. The value of currency notes on issue, for example, has gone on increasing year after year; it has been equivalent to a fairly steady proportion of GDP (around 4 per cent) over the past 30 years. In terms of payments activity, the current pattern, very roughly, is: 18 billion cash purchases a year; 1 billion cheque payments; 0.5 billion direct entry funds transfers; and 0.5 billion plastic card purchases. Clearly, then, we continue to rely heavily on 'cash'. Plastic cards and direct entry systems have been making some inroads but these have been mainly at the expense not of cash but of relatively high-cost cheque services (which are subsidised in part from margins on deposit and loan business). Driven by computer-chip technology, possible alternatives to conventional currency are now emerging in proposals for the socalled 'electronic purse', in the form of prepaid, stored-value cards, and smart cards which can be 'recharged' through ATMs, EFTPOS terminals, and so on. Basic storedvalue cards - such as Phonecards - have been available for some time but stored-value cards which can be used to purchase a range of different goods and services are new, and they have still to prove themselves in practice to be superior to conventional cash in terms of cost, security and convenience. Various smart card schemes are being developed and trialled around the world, including in Australia, although their widespread use would seem to be some years away. They raise important issues for retailers, consumers and card issuers. Central bankers also have obvious interests in vital aspects of electronic currency - including the integrity of the issuers, the security and efficiency of the technology, their scope for laundering money, and the ownership of the seigniorage earned on the issue of currency. These and other aspects are being assessed and we will have more to say about them later on. Finally, a brief word about financial institutions and the problems they sometimes get into. Central banks usually get involved in these problems when they occur, through their role as supervisors of the banks. Barings, which closed its doors in February, and lost its shareholders about A$1 billion, was the most recent high profile collapse. The Bank of England explored different avenues for keeping Barings afloat, including support from the Bank itself, but decided against this, apparently on the grounds that the failure of Barings was unlikely to destabilise the broader banking or financial system. An official inquiry into the collapse was initiated almost immediately by the Bank of England and the report of that inquiry is expected to be released in the next couple of weeks. We will have to await that report for confirmation, but a widely held view is that Barings' problems stemmed primarily from fraud and management failure, rather than something more exotic, like a derivatives 'meltdown'. The derivatives in question were of a relatively straightforward variety. Supervisors obviously have to do what they can to minimise these kinds of risks. Short of positioning armies of trained staff to look over the shoulders of dealers, and to second guess their decisions, however, there will always be some residual risk. If management cannot control fraud and malpractice, it would seem unreasonable to expect supervisors to be able to do it for them. Australia has had its share of problems with financial institutions. The shareholders of several banks, including a couple of former State government-owned banks, have paid dearly for their banks' miscalculations and ineptitude. But we have not seen the major bailouts of banks with public funds that have occurred in the US and the Nordic countries - and might yet occur in Japan. Outside the banks, we have seen the collapse of the Farrow Group of companies, which has spawned a complex set of legal proceedings. The Reserve Bank has been dragged into a number of these proceedings with, in effect, the Victorian Government and various other parties seeking to be compensated by the Reserve Bank if certain claims for damages should go against them. As you might imagine, we are not particularly happy about any of this. I will not go into details but the main line of argument against the Reserve Bank seems to be that, although the Bank was not responsible for supervising the building societies, it allegedly knew more about them than the responsible supervisor - the Registrar of Building Societies in Victoria - and should have been more forthcoming in conveying that knowledge to the Victorian authorities than we allegedly were. I think it is all very fanciful but we are obliged to defend our position in the courts. Our latest advice is that the cases could get underway early in 1996, which will be almost six years on from when the Farrow Group collapsed. It is a good bet that the lawyers involved can look forward to a succession of field days, poring over old statements of who said what to whom, uncovering and testing meanings in particular sentences and particular words which even the authors never intended. We have budgetted over $600,000 for the direct legal costs of defending ourselves in these actions in 1995/96. We expect to be successful and, in that event, we might get back about half our direct costs. I mention this episode not by way of any special pleading on the Bank's part, but as an illustration of a process which, I sense, is being played out in many spheres all over the country. It raises some interesting and difficult questions as to the value added by the process and, more crudely perhaps, about who is making money from it.

r950925a_BOA

australia

fraser

I am pleased that cooperation among countries in Asia is such a prominent theme than ever before, we are living in an era of global markets, but that does not mean regional groupings are losing their relevance. Indeed, given that we have an international monetary system that is more akin to a patchwork quilt than a seamless robe, well crafted regional cooperative arrangements will actually help countries to reap the full benefits of more open world trade and financial markets. A lot has been said in recent years about the 'Asian region' and of Australia's involvement in it. This talk has been mainly trade related, that being the area of perhaps the greatest - and certainly the most obvious - opportunity. But in other areas, too, improved cooperation among countries of the region could yield substantial benefits. These include areas of central bank cooperation, which is the main focus of my talk today. How the 'Asian region' is defined is largely a matter of choice. In my view, it is appropriate that we have a number of different groups: it is inconceivable that any one group would be optimal for all purposes. In practice, different groups co-exist, overlap and change over time. What is important is that each group be capable of generating tangible and mutual benefits for its members. Our interest is understandably greatest in groups which include Australia. In the field group from Australia's perspective. The group was formally initiated in November 1989, with the aim of promoting cooperation on trade and investment issues. APEC now comprises 18 members, including some non-Asian countries. It is a substantial bloc. APEC countries account for 39 per cent of the world's population, 51 per cent of world GDP and 43 per cent of world trade. Its members have always traded extensively with one another, and intra-APEC trade currently represents around 75 per cent of the group's total trade. This share is likely to increase further as existing trade barriers are gradually dismantled. commits developed members of APEC to open trade and investment flows with other members by 2010; developing country members are committed to achieve the same objectives by 2020. These deadlines seem too close for some, and too distant for others. Seen in an historical context, however, their realisation would be a substantial achievement; in Europe, 35 years elapsed between the Treaty of Rome and the creation Many hard decisions lie ahead, but the APEC initiatives are clearly supportive of the cause of freer world trade. If countries which account for nearly half of the world's trade succeed in removing barriers among themselves, that should strengthen the multilateral trading system. It should also enhance APEC's leverage on other regional and international groups professing similar objectives. Another part of APEC's charter is to remove barriers to the flow of capital among members over the timeframes mentioned. These flows help to sustain robust rates of economic growth, but they can also raise problems for policy makers. They can, at times, destabilise financial markets, and this risk would be heightened by moves to lift exchange controls on capital flows, unless other policies are also changed. For this reason, APEC Finance Ministers have been turning their minds to ways to counter any unintended consequences which could frustrate freer trade and investment in the region. In their Jakarta Communique, they noted that uncertainty and ignorance in financial markets were often causes of destabilising capital movements, and resolved to try to ensure a better flow of information to financial markets. They acknowledged, too, the need for capital markets in the region to be further developed and deepened. Some of these issues - including the monetary policy implications of large capital inflows - are obviously relevant to central banks. In varying degrees, the central banks of APEC countries do become involved when these matters are considered. For the most part, however, APEC seems likely to remain the domain primarily of Trade, Finance and Foreign Ministries, and to concentrate on areas in which those ministries (rather than central banks) have the greatest comparative advantage. As I said, my focus today is on central bank cooperation. I should also make clear at the outset that the emphasis is very much on cooperation - not economic and political integration on the European model, with its associated goals of a common central bank and currency. Several associations of central banks already exist in the Asian region. One of the oldest established in 1957 to conduct intensive, biennial central bank training courses. Membership has grown from the original five central banks to the current 17. SEANZA training courses bring together officers from what are quite diverse central banking systems. This diversity is their distinguishing feature, although it also complicates the task of structuring courses which are relevant to the needs of all the participants. Annual meetings of SEANZA Governors are also held; these bring together, albeit briefly, central bankers from what is arguably the broadest possible definition of 'Asia'. The very diversity of this group, however, argues against its practicality as a platform for more intensive central bank cooperation outside the training area. Another group which also holds annual meetings of Governors and operates a training currently has ten members - Indonesia, the Australia is not a member of SEACEN, but the Reserve Bank regularly makes available senior officers to lecture at SEACEN training courses. The newest regional central bank group is EMEAP, a less-than-memorable acronym which stands for Executive Meeting of East grew out of an initiative by the Bank of Japan. The first meeting was held in February 1991, and was attended by central bank representatives from Australia, Indonesia, Thailand. Membership was later expanded to eleven, with the addition of the central banks of the People's Republic of China and Hong Kong. EMEAP meetings are held twice a year, hosted alternatively by the Bank of Japan and another member central bank; representation is usually at Deputy or By any measure, its member countries make EMEAP a substantial group. Just how substantial can be seen from the following comparisons with the 15 member-country The half-yearly meetings of EMEAP are valued highly by the Reserve Bank and, we believe, by other participating central banks. The meetings are relevant and informative; the fact that Japan is a member of G3 and G7 provides potentially useful linkages for information sharing with those other groups. EMEAP does not, however, have any policy development or operational functions. The questions I want to explore today are whether cooperation among regional central banks should be extended into these (and other) areas, and how that might be best achieved. My answers, in brief, are that greater cooperation is desirable, and that a new regional institution is the best way to achieve that. Perhaps the single most important argument for a new regional institution is the advent of global markets - including for currencies and financial instruments, which are of special interest to central banks. This seemingly relentless process offers the prospect of stronger growth in world trade and development, through better use of the world's capital and other resources. But it also promises a bumpy ride for many countries. Those countries which have not yet done so can expect to come under mounting pressure to liberalise their financial markets. Concerted discussion, and the sharing of experiences of both the macroeconomic and regulatory implications of financial liberalisation will require a more deliberative forum than that provided by current EMEAP arrangements. Globalisation of markets also increases the chance that problems in one part of the world economy will break out elsewhere. We had a foretaste of this with the currency crisis in Mexico earlier this year, which posed certain threats to some countries in this region. In other words, globalisation is elevating the international dimension of monetary cooperation. Domestic policies will always have to be the main line of defence in response to these threats, but even sound domestic policies may not be sufficient in the face of massive short-term swings in cross-border capital flows. Cooperative and coordinated responses on the part of several central banks might be called for, as well as - on occasions - access to emergency financial support. How is this international dimension best handled? Existing institutions are relevant but (ADB) is an important financial institution in the region but its forte is longer-term development assistance. The IMF is an important international financial institution; it can, for example, exert pressure on domestic policies by attaching conditions to the assistance it provides. Most EMEAP countries, however, are unlikely to be frequent recipients of conditional loans. In any event, assistance that might be available from an institution as large as the IMF (it has the interests of 179 members to reconcile) might not be available as quickly as it is required. The IMF is currently exploring options to improve its responsiveness to situations requiring emergency financing, but there is still a case, in my view, for close neighbours to have their own mutual support arrangements to deal quickly with emergency situations. (BIS) is a promising model in this context. central banks, and it has become the principal forum for discussion, consultation and cooperation among central bankers in western countries. Its main drawback from an Asian perspective is that - notwithstanding its name - its membership is 'international' only in a quite narrow sense. All but five of its 33 shareholders are central banks of European countries and 13 of its 17 Board members are Europeans. Despite the progress towards broader participation that has been achieved in some areas by the current General Manager, the BIS remains quintessentially a G10 institution, with an overwhelming European orientation. In short, no existing institution could expect to match the particular focus or immediacy of a regionally-based institution dedicated to central bank cooperation. An alternative to a new institution is, of course, enhancement of the non-institutional EMEAP arrangements. That, too, would be a matter for the central banks concerned. My own view is that, as valuable as current EMEAP arrangements are, deeper and on-going central bank cooperation will require a proper institutional framework. For that to materialise, a sufficient number of central banks would need to be satisfied that the potential benefits outweighed the costs. I want now to indicate in a little more detail the kinds of functions an institution modelled on the BIS and serving EMEAP-based central banks could perform. In essence, the aim would be to perform broadly similar functions to the BIS in the Asian region. It would complement, rather than compete with, the BIS. Operating with similar objectives, the new institution would hopefully contribute to more effective cooperation among central banks on the global stage (in much the same way that APEC will hopefully contribute to the objectives of freer world trade and investment flows). The main functions which I will mention are, to a degree, mutually reinforcing. I noted earlier that EMEAP countries add up to a substantial bloc. Their economies, on average, have grown about three times faster than the average for OECD economies over the past decade. Given their generally high saving ratios and growing intra-regional trade and investment ties, their relatively rapid growth rates are likely to continue. These, in the normal course, will throw up their own challenges for economic policy makers Increased cross-border capital flows consequent upon the progressive deregulation of domestic financial markets can be expected to bring an additional set of challenges. In this environment, the task of maintaining growth and controlling inflation will become more difficult, with additional constraints on the operation of monetary policy, especially where exchange rates are fixed or sticky (as they are in several Asian countries). Central banks will not be the only policy makers affected by these issues, but they will have a pivotal role to play in most countries. A regional institution would provide for more structured and sustained discussion, experience sharing, monitoring, research and cooperation in these policy areas than is possible under the current, informal arrangements. A permanent secretariat - not large but competent - would be required to help give focus and continuity to this cooperation. Crises can and do occur but they are virtually impossible to predict. Being prepared requires on-going discussion and effective contingency plans. It can also entail emergency assistance in exceptional circumstances. This contingency planning and response capability constitute a second broad function of a new regional institution, and a logical extension of the first. Notwithstanding their high saving ratios, many EMEAP economies also have a significant reliance on foreign capital. Increasingly, this is taking the form of private short-term capital flows, which are potentially volatile and likely to become more so as the globalisation of currency and financial markets spreads. These flows can react quickly to changes in market expectations and news, often independently of changes in economic fundamentals, and often in response to developments outside the region - something like guilt by association, however mistaken that might be. Central banks can respond to serious destabilisation of this kind in different ways to meet a variety of needs. Responses could range, for example, from information sharing, through coordinated foreign exchange operations and foreign exchange swap agreements, to more highly structured temporary credit facilities. A regional institutional framework could usefully facilitate all these kinds of activities, and would probably be essential in the case of more highly structured facilities. It would have the focus and primacy to pursue effective action, which usually means quick action. Generally speaking, central banks have more freedom to act in their particular spheres of responsibility, and can usually move more speedily than other organs of government when they need to. They are more able to, as they say in the Nike ads, 'just do it' (after, that is, they have established their guidelines, including in this context, the basis on which any new regional facility would co-exist with other international facilities). Certainly, there can be no doubting the capacity of regional countries to mount a new facility, as well as to participate fully in broader support schemes. The total foreign exchange reserves of the seven EMEAP countries with the largest reserves, for example, more than match the total of G7, widely regarded as the world's most influential economic group (see reflection of the remarkable - but still not widely appreciated - changes which have occurred in many countries in the Asian region over the past decade.) Many EMEAP countries are likely to be under increasing pressures to liberalise their financial markets, not only from outside but also domestically as capital requirements for business and infrastructure outgrow traditional sources and institutions. It is possible that the existence of some regional emergency support mechanisms would be helpful in this regard, to the extent that it provided some additional confidence to the authorities contemplating liberalisation measures. More generally, central banks will be involved in the supervision of their banking and financial systems through what are likely to be rapidly changing circumstances. No supervisory model is applicable to all countries, irrespective of their stage of development. What is appropriate for Australia or Singapore, for example, is not necessarily appropriate for Indonesia or China. This suggests an argument for a regional institution to facilitate discussion and the sharing of experiences and insights among central banks on bank supervision issues, similar to that raised in the context of the monetary policy implications of volatile crossborder capital flows. Again, existing international arrangements are not ideal from an Asian perspective. Most of the running on the big changes in bank supervision has been made by the Committee on Banking Supervision established 20 years ago by the G10 countries under the aegis of the BIS. It was this Committee which devised the capital adequacy requirements in relation to credit risk (that is, the risk of counterparty failure) and which is currently putting the finishing touches on proposals to require capital to be maintained against market risk (that is, risks from movements in interest rates, exchange rates and equity prices). Once standards or requirements of these kinds are agreed in the Committee, and adopted by the central banks in G10 countries, there is considerable pressure on others to follow suit - otherwise their banks risk being perceived as somewhat inferior institutions in competitive situations. The Reserve Bank is a shareholder of the BIS but, not being a member of the G10, it is not a member of the Committee on Banking Supervision where these issues are discussed and largely decided. We do have an opportunity to comment on proposals before the Committee (such as the current market risk proposals), but that is very much a second best situation. It is, however, ahead of the position for most other countries in the region. Even those with sophisticated banking systems are effectively and unfairly discriminated against because certain concessions in the current BIS risk weights for capital adequacy purposes are restricted to banks from countries which are members of the OECD (at present only Japan, countries are members of OECD). A regional institution might help to make the views of countries in the Asian region better known in bodies like the BIS and its importantly, it could facilitate cooperation on the growing international element in financial surveillance as banks and other financial institutions spread across national boundaries. Regional banking systems are likely to become increasingly interdependent as trade and investment links develop further. This will generate a growing community of interest in safe and efficient banking systems in individual EMEAP countries. Similar comments could be made about clearing and payments systems. These systems are critical to the proper functioning of all our economies but we hear little of them (until something goes wrong). Currently, about half the central banks of EMEAP countries (including Australia) either have or are in the process of establishing payments systems for high value interbank payments which are from deferred) time, such systems eliminate interbank settlement risk, and minimise the possibility of systemic difficulties arising from problems in one area of the financial system. They also eliminate settlement risk in foreign exchange markets. As economies grow and markets of all kinds are progressively deregulated, the volume of transactions flowing daily across the borders of regional countries will go on increasing dramatically. A valuable and legitimate function for a regional institution of the kind envisaged here would be to help strengthen the linkages among payments systems within the region, and between the Asian region and other regions. Finally, and in part as an adjunct to its other functions, a new regional institution of the BIS model would be able to offer member (and non-member) central banks a range of financial and investment services. In this role, it would be a bank for central banks, in the way that the BIS has become. (In this role also it would be, to some extent, a competitor The BIS assists central banks to manage and invest their foreign exchange reserves, and is active in foreign exchange and financial markets as an agent of central banks. It provides deposit and other investment facilities which are tailored to the particular needs of central banks in managing their reserves, and which are of a kind (and with a credit rating) commercial banks could not provide. Some 100 central banks hold short-term deposits with the BIS; these are estimated to be equivalent to about 10 per cent of global foreign exchange reserves, and include substantial sums from central banks in the Asian region. The spread which the BIS makes on these deposits and transactions not only covers its operational expenses, but also generates profits and dividends for its shareholder central banks. There is no reason why Asian central banks could not organise a regional institution to provide competitive services of these kinds, essentially as an adjunct to its other functions. Certainly, the talent, financial resources and opportunities exist in the region to make this practical. In summary, a good case can be made, in my view, for establishing a new institution to promote cooperation among central banks of the region ( not a regional central bank). A minimum approach might be a modest permanent secretariat servicing regular meetings of member central banks, but a much better prospect, in my view, is the BIS model. That is, an institution with its own capital (to be subscribed by member central banks) and its own balance sheet. As such, it would have the flexibility to perform the range of functions and financial services I have alluded to. Its establishment could proceed in general harmony with on-going moves to strengthen trade and investment ties in the region (in their various configurations), but on its own track and timeframe. Building upon the strengths of its member central banks, but operating within a broader, enlightened international framework, it could contribute to both regional and world prosperity. That is the thought I would like to see explored further by my colleague central bankers in EMEAP. It is the thought I would like to leave with you this morning.

r951019a_BOA

australia

fraser

Once again, we welcome the opportunity to meet with the Committee, not only to elaborate on our activities during the past year, but also to respond to falsehoods about the Bank which surface from time to time. We see public accountability in this way as a necessary corollary of our independence. We had not intended to make an opening statement. In our view, the Annual Report and other material emanating from the Bank constitute a reasonable basis for launching this morning's discussions. We certainly put a lot of effort into describing and explaining our activities these days. I understand, however, that the Committee has formally requested an opening statement on this occasion which would deal with the role of the Reserve Bank in formulating and implementing monetary policy, and with the outlook for monetary policy in 1995/96. This request seems to be related to the Committee's desire to see greater parliamentary scrutiny of monetary policy (although what, specifically, the Committee has in mind here is not entirely clear to us). As you know, the charges the Bank with the responsibility for formulating and implementing monetary policy. It also provides for consultation between the Bank and the Government, an arrangement which both parties consider sensible and important. Formulation of monetary policy can be viewed as covering the research and analytical activities of the Bank which can lead to a formal decision by the Board to change monetary policy. That decision is implemented through the Bank's operations in the money market, which raise or lower the interest rate on overnight funds in the first instance; such adjustments tend to flow through quite quickly to all short-term interest rates, including those charged by banks and other financial institutions on most loans. requires the Bank to be concerned with economic growth and employment, as well as inflation. This focus on multiple objectives is considered unfashionable in some quarters where it is argued that central banks should concentrate exclusively on containing inflation. We do not accept that argument. Keeping inflation in check is important, but so too is the maintenance of a sustainable rate of growth in economic activity and employment. These broad objectives can sometimes conflict with one another - not always but sometimes - but that conflict is not avoided simply by ascribing an inflation-only objective to the central bank. Over relevant policy horizons of a year or two, monetary policy does impact on activity as well as on prices, and monetary authorities are often called upon to make implicit trade-offs between inflation and employment. If, for example, the rate of inflation were to rise above some targeted range, how quickly it might be brought back within the target range implicitly raises questions of a trade-off with employment and unemployment. And the public is, of course, concerned about shortterm fluctuations in employment. Put in different words, monetary policy can focus on achieving low inflation over the medium term, while also taking into account short-term activity and employment outcomes. For this and other reasons, we are perfectly comfortable with the Reserve Bank's present 'charter'. Like other central banks, we have an inflation objective or 'target' to help guide monetary policy. This is to hold underlying inflation to 2-3 per cent on average over a run of years. As we have explained on many occasions, this does not mean that underlying inflation should be between 2 and 3 per cent every year; rather, it means that over the cycle the average rate of inflation should be '2 point something'. At times it will exceed 3 per cent, just as at times in recent years it was below 2 per cent. Over the year to June 1995, the increase was 2.5 per cent but, as we indicated in the Annual Report, we expect it to exceed 3 per cent over the quarters ahead; the Budget forecast was for a rise of 3 per cent in the year to June 1996. We do not view such outcomes as inconsistent with our objective, although achieving that objective obviously requires inflation to return to 2-3 per cent within a reasonable period of time. As well as serving as a guide to the Reserve Bank, the 2-3 per cent objective - which has been endorsed by the Government and the ACTU - performs a useful role in helping to focus public discussion and debate on monetary policy. Given our interest in growth and employment, as well as inflation, in formulating monetary policy we analyse a host of data bearing on developments in those areas, and then come to judgments as to whether or not monetary policy should be adjusted. In the Annual Report we commented that 'finding the appropriate balance between the activity and inflation objectives of monetary policy remains a challenging task', and that 'there are risks both ways'. Not much has happened to change those comments in the two months since the Annual Report was tabled. Our latest assessment is contained in the , which was released yesterday. I will not, therefore, go into detail here but, in brief, the economy overall appears to be growing at between 3 and 4 per cent; the Budget forecast was for growth of indicators of consumer spending remain strong while business investment is continuing to grow, although less rapidly than in the past couple of years. Employment growth also has moderated, partly as a lagged reaction to the slowing in activity from the unsustainable pace of 1994. On the other hand, on-going adjustments in the housing sector, and in inventories, are likely to detract from growth in 1995/96. Parts of the world economy also appear to be experiencing some slowing in growth (e.g. Europe), while economic recovery in Japan is still to get underway. It remains to be seen how these divergent forces balance out over the months ahead - in particular, whether, aided by the expected boost to rural incomes, growth bounces back towards (or through) the top end of the 3 to 4 per cent band, or whether it slides towards (or through) the bottom end. Less uncertainty attaches to the outlook for inflation. As I noted earlier, underlying inflation is expected to exceed 3 per cent during this year, propelled in part by higher unit labour costs, consequent upon a pick-up in wages and executive salaries and a cyclical falling off in productivity growth. Looking ahead, slower economic and employment growth should help to moderate recent rates of growth in wages. A stronger exchange rate, and some squeezing of profit margins, would also help to cushion - for a time - the effect of higher labour costs on consumer prices, but could not do so indefinitely. In summary, activity is, if anything, a touch weaker than was envisaged in the Budget forecasts, while wage costs are a touch higher. For the time being, however, current monetary policy settings remain broadly consistent with projected trends in economic growth and inflation. Monetary policy needs to be forward looking, but it needs also to be based on considered judgments about likely trends in activity and costs, not short-term movements in particular indicators. Over the months ahead, we will be monitoring closely these trends in coming to judgments as to what changes - if any - need to be made to monetary policy.

r951130a_BOA

australia

fraser

It is a pleasure to talk to CEDA again. Debt is my main topic this evening. Before coming to that, however, I would like to comment briefly on current economic trends. The economy is emitting mixed but reasonably predictable signals. Yesterday's national accounts pointed to further strong growth in the September quarter, bringing the rise in GDP over the past year to 3.3 per cent. That growth partly reflects a very welcome rebound in rural production; the growth in the rest of the economy was slightly lower - at 3.1 per cent - but still robust. Business investment remained at historically high levels and, reflecting our good international competitiveness, exports made a solid contribution. On the other hand, after being very strong earlier in the year, growth in employment has fallen off in recent months. The national accounts and employment data are, of course, backward looking. Central bankers have to be forward looking: they have to take a view about economic developments a year or so ahead, when any change in monetary policy would have its full impact. This is always a hard call, not least because economies move in cycles, rather than straight lines. At the moment, non-farm growth is at the bottom of what is generally considered a sustainable growth rate for Australia of 3-4 per cent. This follows a sharp but necessary adjustment from the unsustainably rapid growth rate of nearly 7 per cent in 1994. Given this adjustment, the recent slowing in employment growth is not unexpected. We expect economic activity to pick up during 1996 as the effects of some contractionary forces pass through the system: First, the downward phase of the housing cycle should start to flatten out, as new construction comes back into line with underlying demand. The earlier excessive rate of construction and rising stocks of unsold houses have been driving the downturn in this sector, not higher interest rates. Mortgage interest rates rose less than the rise in official interest rates in late 1994, and keen competition among lenders has seen rates decline since then. Although the standard variable mortgage rate is per cent, the average rate actually paid is currently about 9 per cent, down from 10 per cent at the end of 1994. Second, stocks of non-farm goods also have built up to excessive levels in recent quarters. Efforts are likely to be made to reduce these to more normal levels over the next couple of quarters and, as that adjustment occurs, activity and employment will come under downward pressure. Housing and stock cycles are integral to the dynamics of economies, and they have to be allowed for in forward looking economic assessments. They imply some further - but temporary - areas of softness in the economy before they have run their course. Two additional reasons exist for expecting a pick-up in the pace of growth during 1996: One is the likelihood that Japan will start to grow again in 1996, after several years of virtually no growth. The second is the recovery in farm production. The initial impact of this already has been recorded in yesterday's September quarter national accounts, but the full impact will be felt as farmers receive - and spend - their higher incomes. The other key determinant in the formulation of monetary policy is the outlook for inflation. As you know, underlying inflation in the year to September - at 3.1 per cent - was a little above our 2-3 per cent objective, which we aim to maintain over a run of years. With growth in activity and employment now at more sustainable rates, and likely to remain thereabouts over the year ahead, some moderation in price and wage rises can be expected. The large increases in the CPI in the June and September quarters mean, however, that it will take a few quarters yet before the 'year to' measure of underlying inflation reflects this moderation; in fact, the 'year to' rate could rise further before it eases back towards the 2-3 per cent objective in the second half of 1996. In summary, current interest rate settings are appropriate for the economic outlook I have sketched. If the accumulation of data were to lead to major changes in that outlook - if, for example, the slowdown were to take on longer-term characteristics, or if growth were to rebound strongly before wage pressures had subsided - then, of course, the stance of monetary policy would need to be reassessed. Policy deliberations in coming months will not be made any easier by the kind of debate which usually precedes an election, and which does little to promote either informed economic discussion or confidence in the economy. We will have to cut through all the hype to get to the truth. One issue which has already attracted a good deal of media coverage is the extent of indebtedness in Australia. Whether the focus is on foreign debt, government debt or the corporate debt excesses of the late 1980s, the tone is always negative. Perhaps it was ever thus: everyone from Polonius to Micawber has warned against the evil of debt. Few actually live by such admonitions, but many have a sneaking regard for the simple virtue they imply. The view that debt is always and everywhere a bad thing misses the important point that borrowing allows individuals, companies, governments and nations to pursue opportunities that otherwise would go untapped. A couple can borrow to buy a house and live in it while young, rather than facing a lifetime of saving before buying a house outright in old age. Governments can borrow to build roads, schools and other infrastructure which raises the economy's productive capacity and delivers benefits to both present and future generations. Shibboleths about debt are, therefore, easily dismissed. But genuine concerns can arise when debt builds up sharply or when capacity to service debt falls off sharply. These concerns give rise to a variety of questions. Are borrowers living beyond their means? Are the borrowings being directed to productive uses? Can the debt be comfortably serviced and repaid? These are all legitimate questions. Experience tells us that borrowers do sometimes miscalculate and get themselves into trouble through being unable to service their debts. The real question is not whether debt is intrinsically 'bad', but at what point does it become a worry. Clearly, at some point debt servicing does become 'too high', but there is no 'magic number' to trigger warning signals. Fundamentally, it is a matter of assessing the conditions under which debt is accumulated, and coming to a judgment about its sustainability. In this, we should be particularly watchful where, relative to longterm trends: the level of debt rises substantially; the debt servicing burden rises substantially; and asset prices rise sharply. Against that background, I want to look at what has been happening to debt in four major sectors - namely, companies, governments, households and foreign investors. (Financial institutions also play a role, but theirs is mainly a facilitating - or intermediary - role.) By way of an overview, if we look at net financial flows among these sectors since the the corporate sector is a persistent net borrower of funds; the public sector was in small surplus through the 1960s and early 1970s, but has been a substantial net borrower over most of the past 20 years; the household and overseas sectors have been net providers of funds; the household sector is a perennial net lender, but to a diminishing extent; and corporates and governments have persistently drawn a substantial proportion of their funding requirements from abroad. Corporate debt We start with the corporate sector, which doubled its gross debt in the 1980s, to the equivalent of almost 70 per cent of GDP around 54 per cent. Much of the debt taken on in the late 1980s was in anticipation of continuing rapid rises in asset prices and rapid enrichment of the borrowers. Financial deregulation played handmaiden to speculative activity, facilitating greater access to borrowed funds and leverage. When asset prices corrected, as they inevitably do, the adjustment was painful, and not just for speculators. Extensive leverage exacerbated financial distress and delayed economic recovery; in many firms, retained earnings were used to retire debt, rather than to finance new investment. The corporate sector's experience in the 1980s stands out as a classic example of a 'bad' expansion of debt. It also highlighted the seductive part played by high inflation in elevating expectations about asset prices and encouraging speculative activity. Assets were acquired with borrowed funds in anticipation of on-going price rises. That, rather than the 'old fashioned' route of productive investment, was seen by many businesses and their bankers as a short-cut to wealth. As debt rose in the 1980s so did the servicing burden, boosted in part by rising interest rates. By the beginning of the 1990s, interest payments represented 40 per cent of gross profits, about double the figure five years earlier. In other words, for every dollar of profit, 40 cents went in interest payments. This situation was not sustainable and it provoked a concerted effort by companies to reduce their indebtedness. As a result of these efforts, aided by lower interest rates, debt servicing has fallen back to about 20 cents in the dollar. Applying the tests mentioned earlier, corporate debt today is no longer a serious problem. Corporate balance sheets have been repaired, and debt to equity ratios have returned to more normal levels. What is judged to have been genuine productive business investment has been increasing strongly and asset prices have remained fairly subdued. Government debt I turn now to government debt, which had been declining as a share of GDP until the late 1970s. It has fluctuated since then, but budget deficits pushed up the debt level in the early 1990s, but these are now being wound back, and the ratio of public debt to GDP is projected to decline in 1995/96. The public debt servicing burden began to rise sharply in the early 1980s, with higher interest rates and a run of large budget deficits. Since the late 1980s, the combination of greater fiscal discipline and generally lower interest rates has seen the servicing ratio fall back to the equivalent of about 10 per cent of government revenues. It is not widely appreciated, in all the loose talk that one hears about debt, that the gross debt of the general government sector in Australia is about the lowest of any OECD measures, the ratio for Australia in 1994 was 35 per cent, or about half the OECD average. The servicing burden is similarly very low by international standards. In other words, Australia has not run up large debts through fiscal excesses. We are much better placed than most OECD countries where, typically, chronic budget deficits have generated on-going debt servicing problems and severely curtailed the scope for discretionary fiscal policies. One measure of Australia's more aggressive fiscal strategy is that, excluding asset sales and other special transactions, the budget is projected to be in virtual balance next year. In the United States, any budget balance appears to be at least seven years away. In aspiring participants in Stage 3 of Economic inter alia , to have government debt to GDP ratios of no more than 60 per cent, and budget deficits of no more than 3 per cent, by 1999. Australia currently satisfies both fiscal tests but, of the and Luxembourg presently do. In brief, on all the usual criteria, public sector debt in Australia is well below that in other countries, and both debt and debt service ratios are at manageable levels. But, as impressive as that performance is compared with other OECD countries, it needs to be more impressive because Australia has a greater reliance than most on foreign saving. Indeed, because private saving in Australia is relatively low and difficult to turn around, we need an even larger buffer from public sector saving. I will return to this point later. But first, a look at the household sector. Household debt In aggregate, households are net savers - and a source of funds for other sectors - although their contribution to national saving has Although households are net savers, this net position reflects the outcome of their borrowing and lending, both of which have been rising. After a long period of fairly gradual increases, household debt spurted ahead in the first half of the 1990s (Graph 5). This spurt has been driven by borrowings for housing, and reflects increases in the number of households with housing loans and in average loan sizes. In 1990, the average new housing loan was equivalent to around 165 per cent of annual household disposable income; the comparable figure today is over 200 per cent. (Unincorporated businesses are usually included with households in the statistics. Like corporations, they too have shed a lot of debt and, as a group, seem reasonably placed to service their current debt levels. This cannot be said, however, of the rural sector. Farmers' cash flows are subject to more vagaries than most, and persistent drought conditions in many areas have resulted in sustained rises in rural debt and debt servicing burdens. Farmers - and, no doubt, their bankers and other creditors - will be heartened by recent drought-breaking rains, but many will require a run of good seasons to repair their balance Gross interest payments by the household sector reached a peak equivalent to about 9.5 per cent of household disposable income in part, the high interest rates at the time and, as rates declined, so too did the debt service ratio. The overall interest burden has picked up again in recent years, but remains below its 1989 peak and appears to be quite manageable. The fact that interest payments remain a relatively low proportion of household income helps to explain why households have increased their gearing in recent years. I suspect that many households would have liked to have taken advantage of the opportunities created by financial deregulation in the late 1980s to the same extent that corporates did, but were precluded from doing so largely by high nominal interest rates then prevailing. In the 1990s, with lower interest rates, households could afford to borrow larger sums, especially for housing. And banks and others have been keen to lend to them. In effect, Australians have been catching up with households in other countries where relatively low inflation coincided with financial deregulation and led to an earlier rise in household indebtedness. Notwithstanding this recent catch-up, Australian households remain less highly geared than their counterparts in many comparable countries. While low inflation, and its accompanying low interest rates, make borrowing for housing more affordable (including for low income earners), it also removes some of the traditional gloss of residential investment. With house prices rising less rapidly, the incentive to gear up for speculative gains is less attractive. Moreover, with low inflation, the real debt burden does not fall away as quickly as it did when inflation was high. Rather ironically, therefore, low inflation has increased individuals' access to debt, but it has diminished the attractiveness of borrowing 'to the hilt' to speculate in the housing market. This is a fairly new message but, as it sinks in, I think more people will begin to switch their investments from housing to other productive assets. That will be no bad thing from an economic perspective. How should we assess household indebtedness at this time? Applying our three tests suggests the following answers: Household indebtedness has increased above its longer-term trend. This bears watching, but it is not a cause for alarm. To some extent, the recent rise can be seen as a once-off adjustment to lower inflation. Debt levels remain well below those in the United Kingdom and some other countries in the 1980s, when many households were over-burdened. Debt service ratios in Australia are below their peaks of the late 1980s and do not appear excessively burdensome. Default rates on housing loans have increased recently, but from a very low base; the proportion of housing loans falling into arrears is currently about half what it was in the late 1980s. The rise in indebtedness has been largely for acquisition of housing, but this has not been associated with rapid inflation of housing prices. Nor, for that matter, is there any evidence of widespread negative equity in housing, as there was earlier in This brings me to the fourth category of debt, namely foreign debt. It is here that we encounter most of the hype about Australia and Australians being in hock. What are the Australia's net foreign debt is currently equivalent to about 40 per cent of GDP (and about 49 per cent in gross terms). This debt, of course, forms part of the debt of the sectors we have discussed already. In fact, about twothirds of Australia's foreign debt is owed by business and financial institutions, and onethird by the public sector. Most of the growth in Australia's foreign debt occurred in the first half of the 1980s, when net debt rose from 6 per cent of GDP to about 35 per cent. The increase since then has been more gradual, peaking at nearly 42 per cent in 1993, before easing back to Several factors affect the level of foreign debt, apart from the on-going calls on foreign saving to help finance our investment. Over 50 per cent of the gross debt is denominated in foreign currencies, so changes in exchange rates are obviously important; part of the sharp rise in the mid 1980s reflected the similarly sharp depreciation of the Australian dollar at that time. Switches in the composition of foreign capital inflow between debt and equity are also important. My focus is on foreign debt , but we should also keep an eye on equity flows. In the 1980s, borrowing replaced a lot of equity and this boosted the growth in debt. In more recent years, we have seen higher rates of equity investment. Equity tends to be more expensive to service than debt but it has certain attractions, one of which is the direct linkage of service (dividend) payments to the profitability of the underlying investment. How sustainable is our foreign debt? In terms of levels, Australia's net foreign debt is relatively high by international standards. It is, however, somewhat below that of countries such as New Zealand, Sweden and Canada. In debt service terms, it is being accommodated. Service payments rose rapidly in the 1980s, from the equivalent of about 5 per cent of exports of goods and services at the beginning of the decade to over lower interest rates and good export growth have seen this service ratio almost halved, to about 11 per cent of exports. This is about the same ratio as in the mid 1980s. Like other categories of borrowing, the critical factor is whether debt can be serviced adequately. The numbers I have just quoted suggest that Australia's foreign debt is being managed adequately. As with other forms of debt, access to foreign debt can bring benefits, but excessive reliance on it can also bring dangers. Capital flows tend to be increasingly footloose and volatile these days, and high levels of foreign debt can unnerve foreign investors. This brings an additional dimension to foreign debt. Debtor countries are especially vulnerable to the sharp changes which can occur in foreign investor sentiment and capital flows, not always for sound reasons. This vulnerability means that, while Australia's foreign debt to GDP has broadly stabilised and debt service relative to exports has declined, life would be more comfortable if those ratios were lower. Policy has a role to play here. To begin with, we need to make better use of our existing capital stock; on- going efforts to make the public and private sectors more competitive are contributing to that. But we also need more investment: this means that the main focus of policy action has to be on increasing domestic saving. In addition to narrowing the domestic saving-investment gap and thereby reducing our potential vulnerability, other, more subjective reasons can be advanced for striving to reduce our reliance on foreign saving. In subtle ways, who owns the capital we use is of some consequence. In tomorrow's world, will the best jobs go to the 'hewers of wood and drawers of water', or to the owners of the capital? Will foreign companies be as ready to put Australians in top management positions, or will they prefer their compatriots? Will foreign ownership compromise aspects of national policy? Will we, as a country, feel as content with our lot if the 'icons' of Australian production are owned overseas? I hope I can raise these questions without being accused of beating some kind of jingoistic drum, or - worse - of advocating restrictions on foreign investors or on Australian investments abroad. Rather, I see them as further aspects of the case, pure and simple, for Australians to save more so that we might own more of our assets. If more proof of this case were required, we need look no further than the fast growing east Asian economies. They have invested prodigiously to achieve this growth, and most of that investment has been funded from their own domestic saving - which, in many cases, is equivalent to one-third or more of GDP, or roughly double the figure for Australia. Growth and saving feed back into each other in a virtuous circle of saving-investmentgrowth-saving. Theoreticians argue about whether high investment causes high savings or vice versa, but practitioners know that a good saving and investment performance yields strong output and employment growth. Policy makers in Australia are aware of our saving problem and are moving to tackle it, although the community generally is less seized with the problem. Recent initiatives to increase superannuation contributions will, in time, raise national saving, as will the projected path to budget surpluses. Action on both fronts is critical, but it is in the latter area where, with concerted fiscal discipline, the largest and quickest contributions have to be made. It is also the area where, without such discipline - including in periods around elections - the whole process can most easily unravel. Many people talk a lot about Australia being in hock, but then shy away from the consequences of measures to reduce budget deficits. In summary, the major sectors of the domestic economy - corporates, government and households - are in reasonable shape financially. They are not manifestly deep in debt, they can service their debt adequately, and they have something to show for that debt in the form of long-lasting assets. At the same time, foreign debt shows signs of levelling out. Collectively, however, we are not saving enough to finance all the investment we want to make, necessitating substantial overseas borrowings and other calls on foreign saving. The real issue for Australia in the debt area is not the debt burden of any particular sector, but the macroeconomic task of raising national saving. Policies are now addressing this task. Persistence and patience will be required for these policies to bear fruit.

r960328a_BOA

australia

fraser

I always enjoy talking to the ABE. More than most, business economists understand that government policies do make a difference, but they also understand that the fate of businesses ultimately rests in their own hands. It is timely to reflect on this point as the economy continues one of its longest ever periods of uninterrupted growth, and as wage negotiations begin in the post-Accord environment. In a sentence, I believe Australia is in very good shape to sustain further solid growth, although that will, inter alia , require us to keep inflation under control, and to do something about our inadequate national saving. I start from the obvious point that strong, sustained economic growth is central to our future well-being. It is growth which largely determines how well we live, and which gives us the ability to help those to whom fate might have dealt a difficult hand. By the standards of other developed countries, we have not done badly. The economy has expanded by more than a third over the past decade, and a proper interpretation of the data - as well as casual observation - suggests that the vast majority of Australians are better off today than ever before. To be distracted by concerns that other countries (including some of our Asian neighbours) have caught up or surpassed us is to confuse the issues at stake. We should be pleased that other countries have come to share our standard of living, and welcome the opportunities that this creates. Over the past year or so, the economy has behaved much as we might have wished. Helped by some 'pre-emptive' interest rate rises in the second half of 1994, growth slowed from an unsustainable 5 per cent in that year (6 per cent in the non-farm sector), to around 3 per cent in 1995 (2 per cent in the non-farm sector). With no serious imbalances in the domestic economy, and the international economy beginning to look a little stronger, growth is likely to pick up somewhat during the course of the next year or so. In these days when it is fashionable to benchmark everything that moves, I think we would be doing quite well if, over the next three years, we could match the performance of the past three years. In that period, GDP growth averaged 4 per cent a year, and underlying inflation averaged 2 per cent. This might be seen as an unfair benchmark, given that economies typically grow more quickly during the early stages of recovery. There is some truth in that, although the current recovery goes back almost five years, to the middle of 1991. In other respects too, the past three years carried their own burdens, such as severe drought conditions, low commodity prices and virtual economic stagnation in Japan, our largest export market. Is 4 per cent a sustainable growth rate for Australia, or should we settle more prudently for 3 per cent? The difference is not trivial; assuming that population continues to grow at about 1 per cent per annum (as it has in the past decade), 4 per cent growth would see living standards double in 26 years, compared with 40 years in the case of the lower figure. Faster growth would also deliver larger winddowns in unemployment. I would like to spend a little time exploring this question. I do so not because I want to advocate any particular target for growth - too many targets succeed only in confounding policy makers - but because a better understanding of the sources of, and constraints on, growth will help to demonstrate the difficulty of sustaining, say, 4 per cent growth. I would like to believe we could grow at such a rate, but it is not nearly as straightforward as some people might think. When economists talk about 'potential' growth rates in the industrialised countries, they tend to come up with quite small numbers. The maximum rate which the United States, for example, can sustain without sparking inflationary pressures is usually put at 2 to 2 per cent a year. Estimates for Japan and Germany tend to be of a similar order. These low numbers are explained mostly in terms of the slow growth in the labour force and in measured productivity in 'mature' economies - the two main determinants of potential growth rates. In Australia, 3 per cent is about the best growth rate we have been able to sustain over any length of time. For clues as to whether we have the potential to do better in future, we need to examine trends in the labour force and its productivity. labour force is set largely by growth in the working-age population, and by the participation rate. On the basis of current demographic factors and trends in participation, growth of the labour force is projected to decline from around its current 2 per cent to perhaps 1 per cent by the turn of the century. Over this period, however, we do have the opportunity to draw upon presently unemployed resources; if we could trim back the unemployment rate by, say, per cent each year, the labour force could continue to grow at 2 per cent or more for some years. growth, which depends on the level and quality of investment, and the skills and cultures of labour and management, is much harder to measure, particularly in service industries. In production-type operations it can be measured fairly reliably because output can, in a sense, be 'counted'. The Statistician publishes such data for the non-farm market sector; these are based on output per hour worked in a group of private sector industries which accounts for a little over 60 per cent of GDP. On this basis, productivity growth has averaged about 2 per cent a year in the 1990s, roughly double that in the 1980s. This lift tallies with other indicators - such as the exceptionally rapid growth in exports of manufactured goods - which also point to improved efficiency in many Australian industries. 'Counting' output in the services sector is much more difficult - so much so, in fact, that the convention for some services is to measure output in terms of labour input. In effect, statisticians assume no productivity growth in these industries, even though it is hard to believe that genuine productivity gains are not being made in many instances. As others have remarked of similar situations in the United States, '... we see technological advance everywhere but in the productivity statistics'. The conventional measure of economy-wide productivity growth is probably an underestimate but it is the measure we have to use. It suggests an average increase of about per cent in the 1990s. A continuation of that growth, combined with growth of 2 per cent or a little more in employment, implies that 4 per cent growth is potentially attainable through to the turn of the century - but only just! The main purpose of this discussion, however, is not to dwell on the arithmetic, but rather to make three general points. First, good monetary and fiscal policies can help to raise economic growth by promoting productive investment, but they have little immediate influence on either the labour force or productivity. Microeconomic reform is the major spur to improved productivity, and government policy will need to make further progress in this area to sustain the recent revival in productivity. That will be best achieved, in my view, by building on the measures already in place to promote efficiency and competition; it is not a matter of starting from scratch - not even on the The second point flows from the first. Given the clear difficulty of sustaining 4 per cent growth, it is not realistic to think that Australia can somehow embrace a new growth formula or culture which would permit us to match the 6 or 7 per cent rates routinely achieved by some Asian economies. The labour forces in those countries are growing about 1 times that in Australia, boosted by the mobilisation of workers from non-productive sectors. Their higher productivity growth rates reflect, in part, their greater scope to apply new technology (to 'catch up') in relatively large non-service sectors; in part also they reflect saving and investment ratios which are about double those in Australia. The third point is to repeat that while an average 4 per cent growth rate is perhaps within our reach over the years ahead - if we are policy smart (and a little lucky) - it is not being advanced as a growth target. At any point in the cycle, the most pressing issue for policy makers is not the pursuit of some predetermined growth rate, but whether the economy is moving forward at a rate sufficient to absorb new entrants to the labour force and to reduce unemployment, without running into serious problems. Such problems, traditionally, have taken the form of blowouts of the current account deficit and/or inflation, which have necessitated strong and often painful policy responses. How should we view these two familiar constraints - and their implications for policy - in today's environment? First, the current account deficit . Some people still get quite excited about monthly movements in the current account deficit. But even quarterly and annual figures can be distorted by the effects of such factors as droughts which temporarily depress rural exports, or surges in business investment which temporarily boost imports of plant and equipment. Moreover, the cushioning provided by our floating exchange rate and ready access to global capital markets should make for a less obsessive focus on the current account today, compared with the days of fixed exchange rates and restricted capital mobility. I know it is a forlorn hope, but national stress levels would be lowered dramatically if commentators were more analytical and longer-term in their assessments of current account data! For all that, we are continuing to run a current account deficit which is too high. The facts are well known. The deficit has averaged about 4 per cent of GDP since the early 1980s; at its cyclical peak, it has typically reached about 6 per cent. The aim is not to eliminate the deficit altogether - we clearly benefit from being able to draw on foreign savings - but to reduce it to a more comfortable level. I have suggested previously that we would be more comfortable with a current account deficit which averaged 2 to 3 per cent of GDP, rather than 4 per cent. We would then be less dependent on regular, large inflows of foreign capital and, therefore, less vulnerable to being dumped in international financial markets. Players in those markets do not always behave rationally and they often overreact; on the other hand, it is not irrational to be wary of countries with persistently high current account deficits and foreign debt levels. It is now generally recognised that the current account deficit reflects a domestic saving/investment imbalance. We simply do not save enough ourselves to finance all the private investment we want to make, as well as all the government spending we vote for. The resultant gap is filled by foreign saving, the counterpart of which is the current account deficit. This imbalance has to be corrected by restraining consumption and lifting saving - not by reducing investment, which enhances productivity and contributes to higher living standards. Genuine increases in private saving are difficult to engineer, although compulsory superannuation arrangements now in place will, over time, help to raise national saving. The priority route, however, has to be more public public sector debt and budget deficits are low by international standards, but they are large relative to our domestic saving. We have made some progress recently, but not enough. How much ground has been made and lost, and how much remains to be made up, are difficult questions to answer. As the figures released by the incoming Government three weeks ago showed, budget estimates are very sensitive to the forecasts of economic growth and other major parameters. Of the $7 billion deterioration since May 1995 in the budget estimate for 1996/97, for example, 90 per cent reflects revisions to the economic forecasts. The latest parameter forecasts are subject to further changes. My own hunch is that growth in 1996/97 will be a bit stronger than per cent, implying a lower starting point deficit. Should it occur, any 'dividend' from faster growth should go straight to improving the budget's bottom line, not to reducing the fiscal consolidation task. Next year will mark the sixth year of economic recovery; in terms of the economic cycle, we should already be in underlying surplus, and - in terms of our large current account deficit and low private saving - a substantial surplus at that. The Government proposes to make savings on the latest budget estimates of $4 billion in each of the next two years, with the aim of delivering an underlying budget balance in 1997/98. Such reductions would be broadly comparable - relative to GDP - with those achieved in the late 1980s; and, like those earlier efforts, they will require a lot of hard pounding by all members of the new fresh to the task should, however, be an advantage. I hope that the foreshadowed cutbacks can be achieved in ways which protect those genuinely in need. Just how they are made is, of course, a matter for the Government, although I personally think it is a pity that tax measures have been ruled out, both because these are a legitimate instrument of fiscal consolidation and public saving, and because they can bear upon the fairness of the whole exercise. And fairness is important. What does all this mean for monetary policy? The short answer - accepting that the foreshadowed fiscal restraint will be delivered - is probably not a lot. With the economy likely to be growing quite strongly in 1996/97, the impact of the cutbacks in government spending on aggregate demand should be well cushioned. Moreover, experience in Australia in the late 1980s - when there was also good underlying growth in the economy - suggests that large and sustained deficit reduction programs might actually stimulate private spending by more than they reduce public spending. There can, therefore, be no presumption at this time of any trade-off between fiscal restraint and interest rate reductions - and certainly not in the short term. This brings me to that other potential constraint on growth, inflation . To grow as fast as we can, and for as long as we can, we need to keep inflation under control, basically because economies work better with low inflation. Once inflation starts to slip it tends to go on slipping, necessitating measures to slow the economy until inflation is brought back on track. Things have been under control lately, with underlying inflation of 2 per cent on average over the past four years. In the year to the December quarter the increase was 3.2 per cent, a little above the target of 2 to 3 per cent. Underlying inflation is the best measure for policy makers to track, but broader measures tell a similar story; the price deflator for private consumption expenditure, for example, shows an average increase of less than 2 per cent over the past four years, and a rise of 2.8 per cent over the course of 1995. In twelve-months-ended terms, underlying inflation is likely to rise a little further in the March quarter - perhaps to around per cent - but should come back after that. The stronger exchange rate, and the inventory adjustment, are providing some assistance to this end but neither can go on forever. The longer-term trend will be determined mainly by what happens to labour costs. Our best guess is that, adding in about per cent for employers' superannuation levies, these have risen by 5 per cent, or a little more, over the past year. The comparable increase over the previous year was about per cent; the acceleration, in part, reflects a lagged response to the economy's surge in 1994. On-going increases in labour costs at their recent rate would not be consistent with the 2 to 3 per cent inflation target. The recent slowdown in the economy would normally be expected to be accompanied, with a lag, by slower wages growth. To date, however, there are few signs of any moderation. How then should we view the outlook for wages in the post-Accord I speak, as you know, as a consistent supporter of the Accord process. I believe it has helped to moderate wage increases over the past decade. This, in turn, has contributed to job creation, lower inflation and a higher profit share. It has helped monetary policy to maintain growth in activity and employment while delivering lower inflation, and it has also helped to reduce the incidence of industrial strife. In recent years, the role of the Accord as a device for centralised wage fixation has diminished, and the focus has shifted to a system of wage negotiation which seeks to incorporate productivity improvements and to reflect the rigours of the market place. These are, as I understand it, the essential characteristics of a deregulated labour market, and all the participants have been gaining some experience in this new environment. There is growing - although still far from perfect - understanding of the realities of the bargaining environment, and of the implications for jobs, profits and interest rates if wage rises get out of kilter with genuine productivity gains. On-going tariff reductions and other microeconomic reforms are working to emphasise the changes in the environment for so many firms, as is the fact that a quarter of manufacturing output is now sold in export markets. Against this background, I expect that the parties most directly involved - namely, the managers and employees - will want no more than to continue to get on with their task, Accord or no Accord. The Government has an important role here to see that this framework operates as effectively and fairly as possible. Some proposals to this end are reported to be in gestation. The Reserve Bank too has a role. The particular 'reality' we bring is a firm commitment to hold inflation to an average of between 2 and 3 per cent over the course of the business cycle. Wage and price setters should heed this: those who build in higher increases could find themselves with real wage rates which make them uncompetitive (putting their jobs at risk), and prices which are out of line with the competition (in domestic and export markets). If in this environment of 2 to 3 per cent inflation there is no room for large, across the board, price increases, then there can be no room for large, across the board, increases in wages or executive salaries. I have talked about the 5 per cent increase in labour costs over the past year being inconsistent with sustained 2 to 3 per cent inflation, and of the need for these to be wound back a 'notch'. What is a 'notch'? In terms of aggregates, if we take the mid-point of the 2 to 3 per cent inflation objective and allow (at best) 2 per cent for economy-wide productivity growth, then all-up wage costs should be increasing by no more than per cent. This is a notch below the average increase in labour costs over the past year. It is also several notches below some recent settlements (in parts of the banking sector, for example) and below what is in danger of becoming the going 'ask' in current wage rounds. It is helpful to talk in terms of these aggregates and averages for purposes of illustration. In my view, however, it is not appropriate to be seeking to lay down such 'norms' for individual wage settlements in the kind of deregulated labour market we have been moving towards over recent years, and which seems destined to be pursued more vigorously in the post-Accord period. In that kind of labour market, we would expect quite a range of wage outcomes. Several points seem to me to be worth emphasising at this point. First, inflation is in sight of coming back within the 2 to 3 per cent target; price and wage setters should take fully into account both this expectation and the Bank's commitment to keep inflation under control. Secondly, genuine productivity gains provide a basis for above-average wage increases but there is no basis for the whole of any such gains being pre-empted by increases in wages, salaries or bonuses. Rather, part of the gains should be shared throughout the community in the form of lower prices. This is the process through which we all move to a higher productivity/higher wage economy. Effective competition (either domestic or international) is probably the best hope for delivering these kinds of price reductions. Thirdly, while it is understandable that people in one sector will have regard to wage and salary arrangements in other sectors, increases determined or rationalised on this basis - and perhaps disguised by phoney productivity 'gains' - do not make for either viable businesses or viable jobs. As I indicated earlier, in the system we are now moving towards, these difficult issues are best resolved by the parties most directly involved. Ideally, management and employees will work more closely together to effect changes which will warrant higher wage rises. With the passing of the Accord, however, I expect that the onus will be on employers to a greater extent than before to resist unwarranted rises in wages and salaries. Notwithstanding the size of some recent wage settlements, and of some claims in the pipeline, we are not in panic mode. It is still possible that the recent slowdown in growth, the continuing high levels of unemployment, the improved outlook for inflation, and the effects of on-going micro reforms will cause wages growth to moderate. That needs to occur during the current phase of slightly slower growth, before the economy starts to move forward again at a faster pace. If the good sense of negotiators and the pressures of competition do not bring about the necessary moderation, however, then we will need to respond with tighter monetary policy. In other words, if wages growth continues to pick up, rather than come back a notch, there will be little option but to raise interest rates. That might well put paid to aspirations of sustaining 4 per cent growth and making significant reductions in unemployment, but any resumption of large increases in prices and wages would have even worse consequences for growth and employment. For that reason alone, monetary policy cannot allow the hard-won gains on inflation to slip away from us.

r960510a_BOA

australia

fraser

I am pleased to have been invited to this Symposium to mark the 25th anniversary of the Monetary Authority of Singapore, and to have the opportunity to express some views on 'optimal' inflation targets. Inflation targets are the central banking vogue of the first half of the 1990s, and it is appropriate to ask whether they are of real value, or just another fad. I should say at the outset that I doubt there is such a thing as an 'optimal' inflation target, certainly one which is universally applicable. Perhaps it would help if we knew what the optimal rate of inflation was, but that is itself a big subject. Some developed countries, such as the United States, Germany and Japan, enjoy low inflation without a formal target, while some Asian economies are able to operate quite efficiently with relatively high rates of inflation. Modesty and realism, therefore, suggest a quest for what is 'effective', rather than what is in some sense 'optimal'. I would like to offer a few observations on what I think inflation targets should and should not do; to illustrate those observations by reference to recent experience in Australia; and to end with a few general conclusions. An effective inflation target would, in my view, have the following attributes. On the other side of the ledger, there are a couple of things an effective target should avoid. You will not be surprised to hear me say that Australia's inflation target scores highly on my criteria. To this point, it has worked quite well for us, although I acknowledge that our approach might not generalise to other countries. The target was introduced tentatively about four years ago, without any great fanfare. In contrast to more formal processes, where inflation targets have been introduced by the national government, or by agreement between the government and the central bank, in Australia the target was effectively self-imposed by the central bank. We repeatedly espoused the view that underlying inflation should be held to 2 to 3 per cent over the course of the business cycle; this view soon came to be identified as the Reserve Bank's inflation target. It was then picked up and endorsed by the former Labor Government. It was also supported by the peak trade union body, the Australian Council of Trade Unions (ACTU), in the context of that body's last Accord with the Labor Government. When the new Government came into office last March it was quick to endorse the same target. Over the past four years, the underlying rate of inflation in Australia has averaged 2 1/4 per cent. This performance, which has coincided with a period of strong economic growth (averaging more than 3 1/2 per cent), has added a certain amount of credibility and prominence to the target. It has helped to anchor inflationary expectations during the cyclical upswing at much lower levels than we were accustomed to in the 1980s (see Graph 1). More recently, the evidence that inflation remains consistent with the target has helped to bring about a narrowing of the spreads between yields on Australian bonds and those of some other countries (see Graph 2), although that performance will need to be sustained over a longer period for these premiums to decline further. It has also met the test of being a discipline - and a forward-looking one - on policy. In the second half of 1994, official interest rates were increased decisively and pre-emptively, rising by a total of 275 basis points in three discrete adjustments. These adjustments were made to head off a potential blowout in inflation, even though inflation at the time was still quite low (around 2 per cent) and unemployment was still uncomfortably high (around 9 1/2 per cent). Those higher interest rates were held throughout 1995 and into 1996, when many other countries were easing their monetary policies. While helping to deliver this discipline on policy, the target is not so narrow or inflexible as to prompt sharp swings in monetary policy and risk an increase in instability. As I said, our aim is to hold underlying inflation to 2 to 3 per cent on average over the course of the business cycle, rather than at every moment. This approach recognises that there is a cyclical element in inflation, which will take the rate outside 2 to 3 per cent on occasions - in both directions. For this reason, the 2 to 3 per cent figures were always expressed as indicating a central tendency for inflation, not the limits of a narrow target band. At 3.3 per cent, the current 12-months-ended rate for underlying inflation is a little above our target, just as earlier in the recovery phase it was a little below. We are confident that the rate will be back under 3 per cent in the second half of 1996. Because we had anticipated a temporary move above 3 per cent - and had stated our expectation publicly and set policy accordingly - the temporary departure from the medium-term target has been accepted readily by the financial markets and the community generally. I know that some people see our target as too 'soft' and its formulation as too flexible. I do not. If we can contain inflation to an average of 2 to 3 per cent over the course of the business cycle - that is, to an average of 2-point-something over a long period of time - then I believe we will have been quite successful in keeping inflation under control. As to the flexibility of its formulation, that to me is a sensible feature, and one of the strengths of our approach - particularly given the variation in inflation (even in low inflation countries) over the cycle. The Reserve Bank has explicit multiple objectives - which I happen to be in favour of - and the flexibility of our inflation target helps us in pursuing an acceptable balance between growth and stability objectives. The issue of what is an appropriate degree of flexibility in an inflation target is an important one. There is no unique answer. Given the substantial uncertainties inherent in pursuing a forward-looking monetary policy - which require policy makers to assess probabilities, balance risks and make lots of judgments - we have steered away from narrow, hard-edged target bands for inflation, and from promises that inflation will hardly ever move out of such bands. Participants in financial markets and some others, in their desire for simplicity in a complex and uncertain world, might hanker after such apparently strict targets, but we simply do not believe such a commitment can be made credible. It is performance that counts in building credibility, not the announcement of tough targets. In our view, a narrow, supposedly hard-edged band risks a serious loss of credibility when the edges prove, as they inevitably will, to be less hard than they earlier appeared. On the other hand, a band wide enough to encompass the genuine uncertainty inherent in inflation formation and forecasting processes could well have to be so wide as to lack any real credibility. For these reasons, we believe it is best to indicate a central tendency for inflation that we are determined to achieve over the course of the cycle; to avoid promising to hit it at every reading; but to be prepared to adjust policy in a way that is consistent with the target we have defined. I will end with three general conclusions.

r960705a_BOA

australia

fraser

Today I would like to share a few thoughts with you on some of the regulatory issues that will confront the Financial System Inquiry. I want to say at the outset that the Reserve Bank has supported the notion of an inquiry into the financial system. After a decade of financial deregulation and rapid technological change - one manifestation of which is the globalisation of financial markets - it is time to review how well current regulatory arrangements are working, and how they might be improved to meet future challenges. It is a tall order, and the timetable is very tight. There will, therefore, be pressure on everyone involved with the Inquiry to concentrate on actual problems, and to resist the temptation to dwell on things which are not really 'broke'. 'Regulation' is to be the main focus of the Inquiry. That label covers many subjects, including policies on competition and consumer protection; supervision of financial institutions; and rules governing behaviour in capital markets. Important issues arise in each of these areas. In the area of competition and mergers, for example, regulation raises issues which affect the costs of financial services. The banks have recorded generally good profits in recent years, but they remain relatively high cost, high margin providers of retail financial services. This high margin business is under permanent threat of being competed away, as the mortgage originators have been doing; they now have 8 per cent of the new housing loan market, compared with virtually nothing 18 months ago. To maintain profitability as margins decline in these areas, banks will have to reduce their costs or increase their fees. Rationalisation of branch networks is one way of reducing costs, but the scope for further cost saving through this channel will depend in part on competition policy. In particular, it will depend on whether changes are made to current policies which preclude mergers among Australia's four largest banks, and which make the absorption of regional banks by major banks conditional on the presence of a substantial fifth player in the relevant market. The Inquiry can be expected to assess the extent to which these policies are inhibiting bank rationalisation (and, therefore, cost and margin reduction through that process), as well as the implications of possible changes for bank customers. I think these are among the most challenging questions likely to come before the Inquiry; my own hunch is that, subject to certain safeguards, scope does exist to ease these policies without reducing competition. These issues cannot be pursued today but, whether or not competition policy is changed, I assume that the Australian Competition and Consumer Commission (ACCC) will remain the agency responsible for regulation of competition and mergers in the financial sector. I assume also that the broad principles adopted by the ACCC in relation to the financial sector will be consistent with those applicable to other sectors. This regulation related to competition should be distinguished from prudential regulation; although one form of regulation can have implications for another, each has its own objectives which necessitate different approaches and can justify different administrative structures. My focus today is on regulation directed towards maintaining prudent institutions, and fair and informed market activities, in the financial sector. In respect of this regulation, I want to make a very important but not entirely satisfactory distinction between 'prudential' and 'other'. 'Prudential' regulation aims to ensure the prudential soundness of financial institutions and is, by definition, institution-based. It is the failure of institutions, not particular products, which poses the greatest threat to those who seek maximum security for their savings and, at the macro level, to stability in the financial system. Such regulation can be distinguished from other regulation directed more towards the integrity and even-handedness of financial markets and products. This distinction will figure prominently in my talk. I think we need both institution-based product-based regulation. I believe also that a certain amount of tension between the two - that is, between promoting the prudential soundness of institutions and achieving comparable treatment of similar products across institutions - is inherent in all financial systems. How this tension is handled will depend largely on how effectively the different regulators co-ordinate their activities. But that is jumping ahead. Currently, the 'prudential' and 'other' regulators in Australia comprise the Reserve Bank, the Australian Financial Institutions Commission (AFIC), the Insurance and Superannuation Commission (ISC), and the Australian Securities Commission (ASC). Each has some characteristics of both categories of regulation, but the Reserve Bank and AFIC are the most prudential in the sense defined, while the ASC is the most 'market' focussed regulator of the four. Together, they constitute the Council of Financial Supervisors (COFS) and 'cover' institutions with over 95 per cent of the total assets of all financial institutions in Australia. How might this regulatory framework be improved, viewing 'improvements' as changes which would lead to a more dynamic and innovative - but still fair and stable - financial sector? To answer this question properly, we should first be clear about the shortcomings in the current framework. Things can always be done better, but many of the usual criticisms appear to me either to lack a lot of substance, or reflect problems which are not capable of being corrected simply through changes in regulatory regimes. They are along the lines that: I would like to make a few comments in response to these kinds of criticisms, mainly from the perspective of a banking supervisor. Practitioners know that regulatory arrangements in the Australian banking sector have not stood still over recent years: Other sectors also have undergone some substantial changes. AFIC, for example, was established in 1992 to lift the standard of prudential supervision of building societies and credit unions. The Council of Financial Supervisors was also established in 1992, to help plug gaps and avoid overlaps and inconsistencies in the approaches of different regulators. New insurance company legislation was passed in 1995. In part, the assertion that current arrangements are outdated probably reflects a perception that regulators have not kept up with the 'blurring' which has occurred in the roles and products of different financial institutions. We see this blurring in, for example, mortgage originators and insurance companies offering home loans, and in funds managers offering deposit-like investment products. It is the outcome of a dynamic financial sector and it does not appear to have inhibited unduly financial institutions pursuing their corporate stratregies. Banks, for example, have been able to establish their own funds managers and insurance companies; when these are included, banking groups have actually increased their share of total financial assets from 52 per cent in 1984 to 59 per cent at present. (It has been government taxation and superannuation policy - rather than prudential regulation - which has prevented banks from offering retirement savings accounts on their own balance sheets; as you know, this policy is about to change.) I think it is significant that this blurring of different activities and products has not 'merged' to the point where they are all being offered on the one balance sheet. The fact that some products (eg bank deposits) require capital backing, while others (eg unit trusts) do not, effectively requires the establishment of separate entities to conduct the different activities. This facilitates their supervision by different regulators, although it also puts a premium on co-ordination among regulators when the different activities are grouped under common ownership in conglomerates. This is another, generalised criticism often levelled at current arrangements. For some, of course, regulation is innately too costly and burdensome. But a degree of supervision is the for deregulated markets; without it, deregulation would not find reasonable community acceptance. Markets are usually more efficient than the alternatives, but they can operate in ugly ways - and sometimes not operate at all - justifying official intervention. It has been suggested that consumers and regulators should rely on disclosures by financial institutions about their affairs, rather than expensive inspections and form filling. In practice, disclosure and 'hands on' supervision can both be important, with disclosure perhaps being of greater value in relation to, say, funds managers than deposit-taking institutions like banks. Disclosure by banks of their financial standing is a prominent feature of bank supervision in New Zealand, although reports of the extent of that country's 'hands off' regime are often exaggerated; banks in New Zealand are subject to essentially the same capital adequacy rules as banks in Australia. Personally, I do not believe regulators can rely on disclosure, especially in the case of the vast numbers of ordinary customers of banks and other deposit-taking institutions. These customers have effectively delegated the task of monitoring the financial health of these institutions to the prudential regulator. In these circumstances, reliance on disclosure is unlikely to constitute an unassailable defence in the event of an authorised bank getting into difficulties. The Reserve Bank has even found itself being sued in relation to some failed building societies - institutions which it has never authorised or supervised. And I fear we are becoming more litigious, not less. In my view, the Bank's best all-round defence is to do all it can to make the institutions under its wing look after themselves properly - and then a bit more as well. Some of the costs which bank executives complain about most have little or nothing to do with prudential supervision as such. The costs to the banks of compliance with prudential regulation would be swamped, for example, by the costs of their uneconomic branch networks. (As I noted earlier, the latter owe something to the obstacles to branch rationalisations implicit in current competition policy, as well as to community and political opposition to branch closures.) Some of the costs of arrangements intended to protect consumers, such as Uniform Credit Legislation, codes of practice, the Banking Ombudsman Scheme and other financial sector complaints mechanisms are also distinct from costs of prudential regulation. This is not to say that none of these arrangements involves excessive costs; some probably do, but the door is open for the Inquiry to propose cheaper and more rational arrangements. The sub-commercial rate of interest now paid on the non-callable deposits (NCDs), which banks are required to hold with the Reserve Bank, can be viewed similarly. The cost to the banks (and their customers) is around $185 million annually. Although it has been presented as being in the nature of a payment for the 'benefits' which come with bank authorisation and supervision, it is essentially a budget revenue raising measure. The capital adequacy requirements which banks have to meet are usually seen as a regulatory cost. This a prudential matter, but it reflects international standards in what is increasingly a global industry. There is not much Australia acting unilaterally can do about these standards, even if we wanted to. Indeed, any move by Australia to 'go it alone' and depart from the standards could prompt negative reactions by counterparties, ratings agencies and regulators in other countries. The fact that the average risk-weighted capital ratio for banks in Australia is currently about 11 1/2 per cent - well above the Bank for International Settlements (BIS) minimum of 8 per cent - suggests that, at this stage at least, the minimum capital requirements themselves are not imposing a major cost burden. These comments are not meant to imply that current regulatory arrangements cannot be made more cost effective. But we do need to be more explicit in identifying shortcomings than we have been to date. The Bank supports the weeding out of unnecessary processes and avoidable compliance costs, although what is 'unnecessary' and 'avoidable' is not always clear-cut. The Inquiry provides an opportunity for industry participants, consumers and regulators to think afresh about what constitutes the 'right' balance of interests. Talk of changes to the regulatory structure seems a little premature until the problems in the present structure are better identified. I would like, nonetheless, to speculate in general terms on some broad options for change. One option is to allow the present structure of prudential and other regulation to continue to evolve in response to technological and other changes. This option is not without attractions. Australians suffered from the excesses associated with the early years of financial deregulation but, unlike many other communities, we did not have to dig into the national budget to prop up the financial sector. In fact, our institutions dealt with their problems quite expeditiously, assisted by five years of sustained economic recovery; they are now generally in good health, and customers are at last seeing the benefits of deregulation, in the form of more innovative and competitively priced products. It is not a 'do nothing' option. Prudential regulation is an evolutionary process and, as noted earlier, many changes have occurred in recent years in the way financial institutions are regulated. Many of today's regulatory structures - including AFIC and COFS - are barely a few years old. In other words, within the existing framework, we can expect change to be a constant. And, as also noted earlier, this framework does not appear to be unduly inhibiting financial sector developments. All regulators worth their salt attempt to anticipate developments in the market place. Occasionally, they may seek to head off a particular development, but their more usual role is likely to be one of trying to accommodate market developments. This seems to me to be the right position for regulators to take up - in trotting parlance, to be 'one out and one back'. It is a 'market friendly' position. An innovative financial sector requires ample scope for private initiative, and for banks and other financial institutions to perform their important risk-taking function. If they want to get out in front and try something new, they should do so in a prudent way but they should not be reined in by pre-emptive regulations. By sitting a little to one side, regulators are well placed to balance risk-taking and stability, market incentives and regulations. A particular illustration of this important general point is the emergence of stored value and other 'smart cards'. These seem destined to grow in significance over time, and banks and others - including non-financial players - are jockeying for positions. The Reserve Bank is monitoring various trials of different cards, and assessing their policy implications. We would be getting ahead of ourselves, however, if we were already promulgating new regulations to govern their issue and use. Sometimes it is better not to be pre-emptive! Where different institutions are linked by ownership or offer some similar products, effective co-ordination of the activities of different regulators is clearly important. The Council of Financial Supervisors is a good base to build on here. It has had a low profile to date - partly because it has not had to contend with any major problems - but it has been working quietly in several areas on contingency plans for managing serious situations. Steps have been taken to remove obstacles to information sharing among regulators (which, in some instances, are entrenched in legislation), and to developing procedures for ensuring that financial conglomerates and holding companies are effectively supervised. (The latter are moving towards the 'lead regulator' model, where one member of the Council would have responsibility for overseeing a particular conglomerate or holding company.) More work remains to be done to develop the Council's role, but it is shaping up as a workable approach to the problem of co-ordination. Notwithstanding the attractions of this evolution option, time will tell whether the Inquiry will be so bold as to recommend it. A second option is to reshuffle the pack of financial institutions and regulators. The resultant number of regulators could be the same or greater than at present, although there seems to be a presumption in favour of it being smaller. This option too has its attractions, in principle, but we have to remember that we are not starting with a blank sheet of paper. We need always to ask whether a different structure of regulation would work better than the present one, and at what cost. There is no value in forcing everything into a couple of simple moulds just for the sake of tidiness, or looking for a reduction in the number of regulators unless this made for better arrangements. One reshuffle would separate banks and other deposit-taking institutions from the rest. This could be argued partly on the grounds alluded to earlier, namely the large number of ordinary customers who hold the highest expectations regarding the security and eventual return of their deposits with those institutions. Such institutions should, therefore, be subject to rigorous prudential regulation, including capital requirements. In the case of other products (eg unit trusts), where investors understand that greater risks are involved and they stand to make losses, the same kind of prudential regulation is not required; such products do not need to be capital-backed because the investor bears the risk of loss. The other important part of the argument for distinguishing banks in this way is that they are the institutions which are most relevant for stability of the financial system, and for the smooth operation of the financial intermediation process, which is vital to the macroeconomy. The neatest group of deposit-taking institutions comprises the banks, building societies and credit unions. Banks are supervised by the Reserve Bank, while the others are supervised by AFIC in conjunction with State government agencies. All are perceived to be at the safest end of the risk spectrum, and are subject to similar prudential requirements these days; the average risk weighted capital ratio for building societies and credit unions (14 per cent) is currently above that for banks (11 1/2 per cent). The building society and credit union industries, and the States, might have views on being combined with the banks, but it could be a practical option if rationalisation of regulatory structures was seen as a significant issue. If building societies and credit unions were to share a common regulator with the banks, they would be perceived to be even more akin to banks, and subject to similar degrees of public 'protection'. This perception need pose no insuperable problems, particularly given the degree to which prudential requirements have been harmonised in recent years. Most, if not all, building societies and credit unions - along with many banks - would be too small to give rise to systemic problems if they were to fail, but it would be hard to argue for a different prudential regulator for a sub-group of these institutions based on size. The issue which next arises is whether the rest of the financial sector could be covered adequately by a separate regulator with an emphasis on products and disclosure arrangements, rather than institutions and capital requirements. Activities like unit trusts and investment advice would seem to fit neatly enough, but others might not - some insurance products, for example, are not unlike deposit products in that they entail contractual obligations and are capital-backed. Should institutions offering these latter products also come under the prudential regulator? What about superannuation funds? What should we do about merchant banks and finance companies? Just to raise these few questions is sufficient to illustrate that there can be no clear-cut division of existing (and changing) financial institutions and products. It would be difficult, for example, to devise a sensible two-part division if we start with banks, building societies and credit unions as one part. Tests like the riskiness of investments, and the implications for financial system stability are helpful, but they still leave a lot of fuzzy edges. Another option, which has attracted some airplay, is to have a single, mega regulator for all financial institutions (but not competition or consumer policy). Frankly, I have some doubts about this, mainly because of the point I have laboured already, namely the need for both institution-based and product-based regulation. In theory, a mega regulator could be totally product-based, with risk-related regulatory requirements determined and assigned to each financial product. But not only is there no practical basis for doing anything like that, the theory neglects the institutional basis of prudential regulation. I understand that Denmark, Sweden and Norway have single regulators for their banking, insurance and securities industries, while Canada has a single regulator for banking and insurance. Again, however, I think the relevant question for us is not whether such a model will work, or is working elsewhere, but whether it will work better than our existing arrangements or some other alternative. A mega regulator along the lines of Scandinavian models - covering all major institutions - would need to establish separate divisions with different skills and regulations to handle different industry and risk categories. In these models, the co-ordination role which the Council of Financial Supervisors is currently developing would be 'internalised'. Perhaps with everything under the same roof, decision making and problem resolution would be more efficient, and level playing fields more easily maintained. But that is far from clear, to judge from the large coordination tasks which already confront most regulators. I have said before, only half facetiously, that the main problem with super regulators is that there are too few supermen (and women) to run them. Having responsibility for everything from the safest deposit to the riskiest investment under a single regulatory umbrella could raise public perception - or 'moral hazard' - problems. The community might come to the view that financial institution would be allowed to fail. This would not be a healthy state of affairs, given the risk-taking role of financial institutions; prudential regulators exist not to eliminate risk-taking, but to see that this is properly managed. Whatever the large and fine print might say, people who lose money in financial institutions will always seek to implicate the regulators - by its nature, a mega regulator is likely to be an easier target than a 'specialist' regulator. My scepticism about mega regulators would remain, incidentally, even if the mega regulator were to be the Reserve Bank. The more usual thought, however, seems to be that the responsibility for bank supervision might shift from the Reserve Bank to another regulator; this could give rise to a separate set of concerns. Perhaps I am tilting at windmills here, but I would like to register a few points nonetheless. I hope my remarks today will not be construed as an attempt to protect the Reserve Bank's patch. That has not been my intention - in a couple of months my interest in financial regulation will be confined to how well it is serving the needs of users! There is no doubt that all areas of regulation affecting the financial sector - competition, consumer protection and prudential supervision - can be improved, some more than others perhaps. The Reserve Bank will detail its views on some possibilities in its submission to the Inquiry. My remarks today are more in the nature of a primer on some of the questions that should be asked, and the complex issues they raise. We are not starting with a blank sheet of paper, and we should not overlook the transitional costs that would arise in moving to a radically different regulatory framework. The short gestation period for the Inquiry to report also emphasises the need to focus on real problems and practical solutions. With that focus, the Inquiry has an opportunity to make important renovations to the existing regulatory structure. But if it wants to completely demolish that structure and construct something new in its place, it would need to look at a confinement not of nine months but several years.

r960716a_BOA

australia

fraser

I am pleased to have this opportunity to speak to The 500 Club and, in effect, take up the challenge issued by John Paterson last Australia has had five years of good economic growth with low inflation, which is a better experience than practically every other OECD country. Yet there is not quite the zip about things that might have been expected, given this macroeconomic performance. I would like to offer a few thoughts on why that might be so, and on some implications for policy. First, a few facts. Australia's economic recovery has been have now had five years of continuous growth since the recovery commenced in mid 1991. Since then, the economy has grown by about 20 per cent, an average of 3.6 per cent a year. Over the same period, inflation has averaged 2.4 per cent a year. Among OECD countries, only the United States and New Zealand have had similarly long and robust recoveries in this cycle. It has been an uneven recovery, both across time and across the economy. Growth was gradual to begin with, spurted ahead in 1994 and has since eased back. Large parts of the rural economy have been buffeted by drought, often in combination with low wool and beef prices. Housing surged for a couple of years, to be followed by a similarly protracted cyclical downturn. It has been a period of substantial change involving, inter alia, tougher international and domestic competition; the resultant pressures on prices, combined with relatively large wage increases, have squeezed margins - along with profitability and employment - in several industries, especially manufacturing. And low inflation, despite its longer-term benefits, has disappointed those who had become accustomed to big nominal increases in their pay packets and house values. This backdrop of uneven growth and relentless change helps to explain the Annual average percentage change over the past 5 years disenchantment of particular groups which has been evident throughout the recovery. That discomfort has been real enough for the individuals and businesses affected, but it needs to be kept in perspective. At the moment, for example: measures of consumer sentiment, although well off their peaks of two years ago, have remained at levels consistent with solid growth in consumer spending. And that is what has been occurring, at least until recently. Consumer spending by households rose by 4 per cent in the year to the March quarter, outstripping the growth in their disposable incomes. Spending in the June quarter, however, appears to have been somewhat weaker; and surveys indicate that business sentiment is also subdued, but business investment spending has been rising strongly (up by about 12 per cent in the year to the March quarter), and seems set to grow strongly again over the year ahead. One conclusion from all this is that, unlike some other countries, the 'feel bad' factor has not been strong enough to depress spending propensities. The main conclusion, however, is that even when the economy overall is growing robustly, there will always be some groups who miss out, and some problems which stand out. Time will help with some of these problems - such as the community's adjustment to the more competitive and lower inflation environment - but others will also require policy adjustments. Two macroeconomic problems which have persisted throughout the recovery, and which continue to attract considerable public and policy attention, are the current account deficit and unemployment. These are the focus of my talk today. The monthly current account figures are a regular reminder of a problem, but they are not a lot more than that. The current account deficit is a problem but it is a medium-term problem, not one to agonise over monthly, or even quarterly. The deficit in 1994/95 totalled over $27 billion, equivalent to 6 per cent of GDP. This, to some extent, reflected a number of special factors, including the effects of the drought on rural exports, and of the surge in economic growth in 1994 on imports. In 1995/96 - a more 'normal' year in certain respects - the current account deficit totalled about $20 billion, equivalent to a little over 4 per cent of GDP. That figure is still too high, but it is moving in the right direction. Looking behind the deficit bottom line, we see that exports grew strongly last year (by about 10 per cent), aided by a good rebound in rural exports after the drought. Other exports also continued their solid growth, especially exports of manufactured goods which rose by about 20 per cent. The growth in total imports last year (about 6 per cent) was less than that in exports. It was concentrated in capital goods and, to a lesser extent, intermediate and service imports, consumption goods imports have been fairly flat for some time. Further strong growth in capital goods imports is expected in the coming year. Over time, the current account should benefit from improved international competitiveness and its closer integration with the fast growing markets of Asia. One illustration of the on-going effect of these changes is the sustained growth in exports of manufactured goods, these have grown by an average of 18 per cent a year over the past decade, and are now comparable in value with total exports of rural commodities and total exports of services. The exchange rate is an important influence on competitiveness, but it is one of many and, over time, other influences - such as cost controls, quality and reliability, marketing skills - are likely to be of greater consequence. In the past year, the Australian dollar exchange rate has rebounded from the unusually low level reached in mid 1995. That was the time when a number of negative factors came together: world growth had slowed, commodity prices had softened, and expectations of further interest rate rises in Australia had evaporated as the economy slowed. On top of those factors, the outlook for the current account deficit worsened, shaking the confidence of foreign investors. Since then, however, most of these worries have largely dissipated: the world economy is looking a little stronger and this is helping to underpin commodity prices, while earlier concerns about the current account have settled down. We should, therefore, expect the exchange rate today to be a good deal higher than it was a year ago. Has the rise in the exchange rate been overdone? This is difficult to judge but, in trade weighted index (TWI) terms, the exchange rate today is only slightly (about 5 per cent) above its average level of the past decade - a period which has seen a fivefold increase in exports of manufactured goods it is about 6 per cent above its average level of the past decade. I can understand that some exporters would prefer to see it lower, but around current levels the exchange rate could not be said to be badly out of alignment with the 'fundamentals' - including trends in commodity prices and interest rate differentials. our international competitiveness is obviously important in tackling the current account deficit problem. In a more fundamental sense, however, we also need to increase national saving so that we can fund more of our investment ourselves, and reduce our dependence on foreign capital inflow, which is the flipside of the current account deficit. We are moving in this direction, through both compulsory superannuation arrangements to increase private saving, and reductions in the budget deficit to curtail public sector dissaving. But it takes time to boost national saving, even with the 'right' policies. Stripped of special transactions, the 'underlying' budget deficit in 1995/96 appears to have been equivalent to about 2 per cent of GDP. This is down from the peak of a little over 4 per cent in 1992/93, but it nonetheless represents disappointingly slow progress after such a long period of economic recovery. On current projections, it will take another two years to get the underlying budget into balance. No-one pretends it is easy for governments to cut budget deficits, and how they go about that task is essentially a political matter. As a matter of practicality and equity, however, the task would appear to be more manageable if the net was cast on the tax side, as well as on the expenditure side. That seems an unexceptional argument to me, for the following reasons. With a relatively large current account deficit and relatively low private saving, it is incumbent on the Government to take the lead in increasing national saving and reducing reliance on inflows of potentially volatile foreign saving. We need to get the budget into surplus as quickly as we can, and keep it there as long as we can. To this end, low priority and poorly targeted expenditure programs should be weeded out (not just the people who administer them), but it is a mistake to assume that ineffective programs do not exist also on the revenue side; they too should be weeded out. Perhaps when all such programs are weeded out, the budget will be safely in surplus. If it is not, the options then are to cut into priority expenditure programs, or find additional revenue. If health care programs, for example, are judged to be essential to the quality of life we want in Australia, but Australians are not able or prepared to save voluntarily for them, should those programs be curtailed, or should they be funded by 'compulsory saving' through higher taxes? As I say, these kinds of questions have to be resolved at the political level, but they are reasonable questions to ask. Unemployment is the second problem I want to talk a little about. It is rightly seen as a serious qualification to the good growth and inflation performance of the past five years. Just how serious, however, is difficult to assess, not least because there is no clear 'full employment' benchmark any more. In Australia, the major deterioration in unemployment occurred in the mid 1970s, when we changed from being an economy which could function without inflationary pressures with unemployment of around 2 per cent, to one which, as we entered the 1980s, generated inflationary pressures with unemployment of around 6 per cent than to try to predetermine a precise rate of unemployment below which inflation begins to accelerate. This is because the level of unemployment at which inflation starts to spiral depends on a host of factors, including expectations about inflation, rigidities in different markets, the pace of growth in employment, and wage bargaining conditions. Moreover, whatever the full employment rate is, it can be expected to change over time in response to attitudinal and institutional changes. Nonetheless, this conceptual framework of 'full employment' - in which the test of what is 'full' employment is the inflationary consequences which arise if the economy operates above that level - is useful. It serves, for example, to divide the policy dimensions of unemployment into two parts: how to reduce the 'full employment' rate of unemployment through institutional and attitudinal changes; and how to operate the economy closer to the 'full employment' rate through macroeconomic policies. On the first, I believe well-targeted employment support and training programs, properly administered, can make a difference. Good targeting is the difficult part: the challenge is to find an acceptable path between forcing unemployed people into poverty-level paid employment, and encouraging them to rely on unemployment benefits. The fact that we have not yet found an acceptable middle way is no reason for giving up the search. People with no work experience and only limited skills would seem to be especially vulnerable in today's labour market and, therefore, deserving of careful targeting. Young people figure most prominently here; 40 per cent of today's unemployed are aged between 15 and 24 years, suggesting that there is a real problem of transition from education to the workforce. Pay levels also have a bearing on the likely effectiveness of programs to get more unskilled and inexperienced people into gainful employment. All new workers require a certain amount of training and only become fully 'productive' over time. Wage arrangements need to be flexible enough to reflect this situation, with appropriate safeguards to protect people from being locked permanently into low paid employment. The second dimension has to do with macroeconomic management - with trying to ensure that sufficient new jobs are created to provide opportunities for people seeking work. This means sustaining a rate of employment growth sufficient both to absorb new entrants to the labour force, and to make inroads into the ranks of the unemployed. Over the past year, employment growth has been fairly modest - about 1 per cent in the year to June; over the past six months, it has been virtually flat. This growth has not been fast enough to make any impact on the unemployment rate, which has stuck at around 8 per cent, having declined steadily from over 11 per cent during the two preceding years. As I noted earlier, the actual rate of unemployment at which inflation starts to accelerate is not something that can be known in advance. We can be confident, however, that it is not the 2 per cent figure which Australia averaged in the 1960s, and we can be reasonably confident that it is somewhat less than the current figure of 8 per cent. The question which next arises is whether economic and employment growth during 1996/97 is likely to be strong enough to make a further dent in unemployment. The national accounts to be released with the budget next month are likely to show good growth in GDP in 1995/96 as a whole (productivity has been rising faster than employment), despite some sluggishness in the June quarter. Activity generally should pick up from current levels over the year ahead. This should occur partly as a result of the unwinding of the housing and stock cycles, but mainly from projected further strong growth in business investment. A gradual upturn in world economic activity, as recoveries in Japan and Germany take hold and robust growth continues in the United States, should also lend support to the domestic economy. The potential effects of the forthcoming budget on aggregate demand are more difficult to predict: they will depend on the extent to which the direct contractionary effects of lower government spending are offset by more confident private spending. Any negative short-term impact which the budget might have on economic activity, however, is unlikely to detract significantly from the other positive influences at work in 1996/97. Over the longer term, on-going fiscal consolidation can be expected to have a positive effect on both national saving and interest rates. In summary, activity is likely to pick up a little from current levels over the year ahead. Given that starting point, employment could grow more quickly than it has in the past year without running any serious risk of the economy 'overheating' and inflation accelerating. In contrast to the United States, a good deal of surplus capacity remains in the labour market and elsewhere in Australia. Wage outcomes will still be important for employment; businesses facing strong competition and narrowing margins will be hesitant about hiring more staff if wages rise too quickly. The Reserve Bank has a two-dimensional charter which requires it to take account of trends in growth and employment, as well as in inflation. I happen to believe that this is the right approach, and that monetary policy should be managed in a way which simultaneously keeps inflation under control and helps to sustain good growth in employment. We are different in this regard from some other central banks which are more narrowly focused on inflation, although continuing high levels of unemployment are compelling central banks in those countries to pay more attention to that problem. Each month, as part of its review of monetary policy, the Reserve Bank Board assesses the scope for the Australian economy to grow faster without setting off an inflation spiral or other problems. So far in this cycle, we have had five years of non-inflationary growth, but we need several more to help get unemployment down: these are within our reach, provided we all do the right thing. The short-term outlook on inflation is quite encouraging. The figures to be released next week should show underlying inflation in the year to the June quarter falling to around 3 per cent. We expect inflation to be comfortably within the 2-3 per cent objective in the second half of 1996, and into 1997. Others are coming to share this outlook, including international bond investors. In the second half of the 1980s, yields on Australian long-term bonds were typically 5 or 6 percentage points higher than US yields, but the differential now is under 2 percentage points. How far into the future we sustain this low inflation performance will depend on developments in a number of areas, including the exchange rate. State taxes and charges, and the labour market. Labour costs are the largest single influence on the price of most goods and services, which is why we worry most about them. After rising by around 5 per cent in 1994/95, labour costs across the whole economy are estimated to have grown by about 4 per cent over the past year. Some additional data on earnings will also be released next week. The recent rate of increase in labour costs, if sustained, would be broadly consistent with an inflation rate a little below 3 per cent. The intensification of global and domestic competitive pressures flowing from a decade of structural change will be working in this direction, and these are potent influences. The expected falls in inflation over the quarters ahead should also be making for some moderation in wage and salary increases. If wage negotiators (on both sides of the table) were to seize this rare opportunity to entrench low-inflation expectations in Australia, unemployment could fall a long way without triggering a return to higher inflation. If we could be more confident that these influences would win the day, it would be easier for the Reserve Bank itself to adjust to low-inflation. That confidence has not evaporated but it has to be qualified. To judge from the size of settlements in some recent enterprise agreements, and the size of some current wage claims, there is not a lot of evidence at the moment that wage negotiators generally are factoring in lower-inflation expectations. You will appreciate that I cannot talk more explicitly about possible changes in monetary policy. I hope, however, that my comments today will give you a better understanding of the issues which confront the Reserve Bank Board, and the kinds of pragmatic judgments it has to reach.

r960808a_BOA

australia

fraser

I am pleased to have this opportunity to talk with you about a particular form of co-operation in the Asian region, namely co-operation among central bankers: in fact, we now have the beginnings of what could, in time, prove to be an interesting case study in regional central bank co-operation. It is not surprising that so many people - central bankers included - should be interested in Asia these days: it makes up a substantial portion of the world economy, and constitutes the fastest growing market in the world; where you draw the boundary can be significant but, broadly defined, non-Japan Asia accounts for nearly a quarter (23 per cent) of the world's output, and Japan for a further 8 per cent; and non-Japan Asia has grown at an average rate of about 8 per cent a year over the past 15 years, about three times the average for industrial countries (2 per cent). Other indicators tell much the same story: non-Japan Asia accounts for about a fifth of world trade and Japan for a further 8 or 9 per cent; the East Asian countries alone are the recipients of about a quarter of global flows of foreign direct investment; and the financial markets of Japan, Hong Kong and Singapore represent 23 per cent of global foreign exchange turnover (April Asian countries themselves have been quick to exploit these opportunities: intra-regional trade has been pivotal in their rising prosperity; and in 1994, 37 per cent of the total trade of non-Japan Asian countries occurred within that group of countries, up from 25 per cent a decade earlier. Other countries are now seeking to get into the action: the share of OECD countries' trade with East Asia has doubled since the early OECD countries source about 11 per cent of their imports from, and sell a similar proportion of their exports to, East Asia; and these ties are strongest with Japan and the United States - Europe's trade links are smaller, but growing rapidly. Per cent Australia is also in there in a substantial way: about 60 per cent of Australia's total exports go to Asia, 25 per cent to Japan, and 35 per cent to other Asian countries; in 1994/95, Australia had a current account surplus of about $12 billion with Australia is Asia's fourth largest export market; these figures suggest a degree of engagement in Asia large enough for Australia to be viewed, rightly, as part of despite the strong trade links, the capital flows generally have been quite small, although the 'people' flows have been strong; and visited Australia (22 per cent of all tourists The broad thrust of these figures will be familiar enough to you: I mention them as a reminder of the dramatic rise of the Asian region on the global scene over the past decade or so; typically, this rise has been based on trade flows, and on capital flows which have augmented what were exceptionally strong saving ratios to begin with; and with half of the world's population, and living standards which still have a lot of catching up to do, the potential for further growth is enormous. Various regional bodies have emerged to promote closer co-operation on trade and investment matters: these are the areas where the largest and most tangible economic benefits are to be made; ASEAN, for example, has evolved into its own free trade area, with an explicit timetable to eliminate tariffs within the group by 2003; the broader APEC forum seeks 'free and open trade and investment' among industrial member countries by 2010, and among developing members by 2020; the ADB has been promoting development in the region for about 30 years; and central bankers are sometimes involved in these particular regional bodies, but they are predominantly the preserve of Trade, Some longstanding arrangements for central bank co-operation in the Asian region do exist but these mostly have a training flavour about SEANZA and SEACEN are two prominent examples; for the most part, however, central bankers have tended to lag behind the mostly traderelated regional initiatives; perhaps they have been too pre-occupied with their domestic problems, or perhaps they have been content to leave co-operation in monetary and financial matters to multilateral bodies like the IMF. Whatever the reasons in the past, that situation is now changing: advances in communications and IT generally, combined with on-going financial deregulation, are creating truly global financial markets; these days, data releases and rumours in one market appear almost simultaneously in markets all around the world; regional markets for financial services are starting to function as if they were a virtual single market; and the functions of central banks, much more so than ministries, tend to be rooted in the financial markets. Modern communications can transmit negative messages as effectively as they can positive messages, and these can cause instability in financial markets for what might sometimes be quite irrational reasons: are a recent case in point, and resulted in considerable volatility in the markets of Hong Kong, Thailand and some other countries, although the 'fundamentals' in those countries were quite different from Mexico's; financial instability is obviously a threat to economic development, and domestic policies will always be the first line of defence in response to any such threat; but even sound domestic policies might not be sufficient in the face of big swings in short-term capital flows; and in this way, the liberalisation and globalisation of financial markets have heightened the international dimension of monetary policy making, and opened the way for greater co-operation among regional central banks. A second strand to the changed situation has been a growing realisation that existing international institutional arrangements are not keeping up with these market the IMF remains an important institution but it has the interests of over 180 member states to reconcile, and its capacity to respond quickly to volatile situations is questionable; and unless you are, say, a Mexico or Russia (and have powerful friends like the United States and the major European countries), your troubles are likely to be less urgent in their deliberations. And the BIS, the premier forum for consultation and co-operation among central bankers in western countries, has always had a distinctly European orientation: Australia is a shareholder in the BIS, as is Japan, but no other country in the region currently is (all but five of its 33 shareholders are central banks of European countries, and 13 of its 17 Board members the BIS does a lot of things which are interesting and relevant to central banks, but it has been reluctant to recognise the changed weights of Europe and Asia in world economic affairs, despite concerted efforts on the part of its current General There are, therefore, some strong and obvious reasons for promoting closer co-operation among Asian central banks at this time. It was against this background that I proposed last September that central banks in the Asian region should co-operate more closely with one another, perhaps modelling this co-operation broadly on what the BIS does (hence its shorthand description as a the essential rationale was to provide a more focussed forum than presently exists in the region to help central banks cope with the emergence of deregulated, global financial markets and their consequences; the emphasis was very much on co-operation, not economic and political integration on the European model - neither an ERM nor an EMU have any relevance for Asian countries at this stage of their development; and the idea was that we would build on an existing regional grouping of central banks and enhance co-operation in that framework, with the prospect of establishing a new regional institution in time, when the need for such a body had been demonstrated. EMEAP appealed as the most appropriate grouping to begin with: EMEAP stands for Executives' Meeting of this group grew out of an initiative by the Bank of Japan in 1991, and has been meeting twice a year over the past five years, usually at Deputy or Assistant Governor level; and the group comprises the central banks and monetary authorities of Australia, By any measure, its member countries make EMEAP a substantial group: compared with the European Union, for example, the population of EMEAP countries is more than four times as large; its GNP is 20 per cent larger; the growth rate is four times as rapid, the savings ratio is about double; and foreign exchange reserves are about one-third larger. As useful as past meetings have been, EMEAP does not have any policy development or operational functions. We have suggested four areas where EMEAP central banks might co-operate more closely and develop some of their functions, namely: and experience sharing on macroeconomic policy, particularly in the context of the challenge to maintain growth and control inflation in the face of rising and potentially volatile cross-border capital flows, and managed exchange rates (which they often are in Asian (ii) similar information and experience sharing in the area of supervision of the banking and financial systems, in what is a diverse and rapidly changing environment in Asia. In time, this process could lead to a concerted 'Asian' input into the has been making most of the international running in these areas; (iii) the development of contingency plans to deal with crises, which might arise from shocks either inside or outside the region. These arrangements can range from information sharing and foreign exchange swap arrangements right through to a regional capacity to provide emergency support to participating central banks in exceptional circumstances; and provision of reserves management and other central banking services to member central banks - something which the BIS currently does but which could easily be provided by a regional institution. What then have been the reactions to this proposal over the past 10 or 11 months? the answer, in brief, is that 'encouraging' progress is being made. There has been some predictable, but limited, muttering that this is not the way to go, that we should rely on multilateral bodies like the IMF and not seek to break the world into regional blocs: it is fair enough to ask whether, in an increasingly global world, there is room for regional bodies; I think there clearly is, and just as we pursue a three-pronged approach in other aspects of diplomacy without any embarrassment (that is, multilateral, regional and bilateral), we can do the same thing in respect of the central bank's international relations; provided their approaches are consistent with the sensible aims of multilateral institutions, regional bodies can actually help to reap the full benefits of more open goods and financial markets; I think they can help too with the sheer management task that is involved in promoting and monitoring global financial markets; a well prepared regional body might also have shorter response times in crisis situations, particularly in the case of smaller and/or less well connected countries; and an Asian BIS could, therefore, operate in ways which would complement the IMF and the BIS, not compete with them. So far as the BIS itself is concerned, I think it is fair to say that the floating of this proposal sent a loud wake-up call to some members of it has probably strengthened the hand of the General Manager in his efforts to make the BIS genuinely more 'international'; it is possible, consistent with those efforts, that some additional countries (including several from the Asian region) will be invited to become shareholders in the BIS; if this were to happen, it would increase Asia's representation on the BIS share register, although I am not sure it would do a lot more than that, at least in the short term; and it would not in itself do much to enhance co-operation among central banks in the Asian region. Among EMEAP central banks, the reaction has been varied but generally positive: some were quite enthusiastic and keen to move quickly towards the establishment of new institutional arrangements; others wanted to proceed more cautiously, and enhance existing arrangements before establishing any new regional institution; and in one or two countries the involvement of other parts of the bureaucracy in what are typically central bank functions - such as management of foreign exchange reserves and bank supervision - has complicated matters. Since the proposal was floated last September, various meetings of EMEAP representatives and working groups have been held to plot the path ahead: the preferred course to emerge from this process is to build gradually, rather than move immediately to establish any formal new institution; and three concrete developments are worth reporting. First, and symbolic of the more co-operative spirit now emerging, a large number of bilateral repurchase agreements has been signed between EMEAP central banks over the past year: for its part, the Reserve Bank has signed agreements with the central banks of and Thailand; these repurchase agreements allow a participating central bank to raise funds by selling securities held as reserve assets to the other central banks, subject to an undertaking to repurchase the securities at some future date; and the repurchase agreements will enhance the liquidity available to central banks in times of need. Given the way these things go and the obstacles that inevitably arise, I think there has been an encouraging degree of progress over the past year: things are moving, and solid foundations have been laid down on which a permanent structure of enhanced central bank co-operation might be built; certainly, a stock of goodwill exists which, in time, can wear down the hurdles which remain; it is now up to the various working groups which are about to get under way to develop practical proposals for closer co-operation; if these working groups can deliver benefits which outweigh the resource and other costs involved - which they obviously need to do if they are to lead anywhere - I would not be surprised to see an Asian BIS-type institution established in the next three to five years; and that might be no big deal to most of you in this audience but, provided it is well designed and implemented, I believe it could make a significant contribution to both regional and broader prosperity. There is perhaps another, less obvious, more selfish reason why Australia should be promoting this kind of co-operation: as a middle-ranking country in a region of fast growing and potential economic heavyweights, we have to utilise our comparative advantage if we are to go on 'fighting above our weight' in international economic relations; and we do have a comparative advantage in many areas of central banking, and enhancing EMEAP and establishing an Asian BIS is one way of using our comparative advantage to help cement a secure role for Australia in our rapidly changing region. Second, a meeting of EMEAP Governors was held in Tokyo last month: this was the first time Governors of this group had met, even though representatives of EMEAP central banks have been meeting twice a year since 1991; the Governors agreed that they should meet at least once a year in future; and the meeting next year will be hosted by the People's Bank of China, a very enthusiastic supporter of closer central bank co-operation. Third, the Governors agreed, on the basis of recommendations contained in a report from EMEAP officials, to establish three permanent working groups to study and report on various central bank functions: specifically, a working group on financial market developments - which will study the development of bond, money and foreign exchange markets, along with payment systems and other elements of financial infrastructure relevant to the promotion of these markets; (ii) a working group on central bank operations - to look at various central banking services, but particularly the management of foreign exchange reserves held by central banks. It will also look at possible institutional developments. This group will be chaired by an officer of the Reserve Bank, and will hold its first meeting in Sydney next month; and (iii) a study group on bank supervision - to upgrade and share information on bank supervision issues in the region. Among other things, this group will assess the policy and practical implications of adopting the standards of the BIS Committee on Supervision, and can be expected to develop a close working relationship with that Committee.

r960815a_BOA

australia

fraser

In my first talk as Governor I discussed the Reserve Bank's independence. I would like to return to that topic today. It is a topic which has provided a good deal of copy for journalists over the years. Perhaps it is all the conflict and intrigue which has given it such instinctive media appeal. Conflicts have been perceived, for example, within the Bank, and between the Bank and practically every conceivable body from the Treasury, the Treasurer, the Government and the Opposition, through to the financial markets. All have been spotted and reported at one time or another. To be fair, journalists are not the only ones who have perceived such conflicts, or tried to make something of them. And, although far less frequent than their reported sightings, occasional tensions have arisen, inevitably so, I think. Sometimes these have been sustained by the odd colourful utterance from one or more of the protagonists. 'Independence' as an issue might have been expected to go off the boil following the March election and the new Government's clear commitment to recognise and respect the to ensure the continuation of what, in reality, was an independent Reserve Bank under the previous Government. But the very time when everyone is publicly declaring the Bank to be independent is the very time when the media should be showing more - not less - curiosity in the issue. That now seems to be emerging. Against that prospect, I want to offer some comments on what I think Reserve Bank independence means in practice, and on the checks and balances necessary to appropriately protect and temper the exercise of that independence. I will obviously draw on my years at the Bank, but I will try also to be forward looking. Talk of 'independence' occurs mainly in the context of the freedom which central banks have to conduct monetary policy without political interference. It is not the only form of independence which is relevant to central banks, but it is the best place to start. The usual argument for an independent central bank is that governments and politicians cannot be trusted to do the right thing with interest rates. They are assumed to be driven by the electoral cycle, and prone to manipulate monetary policy for short-term political gains. It is an argument which might find wide acceptance in this audience, but I think it is a bit simplistic, and perhaps a touch cynical. A lingering temptation to engineer interest rate changes for short-term political reasons no doubt persists, but it is countered somewhat these days by the knowledge that any such manipulation will be caught out - that the financial markets, in particular, will see through the ruse, and punish the perpetrators. Today's politicians appreciate that extended front page reportage of a plunging exchange rate, for example, could easily outweigh any positive effects of a politically inspired cut in interest rates. The corollary of this argument is that an independent, expert body not bound up in the electoral cycle would do a better job than politicians in conducting monetary policy. This seems to me to be the strongest reason for entrusting responsibility for monetary policy to an independent central bank, although I would want to add a very important caveat - namely, that the bank's independence should be exercised within an appropriate framework. Monetary policy is, in a number of respects, more 'technical' and less 'political' than fiscal policy. Having said all that, I must also add, of course, that central bankers have no monopoly of wisdom or judgment, and are certainly not infallible. Their performance over time - their track record - will afford the best test of the validity of this corollary. It has always seemed sensible to me that the Reserve Bank should exercise its independence in a consultative way with the Treasurer of the day. There are several reasons for this. To begin with, the Bank is required by law to consult with the Treasurer, as well as with the Secretary to the Treasury. This helps to avoid surprises, and the transmission of conflicting signals to the markets and others: it is obviously sensible, after a change in interest rates, for both the Bank and the Government to tell much the same story. Secondly, central bankers occupy only part of the economic playing field, but they are affected by what is happening elsewhere. Regular consultations provide opportunities for the Bank to keep abreast of what is developing, for example, on the fiscal front, and - in earlier times - on wages policy. It has puzzled me that this brand of 'consultative independence' sometimes has been interpreted as reflecting weakness - and a lack of independence - on the part of the Critics have peddled the line over the years that the Bank was 'political', but no hard evidence has ever been advanced. There is none. Three federal elections have been held in the past seven years and only in one of those instances were interest rates reduced shortly ahead of election day. This was the March 1990 election. On that occasion, rates were reduced in the preceding January and February; these reductions were criticised widely as being both 'political' and inflationary - but so were several of the following 13 reductions which were made between April 1990 and July 1993. In retrospect, no objective observer could reasonably challenge the economic soundness of any of that long series of reductions. Much of the wind beneath the view that the Bank was 'political' flowed from Paul Keating's comment at a press conference in February 1989 that 'they do what I say', and from a more celebrated but harder to document comment at a supposedly private dinner in December 1990 that he had the I believe Mr Keating regretted being associated with those throwaway lines and, to my knowledge, he never repeated them. On more than one occasion, he complained that the Bank had acted in ways which were contrary to his own preferences - clear enough evidence, I would have thought, that the Bank was not in his pocket. I also have denied that the alleged 'in the pocket' jibe was ever an accurate description of the relationship between the Treasurer and the Reserve Bank, as did my predecessor, Bob Johnston. The original quip was unfortunate enough, but its repetition ad nauseam , in the face of all the denials, was even worse in my view; it certainly did nothing to enhance the Bank's standing in financial centres around the world. To concoct evidence where none existed, critics even impugned sinister overtones to my 'mateship' with Paul Keating. Some went so far as to suggest that Mr Keating only had to get on the phone to me and I would do his bidding. As well as being malevolently ignorant, such stories were extremely offensive to the other Bank staff and Board members involved in all the Bank's decisions on monetary policy. For the record, I always have been pleased to be counted a 'mate' of Paul Keating, in the proper sense of that term. I had hardly spoken to Mr Keating before he appointed me to the naturally saw a good deal of him over the ensuing dozen years, both in that position and as Governor of the Reserve Bank. I admired his resolute commitment to change things, and shared many of the broad value judgments which lie at the root of that commitment (several of which, incidentally, are encapsulated in the Reserve Bank's 'charter'). I will always be enormously grateful that he had sufficient confidence in me to appoint me to two of this country's top policy positions - without his confidence, I do not believe I would ever have had the opportunity to serve in either position. But none of this provided any basis for glib assertions of cronyism and worse. Commentators should not be surprised, nor should they suspect intrigue, if a Treasurer and a Governor happen to see eye to eye on particular economic policies or strategies; and the Governor should not have to engage in public slanging matches with the Treasurer to demonstrate the Bank's political independence. In a similar vein, while they sit somewhat uneasily with their declarations of central bank independence, I think it is understandable that Prime Ministers and Treasurers will make public comments on monetary policy from time to time. Intrepid questioning by members of the media alone is guaranteed to elicit an occasional comment from even the everywhere, including in countries like the boast independent central banks. In Australia, both the Prime Minister and the Treasurer have commented on possible interest rate movements in recent weeks, and similar kinds of comments were made by their counterparts in the previous Government: then, as now, these should be seen as views which Ministers are entitled to express, and not as evidence of political interference in monetary policy making. During the recent election campaign, the Coalition parties stated in very clear terms that they would 'protect the integrity and independence of the Reserve Bank', and this has been reaffirmed several times subsequently by the Treasurer. On a number of occasions also, the incoming Government has endorsed the Bank's 2-3 per cent inflation objective, and the multiple goals of the , which require the Bank to have regard for economic growth and employment, as well as for inflation. Overseas, there has been quite a push also to give more independence to central banks. In Europe, in particular, several countries have passed legislation to this effect, and it is a condition of entry into the European Monetary Union that members' central banks be independent. What, to me, is noteworthy about this push is that it has been conducted largely in terms of inflation objectives and targets. Even in Australia, where the incoming Government has endorsed the multiple objectives in the , there has been a tendency to emphasise low inflation. That accords with good central banking orthodoxy but, to my taste, equating independence with inflation targets alone is a form of Clayton's independence. Behind these subtle differences in taste are deep debates about trade-offs between inflation and unemployment. Without going into detail, it is generally agreed that no such trade-off exists in the long term; the policy implication which flows from this is that the best contribution monetary policy can make to sustained economic growth is to hold down inflation. The problem with this argument, however, is that the long term can be quite long indeed - five years or more. In the short term - that is, in the year or two ahead, which is clearly a highly relevant period for most people - trade-offs do arise. As everyone knows, monetary policy affects both output and inflation (and both are affected by other policies as well). In fact, the impact of monetary policy on inflation comes about largely through its impact on output and employment - that is, by creating slack in the goods and labour markets. Central banks have a duty to try to minimise economic fluctuations, but they can tackle this task in different ways. When inflation, for example, threatens to go off the rails, judgments have to be made about how quickly it should be brought back on track; these judgments involve real trade-offs between inflation and unemployment. In the second half of 1994, when it appeared likely that future inflation would exceed the Bank's 2-3 per cent objective, monetary policy was tightened quite decisively to limit the extent and the period of the expected rise above 3 per cent. Monetary policy could have been tightened in a more draconian way, with a view to minimising the period with inflation above 3 per cent. By not following that course, the Board was saying implicitly that the possible benefits of such action fell short of its potential costs in terms of lost output and jobs. Similarly, the reduction in interest rates announced two weeks ago could have been held over until inflation was firmly back within the 2-3 per cent band, but again a judgment was made that the benefits of a little insurance against the economy faltering outweighed any risk that inflation might kick up unexpectedly. Monetary policy decisions frequently raise questions of trade-offs of this kind, although they are not always explicit. The multiple objectives of the help to make the trade-offs explicit in Australia, which is one reason why I have always championed our approach over the more fashionable, inflationonly objective of many other central banks. This is not a theoretical issue. There is no doubt in my mind that had the Reserve Bank been charged with fighting inflation only through the 1990s, monetary policy would have made much less of a contribution to economic recovery than it actually did; interest rates would have gone down more grudgingly in the early 1990s, and up more enthusiastically in the mid 1990s. With the independence which the Reserve Bank has enjoyed over the years has come extra responsibilities. One of these is greater accountability. The Bank has worked hard to explain clearly to the public, the Parliament and the markets where it has been coming from, what it has done, and why. I think the Bank has come a long way in this regard, and much further than most other central banks - which is not to say that we should become so transparent as to expose all the intricacies of the Board's decision making processes, or to permit financial markets to anticipate the Bank's every move. Accountability also requires credible performances by the Bank in relation to all its objectives, not just inflation. I should emphasise at this point that, in seeking to keep output and employment considerations to the fore in monetary policy deliberations, I am not seeking to downplay or backtrack on the inflation objective. I have made too big a commitment to lowering inflation over the years to start backtracking now. The issue, instead, is that both inflation and employment are important, and both can be progressed simultaneously, as we have seen in Australia and the United States, for example, over recent years. It is the job of central banks to worry about inflation, and they are innately inclined to do that. But they should not be fixated solely with inflation, and we should not be loading the dice even more in that direction. I think we are fortunate in Australia in having evolved a 'framework' which helps to protect the Bank's independence and encourages it to be exercised in a balanced way. The four pillars of this framework are as follows. Multiple objectives . As I have said, I see the Bank's explicit multiple objectives as a counter to the (understandable) preoccupation of central banks with low inflation. I therefore welcome the Government's decision not to seek to change the Bank's charter. I would not be surprised if, over time, some central banks with a single inflation objective were to come under pressure to give more weight to employment considerations, to help revive their sluggish economies and reduce unemployment. A flexible inflation target . Targets can be helpful in providing an anchor for inflation expectations, and a discipline on monetary policy. But they should be flexible enough to serve those purposes, and to avoid any proclivity to press the alarm button every time inflation threatens to go above the target. The Reserve Bank's target is flexible; it is expressed in terms of keeping underlying inflation in the 2-3 per cent range over the business cycle. It is consistent with the multiple objectives approach in recognising that inflation has a cyclical element, which policy should allow for, and it also recognises that if inflation goes outside the target range the speed of its return should be determined by weighing up the risks on both employment and inflation. I am pleased that the present Government, like its predecessor, has expressed its support for this target. Consultations between the Bank and the . These have developed over the years, and have become more structured in recent times under Mr Willis and Mr Costello. As well as being required by law, these serve several useful purposes, as I noted earlier. They also constitute an important check on errant egos. The Act provides that, in the event of a disagreement between the Board and the Treasurer over the direction of monetary policy, the Treasurer's view shall prevail but, in that situation, the Treasurer is required to table both the Board's advice, together with his reasons for over-riding that advice, in both Houses of Parliament. So far, and for reasons which are not hard to fathom, that situation has not arisen. . The Board is the formal decision making body of the Bank and is involved in all changes in interest rates. It is an important part of the present framework: it helps to keep the Bank team honest; it brings a 'real world' dimension to policy discussions, consistent with the charter's emphasis on employment as well as inflation; and it adds to the authority of the eventual decisions. Members generally have stuck to their self-imposed rule that only the Chairman should speak for the Board, but I can tell you that they take their responsibilities very seriously, and work hard at them - notwithstanding the occasional cheap shot in the media that they merely rubber views. During my 12 years on the Board, I have had the opportunity to work with many competent, decent people committed to ensuring that the Bank did all it could to promote, not sectional interests, but, in the words of the Act, 'the economic prosperity and welfare of the people of Australia'. I hope that future appointees to the Board will keep this aspect of the Board's role in mind. My thoughts for today's talk were assembled before I became aware of yesterday's accord between the Treasurer and the new Governor. The words and the emphasis are different, but much of the thrust of the framework I have been describing is reflected in the agreed statement on the conduct of monetary policy. Considerable effort also appears to have been directed towards ensuring that the statement was consistent with the . It is a neat match - some might say suspiciously neat. It is no longer my business, but so long as that basic consistency with what is in the Act is maintained, the statement would not cause me any particular difficulties. In fact, because it essentially formalises current practices, it has a rather sweet ring to it for me. It suggests that we are all marching to the same tune now, something that seemed impossible only a few years ago when the present Government was in Opposition. Whatever the framework, there is always scope for different people to emphasise different aspects. This is where personalities can be important. I have made clear my preference not to see the present balance of objectives biased any more towards lowering inflation - not, I repeat, because inflation is unimportant, but because growth and employment are also important. While I see no particular need to be further emphasising the inflation objective, that will, no doubt, be welcomed by many in the central banking fraternity, the financial markets and at least some parts of the media. At the end of the day, however, what will matter most is not nuances contained in joint statements or in legislation, but the community's assessment of the Bank's performance in helping to deliver sustained non-inflationary growth and lower unemployment. So much for keeping the Reserve Bank independent of political pressures. To do the job it is required to do, the Bank also needs to be free of financial market pressures. It would be ironic if one form of influence were to be substituted for another: if the short-termism of politicians were to be replaced by the shorttermism of the financial markets. The issues which arise with the markets are not dissimilar from those associated with politicians. It is not a matter of never trusting the markets, or of assuming they are always wrong, or of 'taking them on'. Perceived conflicts of the latter kind might help to enliven the reportage of market developments, but that is not the way the Reserve Bank normally interacts with the financial markets. My oft-stated view is that markets - including financial markets - are not perfect, but they tend to do a better job than the alternatives. We should listen to them, but we should also be aware of their shortcomings. Financial markets summarise the views and judgments of large numbers of participants. This has led to claims that the collective wisdom embodied in market prices is superior to that available to even well-staffed central banks or Treasuries. Be that as it may - and more often than not central banks will view the same data in much the same way as the markets - it is not the real issue. Markets are not infallible; they are often quick to change their collective minds; and they have their own frameworks, which can be quite different from that of the Reserve Bank. The last point is the real issue. Most financial market participants rate low inflation ahead of the Reserve Bank's other objectives. This reflects a number of factors, but the financial harm that is done to holders of bonds when inflation and interest rates rise is the main one. We see their (understandable) priorities in market reactions to different economic indicators: weak economic activity and employment numbers, for example, are generally welcomed because they imply lower inflation and higher bond prices, while strong numbers are generally frowned upon because of concerns that they will be followed by higher inflation and interest rates down the track. A lot of what is written about the Reserve Bank's 'credibility' is in the narrow context of the Bank's credibility with the financial markets for delivering low inflation. This is important, but to actually deliver low inflation the central bank needs credibility in labour and other markets more than it does in the financial markets. To build this broad community support for its anti-inflation objective, the Bank also needs to build credibility in relation to its other objectives. Community support for low inflation is likely to dissipate unless the Bank can help to deliver some gains in employment and living standards. I think there is an important point here, and one which commentators might ponder next time they are rushing off to seek reactions to a change in monetary policy. Not only do financial markets participants have an understandable pre-occupation with low inflation, they also have more ready access to the media than people in other sectors of the economy with a probable greater focus on output and employment. The most notable feature of the survey of 32 economists conducted ahead of the recent interest rate cut was not that practically no-one picked the reduction, but that virtually everyone polled was from the financial sector. The Reserve Bank obviously needs to work closely with the financial markets, and they will often be useful allies in maintaining discipline in macroeconomic policies. But their often different priorities should not be overlooked. In my view, the Bank's best protection against being swayed unduly by the financial markets is close adherence to the same framework which I outlined earlier to help avoid political interference. Of special significance in this connection are the multiple objectives of the Bank, and the appointment of competent Board members with a national perspective.

r960905a_BOA

australia

fraser

This is the fourth opportunity I have had to participate in BZW's annual Australia Day seminar in Tokyo. On each occasion in the past I have been telling a story of progress in the Australian economy. And, happily, subsequent developments have tended to support this story - which probably explains why I have been invited back! Over the past five years, Australia's real GDP has grown by more than 3 per cent a year, while inflation has averaged 2 per cent a year. This combination of good growth and low inflation is quite impressive by the standards of the major industrial countries, as Table 1 indicates. Solid growth and low inflation are set to continue in Australia for some time yet. I will say more about that outlook shortly. But first, I would like to reiterate the point I have been emphasising in my earlier talks - namely, that the Australian economy today is very different from what it was a decade or so ago. Today, it is much more productive and competitive and outward looking. It is those changes, which I expect to be sustained and built upon, which make me confident about Australia's future. They should, I suggest, also boost the confidence of Japanese investors in Australia. In many respects, the interests of the Australian community and foreign investors coincide, with returns on investments and rising standards of living both dependent largely on sustained economic growth. Improvements in the way economies operate are as important as sound macroeconomic policies in sustaining growth, although they can take years to show up. We are now, however, seeing some of the benefits of the many profound changes that have occurred in Australia over the past decade, often as a consequence of policy actions. Productivity growth is the key to sustained 'Productivity isn't everything, but in the long run it is almost everything. A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.' On this point, we have grounds for optimism about Australia. If we measure productivity in the 1980s and 1990s from the low points of the recessions which occurred early in each decade, we see that productivity growth in the initial years of each cycle was quite robust. But, later in the cycle, when it becomes more difficult to sustain fast productivity growth, we see that productivity has continued to grow strongly in the 1990s, while in the 1980s it productivity in the market sector of the economy has grown at an average of per cent a year, compared with 2 per cent a year in the corresponding period of the 1980s cycle. Measurement and other problems can complicate the interpretation of trends in productivity, but there does appear to have been a structural lift in productivity growth in the 1990s. Indeed, it would have been most disappointing if such a lift were not occurring, given the substantial microeconomic reforms which have been implemented over the past decade. I will not catalogue those reforms, but some of the underlying forces warrant a mention because they have on-going implications for the Australian economy and investors in it. More intense competitive pressures in Australia have provided a major spur to better productivity performance. Reductions in tariffs and other trade barriers have been important here. So too has a range of other policy actions, from floating the Australian dollar and deregulating the financial system to privatising many services provided previously by government bodies. These and other reforms have been reinforced by the emergence of more confident and more outward-looking attitudes in most sections of the community. Several measures show how the structure of the Australian economy has changed over the past decade. In the area of trade, for exports of goods and services as a share of GDP have grown from 16 per cent to 20 per cent; the share of rural and other commodities has declined from 74 per cent of total exports to 58 per cent; and exports of high value-added manufactured goods have shown the strongest growth - averaging 16 per cent a year over the past decade - followed by tourism and other service exports. As a by-product of this export diversification, Australia's terms of trade are becoming less sensitive to fluctuations in commodity prices. The gradual decline in the share of commodity exports also raises the prospect of less volatility in the exchange rate; this could be a significant change for long- term investors, although it has not yet been widely perceived in foreign exchange markets. I will say a little more about the exchange rate later. The geographic base of Australia's exports has also changed. Japan remains Australia's single most important export market, accounting for almost a quarter of total exports of goods and services. Since the mid 1980s, however, the share of exports destined for non-Japan East Asia has risen from 20 per cent to 35 per cent; this growth has been partly at the expense of Australia's more traditional markets in the United States and top ten merchandise export markets are now in East Asia. This closer trade integration with the fast growing economies in Asia has supported Australia's relatively strong growth in recent years, and this support should continue in the period ahead. The corporate and banking sectors in Australia have come through the changes - and occasional turbulence - of the past decade in good condition. Ten years ago, Australian companies were in the middle of a gearing up phase which ended with the recession of the early 1990s. This phase reflected a number of factors, including the deregulation of financial institutions, which encouraged banks and others to lend vigorously, and a long period of strong economic growth and rising asset prices, which encouraged investors to borrow just as vigorously. Despite high nominal and real interest rates, corporate borrowing continued to rise in the second half of the 1980s, reaching a peak equivalent to almost 70 per cent of GDP in 1990. After the bubble burst, businesses set about repairing their balance sheets and restoring their gearing ratios to more comfortable levels; corporate debt is currently about 57 per cent of GDP. In the past couple of years Australian corporates have returned to the debt market, showing a willingness to grow their business through both debt and equity. The share of corporate profits in national income, which fell to dismal levels in the 1970s, recovered during the 1980s; it has sustained these higher levels in the 1990s The banks were significant contributors to the 'bubble', and they suffered heavy losses when it burst. Generally speaking, however, banks in Australia adjusted quickly to this turn of events; in contrast to some other countries, their adjustment was assisted by an early and sustained recovery in economic activity from mid 1991. Banks in Australia have returned an average of 16 per cent on shareholders' funds in the past two years, and bad loans have declined from a peak of 6 per cent of total assets in early 1992 to around 1 per cent at present; the average capital ratio for all banks in Australia is currently about 11 per cent, which is comfortably above the BIS minimum of 8 per cent. Australia's 'bubble' experience was not unique, as this audience knows only too well. That episode, however, is now well and truly behind us, although bankers, borrowers and supervisory authorities are all likely to remember its lessons for a long time to come. In the meantime, the current sound financial structure of Australian corporates, including banks, is another reason for expecting solid investment and economic growth to continue in the years ahead. The Australian labour market has undergone a good deal of change over the past decade. In the eyes of some people, deregulation of the labour market has lagged far behind that in the product and financial markets. Perhaps it has, but advocates of rapid labour market reforms sometimes overlook the point that people have to be handled with more sensitivity than chattels or financial 'products' if changes are to endure. The Accord - or incomes policy - agreed jointly by the previous Government and the trade union movement in the early 1980s initially involved a centralised wage fixing system. This system generated uniform wage rises across the economy which, at the time, were consistent with strong growth in employment and a decline in inflation. The same discipline also helped to restore the corporate profit share mentioned earlier. Over time, wage setting moved gradually from this centralised system to a less rigid, more decentralised model of enterprise agreements, and the Accord process evolved to permit these changes to occur in an orderly way. Today, formal enterprise agreements negotiated by employees and managements of individual enterprises determine wage outcomes for about one-third of the workforce. Another third of employees has its wages regulated by industrial awards, while the remaining third (which includes executives) generally relies on individual contracts. The Accord framework ceased to exist with the change of Government in March this year. The new Government is proposing to amend the industrial relations legislation in ways which will increase the scope for employers and employees of individual enterprises to bargain their wage and other conditions, and reduce certain legal protections currently afforded to the unions. To the extent that these amendments, when implemented, help to better align wage increases with productivity increases, they will improve the prospects for sustained growth and low inflation. Whatever the impact of these legislative changes, however, the on-going effects of the more fundamental changes mentioned earlier - and particularly the growing exposure of Australian producers to international competition in both domestic and export markets - will remain. Employers and employees who attempt to ignore these seemingly irreversible changes are likely to suffer heavy penalties in terms of squeezes on profits and jobs, and lost opportunities for both. I think that most of the parties involved are coming to understand this fundamental point. Industrial disputes have declined markedly during the past decade, notwithstanding the considerable workplace dislocation associated with many structural changes. Over the decade since 1986, an average of 170 working days a year were lost per 1,000 employees in Australia; this is 60 per cent fewer than the average of 440 days a year lost in the previous decade. In recent years, days lost through strike action have been at historical lows, and Australia has been roughly in the middle of the pack of OECD countries on this measure. Trade union membership is now down to 35 per cent of the workforce in Australia - compared with 45 per cent ten years ago - but the process of structural change will still need to be managed sensitively if the downward trend in industrial action is to continue. Another major change has been Australia's return to the ranks of low inflation countries. As noted earlier, inflation in Australia has averaged 2 per cent in the past five years; this compares with an average of 8 per cent in the 1980s. Higher levels of productivity growth are helping the economy to grow more quickly than in the past without setting off inflation alarms. The prospect of sustained lower inflation has also been strengthened by certain institutional changes, most notably the Reserve Bank's explicit commitment to keep inflation under control - a commitment which has been endorsed by current and past governments. The commitment is expressed in terms of a target to hold underlying inflation to 2-3 per cent a year, on average, over the course of the business cycle. We see several advantages in formulating our inflation target in these terms. To begin with, 2 to 3 per cent represents about as low a rate of inflation as any country is likely to be able to achieve over a sustained period of reasonable economic growth. It is worth repeating that Australia has met this inflation target over the past five years while achieving relatively strong economic growth; this is in contrast to the experience in several other countries where low inflation in recent years has coincided with very slack economic conditions. A second advantage is that, our formulation helps to achieve a reasonable balance between the Reserve Bank's twin objectives of low inflation and sustained growth. It does this because it recognises that inflation has a cyclical component which will tend to rise as growth strengthens, and to fall as growth slackens; in our view, any attempt to eliminate these cyclical movements in inflation would involve unwarranted losses in production and employment. Finally, our formulation avoids conveying the impression - as a narrow, 'hard-edged' target might - that inflation can be contained within bounds which, realistically, central banks cannot achieve if they are also to support growth in activity and employment. In each of the areas I have mentioned so far, good progress has been achieved over the past decade. One area where we have not done so well - indeed, where we have gone backwards - is our national saving performance. As a nation, we simply have not been saving enough to fund all the investment we have been undertaking. As a result, our reliance on foreign saving has been increasing. One manifestation of this has been the rise in Australia's current account deficit; this has averaged 4 per cent of GDP over the past 15 years, about double the average over the preceding 15 years. These figures do not imply that we are facing a debt or any other kind of 'crisis'. Far from it. The increased capital inflow - which comes with increased current account deficits - has actually supported a higher level of investment in Australia than would have been possible from domestic saving alone. Moreover, although the level of Australia's net external liabilities - that is, both debt and equity - has risen sharply over the past decade, it has tended to stabilise in recent years at levels around 60 per cent of GDP. Interest and dividend payments on these liabilities are currently equivalent to about 18 per cent of annual export earnings, well down on the peak of 26 per cent in 1989/90. There is, then, no impending 'crisis'. Rather, the problem is our vulnerability to possible adverse shifts in foreign sentiment about Australia which comes with such a heavy reliance on foreign investors to fill our saving gap. The best way to reduce that vulnerability, and avoid the potentially severe policy consequences which go with it, is to increase our national saving (rather than reduce national investment, which is the main source of improvements in productivity and living standards). Over time, as higher national saving comes to be reflected in lower average current account deficits, the risk premiums which Australian borrowers currently have to pay for funds would also tend to decline. For these reasons, the Reserve Bank and others have argued consistently that Australia must raise its national saving, through both private and public channels. This argument has been accepted by governments, and steps have been taken in recent years to gradually raise private saving through compulsory provisions for retirement, and public saving through reductions in the budget deficit. The main focus is on public saving, where most of the deterioration in national saving over the past 20 years has occurred. Last year, the Federal Government's underlying budget deficit was around 2 per cent of GDP; this is estimated to decline to around 1 per cent in the current year, and to be close to balance in two years' time. In addition, the present Government has committed itself to a fiscal strategy which seeks to balance out budget deficits and surpluses over the course of the business cycle - and thereby avoid any net increase in government debt over the course of the cycle. If it is realised, this budget strategy, in combination with the planned increases in compulsory retirement provisions, will go a long way towards reversing the deterioration in national saving which has been on-going since the 1970s. But it will take time. Turning to the short-term outlook, Australia is now into its sixth year of uninterrupted economic growth, and this phase is set to continue for some time yet. Interruptions to growth in Australia usually occur as a result of a slowdown in the world economy, or a severe shock to the domestic economy - such as a surge in spending or a blowout in wages - which threatens to bring on inflation or current account problems. No such threats are on the horizon at this time. Although some economies in Asia are coming off the boil, the indicators for most countries, and particularly the United States, are reasonably encouraging. Our domestic forecasts suggest that 1996/97 will be a year of reasonable growth in Australia, with inflation comfortably within the 2-3 per cent target and the current account deficit relatively subdued. The main key to achieving the 3 per cent GDP growth forecast for 1996/97 is business investment. This is estimated to grow by 14 per cent in real terms in 1996/97, after growing by 10 per cent last year, and by 17 per cent the year before. Consumer and government spending are both forecast to grow by about 3 per cent. The current account deficit is forecast to be 4 per cent of GDP, compared with 4.2 per cent last year. Unemployment, however, is forecast to decline only slightly from its current high rate of 8 per cent. Underlying inflation in the year to the recent June quarter was 3.1 per cent, slightly above our 2-3 per cent target. When the figure for the year to the September quarter is released next month, however, we expect it to be well within the 2-3 per cent band, and to remain there over the year ahead. It was this encouraging inflation outlook, together with the less promising outlook for unemployment, which prompted the Reserve Bank to reduce official overnight interest rates by half a percentage point (to 7 per cent) at the end of Unemployment aside, the official forecasts for 1996/97 look fairly comfortable, indicating as they do another year of per cent growth and 2-3 per cent inflation. At face value, they suggest little need for early monetary policy action. Like all forecasts, however, they are subject to many risks - in both directions. Policy makers understand these risks, which is why monetary policy remains under constant review; in their monitoring of economic developments, the Reserve Bank will be alert for any early signs that business investment or wages growth or unemployment, for example, might be diverging significantly from the current forecasts. I will end with a few comments on some developments in financial markets. Here too, major changes are evident - partly as a result of changes in the domestic economy, and partly reflecting international developments. Over the ten years from September 1986 to yields on 10-year Australian bonds have declined from about 14 per cent to about 8 per cent; short-term interest rates have declined from around 18 per cent to 7 per cent; and the Australian dollar has moved from being worth around US62 cents and 99 yen ten years ago, to around US79 cents and 86 yen today. The much lower interest rates in Australia today reflect mainly the dramatic reduction in inflation which has occurred over the decade, and widespread expectations that low inflation has been locked in. This has reduced the inflation premium built into domestic interest rates, especially at the longer end, and allowed nominal rates to fall. The exchange rate of the Australian dollar, in trade weighted index (TWI) terms, has fluctuated in quite a wide range over the decade, usually in response to fluctuations in commodity prices. A country like Australia has to expect considerable fluctuations in its exchange rate, notwithstanding the gradual decline in the share of commodities in total exports. Significantly, these fluctuations over the past decade have been around a flat trend rebounded strongly over the past year, the current TWI rate of about 58 is only 3 per cent With inflation at low levels, the budget moving towards balance, substantial structural change achieved and the prospect of more to come, the Australian dollar exchange rate today looks to be more solidly based than it did a decade ago. It will - and should - continue to respond to 'fundamental' factors, including cyclical changes in commodity prices and interest rate differentials, but it can also be expected to be more stable in the face of other pressures than it was ten years ago. Over the past decade, Japanese holders of Australian bonds were amply rewarded for the perceived risks they incurred. As well as receiving high coupon income, they benefited from the capital gains flowing from the large fall in long-term yields in Australia, which more than offset the effects of the Australian dollar's depreciation against the yen. In yen terms, Japanese investors in long-term Australian government bonds would have earned 12.8 per cent per annum over the past ten years, compared with 7.1 per cent on comparable Japanese bonds. That is, after allowing for changes in the exchange rate, a large additional return would have been earned on Australian bonds. The ten-year period of this comparison was particularly favourable for Japanese investors in Australian bonds, but Japanese investors would have earned some additional returns on Australian bonds purchased in all but two of the past ten years. Against the yen, the Australian dollar has depreciated over the past decade, but so have most major currencies. In fact, the performance of the Australian dollar against the yen over this period has not been significantly different from that of the German When I first addressed this Seminar in 1993, I offered the view that: '... the structure of the Australian economy is changing in ways which will create favourable investment opportunities for those prepared to see and seize them.' I believe that view remains relevant today. We have a very different economy in Australia today compared with a decade, or even five years, ago. In particular, we have lower inflation and a medium-term policy framework to keep inflation low. This suggests that there will be further gains for those investors willing to show confidence in that framework. Of course, to the extent that sound policies are followed in Australia, we can expect the premium paid on borrowed funds to be rather lower over the years ahead. The progress being made in this regard is reflected in the narrowing of interest rate spreads shown in Table 2. The spread on 10-year bond yields relative to the United States, for example, has narrowed from around 250 basis points a year ago to around half that margin today.

r960925a_BOA

australia

macfarlane

I would like to start by congratulating the Economic Society for putting together this policy forum. They certainly have been evenhanded - one Central Bank Governor and one Secretary to the Treasury as speakers, a chairman who is a Secretary to the Treasury and a discussant who has been both a Central Bank Governor and a Secretary to the Treasury. I will not be able to get away with much in this company. Fortunately my aim is modest, and I do not want to introduce anything particularly new. Instead, I would like to look back over a subject that has been of great policy interest in Australia and elsewhere over the past decade. It is the issue of what is the optimal institutional structure for making monetary policy. What should be the respective roles of the Government and the central bank? This usually goes under the rubric of central bank independence, but it would be just as sensible to see it as a discussion of the optimal degree of delegation, including the circumstances in which the delegation could be withdrawn. Since the beginning of central banking, the relationship between the Bank and the Government of the day has been an issue, with central banks routinely having a degree of independence that made them unlike government departments and more like the judiciary. The motivation for this separation was to provide some discipline on governments, by putting temptation out of harm's reach. Initially, the objective was to remove the temptation that governments might fund expenditure from the central bank, ie by money creation. See Keynes (1913) and Coombs (1964) for earlier statements of the issue. Discussions of this subject were revived in Australia in the late 1980s, at about the same time as in a number of other countries. Almost from day one, however, it got caught up in politics, with one party putting a rather doctrinaire version of it straight into its platform, and the other party professing to see no value in it at all. This kept accusations of a lack of independence in the news, and it also made it difficult to have a calm and rational discussion of the subject. It made it particularly difficult for the Reserve Bank to play a constructive role in the debate. I have not participated publicly in this discussion until now, and I suppose it is a little ironic that my first contribution should come after most of the battle is over, and a reasonably bipartisan consensus has been established. However, this will not deter me, as I think there are still a few things that need to be said. One thing I am not going to do is to argue the pros and cons of independence. I have the luxury of being able to put that to one side, because in Australia both Government and Opposition now accept the degree of independence given in the . Incidentally, it is wrong to think that conservative parties favour central bank independence and labour or social democratic ones oppose it. In New Zealand, independence was introduced by the Labour Party, in France under a socialist administration, and in the United Kingdom the Labour Party is more disposed to it than the conservatives. All I have to do in this talk is to spell out what the situation in Australia was and now is, rather than argue for a new approach. only mentions monetary policy twice, and on each occasion it says that it is the responsibility of the Board of the Reserve Bank. More importantly, the Act does not give the Government any operational role in monetary policy decisions as is done in some other countries' central bank legislation. In the , for example, they are told that they have to follow Treasury directives, and in the old (ie , they were told that their job was 'to carry out the government's monetary policy'. In Australia, we were never in this situation; our Act always gave us a high degree of legislative independence. Of course, the Government always has the ultimate over-ride in extreme circumstances - that is how it should be. In our case, it can do this through Section 11(2) procedures, but these would be extremely politically costly and have never been used. Other countries also have an over-ride mechanism - for example, in the present New Zealand arrangements, the Government can exercise its over-ride by adjusting the inflation target if it feels that the monetary policy being pursued by the Reserve Bank of New Zealand is not appropriate. The important thing is the nature of the over-ride mechanism. If it is easy to use, concealed from view and used regularly, then little central bank independence exists; if it is transparent, politically costly and seldom used, then a high degree of independence exists. Although we are now getting recognised as a reasonably independent central bank, this is only a very recent phenomenon. My predecessor, Bernie Fraser, was constantly having to defend the Reserve Bank against the charge that it was subject to political interference. The following extract from a speech in 1993 gives the flavour: The question I want to address is why were we always on the back foot having to defend ourselves? Why were the charges of political interference so frequent until recently? And why was Australia regarded in international circles as a country whose central bank had little independence? There are a number of answers to these questions. The first concerns the interpretation of the Act. There was a widespread assumption that the Act gave the assumption arose because, for virtually 30 years after it was enacted in the 1950s, monetary policy was implemented as though the Reserve Bank had no independence. Decisions were taken mainly in Canberra, with the Treasurer and the Treasury usually having a bigger say in any decision than the politicians and journalists grew up with this and accepted it as the natural order of things; it was difficult for them to adjust quickly when things changed. How could this situation persist for so long if the Act clearly said that decisions on monetary policy should be made by the Reserve Bank? The answer to this riddle is that the Reserve Bank did not have the instruments of monetary policy at its disposal - before deregulation, they were nearly all in Canberra. If we go back to the late 1970s or early 1980s, the main way of implementing monetary policy was by influencing the way the budget deficit was financed, ie by the setting of interest rates on government securities. This was entirely in the hands of the Treasurer. Bank lending and deposit rates were also centrally determined, ostensibly by the Reserve Bank, but changes required prior approval by the Treasurer. The exchange rate was determined by a group of three (or at times four) officials, one of whom was the intent of monetary policy was contained in an M3 target; this was the Treasurer's target rather than the Bank's, and was announced in the Budget Speech. Major decisions on monetary policy were taken by the Monetary This state of affairs was regarded as normal, and to the best of my knowledge no-one criticised it on the grounds of lack of central bank independence. In the intellectual climate of the times, this was not an issue. It was only later in the late 1980s - by which time the Reserve Bank had gained a fair measure of independence - that this particular type of criticism started. This is not to say that we were not criticised for other reasons in earlier years; there was plenty of dissatisfaction with monetary policy, mainly on the grounds that it was doing too little to combat our high inflation. The big change for the Reserve Bank was financial deregulation. It swept away the interest rate controls, freed up the exchange rate and made it possible to finance the budget deficit fully at market-determined interest rates. This left open-market operations, which effectively determined short-term money market rates, as the only instrument of monetary policy. This was entirely in the hands of the Reserve Bank, which put us operationally in the same position as the US first time, the intentions of the Act and the capacity of the Reserve Bank were in accord. Most of the change occurred in the mid 1980s, with the last interest rate ceiling on banks not being removed until April 1986. It took time, however, for all parties to adjust fully to the new system, and it is not possible to point to an exact date when the Reserve Bank passed from being dependent to independent. In my view, it has clearly been independent in the 1990s, and a good case can be made to show that it was largely independent in the second half of the 1980s. The economic literature on central bank independence and its relation to inflation began to attract attention in the mid to late eighties. Basically, it showed that there was a significant negative correlation between a country's degree of independence and its rate of inflation (ie the more independent the central bank, the lower the rate of inflation). It also showed no correlation between a country's degree of independence and its rate of economic growth, so the improvement in inflation was not bought at the cost of lower growth. This literature put forward a relatively simple proposition, and proved persuasive to a wide range of economists and policy makers from across the political spectrum. One of the best summaries is contained in an article co-authored by Lawrence Summers, who is now Deputy Secretary of the Treasury in the Unfortunately for Australia, a lot of the literature on this subject quoted the earliest ranking of central bank independence those authors deserve great credit for starting (or reviving) the literature on this subject, their particular index of central bank independence is an eccentric one. For example, it rates the Bank of Japan as being as independent as the Federal Reserve Board, and it ranks the Bank of England over the Reserve Bank of Australia. Australia's low ranking on this index was widely quoted until more accurate indices became available. The perception was reinforced by a poor inflation performance relative to other countries in the 1980s. It is now recognised that the two most thorough and reliable guides are the GMT (1991) indices and the indices constructed by 1 below, and it can be seen that Australia is generally in the top half of the field. Of these two measures, the GMT aggregate index is probably the best, and now the most widely used. The GMT index also has the advantage of covering 18 OECD countries. Cukierman's questionnaire is hampered by lack of responses from a lot of OECD countries, and so has a high representation from developing countries. Of course, it should also be recognised that all these measures are just attempts to simplify a very complex structure into one number or ranking. They are all imperfect, which is shown by the fact that they are all different. They take no account of personalities or of other policies which may impact on monetary policy. Even so, if they are going to be quoted - and they frequently are - it is better for us if the most representative are used. Policy issued on 14 August at the time of my appointment was a means of clearing up any remaining ambiguity about the relationship between the Government and the Reserve Bank. In it, the Government stated its understanding of the high degree of independence given to the Reserve Bank in its Act and endorsed the Reserve Bank's inflation target of 2 to 3 per cent on average over the cycle. In one sense, this was the continuation of a direction that was becoming apparent under the previous Government and so shows the essentially bipartisan approach that now exists. The previous Treasurer had endorsed the inflation target and the Reserve Bank's independence, but not in a public document and not by formally relating it to the . As a result, it had received limited recognition. The Statement was well received in Australia, and we have received feedback that it was well received overseas, including by a couple of overseas central banks which showed considerable interest in it. While the Statement has been useful in achieving the objectives outlined above, it should also be seen as part of a more general trend towards establishing a framework for better economic policy. We are confident that the combination of central bank independence and an inflation target endorsed by the Government will help to improve Australia's medium-term economic performance on both inflation and long-term output growth. Similarly, on the fiscal policy side, the focus on the underlying deficit and the commitment to balance it over the cycle contained in the recent Budget will improve Australia's savings and growth performance in future years. They are two recent examples of the proposition that institutional change based on increased transparency is the best way to establish a framework for improved mediumterm economic performance. There are others that have occurred over recent years and which are now firmly established. One that I think is particularly important is the agreement between Treasury and the Reserve Bank on the separation of monetary and debt management policy whereby the Reserve Bank is responsible for monetary policy and Treasury for debt management policy (formerly responsibilities were blurred). Within debt management policy, the commitment is to fully fund the budget deficit by borrowing from the public at market Another example is the practice, introduced by the Bank in 1990, of announcing each change in monetary policy as it occurs and simultaneously documenting the reasons for the change. I am sure we have not yet come to the end of the process. The art of good government is to constantly review practices to see where improvements can be made. The guiding principles should be to design systems that make it clear what the medium-term goals are, to choose goals that can be communicated easily to the public and accepted as being reasonable, and to ensure that the system is transparent so that people can judge whether policy changes are consistent with the goals. , , , November.

r961120a_BOA

australia

macfarlane

I am pleased to be invited to speak to the in Asia. It is a topic to which we at the Reserve Bank of Australia and our colleagues in other central banks in the region have given a great deal of thought. As many of you may know, my predecessor, Bernie Fraser, was a keen advocate of co-operation between central banks in the region. So am I. A little over a year ago, he spoke on that topic, suggesting that the already good relationships between central banks in Asia provided a solid foundation for more substantial forms of co-operation in several areas. He suggested that the kinds of co-operation currently carried out by the eleven EMEAP countries could lead almost naturally to the idea of a purpose-built, Asian institution for central banks, akin to the Bank which I want to re-state today. That suggestion attracted a good deal of attention at the time, as a number of others had also been thinking about ways of furthering co-operation between central banks. In the ensuing period, interest in monetary co-operation in Asia has increased, including from some institutions outside the region. More importantly, within the central banking community, there have been further steps towards genuine co-operation over the past year. It is therefore timely to re-visit the general subject, to assess the progress made over the past year, and to offer one or two observations on possible future directions. In doing this, I will adopt a fairly general definition of 'monetary co-operation'. In particular, the areas where central banks are seeking to establish and further co-operation go well beyond monetary policy, important as that topic is. Monetary policy is primarily a domestic responsibility of central banks, aimed at domestic objectives, but international co-operation in several areas is an important adjunct to good monetary policy. This alone justifies a broad interpretation of the topic, but central banks also have another broad responsibility - namely financial stability, including in most cases supervision of banks and involvement in payments system issues. They are also participants in international markets, as part of the management of the international assets on their own balance sheets. All of these require an international perspective, and so co-operative relationships on several fronts are mutually beneficial. Because the topic is reasonably broad, the set of institutions which will have an interest in it also extends beyond central banks. So later I will also address the question of the appropriate relationship between the central banking forum and other groupings of various kinds. It is worth stating at the outset what such co-operation is not about. I don't think anyone is contemplating monetary integration and there is no talk of a co-ordinated monetary policy, or an 'Asian exchange rate mechanism', despite what some press reports have suggested. Similarly, any thought of a 'yen' bloc seems rather fanciful. There is far too much diversity in levels of economic development, economic structure and rates of growth for such an approach. Neither is central bank co-operation designed to provide a safety net for countries in need of structural adjustment for balance of payments purposes. To the best of our knowledge, none of the central bank participants in the present discussion has this idea in mind. No one envisages an aid or development institution or some sort of regional version of the IMF making loans for the purpose of facilitating structural adjustment. Such institutions already exist, both globally and regionally. Whatever their respective strengths and weaknesses, adding another institution to do similar work would not be a step forward. Even if such institutions did not already exist, it is not the function of central banks to make loans to other countries for which there is a risk that they would not be repaid. A decision to put a country's resources at risk in this way would need to be made by the elected Government. The institution we have in mind is more limited; it would confine itself to offering various services and assistance to central banks to pursue their own legitimate purposes. That may mean, on some occasions, providing international liquidity to central banks on a short-term collateralised basis, but its lending activities would not extend beyond that. Having established what Asian monetary co-operation does not mean, I should restate what I think is involved. The need for co-operation is driven by the fact that there are international policy externalities in a globalised, and increasingly liberalised, environment. Experience suggests that markets operating in a fairly free manner generally produce substantial benefits for the citizens over the long run. But it also demonstrates that a degree of oversight, and a capacity for policy makers to intervene in markets under certain conditions, are likely to be ingredients of a well-functioning system. In today's capital market, where flows are large and rapid, and in tomorrow's world where these tendencies may have increased further, there is an added dimension. Another country's policies, and its problems, can have repercussions in our own countries in more forceful ways than in the past. With the economic and financial growth in Asian countries likely to continue to outpace that of the world generally, more attention needs to be given to regional arrangements for co-operation. Central banks and other policy authorities are obviously vitally interested in these issues, though of course there is a major role for the private sector as well. The appropriate response to this situation is to develop co-operative arrangements between central banks at several levels. * At the most elementary, understanding each other's policies and priorities, and being able to learn from others' experiences. Of course there is much study of various aspects of this by academics, but it is important for central banking practitioners to invest in learning as well. An important part of this process simply involves building up a genuine rapport with our counterparts in other central banks, so that we can pick up the phone and communicate quickly and effectively when needed. * At a more formal level, there is the collection of information on market practices, regulation, supervisory standards and the like on a consistent basis. This also involves sharing timely information on current and prospective developments in economies, financial markets and capital flows, including forming views on policy initiatives coming from the major countries. In times of market instability, basing policy judgments on sound information is crucial. To be able to do that, we need in the more tranquil times to build the information framework and communication channels between authorities across borders. * Generally furthering the development of a sound financial infrastructure, in which we have a collective interest. This includes such things as improving the resilience of payments systems, and exploring the scope for harmonisation or at least co-ordination of policies on market regulation and bank supervision. In ten of the eleven EMEAP countries, the central bank is the bank supervisor, and there is clearly a lot of room to co-ordinate policies and make sure that regional views are heard in international fora such as the Basle Committee. It also involves developing specific mechanisms for co-operation in areas such as foreign exchange markets, in the interests of promoting monetary and financial stability. There is an increasing role, for example, for central banks assisting each other in certain official transactions - be they in the nature of foreign exchange intervention, or structural shifts in reserve holdings. * In an institutional setting, the possibility of providing services to central banks to assist in the management of official reserve assets, which in this region are large and, at present, growing quickly. We should first acknowledge that there has always been a co-operative spirit between many of the region's central banks particularly with respect to training and secondments. Having said that, however, there has been an appreciable lift over the past few years in the progress that has been made in building on existing relationships. One manifestation of this was the signing, at the instigation of the Hong Kong Monetary Authority, of a series of bilateral repurchase agreements in US dollar funds by a number of central banks. This took place last November. A number of further similar agreements have since been signed. The Reserve Bank of Australia, just as one example, now has agreements of this kind with and Japan. Another step toward co-operation was that the Bank of Japan, in conjunction with the Ministry of Finance of Japan, recently established agency arrangements with the Hong Kong to give Japan an enhanced capacity for foreign currency intervention in those markets. This initiative augmented a similar relationship which has existed with the Reserve Bank of Australia for some years. So there are several instances of heightened co-operation developing on a bilateral basis. Some good progress has also been made within the EMEAP forum. This group has been meeting at Deputy Governor level since 1990, but in 1996 it stepped up its activities. The first meeting of EMEAP members at Governor level took place in Tokyo in July, to consider a report of a group of officials convened to study scope for co-operation between central banks. An outcome of that meeting was the establishment of two working groups and a study group to look at issues of financial market development, central banking operations (including various possibilities for institutional development) and banking supervision, in an ongoing capacity. These groups began their work recently, and will report regularly to the meetings at Deputy Governor level, which will continue. The next meeting of Governors will take place next year in Shanghai. The EMEAP group is not, of course, the only forum in which central banks in the region deal with each other. There are several others, some of which have been in operation Zealand and Australia), which was established in the 1950s and has quite a broad membership, has primarily a training function. which also has a distinguished history, fulfils a similar role for its members, with the added advantages of having a permanent headquarters and secretariat in Kuala Lumpur and regular meetings of Governors. All of these have their role to play. The EMEAP forum, however, is the only one which was established specifically to foster high-level engagement between central banks on policy issues at the regional level. It has a fairly wide representation, but is still a manageable group. We in Australia see it as the most promising base for further regional co-operation between central banks, although we understand that individual countries will give high priority to other institutions and bilateral arrangements. Although useful progress has been made, a good deal more work needs to be done in transforming the notion of co-operation into further concrete initiatives. I expect that the EMEAP working groups will make some recommendations over the next year or two. I do not want to pre-empt their findings. I should make it clear, however, that the Reserve Bank of Australia's view remains that there is scope for the development, in time, of a regional institution owned by central banks - an Asian BIS. Such an institution would exist to assist central banks in the conduct of their responsibilities through providing services, a forum for discussion, research and analysis, a point of co-ordination for co-operative efforts in market transactions when needed, an avenue for the management of reserve assets, and a regional voice in dealing with the other major regions on central banking matters including bank supervision. This is not the appropriate forum or time in which to spell out the fine details of such an undertaking. There are a couple of important questions, however, on which I would like to touch. The first is the relationship between an Asian BIS, in whatever form it might one day take, and other important international groupings or institutions. This relationship should be a constructive one. Certainly, the existing international institutions should not see the recent central bank initiatives in Asia as a threat. On the contrary, they should welcome and encourage them. Better international monetary arrangements in Asia will benefit the countries concerned, but that is not all. As the region's economies continue to grow in size, and as financial systems develop and mobilise the considerable flows of savings in the region, good monetary and financial infrastructure will make a tangible contribution to global stability in years to come. The question is how to construct and maintain that infrastructure. The present course seems to offer a good chance of producing the sorts of benefits we are looking for. It would be a mistake, I think, to see the EMEAP forum and a possible Asian BIS at some future time, as competing with existing international institutions, particularly the Basle BIS. The two entities should be complements , not competitors. The BIS is a valuable institution, which provides very useful financial services for central banks and a forum for the resolution of problems common to central banks. It has a lot to offer central banks from this part of the world. The BIS's structure, however, including the structure of its share registry, virtually guarantees that it will always be dominated by the original shareholder countries, with a heavy European focus. That means, I think, that a regional institution in Asia, which could claim to represent the central banks of countries in this part of the world, would have something to offer the BIS, and in turn, the BIS could probably offer a great deal of assistance. So I think there is scope for a constructive relationship between central banks in Asia and the BIS on the question of prospective central banking arrangements. There is also the question of the relationship between the central banking forum for Asian co-operation and other groupings of economic agencies and departments of government. co-operation generally encompasses a much wider range of issues than those which are the core responsibilities of central banks alone. In the financial and monetary field, Treasuries and Ministries of Finance naturally have important interests and responsibilities and some areas of economic co-operation involve foreign policy as well. As a result there are a number of international groupings with wider membership than just central banks. These various groupings will tend to overlap, and each will perhaps want to pay close attention to what the others are doing. But each has its place. This is a parallel to the domestic scene in most countries, where and Ministers all have their own role to play, and where it is important for good policy making to develop and maintain professional and productive working relationships. There is also an important international parallel, where the BIS is the institution at which Governors of central banks of major countries and Treasury Ministers plus central bank Governors meet. Again, the objective should be constructive complementarity, not bureaucratic territorialism. Asian monetary and financial co-operation is gradually developing. It is a common-sense response to the changing circumstances in which countries in this time zone find themselves. Some useful progress has been made. But the process can deliver considerably more, if pursued persistently and sensibly. Initiatives in this area are not intended to threaten in any way existing international arrangements or institutions. Indeed the fact that the central banks concerned have got together with the aim of developing mechanisms which will help in fostering financial and economic stability in the region should be welcomed by other bodies. The central banks will be seeking opportunities to work co-operatively, with the BIS, and with other regional groups. We at the Reserve Bank of Australia look forward to continuing to work with our colleagues in central banks and other institutions in pursuit of the goals of macroeconomic stability and prosperity.

r961128a_BOA

australia

macfarlane

This is not the first time I have addressed CEDA, but it is the first time as Governor. In my new role, I am expected to say something of significance on monetary policy and I hope I will not let you down. On the other hand, my comments are meant to apply to the medium term, and there may be some disappointment to those who are expecting pointers on which way interest rates or the exchange rate will move over the next month. In line with my medium-term emphasis, my starting point is to focus on the current expansion which has been going on for more than five years, ie from the middle of 1991. Most other OECD countries have also been undergoing some sort of expansion over this five-year period, although some of them had a later start. When we compare ourselves with the OECD group during this period, we have recorded a rate of inflation below the OECD average, and yet this has not been at the cost of feeble growth. Along with New Zealand, Australia has grown twice as fast as the OECD average. Of course, we could always have done better but, over this period, most OECD countries would prefer to have had our economic performance than their own. There is some evidence that we are now getting recognised internationally for our improved economic performance, but I am not sure whether there is as much domestic recognition of this change. We often hear of popular dissatisfaction with the state of the economy, summarised by such terms as 'joyless recovery' or 'glum prosperity'. One important reason for this is a feeling that there has been too much economic change, and hence an increased feeling of insecurity. The two main factors here, of course, are globalisation and technological change. The other reason for the disappointment in the recovery is to be found in the third column of Table 1, which shows the unemployment rate. It came down quite quickly for a time, from over 11 per cent, but after five years of growth, it is disappointing that it has not fallen further. It is little consolation to most people that our productivity performance in this upswing has been better than on previous occasions, and better than in other countries during this upswing. What do we need to do to improve our with the unemployment rate at 8.8 per cent and the inflation rate at 2.4 per cent, we would all have to agree that it is the former which is in the greater need of improvement. While we all agree on this point, there is less agreement on what has to be done to bring about an improvement. Unfortunately, there is no panacea - the answer will not be found in any single breakthrough of policy or institutional reform. Every policy and every practice should be reviewed to see whether it is contributing to or inhibiting the growth of employment. Are we putting unnecessary obstacles in the path of investment in new industries? Are our industrial relations practices more concerned with protecting the rights of people in jobs than creating new jobs? Are our welfare and retirement incomes policies encouraging people to seek work or to avoid it? Are the wage bargains that are being struck encouraging firms to put on more labour or to shed it? Is our education system turning out people with skills that make them Naturally, if we are to examine all these policies and practices, it is only right that we should look at monetary policy. As you know, the focus of our monetary policy is an inflation target, which is fully endorsed by the Government. This essentially says that monetary policy should be conducted so that, in the medium run, inflation will average Average annual growth since June 1991 around 2 per cent per annum. Some people have interpreted an inflation target to mean that monetary policy is only worried about inflation, and that it is therefore anti-growth. But this is not the case, as is demonstrated by the results of the past five years - where growth has been substantial while inflation has been low. The other way of expressing an inflation target is to say that monetary policy is set in a way which lets the economy grow as fast as possible without breaking the inflation objective, but no faster. The design of our inflation target gives us the flexibility to put this into practice. Our target recognises that there will still be a business cycle and that, in the fastest growing phase, there will be a tendency for inflation to exceed our medium-term objective and, at some other times, to fall below it. We do not seek to keep within a narrow target band on a period-by-period basis. It also recognises that, in the event of a large shock, it is sensible to bring inflation back on track over time, rather than by some 'cold turkey' measures. The settings of monetary policy in recent years have been consistent with low inflation on average and a good rate of economic growth. Even so, some might argue for an easier monetary policy - effectively saying 'why not ease monetary policy as much as is necessary to encourage faster growth, even if it pushes up inflation?' The problem with this approach is that it does not work. Faster growth may be achieved for a short period and there may be some short-term fall in unemployment, but in the medium term we end up with higher inflation and higher unemployment. This prescription has been tried before in country after country and it has failed. There is no long-term trade-off between inflation and unemployment. You cannot buy a better unemployment performance by accepting a worse inflation one. The unemployment rate would be no lower over the business cycle if we average 5 per cent inflation than if we average per cent inflation. Fortunately, this critical point is becoming increasingly accepted. Averaging a low inflation rate does not inhibit growth or employment. What does the serious damage to growth and employment is when inflation rises to unacceptable levels and the economy has to be squeezed to reduce it. All OECD countries have the experience of three recessions in the past three decades to remind them of this. It therefore follows that the most useful thing monetary policy can do in the long run for employment is to encourage sustainable low inflation expansions. I am not so optimistic to think that we can do away with the business cycle completely, but with good management, we should be able to delay and reduce the severity of any future contractionary phase by ensuring that inflation remains low. As well as explaining our monetary policy framework, we have to ask ourselves whether policy could be conducted better within that framework. We have to make sure that we do not become too risk-averse and impose too restrictive a speed limit. This would be the case, for example, if we failed to take into account factors which were holding prices down, while at the same time opening up possibilities for faster growth. There certainly are many such factors - the reduction in tariffs, for example, and other aspects of globalisation in goods and capital markets; domestic factors which have increased the degree of competition in some industries; and technological changes which are producing bigger productivity improvements than in earlier periods. We recognise that these factors have played a role in our improved inflation performance over recent years and we have taken them into account in setting policy. They are making the job of conducting monetary policy easier, but they are not causing us to 'over-achieve' on inflation. There are also a number of residual attitudes which are making it more difficult, some of which will be covered in the next section. The theme of my first speech as Deputy Governor in May 1992 was that low inflation was here to stay - it was not just a temporary cyclical phenomenon. I am still preaching this sermon and, with five years of low inflation under our belt, plus a world that is in much the same position, a lot of people have come to share the view and have acted on it. This has led to some very useful outcomes. Businesses have become more concerned with productivity, cost control and efficiency. Planning horizons and contracts have lengthened. The best example of this is the rebirth of fixed interest mortgages where the interest rate is locked in for up to five years. Wage bargains also have longer time horizons, with two and three-year contracts not uncommon. As well as providing more certainty in enabling people to plan, there have also been cost savings. As the rest of the world has come to see Australia as a low inflation country, we are able to borrow on international capital markets more cheaply. Ten years ago, yields on Australian dollar bonds were 6 percentage points higher than yields on US dollar bonds; the gap has now narrowed to less than have not been confined to business or government borrowers; mortgage interest rates are as low as they have been for a generation. Our new found credibility in international capital markets has other policy implications. The popularity of Australian dollar investments (along with New Zealand dollar, Canadian dollar and pound sterling) has lifted our exchange rate appreciably at a time of subdued commodity prices. The principal source of this inflow of funds has been the Japanese household investor who has sought alternatives to the near-zero returns on offer in Japan. While the higher currency has been helpful from an inflation perspective, it has put pressure on our export industries and those competing with imports. The pressure will be particularly felt in those industries which have let their domestic cost structure move up too fast. There are a number of areas where the adjustment to low inflation is not proceeding as smoothly as we would like. The one I will talk about tonight is wage bargaining. I suppose this is not surprising, as over the past five years or so we have been moving from a centralised wage fixing system to an increasingly decentralised one. While this is essential to provide the flexibility for Australia to survive in an increasingly competitive world, there clearly have been some transitional difficulties. The difficulties first became apparent in the second half of 1994 when some enterprise bargains produced outcomes for wage increases which were much higher than likely inflation and overall productivity gains. There have been other instances since, and we have spent a lot of time trying to analyse what is happening. It should also be pointed out that there appear to have been a lot of very sensible enterprise bargains and, in addition, there is a large part of the workforce that has received only small wage increases because they have not been part of the enterprise bargaining process. As a result, average wages across the whole economy have not grown at an excessive rate over the past 12 months; they have, in fact, slowed down from growth of over 5 per cent in mid 1995 to about 3 per cent at present. This was, of course, a very important reason why it was possible to ease monetary policy twice in the last six months. The tensions in the wage enterprise bargaining area remain, however, and cloud the outlook for inflation, but more particularly for unemployment. This is best illustrated by developments in the metals industry. Over the past two years, enterprise bargains in this sector have yielded an average increase in wages of over 5 per cent per annum. This looks high relative to a general inflation rate of 2.5 per cent, and even higher compared with the increase in prices in the metals industry, which have been only around per cent per annum. The latter figure suggests that the metals industry as a whole is very competitive and open, and metals manufacturers have virtually no pricing power. They are caught in a wage-price squeeze with potentially debilitating effects - profits in the metals industry were 30 per cent lower in the first three quarters of 1996 than a year earlier. Note that in this sector the high wage increases have not contributed, so far at least, to increased inflation in Australia at all, as is evident by the per cent per annum increase in output prices. The effects, instead, have shown up as flat output and falling employment. In those parts of Australian industry which are open to international forces or where domestic competition is intense, excessive wage bargains are less of a worry because of their inflationary impact than because of the increased unemployment they cause. This is not the whole of the story. In other sectors where the economy is still relatively closed, excessive wage increases will be potentially inflationary. This makes it difficult for monetary policy. We do not know the extent to which excessively high wage settlements will spread to other parts of the economy, particularly if executive pay sets a bad example, as seems to be the case at present. We also do not know the extent to which wages are pushing up unemployment or being passed into higher prices to consumers. To some extent an increase in wage dispersion might be seen as part of the normal adjustment to a less centralised labour market. But, to the extent that the leading increases serve as pace-setters for the economy as a whole, they will have an adverse impact on macroeconomic performance. I would like to end by saying a few words about the 'Living Wage' claim currently before individual wage outcomes which the labour market is delivering will, in general, take account of inflation, productivity growth in the enterprise or industry in question, and the bargaining position of workers. We would not, as a result, expect to see all wages increasing at the same rate, and dispersion of wages would probably increase. This is an implication of the decision by the previous and present Governments to move to a decentralised wage fixing system after so many decades of a centralised one. We have an interest in this subject because, in the present environment, it is difficult to distinguish wage dispersion from the outlook for average wage growth. In one sense, a wider dispersion can be helpful for the smooth running of the economy in that it may well create more opportunities for people with differing skills and experience to find a job. But a significantly wider dispersion may set up tensions and pressures for 'catch up', then 'leap frogging' which can be the driving force of continuing inflation. So finding the right balance in the dispersion of wages is important. Under present institutional arrangements, the Industrial Relations Commission has a role in deciding whether, and by how much, it should boost wages for those not covered by enterprise agreements. In doing so, it will have to balance its equity objectives against the impact of these actions on efficiency. Boosting wages at the lower end of the distribution would have two effects - it would raise the overall wage increase, and compress wage dispersion. Neither effect will be helpful for employment growth, especially for those with low skills or little work experience. Some of the least skilled will be priced out of a job, although the size of this effect is difficult to determine. The community may well, however, wish to see some support provided for the weakest bargaining groups. While there are other policy instruments for achieving equity objectives, such alternative channels also have their efficiency costs. So intervention to nudge up minimum wages is probably a reasonable expression of community preferences. As an example of this, the 'safety net' pursued in recent years has been compatible with low inflation. Continuation of such 'safety net' adjustments, as proposed by the Government, seems sensible to us. But if the interventions are more wide-ranging, the outcome will be slower employment growth - either because individual employers respond to the price/wage squeeze facing them, or because the Bank is forced to respond to emerging inflationary pressures by raising interest rates. Such an economy-wide macro response may seem unsatisfactory, particularly if the wages claims are seeking to re-establish longstanding wage relativities. But the alternative - to allow these incipient inflationary pressures to be transformed into higher actual inflation - is hardly beneficial to the industrially weak. It would simply erode the apparent gains made by workers at the bargaining table and in the Commission, and set the scene for further rounds of wage increases. With the painful experience of reducing inflation still fresh in our minds, we see nothing to be gained - and much to be lost - in accommodating inflationary pressures. In time, the various players in the economy will adjust to the low inflation environment and the decentralised wage fixing system, and I feel confident that we will find, on balance, the changes are worthwhile. But new systems require new skills, and there is still a lot of learning to be done. One requirement is that senior management will have to play a much bigger role in wage bargaining than in the past. In the new world, wages will vary from firm to firm; competitive advantage will not just be a function of which firm has the best marketing, production or finance team, but which one is best at enterprise bargaining. In the new world, wage claims will also bear a closer resemblance to what used to be termed 'capacity to pay'. Wage claims - even ambit claims - of 7 per cent per annum in industries with flat output and pricing prospects will not be treated seriously. Unions which pursue them will increasingly face the questioning of members who recognise that higher wages cost jobs - perhaps their own. All this has concentrated on the linkage from wages to prices. But history tells us that this is a two-way relationship, with wages also responding to inflation, rather than causing it. I want to register with you that I understand that linkage, and understand that if workers make wage deals on the basis of low inflation, then we need to deliver that. The best contribution that monetary policy can make to safeguarding workers' real wages from erosion by inflation is to ensure that inflation stays low. You will sense, from what I have said today, that we take this commitment very seriously.

r970205a_BOA

australia

macfarlane

When Alan Cameron invited me to speak at a conference on electronic commerce I was rather reluctant at first because I am not an expert on the subject. However, when I thought about it a bit more, I realised that the subject was really part of the general story of innovation, and that it had some interesting parallels with financial innovation and electronic banking. Financial innovation is not new, although it proceeded very slowly until about 20 years ago. The pace is now quite rapid and is bound to get faster. This has worried a lot of people, and not just the old and suspicious - a lot of regulators around the world fear that somehow things may get out of control. I would not count myself among that group; I am fundamentally an optimist on this issue. In my experience, innovation has invariably benefited the users of financial services, although they do not always realise it at the time. I also have confidence that regulators - whether their interests centre on prudential supervision, consumer protection, competition policy, market conduct or the prevention of money laundering - will be sufficiently flexible to continue to do their job effectively, while at the same time allowing the benefits of innovation to flow through to consumers. Let me start by quickly reviewing some of the financial innovations of the past two decades. These innovations have benefited users in two ways. First by increasing competition among providers, and secondly by increasing the range and convenience of financial products. Among the first category the introduction of cash management trusts in 1980, which opened up the shortterm money market to the small investor for the first time. This gave them a better return, and forced conventional deposit takers competing for the same funds to match it; at the wholesale level, the development of the euro $A market in the mid 1980s opened an important new source of funding to Australian corporates. Again, business borrowers' choices were widened, and domestic banks had to respond by reducing margins; and more recently, the rapid growth of mortgage originators and the associated securitisation market has brought tangible benefits to both new and existing borrowers. Originators now account for around 10 per cent of new lending for housing and were mainly responsible for the recent fall in margins on banks' home loans. Interestingly, none of these examples was the result of a technological breakthrough; they were mainly the result of normal market forces, though technology has helped in their implementation. The second group of innovations are good examples of the application of technology to improve convenience for customers and reduce costs for suppliers: governments, most large companies and an increasing number of smaller organisations now make salary and many other routine payments directly to bank accounts using the direct entry system rather than cash or a cheque. Increasingly, many customers will authorise their banks to pay routine bills for gas, electricity, rates, school fees, etc using the same system; having got the money into our accounts electronically, most of us are getting it out again the same way through automatic available 24 hours a day, seven days a week. While there was initial resistance to dealing with machines, and some people still refuse to do so, the evidence seems to be that many people, particularly the young, prefer the machines to bankers. Indeed, the number of bank ATMs exceeded the number of bank branches in Australia for the first time last year; even more spectacular has been the growth of EFTPOS transactions, which since their introduction in the early 1990s have grown on average by almost 40 per cent each year and now match the number of ATM withdrawals. On the most recent figures available, which unfortunately only refer to 1994, Australia is the world's third highest user of EFTPOS per head (and a long way ahead of the United States, for example); and telephone and PC banking have only recently begun to take hold in a significant way but, together with the complementary services of mobile lenders with their laptops and modems, are already making access to financial services more convenient. This brings me to electronic commerce itself, but as others have remarked, it is difficult to know exactly where to draw the boundary that separates electronic commerce from conventional commerce. Just like the man who was pleasantly surprised to discover that he had been writing prose all his life, I have been pleasantly surprised to realise that the financial markets in which I have participated are in the general area known as electronic commerce. I refer here to the decentralised markets such as the foreign exchange market and the bond market with their screen-based trading systems and their associated electronic settlement and registry systems. I do not wish to say much about those today because they were already 'electronic' a decade ago and I cannot see them posing major new challenges. Instead I would like to concentrate on the aspect of electronic commerce which has generated the most recent interest - namely, the potential of the Internet to revolutionise the way we shop - how we compare prices, how services are delivered and, at the end of the chain, how we pay for what we have bought. In many respects, the Internet is a more efficient way of doing what some of us have been doing in a less sophisticated way for many years. For instance, one of my colleagues buys all his shirts from a US mail order catalogue and pays for them by signing a credit card authorisation with each order. I have been buying books from a Connecticut bookshop for a number of years, simply by sending a fax with details of the books and my credit card number. If I did not do this, I might have to wait for up to a year before the book was released in Australia because of our peculiar copyright agreements with British publishers. From the RBA's point of view, the most interesting aspect of electronic commerce is the last phase, namely payment. At present, most Internet sales are paid for using a credit card, mostly off-line with confirmation by telephone or fax. Some people are prepared to send details on-line over the Internet, but the experts do not recommend it until new security standards are in place. That will not be too far off, but even then, payments will still be made using an instrument of the 1970s - the credit card. Although the means for transmitting the authorisation will be different on the Internet, the basics will be much the same as when Bankcard was first introduced in Australia in 1974. But in time that will probably change. The credit card is unlikely to be cost-effective for many of the micro-payments that will be needed to realise the Internet's potential to deliver small, targeted pieces of information, such as a newspaper article, a piece of music, a picture, a map or a page of a guidebook for which vendors will want to charge perhaps only 50 cents or a few dollars. These sorts of developments will almost certainly require the use of a payments technology specifically designed for the Internet. This technology - often referred to as electronic tokens or cybercash - is only at the embryonic stage at present, but it will probably develop further. In fact, some commentators predict that this will grow in size and eventually become a sort of 'shadow' or 'alternative' payments system, with large implications for existing providers and regulators. I am sceptical about these wider claims. I have no trouble in seeing a time when a lot of people communicate with their banks through the Internet, but I have more trouble in seeing the large-scale development of cybercash as a payment medium to rival conventional cash or bank deposits. The reasons that I think cybercash will only remain a niche player are: the amounts individuals want to hold on tokens and cards will probably be small, both individually and in aggregate. Even though security will no doubt be greatly improved, customers will probably retain nagging doubts about some hacker emptying their accounts. Balances are also unlikely to earn interest, and it will be easy to keep them low but replenish them from a conventional bank account when necessary; and although some holders will be prepared to hold small claims on issuers who are not banks or other supervised financial institutions, there will probably be some reluctance to risk large amounts with companies that do not have a reputation for financial strength. If some new supplier seemed likely to attract a lot of funds, banks and other existing suppliers could retaliate. Technology could easily be imitated, and tokens and cards issued by banks and other supervised institutions would probably have an advantage in the eyes of the public. This has been well recognised by the developers of schemes such as DigiCash and Mondex who, in Australia at least, are providing their systems in conjunction with banks who will be the issuers of tokens and cards. Nevertheless, things are changing quickly, and it is not inconceivable that a software house or telecommunications company or some other organisation could become an issuer in a major way. In that event, the question would have to be asked whether they were accepting deposits and thus a candidate for a banking licence and supervision? There are obviously huge commercial challenges for corporations, bankers and other financial service suppliers. Many businesses have already recognised that they will have to provide Internet access to their customers, and some firms have already shown that it is possible to have no physical presence in a market, and conduct all their business electronically. But for most, an Internet presence will probably be a complement to their conventional marketing, not a substitute. Just as the number of firms without faxes, computers, mobile phones and credit and debit card facilities is shrinking quickly, so too will those without Internet access and Web sites. For banks, the first step will be to provide Internet access to existing accounts. That is already happening. Customers will soon also expect them to provide additional direct payment facilities for items purchased on the Internet. Those same customers will not be satisfied for long with having to use separate arrangements for payments after they have logged off from their Internet session with a supplier. Security has been an impediment to this so far, but it seems likely that this obstacle will soon be overcome. Firms and their banks will need to respond vigorously to these opportunities. Being left behind will be costly. In the process, there will be much jostling for position and 'ownership' of customers, particularly from software houses and telecommunications companies who will be interposing themselves between customers, businesses and the banks who provide payment facilities. There will certainly be major competitive challenges for all those directly involved, but what about risk? Will electronic commerce increase the riskiness of the financial system? For those whose responsibilities are to protect consumers, to prevent tax evasion or other forms of money laundering or to avoid invasions of privacy, the move to electronic commerce may present them with huge challenges, to which I know they are responding. I cannot comment with any authority on those areas. The only area where I can make a contribution is on whether it will affect the stability of the financial system, that is will it present prudential challenges? My judgment is that there is little reason to fear such a development. I have already explained why I think cybercash, although a useful addition to existing payments instruments, will probably not become a major repository of household or business savings. In essence, there will always be doubts about its susceptibility to loss, fraud or financial failure, so it will be suitable for day-to-day transactions, but not as a place to hold wealth. It bears a striking resemblance to that other much heralded innovation - the stored-value card. And both these innovations are modern versions of the travellers' cheque (first introduced in 1891). They all serve (or will serve) useful purposes, but from a prudential perspective they pose little challenge. If one of the issuers cannot meet its obligations, there may well be inconvenience and possibly distress for individual customers, but the problem is unlikely to be of systemic proportions. It, therefore, does not warrant central bank prudential oversight, although I am sure those responsible for consumer protection will take a much keener interest. In short, I do not see a structural break that causes me alarm. But there is evidence of pressures at the margin that the RBA will be watching carefully. Just as there will be winners and losers in electronic commerce and some firms will do much better than others, so it will be in the complementary services provided by banks. Competition for payment business will get tougher and some banks will find their margins squeezed more than others. Their profits will be more fragile and their balance sheets a little weaker. But this is an inevitable consequence of a competitive marketplace, and one that is worth accepting in order to receive the benefits that competition has to offer. In closing, let me emphasise that we at the Reserve Bank are very encouraged by the developments you are discussing. We welcome technology and innovation in commerce and banking. Technology and innovation have been the life blood of the financial sector over the past few decades. Those injections of new life have not always been smooth or orderly in the past, and we can expect more major changes in the future. But the benefits have clearly outweighed the costs to date and we see no reason why they should not continue to do so in the future.

r970211a_BOA

australia

macfarlane

It is a great pleasure to be speaking at The Sydney Institute, which has done so much over recent years to keep alive informed discussion of public affairs and the arts. In keeping with this tradition, I have chosen to speak on a subject with an historical, economic and political theme. I would like to look back at the 50s and 60s, and evaluate some of the lessons that people take from this period. The further my professional life proceeds, the more value I see in a good knowledge of economic history, even if it is so recent that most of us have lived and worked through it. As you will gather, my views on history are much closer There can be no quibble with the proposition that macro-economic performance in the immediate post-war period, which for present purposes I will refer to as the 50s and 60s, was far superior to any period before or after. This has led a lot of people to use it as a basis for proposing economic policies for today. They look back at how things were done in the 50s and 60s, and say 'if only we did it the same way today, our macro-economic performance would be as good as it was then'. This approach has some merit but, if we are to use it, it is very important that we get our facts straight about what the policies actually were in the 50s and 60s. There are two propositions of policy relevance that are frequently made about this period. The first one is that the macroeconomic success at that time was due to the use of activist and expansionary fiscal and monetary policies. The second is that the world economy was moving along very smoothly in the post-war period, with everything under control, until hit by the external shock of the OPEC-induced oil price rise in late 1973 (and again in 1979). I would like to analyse these two propositions with particular reference to Australia, but in doing so it will be necessary to bring in a lot of international economic and political events, particularly those occurring in the It is not necessary to spend much time demonstrating how successful this period was in terms of macro-economic performance because no-one disputes it. Table 1 shows that the real growth rate for the world economy was more than twice as high in the 1950-1973 period than in the previous 80 years. In Australia there was also a major improvement, although less than a doubling. Inflation, which had been negligible on average until the Second World War, rose to about 4 per cent in the 1950-1973 period, with the average being pushed up by the Korean War period and the early 70s. At other times it was a good deal lower, and even with these periods included, it was moderate enough to permit economic expansion for most of the period. Unemployment remained low throughout the period, although there was some cyclical movement at times. Overall, macro-economic performance was considerably better in this period than in any time before or since, which has prompted economic historians such as Maddison (1991) to refer to this period as There were a number of factors behind this impressive economic performance, but time and space limit me to mentioning only the main ones. The four most important, I believe, are as follows: * there was a big gap to be made up following The 50s and 60s were a period of postwar reconstruction or 'catch-up' for most countries. The largest growth pick-up occurred in the countries most devastated by the war, such as Germany, Italy, Japan and Austria, and the least pronounced (although still significant) was in the * although populations and governments were eager for economic growth, there was widespread restraint in economic behaviour. The privations endured during the Depression and the War meant that as incomes rose, a high proportion was saved. Inflationary expectations too had been conditioned by decades of nearly zero inflation, which showed up in modest pricing and wage setting behaviour for much of the period. Some commentators also stress the political cohesion among western countries as a result of the everpresent influence of the Cold War; * international trade was liberalised and exports and imports grew rapidly. This was a sharp contrast with the inter-war period. Maddison says 'perhaps the least controversial assertion one can make about the Golden Age is that it involved a remarkable revival of liberalism in international transactions. Trade and payment barriers erected in the 1930s and during the War were removed. The newstyle liberalism was buttressed by effective arrangements for regular consultation between western countries and for mutual * governments conducted good macroeconomic policies with a greater emphasis on economic growth than in previous decades. In a number of countries the newfound commitment to growth and low unemployment was enshrined in legislation. In others it was less formal, but in nearly every country the first decades after the Second World War were characterised by well-balanced and successful macro-economic policies. A more detailed examination of these macroeconomic policies, particularly in Australia, is the subject of my next section. and There is no doubt that the dominant principle behind macro-economic policy changed after the Second World War in line with Keynesian teaching, but the change occurred more quickly in some countries than others. The main change was that fiscal policy was to be used actively to promote economic growth by deliberately incurring budget deficits at times of weak economic activity. Fiscal policy and monetary policy together were termed demand management policy, and they were to be adjusted to smooth the business cycle, to increase growth and to achieve full employment. In Australia's case, this approach was enshrined in a document - This approach to policy was very successful in that it achieved its aims of high growth rates and low unemployment for several decades, and it did so with generally low rates of inflation. The achievement was all the greater, given that the 50s contained a major shock in the form of the Korean War commodity price boom. This high level of success has led many people to assume that policy must have been operated with a high degree of activism, ie by choosing very expansionary settings of policy. But this was not the case. For most of the period we are considering, demand management policy was quite restrained and, where necessary, restrictive. Certainly its guiding principle was Keynesian, but it was operated in a very balanced way and was, in any case, subject to an important constraint, which I will come to later. That this was the case should not be a surprise to people who remember the period. which nearly cost the Menzies Government office, have gone into folklore. Of course, there were also periods where policy was expansionary, but on average the result was relatively balanced. While growth was high, on average, there was also a business cycle operating during this period, with a couple of reasonably clearly defined recessions and booms. The fact that policy was well balanced can be shown for fiscal policy by a couple of graphs. Unfortunately, comparable data do not go back earlier than 1961/62, so we will have to lose the 50s from our comparisons. Graph 1 shows the best general measure of the underlying budget deficit. In the 12 years from 1961/62 to 1973/74 the budget was, on average, in surplus to the extent of per cent of GDP, and the fluctuations around the average were not very large. In the period since then, the budget has nearly always been in deficit, with an average deficit of nearly 2 per cent of GDP. You can see the three attempts made to bring it back towards surplus - the first one when Mr Howard was Treasurer, the second one under Mr Keating as Treasurer, and the third one which is being continued at the moment by Mr Costello. In summary, it is the more recent period that could be characterised as activist and expansionary in that there are bigger swings in the budgetary position and, on average, it tends to show a much bigger deficit. Another measure of fiscal activism is the size of government expenditure relative to the economy. It will come as no surprise to see that general government outlays relative to GDP were much lower in the 60s than they are now (Graph 2); in the earlier period they accounted for about 25 per cent of GDP, but over the last two decades they have averaged 34 per cent of GDP. The stance of monetary policy is more difficult to analyse because interest rates cannot be used as the measure of comparison. This is because before the early 1980s the financial system was heavily regulated, with the Government imposing interest rate ceilings on most forms of lending. Tightenings and easings in monetary policy showed up largely through credit rationing - the ease or difficulty in obtaining a loan at a given interest rate. This would be familiar to people who can remember the difficulty of obtaining a housing mortgage at that time. The best way of judging whether monetary policy was tight or loose in such a system was to see how fast it allowed money and credit to grow. The growth of the money supply is shown in Graph 3, and again we see relatively low and stable expansion during the 50s and 60s (except for the Korean War boom), before the turmoil starts in the 70s (in this case, the very I referred earlier to the fact that monetary and fiscal policy had to operate under an important constraint during the 50s and 60s. The constraint to which I am referring is the gold exchange standard, whereby virtually all OECD countries fixed their exchange rate to the US dollar, which in turn fixed to gold. In Australia's case, our exchange rate to the US dollar did not change between 1949 and 1971. This was in a way the centrepiece of our economic policy. Monetary policy and fiscal policy could not get too expansionary without either inflation or the balance of payments threatening the exchange rate. This mechanism effectively meant that our macroeconomic policies (and those of most OECD economies) could not get too far out of line with the policies pursued by the US Government. A recognition of this link means that if we wish to fully understand what happened in the 50s, 60s and early 70s, we have to look more closely at the trends in US economic policy. This also means that we will have to stop looking at the 50s, 60s and early 70s as a whole, and instead divide it into two quite different sub-periods. The role of the United States is crucial here. Despite its having enacted the of 1946, the United States continued to run reasonably conservative demand management policies through the Truman and Eisenhower years and even in the early part of the Kennedy Presidency. In this period US economic policy came in for a fair bit of criticism from economists, particularly outside the United States, for being too cautious. There was some basis to this criticism in that US policy makers did seem to be less keen to expand than their counterparts in other countries, particularly in Europe. American attitudes changed in the early 60s, but nothing concrete occurred until the Johnson years. The turning point was the tax cuts introduced in 1964 and 1965 which were described by one of their architects - Arthur Okun - as 'The largest stimulative fiscal action ever undertaken by the federal government in peacetime ... the first major stimulative measure adopted in the post-war era at a time when the economy was neither in, nor threatened imminently by, recession. And, unlike earlier tax reductions, they were taken in a budgetary situation marked by the twin facts that the federal budget was in deficit and federal expenditures were rising'. This certainly got the United States moving and was soon followed by increased defence expenditure occasioned by the Vietnam War, and other government expenditure associated with the Great Society programs. Some of the proponents of the original tax cuts then argued for tax increases but, not surprisingly, they found these were harder to put into place than were the earlier tax cuts. In the second half of the 60s and early 70s the US economy grew very quickly and inflation began to rise. For a time it was held in check by the Fed's willingness to run tight monetary policy, but with the appointment policy became more accommodating. President Nixon found that expansionary policies were popular, and continued in the same vein as his predecessor. the United States running a large current account deficit, it could no longer hold its commitment to gold, and the US dollar was effectively devalued against gold and against other major currencies. There was now no longer an anchor to the international financial system. Thus, the post-war period should really be divided into two sub-periods, with the US tax cuts of 1965 marking a convenient dividing line. Thereafter, US policy became expansionary, and it ceased to provide a constraint on the actions of other countries. It is instructive to see what happened in a range of countries during this second period, that is between the turning point in US policy in 1965 and the OPEC shock at the end of 1973. The story is very similar for all OECD countries. Their economies continued to grow strongly, but they were not able to get their unemployment any lower than the already low of these expansionary policies was to push inflation to levels that were not consistent with sustainable economic growth. As a general rule, most countries' unemployment rates rose slightly, but their inflation rates doubled (see economy was in an inflationary boom. How did Australia fare in this period? Our story was very similar to the general pattern, although the deterioration in inflation was more marked here. Our inflation rate, which had been about 4 per cent in the mid 60s, reached 10.4 per cent in the year to the September quarter of 1973. That means that we had already got our inflation rate into double digits before OPEC came along to deliver a further inflationary impulse (see by the inflationary boom that the world found itself in in 1972 and 1973. Commodity prices were rising rapidly, as were our export receipts. With the monetary policy instruments then available, and with the fixed exchange rate, it was not possible to quarantine the monetary effects, and the money supply was soon growing at more than 20 per cent per annum. We did not help ourselves very much either with the way we set wages. The National Wage Case of December 1970 resulted in a 6 per cent increase in awards, and the metals industry award of July 1971 added 9 per cent to award wages through that year (when The point of all this analysis is to answer the second proposition that was presented in the Introduction. Was the world achieving good macro-economic performance until hit by the OPEC shocks? The answer is clearly no. In the period after 1965, policies became too ambitious and too expansionary. In colloquial terms, we all lost the plot. Of course, it is easy for me to say these things now because I have the benefit of hindsight - it was much harder at the time to see that we were overstretching ourselves. By 1973, the world economy already had an entrenched inflationary problem, not just a temporary one as in the Korean War period. Whether OPEC had come along or not, it would still have been necessary to re-examine demand management policies and do something about restoring the sort of conditions that existed in the 1945-65 period. History shows that what we got instead was an oil price shock to add to our already considerable self-imposed troubles, and so spent the next decade-and-a-half trying to return to some sort of reasonable equilibrium. I do not want to say anything about that period because that is another story. The period that is loosely described as the 50s and 60s really covers the nearly three decades between the end of the Second World War and the first oil price shock known as successful for most of this time in that they avoided the deflation that had characterised the 1930s, and yet did not move too far in the inflationary direction. However, a closer examination of the whole period suggests that there were two quite distinct sub-periods. The first, from 1945 to 1965 or thereabouts, was the true Golden Age in that sustainable growth with low inflation was achieved against a background of macro-economic policies that did not try to be too ambitious in the short run. The second period, from 1965 to 1973, looked promising for a time, but was ultimately a period of policy failure. Macro-economic policy tried to achieve too much and forgot about the need for sustainability. It ended up with the world economy in an inflationary boom, which set the scene for oil prices to rise sharply, as had all other commodity prices during the boom. A policy reversal aimed at restoring the more balanced approach of the 1945-65 period would have been needed even without the shock of OPEC. Report to the Treasurer of Prosperity , ' , Random House of Prosperity and ,

r970508a_BOA

australia

macfarlane

Thank you, Mr Chairman. It is a pleasure for me, and my colleagues, to be here this morning. This is the sixth time we have appeared before this Committee, but the first time under the new arrangements agreed between the Treasurer and myself at the time of my appointment, and contained in the document known as the Statement on the Conduct of Monetary Policy. That document was an important step in making clear the Reserve Bank's independence, and we have always taken seriously the responsibilities that go with independence. One important responsibility is to explain carefully and honestly to the public and the Parliament what we are doing with monetary policy. That is why we had no difficulty in agreeing to the proposals contained in the Statement on the Conduct of Monetary Policy, including the two points that are relevant to today's meeting: We have decided to co-ordinate these two twice-yearly requirements so that the Statement - which we have named the Semi-Annual Statement on Monetary Policy - is available immediately prior to the meeting, and can form the basis for some of the discussion. The Bank now makes an increasing amount of information available to the public. Years ago, the Annual Report was almost the only vehicle, but now it is supplemented by a substantial flow of information in the form of press releases, articles in the Bank's monthly Bulletin and speeches by senior officers. The additional benefit that the Parliamentary hearings such as this can bring is that they are a two-way process. Monetary policy inevitably contains an element of judgment, which can differ between knowledgeable and well-intentioned people. This forum allows members an opportunity to express different views and to pose awkward questions, two activities I am sure you will engage in to the full. This is a useful addition to the other checks and balances which are part of the democratic process. In my opening statement I would like to say a few words about the economy, monetary policy and the financial markets. I would like to begin by giving you a brief summary of our reading of the economy's current conjuncture and short-term prospects. As usual, the performance of the Australian economy is a mixture of some very good aspects and some that are in need of improvement. Over 1996, GDP grew by around 3 per cent, with inflation about 2 per cent in underlying terms. This - the fifth year of the current economic expansion - is a pretty good result by the standards of developed countries: over that period, only two other OECD countries out of 25 have done better on growth. However, 1996 represented slower growth than in the previous few years and meant that the earlier decline in the unemployment rate halted. We believe in the period ahead that we will see an improved rate of economic growth, which we see as something more like 4 per cent through 1997 than the 3 per cent rates we saw over 1996. We believe 4 per cent growth should be quite sustainable. At this stage, there is no reason why good rates of growth should not be achievable over several years. Behind this view about a pick-up in growth are several factors. Consumer demand, which was weak during 1996, particularly the second half of the year, is now looking stronger. No doubt, short-run figures will still contain a good deal of variation, but the March quarter strength should be a pointer to overall better growth in 1997. We should not, of course, be looking for a boom in consumer demand - the need for improved savings remains great - moderate growth would suffice. To that we can add that an upswing in the residential construction cycle is in its early stages, with a clear pick-up in lending, in local government approvals and now in housing starts Business investment should continue to be solid. The picture varies across industries, but overall investment spending is likely to grow further, driven by quite a strong increase in non-residential construction, and moderate growth in plant and equipment. Unlike the late 1980s, moreover, the construction upswing is broadly based, including in mining and infrastructure spending, not just concentrated in office blocks. The overall financial climate should also underpin investment plans, with share markets throughout the world, including Australia, at record highs, and with bond yields and bank lending interest rates at or near their lowest levels in this cycle. The international environment is generally supportive of the Australian economy, though as always there are things to watch. Growth is proceeding, and most likely strengthening, in Japan and Europe, which have been weak for several years. In the United States, the Federal Reserve has the job of slowing the economy back to sustainable rates of expansion, without over-doing it. We all have a big interest in them succeeding. In East Asia, growth is generally expected to pick up; it is important that it does so, because this region has been the major destination for Australian exports over recent years. This outlook is moderated slightly by the fact that some countries in the forefront of this expansion - such as the United States and the United Kingdom - have reached the phase where monetary policy is being tightened. Overall then, we see reasonable prospects for growth ahead, and we think that it will be somewhat better growth than we experienced in 1996. This should do something to help a lacklustre labour market. The labour force figures have been particularly hard to get a clear signal from in the past several months. Around the turn of the year, it appeared we were getting a good acceleration in employment growth. The past couple of months, however, have seen that unwound. We will get another reading today. Whatever that may show, it is unwise to get too carried away by short-term trends. What can be said with reasonable confidence is that employment growth has been weak over the past year or more, but that leading indicators like vacancies are signalling some strengthening in future employment conditions. We cannot be sure how robust that will be, but some employment pick-up would be consistent with the firmer growth picture we anticipate. This is the thrust of the analysis in our Statement. As always, we will be evaluating all the relevant information as best we can, continually updating our view on the economy and its prospects. Inflation, meanwhile, has come down over recent quarters. Underlying inflation peaked at 3.3 per cent, which is as you know higher than we could accept in the medium term, but has now come down to a level of about 2 per cent on the latest figures. It was this decline which made room for the three easings of monetary policy which we put in place in the second half of last year. The decline owed something to the slower economy, which increased competitive pressure in many markets, constraining firms' ability to raise prices. This same factor helped to produce some slowing in growth of labour costs. A third factor was that the Australian dollar firmed during 1996, and this has pushed down prices for traded goods and services. In the next year or so we expect to see a continuation of this low inflation. Beyond that horizon, as the recent exchange effects wear off, the on-going rate of inflation in the domestic price and cost structure will reassert itself; at present, the domestic part of inflation appears to be higher than the overall underlying inflation rate. For example, private sector service prices are growing at 2.5 per cent and domestically produced goods at 3.3 per cent. Containing growth in labour costs is important to sustaining a combination of good inflation outcomes in the domestic economy, and good growth in output and employment. I will return to this theme shortly. I would like to turn now to some aspects of the operation of the monetary policy regime itself. A central part of our framework is the inflation target, which, in essence, says that inflation should average "two point something" per cent. We think this target has helped to bring the community's inflation expectations down, but there is still further to go. Lower inflationary expectations are important in achieving a good combination of low actual inflation and sustainable expansion in the real economy. Low inflation, and our inflation targeting arrangement, also helps to build credibility internationally for Australia's policy generally. This is not just pandering to markets; it is worth having for genuine reasons. One is that long-term interest rates for all borrowers - government and private alike - are lower if we can convince lenders we are likely to keep inflation down. Because we have an inflation target, some people think that it means we do not pay attention to economic growth or employment. This is not true. To paraphrase my predecessor - "We do - because our charter requires us to but, more importantly, we do so because it is sensible to do so." In thinking about how best to live up to this objective, however, a central bank has to have a longer time perspective than some other observers may adopt. It is long, durable expansions in the economy which offer the best prospects for building a solid base of industry, jobs and prosperity. Our observation of history, moreover, is that good growth and long expansions have always gone hand-in-hand with low inflation. Weaker growth and short expansions have been a feature of the high inflation era, particularly the 1970s, but also in some parts of the 1980s. We want, and need, a long expansion this time. We do not want the expansion to last only six or seven years and be followed by a serious recession, as on the last two occasions. The damage, particularly to unemployment, occurs during these big recessions. The net rise in unemployment in Australia over the past 25 years has not been due to prolonged periods of weak economic growth; it has been concentrated into three relatively short periods of recession. The best thing we can do to improve our employment prospects is to prolong the expansion, improving its durability by avoiding inflationary and other imbalances, thereby delaying and reducing the severity of recessions which will inevitably occur at some stage. Making this a long sustainable expansion is our main objective; continuation of low inflation is a means toward that end. While seeking to maintain that long-term perspective, we are continually monitoring the information that comes in on the economy to see whether it is sending us a message about the need to change policy. When we saw evidence of lower inflationary pressures in the middle of last year, we took the opportunity to lower interest rates on three occasions - July, October and December. I found myself in the position of initiating monetary policy easings at two of the first three monthly Board meetings I chaired. I expect there will be a view that with inflation at the bottom of the 2-3 per cent range, with the possibility that it might go a little lower, and with the economy having grown more slowly during 1996 than its potential, many people would be asking "why not keep easing?". Part of the answer is that the full effects of the previous three easings are still coming through. We need to keep this in mind. One possible hurdle to lower interest rates was removed in the Australian Industrial Relations Commission's decision in the Safety Net Review, which sought to carefully balance concerns about the living standards of the low paid and the economic sustainability of widespread and substantial rises in income for these people. The decision was moderate, and increased the probability that aggregate wages growth would be consistent with continued low inflation. Other information received recently has been less reassuring. The various sources of data on wages paint a picture which is far from straightforward to interpret. One series on which we place a good deal of weight - though not exclusive weight - is average ordinary-time earnings for adults working full-time. This series has been influenced during much of the past year by some quite improbable numbers for public sector wages, but even discounting it to some extent for that effect, wages growth seems to be at levels which are too high, and from the run of quarterly figures one can hardly conclude that the earlier slowing in average wages growth has continued; if anything, the picture the figures paint is of an acceleration. More information about aggregate wages will be available soon, as will data on enterprise bargains. In the meantime, the continuing substantial claims (and, in some cases, settlements) that are contained in some current negotiations, including (but not confined to) the metal industry, give us less than full confidence that the bargaining stream is moderating appreciably. Overall, it is difficult to escape the conclusion that wage bargains and average wage outcomes are somewhat higher than they really should be in an economy characterised by low inflation and quite high unemployment. This conclusion also seems to emerge from international comparisons. As our Semi-Annual Statement notes, most developed countries have inflation rates around 2 per cent and rates of growth of earnings around 3 to 4 per cent. Australia stands out as an exception where low inflation has not translated as fully as it should have into lower wage growth. Whether aggregate wages growth of 4 per cent and enterprise bargains of 5 plus are bound to lead to higher inflation is a moot point. In some sectors, such as manufacturing, they are probably not inflationary; the squeeze there seems to be showing up as higher unemployment rather than higher inflation. Firms may well accept 5 per cent wage increases, but manage to keep the increases in their total wage costs much smaller than that by shedding staff. In other sectors of the economy which are not so open to international competition, such as transport, higher wages will probably be passed on to consumers as higher prices. I would like to be in Alan Greenspan's place where over the past 15 months he has been regularly "surprised" by lower unemployment, and lower inflation and wage growth than expected. In Australia, given the degree of slack in the economy and the level of unemployment, I thought we might also have been surprised by some lower than expected wage numbers. Overall, I am not sure we are in that position; I fear we are still waiting to get that good news. I now turn to financial markets. As we note in the Statement, the exchange rate of the Australian dollar has moved to a flatter trend over the past year after rising strongly in the second half of 1995 and the first half of 1996. If anything, the exchange rate against the US dollar has been a little lower so far in 1997 than it was in the second half of 1996. The exchange rate has also been relatively steady against most of Australia's other trading partners. In trade-weighted terms, however, it has risen recently. At its present level of 60.2, it is about 3-4 per cent above its level a year ago. This rise has contributed to the fall in inflation and has put some pressure on the internationally-traded sector of the economy. Overall, however, the exchange rate remains within 5 per cent of its long-run average. The trade-weighted index reflects a wide range of influences, but the main reason for the rise in the index over the past year has been the extraordinary weakness of the Japanese yen. It has fallen against all major currencies on world markets, but its effect on the trade-weighted index of the Australian dollar is greater than for other currencies because the yen has by far the biggest weight in our TWI. In recent years, the yen has been very volatile (in 1995 it was the strongest currency in the world), reflecting the difficulties experienced more generally by the Japanese economy. There are hopeful signs that Japan is emerging from that difficult period, which will in due course allow the authorities there to return to a more normal setting of monetary policy. That would also provide support for the yen, which, other things equal, would reverse some of the recent upward pressure on Australia's trade-weighted exchange rate. In terms of other financial market developments, we have seen marked falls in interest rates over the past year, not only at the short end but also in the longer-term rates set in capital markets. The yield on 10-year bonds, for example, has fallen by over 100 basis points over the past year to 7.75 per cent. This reflects the improvement in the Government's fiscal position and the fall in inflation, rather than international influences. As such, our yields have fallen not only in absolute terms, but also relative to those overseas. For example, a year ago, our bond yields were 250 basis points above those in the United States; today, they are only 100 points above. The fall in bond yields also has important benefits for business and government, not only in directly reducing their interest costs, but also by increasing confidence in the share market and thereby allowing businesses easier access to equity funds. Share prices in Australia are at record levels at present, reflecting the favourable interest rate environment and generally high levels of corporate profitability. Share markets in most other industrial countries are also at very high levels, suggesting there is a fair amount of confidence among investors about prospects for the world economy over the next year or two. Interest rates on offer through the banking system have also come down sharply over the past year. This has been underpinned by the three easings of monetary policy and, particularly in the case of housing loans, by a marked increase in competition. Business loan rates have fallen by about 1.5 per cent since mid 1996, in line with the reduction in cash rates brought about by the easings in monetary policy. Rates at present are close to the lows reached in 1993/94. In the case of housing loans, rates have fallen by 3 per cent over the year, to 7.5 per cent, the lowest level in a generation. If we also take into account the absence of rationing since deregulation of the financial system, housing finance is probably more affordable and more accessible than at any previous time in Australia's history. It is not surprising, therefore, that we are seeing a healthy demand for credit at present. This, and our more general assessments about financial conditions, leads us to the view that financial conditions are not impeding the expansion in the economy at present.

r970515a_BOA

australia

macfarlane

It is a pleasure to be here in Melbourne, and to be speaking to the Australia-Israel Chamber of Commerce. I was very pleased to be invited to address this distinguished group so soon after I was appointed. If at the end of this address, you feel that I have still left some important questions unanswered, my suggestion is that your next guest be my opposite number from Israel. Jacob Frenkel, the Governor of the Bank of Israel, is a distinguished economist, but a very busy man. My invitations to him to visit Australia have so far been unsuccessful - perhaps this Chamber can swing the balance. I want to take this opportunity today to talk about the economy, monetary policy, and some aspects of unemployment. I propose to do this by looking over a longer period than normal. Most economic commentary concentrates on very current events and focuses on the latest monthly or quarterly economic statistics. This is an inevitable result of the news-gathering process and the need for financial markets to reassess after each new piece of information. In this environment, the outlook for the year ahead is considered a long time. In my view, even that is too short - for monetary policy purposes, we should be looking at a period as long as an economic expansion. That may not be a lot of immediate help to most people because they would be unsure of what timespan was encompassed by an economic expansion. As a point of reference, the last two expansions have lasted for about six-and-a-half years, but I think we can do a lot better on this occasion. The current expansion in Australia has been going on for about 5 years, which is similar to the United States, the United Kingdom and New Zealand, and a fair bit longer than for countries in continental Europe or Japan. Table 1 shows that over that period we have grown at an annual rate of 3 per cent and had inflation of 2 per cent. Our growth rate has been higher than nearly all OECD countries, although not as strong as for the countries of east Asia. Our inflation rate is also very good and close to the average for OECD countries. The results are pretty good by international standards, particularly since there should be a lot more expansion still to come. The main reason that I think we still have a lot more to come is that this has been a low-inflation expansion and remains so. An important reason why inflation has remained low is that monetary policy has been determined to keep it low this time. The centrepiece of our monetary policy approach is a medium-term inflation target endorsed both by the Government and the Reserve Bank. It was also endorsed by the Treasurer in the previous Government and was incorporated into the Accord Mark VIII agreed in June 1995. It is not just something we dreamt up at the Reserve Bank; it has enjoyed wide bipartisan support. And recently, the Industrial Relations Commission made it clear that they felt their own decision had to take note of this framework. The statement agreed between the Treasurer and myself at the time of my appointment saw low inflation as a requirement for sustained growth, which is another part of the Bank's Charter. Containing inflation is not an end in itself; it is one of the pre-conditions for sustained growth. It is not the only one, but it is obviously the one for which central banks have to accept most responsibility. We do attract criticism, however, from people who think that because we have an inflation target it means we are not interested in economic growth. This is not true - as I have pointed out on a number of occasions. In fact, the reverse is true: we are interested in sustaining a good inflation performance because we are interested in growth . Let me make two points I have made before: * The other way of looking at an inflation target is to say that the aim is to grow as fast as possible consistent with maintaining low inflation, but no faster. We say no faster because post-war history has taught us that allowing inflation to rise actually harms growth prospects in the longer term. Strong growth and long expansions have always gone hand-in-hand with low inflation. Weaker growth and short expansions have occurred in the high-inflation era, particularly the 1970s but also in some parts of the 1980s. This 'no faster' idea does not mean that we will panic at unexpectedly strong growth over a short period. It does mean we intend to avoid a 'full steam ahead and damn the torpedoes' approach to policy. * As I said at the start of the talk, we want a long expansion this time. We do not want the expansion to last only six-and-a-half years and be followed by a recession. The damage, particularly to unemployment, occurs during recessions. The net rise in unemployment in Australia over the past 25 years has not been due to prolonged periods of weak economic growth; it has been concentrated into three relatively The best thing monetary policy can do to improve our employment prospects is to prolong the expansion and delay and reduce the size of any subsequent recession. On occasion, that means easing the growth rates back a bit to counter inflationary pressures early, as an alternative to more vigorous application of the brakes when inflation has built more momentum. rule that the economy cannot be allowed to grow faster than 3 per cent. I have seen this claim on a number of occasions, but can assure you that it is not true. I do not know where it came from; perhaps from observing historical growth rates, or perhaps from some misinterpretation of things that the Bank has said on occasion. The figure of 3 per cent is also sometimes regarded as the Government's target. Again, I do not know where this claim came from, but it is probably derived from the fact that government projections, such as those underlying the Budget forward estimates, often assume average growth rates like this, particularly for the out-years of multi-year projections. These assumptions should be seen as what they are - an attempt to base government planning on prudent, conservative assumptions rather than wishful thinking - not as iron-clad limits to growth or short-term 'targets'. There are a number of reasons why it does not make sense to specify a particular number as the 'speed limit' for the coming year. Among those reasons are the following: * Even if we have a clear idea of a long-term average rate of growth, an economy can clearly grow faster than that when it is taking up excess capacity. This would be the case if it was coming off a year when growth was a bit on the soft side (as was 1996, for example) and where inflation was very well contained. * It is not possible to 'fine-tune' an economy to grow at the rate you want over the space of one year. Neither forecasting accuracy, nor the monetary policy process, permits that degree of accuracy. Even with very good economic policy, the economy will grow faster than average half the time and slower the other half. * Just because the economy averaged a particular figure in the past, it does not mean that this average is the one we should project into the future when thinking about potential growth. There is some evidence, as is shown in our , that productivity growth has increased, and hence it is possible that potential growth may have Ideally, we should try to eliminate the business cycle (and recessions) altogether, but that would be too utopian an aspiration. The business cycle has been declared dead before, only to re-assert itself. I do believe, however, that if inflation is kept under control, this expansion will be a lot longer than its predecessors and any subsequent downturn kept milder than in the past. Less pressure would be placed on monetary policy in a late-cycle situation if the aim were only to slow the economy, than if it were necessary both to slow the economy and to reduce an entrenched inflation, as has been the case in the past. Some people would characterise our approach to monetary policy as incorporating 'a speed limit'. In a very broad sense this is true. We do not want the economy to grow so fast that it pushes up wage and price inflation to unacceptable rates. I have already explained the reason for that. However, the concept of a 'speed limit' is unhelpful if we try to use it mechanistically. It has been claimed that the Reserve Bank has a risen. On the other hand, population and labour force growth may well be slower than in the past and this would work in the opposite direction. I hope I have made it clear that we do not regard economic growth as excessive because it has breached a particular figure - say, per cent. We would regard it as excessive if it is pushing up wages and prices in a way which would cause our medium-term target to be exceeded. Obviously, the faster is growth in any particular period, all other things equal, the higher the risk of that problem becomes. But we do not have, and it is not sensible to have, a doctrinaire view of particular growth thresholds which, if breached, are assumed to generate problems. The policy process is rather more pragmatic than that, and proceeds by the rather simple technique of examining the evidence for what it says about inflation pressures in the period ahead. That, to repeat, is the test: not whether a growth rate matches or exceeds a particular pre-determined figure, but whether low inflation performance is being maintained over time. At any point in time we are constantly monitoring wages and prices and making an assessment of the outlook over the next year or so. If we get good news and our assessment is for lower growth in wages and prices, we can, other things equal, let the economy run faster. This may be done by reducing interest rates or, depending on the circumstances, refraining from raising them. If on the other hand we are getting bad news, we may have to tighten or forgo an easing. This idea is not all that novel. It is very similar to the way the monetary policy process is described in the United States. Our newspapers are full of the latest speculation about what Alan Greenspan - the Chairman of the Federal Reserve Board - is going to do this month, next month and thereafter. The big story of 1996 in the United States was that nearly everyone expected monetary policy to be tightened. The US economy was already at full capacity and still growing strongly, people expected that inflationary pressures would soon emerge, and the Fed would have to tighten. On three occasions - July, September and December - the markets were convinced it was going to happen, but on each occasion the Fed was able to sit on its hands. Why was it possible to delay the tightening for nearly a year? It was not because the economy weakened; in fact, it grew faster than initially anyone had forecast, expanding by over 3 per cent in 1996, well above previous forecasts and economists' estimates of its long-run potential growth rate. It was because the Fed continued to receive constant feedback from the economy indicating that rises in prices and wages remained moderate. None of this means that the US economy is somehow entirely freed from all the constraints it has experienced in the past; only that, to date, inflation performance has been a bit better than they expected. To that extent, the Fed has been able to allow the growth to run just a little longer. No-one would be more pleased than the Reserve Bank to see a similar outcome for the Australian economy over the next 12 or 18 months - that is, continuing good news on wages and prices, allowing us to grow faster for longer. It was an assessment of improving prospects for inflation, and the associated scope for additional growth, that lay behind the three easings in the second half of 1996. We would like to have seen that pattern of news continued, but the latest data on wages seems to have been a setback to that expectation. Of course, not everyone agrees with this approach. There are those who think a much higher figure for growth is achievable and should be pursued. Their approach would be to nominate a figure - I have seen 5 per cent mentioned - and expect the Reserve Bank to adjust monetary policy to achieve it in the long run (not just for one year). The trouble with this approach is that it amounts to a gamble with rather poor odds. While we do not wish to take too strong a view on what is 'too much' in any particular short period, we need to keep a reasonably sober perspective on what is likely to be feasible over the long run. A growth rate of 5 per cent, for example, is so far above our historical performance that unless you can specify how improvements on the supply side of the economy have lifted the potential growth rate dramatically, it cannot be taken seriously. Now there may well be some significant benefits coming through on the supply side as a result of structural changes and micro-economic reform. For example, reductions in tariffs and increased competition within the domestic market are two that spring to mind. We may also be getting something out of increased flexibility in some parts of the workforce, though the jury is still out at present on exactly how far that process has brought us. But even though there is some tentative evidence of higher productivity, I think we have still got a lot further to go before we could be confident that supply-side reforms have significantly lifted our potential growth rate. More importantly, our current monetary policy procedures, consistently applied, should guide us to the right answer without having to take such a gamble. If the economy really is capable of much faster non-inflationary growth than in the past, constant evaluation of the feedback we receive from the data should enable us to detect this change. If we receive a flow of information pointing to lower pressures on wages and prices, for example, we can let the economy run faster than earlier relationships might have suggested, as in the Greenspan example. This may not satisfy those with a liking for a punt, because the feedback process takes longer. But it carries less risk of miscalculation. So far, we have been talking about monetary policy in relation to the business cycle. I have argued that we should try to maintain the economy in a position of growth for as long a time as possible. This is best achieved by seeking to remain free of major imbalances, and addressing those which do emerge as quickly as possible. But there is a bigger dimension to Australia's unemployment problem than managing the business cycle. It becomes clear from a consideration of the longer-term history both of our own economy and those of other countries. What I want to suggest is that a common perception that if we could only grow faster, unemployment would go away, is missing an important part of the story. Consider the data in Table 2, which is for the same group of countries as shown earlier in Table 1. The table sets out the average growth rate per capita in these countries and their unemployment performance. This latter concept is measured by seeing how much higher their current unemployment rate is than it was in the first half of the 1960s. There is one country where the unemployment rate is now lower, namely the United States. At the other end of the spectrum, we have the large European countries where the unemployment rate is enormously higher than it was in the 1960s. We are somewhere in the middle - better than the large Europeans, but not as good as the United States, the United We can then pose the question: have the Europeans suffered because their growth rates were inferior to the United States? Is that the reason for their higher unemployment rates? The answer seems to be no, because column 1 shows that most of the major European countries had quite respectable growth rates over this period; for example, Germany, France, Italy and Spain all grew faster than unemployment has been dismal, not because of their growth performance, but despite it. Graph 2 shows that, over this relatively long period, there is no systematic relationship between the growth of the economy and the change in the unemployment rate (if there was, the dots would be clustered around a downward sloping line). There are, no doubt, many aspects to this story, which I cannot go into here. But it seems reasonably apparent that while good economic growth is a very important part of reducing unemployment, growth alone will not be the whole answer. If it was, Europe's unemployment rates would be much more like that of the United States. There is something in the European system which means that growth is not converted into jobs in the same way as it is in the United States. People who have spent a great deal of time studying these issues have come to the conclusion that the highly regulated labour markets that form part of the continental European world can often work against the interests of job creation. Such labour markets usually have an institutional framework which promotes job security, imposes relatively strict minimum wages and conditions, provides easily accessible sickness and unemployment benefits, and increases trade union involvement in decisions. As a result, these systems tend to be good at protecting the interests of those in work - the insiders, but are often not helpful to the longer-term interests of the outsiders - those looking for work. Employers are less keen to offer new jobs because of the higher costs and the difficulty of reversing the decision if it becomes necessary. The unemployed, while having a more generous safety-net than under a US-type system, are less likely to be offered a job and less likely to look for one. A high proportion of long-term unemployed is a feature of continental European countries. Ironically, it seems that measures designed to promote security of employment may well have the effect of limiting the extent of employment. I think we know that there are elements of this story in our own case too. It is not as though the Australian economy has suffered particularly bad growth in the last twenty years. It grew more slowly than in the 1960s, but everyone suffered that slowdown. We have had several periods of reasonably solid growth by international standards. On each occasion, we have, unfortunately, found the limits to growth. But we still have high unemployment by the standards of the United States, more importantly, by the standards of what we ourselves regard as acceptable. Why does our unemployment performance have rather more in common with the continental European countries than we would like? Is it perhaps because our labour market institutions also have much in common? Our labour market was never as deregulated as the United States and we have not gone through recent deregulations to the same extent as have the United Kingdom and enacted some changes to increase flexibility through the . These changes, simplifying and streamlining arrangements and making it easier to strike bargains, seem to be a move in the right direction. It is too early to judge how substantial the beneficial effects of these changes will be (and it will of course depend on how much use the parties choose to make of the flexibility on offer). On the surface, these reforms were less ambitious than those in the Changes to labour market arrangements are, of course, politically difficult. One reason is that the insiders have to give something up. Job security is clearly reduced, and some hard-won entitlements may have to be relinquished. More flexibility in wage setting almost certainly entails a wider dispersion of wage rates - that is more wage inequality - and reform of unemployment benefits would place tougher conditions on the unemployed. It is understandable that many people are unwilling to make these changes and why they foresee such worrying phenomena as the 'working poor'. Most people in our society, in other words, see general fairness as a relevant criterion in choosing policy outcomes. As a result, we would not want to go completely down the US route, with such extreme differences in incomes between senior executives of companies and the shop floor. But we do not have to go as far as the United States - there is a happy medium in this, as in most things. All I am suggesting is that we should re-examine our labour market institutions to see whether they are protecting those in jobs at the expense of those looking for jobs. At the same time, while income inequality may not seem fair, unemployment is not very fair either. Some of our labour market regulations, and many of our attitudes towards labour market outcomes, indeed some of our very ideas about fairness, stem from a time when the unemployment rate was 2 or 3 per cent. It was inconceivable then that unemployment would have an upward trend over twenty years, or that labour market regulation would have any significant role in that process. But the world has changed, and our ideas about what sorts of labour market arrangements are appropriate need to change too. This is already happening, as evidenced by recent reforms. My guess, however, is that this will not complete the process. I began by talking about the need to lengthen the economic expansion. This, achieved by keeping inflation at bay, is the best contribution monetary policy can make to the long-term health of the economy. That long-term focus does not mean that we are too cautious, that we never take a risk; it simply means that we weigh the risks and rewards of policy actions over longer time horizons than many of the commentators on the economic scene which fill our newspapers and airwaves each day. We want an expanding economy, and low inflation. That offers the prospect that progress can be made in addressing the rate of unemployment, which remains too high by any standard in Australia. We fear, however, that the debate about whether unemployment will or will not reach supposed 'targets' over the next year is missing the main point. Faster growth over the next year or two will help reduce unemployment. But it would be a great shame if that decline obscured the longer-term aspect to unemployment, which endures beyond the business cycle.

r970812a_BOA

australia

macfarlane

It is a pleasure to be in Perth to address the Company Directors. It is also fitting that I should be talking about economic growth, since Western Australia has set an example to the rest of Australia by its high growth rate in the 1990s. Some would say this is inevitable, given its resource base, but we have seen internationally that the fastest growth does not coincide with the biggest resource endowments. Enterprise and a willingness to embrace change are also vital ingredients, and here Western Australia has also distinguished itself. In the Reserve Bank we are often drawn into a discussion of economic growth because of claims that we have a 'growth ceiling' of per cent per annum. I do not know where this perceived ceiling came from, and I have on several occasions denied its existence. I will do so again tonight. It has been suggested to me that one of the reasons for this belief is that I have often highlighted the data contained in Table 1 below, particularly when I have been doing my patriotic duty in front of audiences of overseas investors. It shows that over the past six years, that is the period of the current expansion, we have grown at an annual Average annualised growth average growth rate of 3.5 per cent. This is very good by the standards of the 'high income OECD countries'. Only Ireland has done better, and Norway and New Zealand have grown at about the same rate as we have. These are all much smaller countries than we are The other thing that stands out from this table is how well the English-speaking countries have done in the nineties; the six Englishspeaking countries are in the top seven spots. per cent per annum contained in this table is there for international comparisons, not as a yardstick for what we can do this year, next year or the year after. For a start, that six-year average of per cent contains years like the past 12 months where we have achieved only 2.4 per cent, but there are other periods like the year to September 1994 when we managed per cent. While we do not have a growth target or growth ceiling, we do have an inflation target. This says that inflation should average somewhere between 2 and 3 per cent over the medium term. That is, when we look back, we should see that it has averaged 2-pointsomething per cent, even if we have been over 3 per cent on some occasions and below 2 per cent on others. This approach is not, as some might think, anti-growth. It is, in fact, pro-growth by favouring forward looking management of the business cycle, which will help in achieving a stable platform for long-run growth. The other way of expressing an inflation target is to say that the economy should grow as fast as possible consistent with maintaining low inflation, but no faster. We say no faster because post-war experience in a number of countries has shown us that allowing inflation to rise too much actually harms growth prospects in the longer term. Sustained periods of strong growth have always gone hand in hand with low inflation. Weaker growth occurred in the high inflation era, particularly between the mid-seventies and mid-eighties. We have also emphasised that it is the length of the expansion that is important. Our last two expansions were cut short by inflationary pressures after about six-and-a-half years. It would probably be possible on this occasion to engineer a short-lived boom, characterised by rising output and falling unemployment, but also by increasing inflation, unrealistically high asset values, inflated paper wealth and financial instability - which is, of course, a recipe for a slump thereafter. Recessions may come for some other reasons, but there is no reason to run a high risk of a self-inflicted one. It is important that we take a longer view in order to achieve a longer expansion. The value of the inflation targeting regime is that it forces us to do precisely that. That is why I am confident that, under our present arrangements, we will be able to do all that can be done to foster a long expansion. What does this mean for the next couple of years? That is really a matter of forecasting rather than speed limits. With inflation tamed, and with some slack available, we should be quite capable of growing by 3 per cent, 4 per cent, 4 per cent (or possibly even faster) over the next couple of years without any significant detrimental effect on inflation. None of these figures is a target; they are simply illustrative of the sorts of numbers we might reasonably expect to see after a period of sub-par growth such as 1996. Ideally, as we grow fast enough to take up existing slack, businesses would lift investment rates further, pushing the capacity constraints further back. If, at the same time, we found that labour market arrangements were able to bring new employees onto payrolls without generalised pressure on wages, we would be able to sustain faster growth for longer. In other words, by having a longer expansion, we would be able to drive unemployment down further. How likely is that outcome? It is hard to say. We do not have a doctrinaire view on what can be achieved. We will evaluate the evidence as it comes in. Critical in that evidence is the course of prices. The main test of what is sustainable on the growth front is the inflation test: is the rate of growth compatible with achieving the 2-3 per cent average for inflation, looking forward as best we can over a year or two? If the answer is yes, then that growth is sustainable, at least at that point in time. To repeat: we do not have a growth ceiling, beyond which the brakes automatically go on. We have an inflation target, appropriately and flexibly defined, which tells us to tighten when our forecast of inflation has it exceeding the target for any sustained period of time, and to ease when the forecast has inflation sustainably below target. Growth per se does not necessarily trigger this response: it is the inflation outlook which is important. In thinking about the inflation outlook, of course, we need to ask ourselves whether the growth which is occurring now and that which is in prospect are likely to put pressure on capacity to such an extent that inflation might rise noticeably. But that is a judgment based on a range of factors, not a mechanical response to the breaching of some arbitrary growth threshold. Another point I would like to make is that at the moment I do not see that monetary policy is placing any constraint on growth. This is as it should be - one of the advantages of an inflation target is that it makes sure monetary policy is eased when the inflation forecast is below the target average. Hence the five easings over the past year. This might help to reassure those people who think that in order to maintain a low average inflation rate, monetary policy has to be kept continuously tight. It does not - monetary policy will be eased as often as it is tightened. Monetary policy has to be no tighter to maintain an average inflation rate of 2 per cent, than to maintain an average of 5 or 10 per cent. In fact it probably would have to be tighter at the higher figures as it would be fighting against rising inflationary expectations. Another sign that present monetary policy is not restrictive is to look at the effect it is having on the cost and availability of credit. If this was too expensive, we would not see much being used, but that is not the case at present. All forms of credit - business, housing and personal lending - have been growing at somewhere between 8 and 11 per cent over the past year. This does not suggest that the economy as a whole is finance-constrained, although there will always be some individuals or firms that are. Another manifestation of this that may have escaped many people is that we now have lower interest rates out to five years than the United States, which is the usual benchmark for international comparisons. Now this is entirely fit and proper, given the different cyclical positions of the two economies and given our lower inflation. But even so, it would have been unthinkable even a few years ago. Financial markets took it for granted that Australia would always be a high interest country relative to the United States. (International investors put Australia in with a group of countries called the 'high yielders'.) I am strongly of the view that these lower interest rates are a substantial benefit for Australian businesses. So far, we have been talking about growth over short time horizons such as a couple of years or so. Over this horizon, growth can vary quite a lot, and monetary policy will have some influence on the outcome. While monetary policy's major long-term influence will be on the rate of inflation, over shorter periods it can have a significant influence on economic activity and employment. If it is too tight, it will unnecessarily constrain them, and if it is too loose, it could set up the conditions for an inflationary boom. The relationship between monetary policy and economic growth is thus essentially a short-term or cyclical one. But this is not what a lot of people are interested in. They want to know what is Australia's long-term growth potential. Is our potential growth rate relatively low like all the bit higher? Or, alternatively could it be as high, or nearly as high, as the newly industrialising countries of Asia? How could it be raised to a higher figure? These are all difficult questions to answer, and I shall only attempt a very cursory one. But before I do that, I want to make an important point - whatever our potential growth rate is, monetary policy will have little to do with it compared with other factors. Monetary policy mainly works by affecting aggregate demand in the economy. Fluctuations in demand are the normal (though not exclusive) source of business cycles. In thinking about long-run trends, however, it is the supply structure - the economy's capacity to produce and how that can be increased - that is crucial. Perhaps I can take the liberty of illustrating this distinction between short and long run with a stylised diagram. An economy could have an average long-term growth rate as shown in the straight line Trend A. Its actual growth will never be a straight line because of the business cycle, so it is likely to look like the wavy line Actual A. If monetary policy was conducted badly, we could end up with a boom and bust given by the grey line . Alternatively, if monetary policy was conducted well, we should expect to have relatively stable conditions, including low inflation; with a bit of luck, we should also get longer lasting expansions and milder recessions. Because a reasonably stable aggregate price level does not prompt the distortions in economic decisions seen with high inflation, trend growth should be a little higher. But while that difference will be worth having, it only adds a little to trend A, and many people would have trouble noticing the difference. Now, people may be unsatisfied with this outcome and say that they would prefer to be on the faster trend growth line given by Trend B, which is perhaps two or three per cent higher than Trend A. This is a reasonable aspiration, but it cannot be achieved by an adjustment to monetary policy. What factors then explain long-run growth? In simple terms, it is explained by the growth of the productive factors in the economy - the growth of the labour force, expansion of the capital stock and growth in productivity of both labour and capital. This is why there is such focus on microeconomic policies to raise efficiency, rather than manipulation of the macroeconomic instruments, when people talk about long-run growth potential. Again, all that monetary policy can do is to minimise the booms and busts around the higher trend. The only way that the economy can move from Trend A to Trend B is by enacting policies that either increase the growth of the productive factors or increase their productivity. I do not intend to say much about the growth of the labour force, which in the long run is determined by population growth and participation in the workforce. Note, however, that in the short run the economy can grow faster than the labour force constraint would suggest because, if there is enough flexibility, we can move people out of unemployment into employment. The other point that I should register is that I do not think in the long run we will be able to maintain our current low male participation rate. With life expectancy still increasing, we will not be able to continue the luxury of having so many people entering the workforce in their early twenties and leaving in their mid fifties. This is a transitory phase, not a permanent increase in leisure. In thinking about how to ensure that the capital side of production potential is expanded sufficiently, it is hard to go past the simple idea that investment has to be funded by saving, and we would probably have more if we increased our domestic saving. Of course it could be funded by more foreign saving, but that path tends to be a more unstable one. I have no new ideas on how to increase our savings other than through the familiar methods of making sure that the government does not reduce national savings through chronic budget deficits and by enacting measures to make sure that a higher proportion of retirement incomes are funded out of private savings. The really big issue for long-run growth is how we raise productivity. In simple debate, this is often portrayed as producing the same with less people, either by job shedding or by substituting capital for labour. But any business knows that it is not just manning levels which are important. The flexibility of the workforce in using the capital equipment, the skills which they can bring to bear in response to new demands and opportunities, the capacity of the firm to innovate and improve processes in industrial and service applications, the ability to develop and exploit new technology - these are actually more important ingredients in the long run. Of course, all good firms are trying to do this all the time. In a competitive marketplace, they have to keep up with their competitors or fall by the wayside. In a global marketplace, they increasingly have to move towards international best practice, which itself is always advancing as a result of innovation and adoption of new technology. In the process of matching their competitors, the best firms drive the development of productivity and the rise in living standards. Not all firms nor all industries will succeed in doing this. Some will thrive and others will fail. Some industries will grow, and some industries that we do not even know about as yet will emerge. The only thing we know is that there will be continuous change, not just here but in all countries, under the constant pressure of competition, new technologies and globalisation. There is no simple secret to success, but part of the answer must be for both firms and for countries to facilitate change, and to adapt to it, not to resist it. The central issue is that all productivity gains involve change. By their nature they involve producing goods and services in different (and better) ways, or in producing different goods and services. Change is a necessary condition for productivity growth. These major changes are going to occur in the private sector among both large and small firms. The adjustment task will be difficult, but they must try to seek out the profitable and growing areas. While the role of government will be important, the Government will not be able to do the adjustment for the private sector. I find it hard to believe that the Government would be better than the private sector at picking the growth areas, so I believe that the Government's main contribution should be to remove unnecessary obstacles to change, to provide a high quality infrastructure, to encourage saving and to work at lifting and maintaining quality of education. I know this is a difficult message to give to a public which is growing tired of change (not all of it economic). But the alternative of stopping change is really not viable. It has always been the case that the firms and societies that have managed to embrace the challenge of change and seize new opportunities, rather than turning their backs, have been the ones that prospered. It may, of course, be harder for the high income societies like Australia than for the newcomers who feel less attachment to established ideas and who therefore have less to 'lose' in embracing change. But we surely have the capacity to adopt change when we see the need. We have to be convinced it is worth it. The advantages of flexibility have been well demonstrated in the nineties by the superior performance, both in terms of growth and in lower levels of unemployment, of the less regulated English-speaking countries compared to the corporatist European ones. I am not suggesting we should remove all regulation and rely totally on laissez-faire . There is clearly a large role for government, but we should always ask whether particular government initiatives are forward looking, or whether they are protecting an existing industry or an existing privilege. The first requirement of government is to provide as stable a macroeconomic environment as it can. The second requirement of government is to provide first class, low cost infrastructure. This stretches from such items as the legal system and accountancy standards through to more tangible items like the education system and the utilities, including electricity, gas, water and telecommunications. The Government, of course, need not be the provider of each of these, but it will always ultimately set the standards. Inevitably, governments will also be called upon to enact policies which affect one industry at the expense of others. My only plea here is that they do it in a way that encourages adjustment, perhaps even compensates losers, but not to do it in a way which resists change. Australia has recorded quite a respectable growth performance by developed country standards during the current upswing. Even our low point in the mid-cycle growth pause - a bit over 2 per cent - is pretty good compared with many countries' average performances. People are disappointed that more progress has not yet been made on reducing unemployment, but we have made some, and further real progress will be made if we can sustain a long running expansion. As I have noted tonight, I think our current monetary policy framework is serving us well in this regard, by requiring us to take a medium-term view in our policy deliberations and maximising the chances for a long recovery. I hope I have helped to explain our thinking. When we shift our focus to the economy's long-run growth prospects, however, monetary policy should inevitably attract less attention. Price stability is a necessary condition for faster long-term growth, but there are many other policies which have to be got right. That's why it is so hard. If there is a simple message, I think it is that the heart of the long-term growth process is productivity enhancement through innovation, technological change and so on, and that to reap the benefits of those processes, we have to embrace the forces of competition and globalisation, with all the changes and discomforts they bring.

r970929a_BOA

australia

macfarlane

It is a pleasure to be speaking at this year's Conference of Economists on a subject which has been central to my own career. I thought of calling the speech 'Monetary Regimes I Have Known', but that would have given too historical an emphasis. While history is extremely important, and provides a useful antidote to excessively abstract thinking, more is needed to satisfy the conference theme of 'policy challenges of the new century'. I have therefore attempted to respond in a forward looking way, by drawing some conclusions about the direction in which monetary policy regimes are likely to evolve. In broad outline, Australia's post-war monetary policy experience has much in common with that of other countries in the developed world. Certainly the starting point - a fixed exchange rate under the Bretton Woods System - was the same, and several of the subsequent phases have been common to a significant number of countries. We can usefully divide the post-war monetary policy experience in Australia into four main parts: * the fixed exchange rate period, which lasted until the early 1970s; * a period of monetary targeting between * a transitional period which followed the demise of monetary targeting and lasted until the early 1990s; and * the inflation targeting regime, in place since around 1993. While every country has its own particular story to tell, something similar to this four-part schema, with suitable adjustments as to timing, could probably be applied to quite a wide range of other countries over the same period. In making this classification of policy regimes, it is wise to avoid being overly precise about dates. Sometimes regime shifts are quite dramatic and can be precisely dated - for example, the ending of US dollar convertibility into gold, and the United Kingdom's exit from but this is not invariably the case. In Australia, the movement between regimes has tended to be evolutionary, and it is not always possible or helpful to date them precisely. How did these four regimes perform, and what were the critical factors that led to the move from each regime to its successor? To answer these questions we need to have in mind some criteria against which the performance of a monetary policy regime can be assessed. Most practitioners and theorists would, I think, agree on two desirable characteristics of a monetary policy regime. First, policy needs to provide a nominal anchor for the economy: the policy regime must have the characteristic that it systematically resists excessive inflation or deflation, and thereby delivers a satisfactory degree of price stability in the long run. The second objective is to provide a degree of stabilisation in the short to medium term in response to shocks, which includes resisting adverse shocks to output and employment. This objective might be met either through the capacity of a regime to undertake deliberate policy responses when shocks occur, or through automatic stabilisers inherent in the regime. The longest lasting of the four regimes, by a large margin, was the fixed exchange rate, also known as the Bretton Woods System, or the gold exchange standard. At the start of the post-war period, the Australian currency had already been fixed to sterling at an unchanged rate since 1931. Subsequently, there were only two major changes to Australia's international parities until the followed a sterling devaluation against gold and the US dollar, and the second, in 1967, when sterling was further devalued, but Australia did not follow. Thus, Australia's exchange rate against sterling remained unchanged from 1931 to 1967, while the rate against the US dollar - which is more important for current purposes - was unchanged from 1949 to 1971. As was the case for most other countries, the Bretton Woods System of 'fixed but adjustable' exchange rates was operated in practice in Australia in the 1950s and 1960s as a firm commitment to fixed parities. The fixed exchange rate was effectively the linchpin of the monetary policy regime. While it is not possible to pinpoint an exact date at which this ceased to be the case, parity adjustments became much more frequent after the next Australian dollar realignment occurred in 1971. Rather than being the anchor of policy, the exchange rate henceforward was increasingly viewed as an adjustable policy instrument. There were six parity changes in the years from 1971 to the adoption of the crawling peg system in November 1976; and this more flexible system, in turn, gave way to the float in December 1983. The history can thus be characterised as involving essentially fixed parities up until 1971, followed by a gradual transition to greater flexibility and a stronger internal policy focus in the years that followed. An important characteristic of a fixed exchange rate system, of course, is that it provides a nominal anchor, as long as the monetary policy of the country to which the exchange rate is fixed is itself conducted in a way that is consistent with reasonable price stability. This was indeed the case for most of the period up to around 1970. Under the Bretton Woods or gold exchange standard, most currencies were pegged to the US dollar, whose value was in turn tied to gold. central role of the US dollar in the system placed a strong discipline on the macroeconomic policies of other countries. Unless countries were prepared to make significant unilateral exchange rate adjustments, which happened only rarely, their inflation performances in the longer run were effectively determined by US monetary policy. 1997), this system worked reasonably well until the second half of the 1960s. The United States for the most part conducted conservative monetary and fiscal policies that This situation began to change from around the mid 1960s. Tax cuts in the 1964 and 1965 budgets, and subsequent increases in defence spending associated with the Vietnam War, shifted US fiscal policy to an expansionary position. Inflation began to increase, albeit from very low levels, after about 1965, and balance of payments deficits run by the United States meant that a number of other countries began accumulating substantial dollar reserves. This fed the process of money creation in these countries and relaxed the constraints on their domestic macroeconomic policies, with the result in many cases that inflation rates increased. Causes of the eventual breakdown of the Bretton Woods System in the face of these pressures have been much debated, but the core of most explanations is that the system lost its capacity to provide effective policy discipline. This, in turn, reflected the loss of suitability of the US dollar as the system's nominal anchor, the role it had played so effectively over the two previous decades. It is interesting to note that the policy debate in Australia in the 1950s and 1960s paid little or no explicit attention to the nominal anchoring role of the monetary regime. That is not because the problem of inflation was thought to be unimportant - on the contrary, the need to control inflation was well recognised. Nonetheless the main focus, both of practitioners and of the economics profession more widely, was on the second of the two roles of monetary policy that I outlined earlier, namely its role in responding to shorter-term shocks. In fact, many commentators talked of monetary policy as though it was totally discretionary and free to pursue whatever domestic objective it thought most worthy (see next section on Phillips Perhaps the most important reason for this misapprehension was that the existence of the long-run anchor was simply taken for granted . Policy did not need to focus on achieving a good longer-run inflation performance because the fixed exchange rate regime delivered this result in a semi-automatic fashion. In this environment it was natural to focus on shorter-term objectives, with the balance of payments serving as an important barometer of the need for policy action: whenever domestic demand was too strong, this would quickly show up in a payments deficit which needed to be corrected by tighter policy, and vice versa . In this way, the policy regime ensured that actions taken in response to short-term demand pressures had the effect of consistently tying the economy in to the long-run anchor. The eventual failure of the fixed exchange rate system to ensure continued good macroeconomic performance reflected a combination of circumstances. The expansionary shift in US policy, to which I have already referred, meant that the external anchor became increasingly a source of inflationary pressure rather than of price stability. This was the case not just for Australia, but worldwide. In Australia's case, however, the effect was amplified in the early kept budgets close to balance and inflation low, and this underpinned a period of sustained low inflation in other countries. In Australia, apart from some periods influenced by sharp commodity price movements, inflation was generally low and close to US 1970s by the related phenomenon of rising commodity prices, which had a disproportionate effect on Australia, given our high commodity export exposure. The effect was to relax the balance of payments constraint and allow a further loosening of domestic policy discipline, with the result that the rise in Australia's inflation rate soon overtook that in the United States. The role of the 1973 oil shock in all of this was also important, but it should be remembered that inflation in Australia had already reached double-digit rates before the oil shock occurred. The early to mid 1970s was a period of reevaluation of the earlier conventional thinking about monetary policy, prompted by the experience of a number of years of rising inflation. It is interesting to focus on the nature of that re-evaluation because it remains relevant to policy today. In the 1960s, the conventional thinking was summed up in the widely influential notion of a stable downward-sloping Phillips curve. Inflation was thought of in terms of demanddriven processes that would move the economy along the curve, so that high levels of demand would produce a combination of high inflation and low unemployment, and low levels of demand the reverse. The role of policy was to manage aggregate demand so as to achieve a preferred combination of outcomes, taking the position of the Phillips curve as given. Of course, not all economists subscribed to this simplistic world view, but I think it is a fair representation of the consensus among those economists who were most influential and among a broad range of other policymakers, politicians and journalists. There was considerable confidence for a time that policy could effectively manage the trade-off. before about 1970 had been quite successful: periods of clearly excessive inflation had been rare, and were quickly reversed when they occurred. But there developed a general tendency among policy-makers in the late 1960s and early 1970s to try to exploit the trade-off to extract more growth, in the belief that the cost in terms of inflation would not be too great. The experience of the 1970s - the simultaneous rise in inflation and unemployment, and their persistence at high levels - proved this understanding of the economy to be too simplistic and an inadequate guide for policy. To a mindset based on the stable Phillips curve, the combination of high inflation and high unemployment could not be readily explained. Indeed, it appeared internally contradictory, since inflation was thought of as a symptom of excess demand while high unemployment signalled that demand was deficient. Two factors needed to be brought into the conventional model in order to understand the 1970s experience. The first, which had been emphasised both by Friedman and by Phelps, was the role of expectations. The short-run Phillips curve was to be thought of not as a permanent trade-off, but as conditional on the expected rate of inflation. Expansionary demand conditions were associated with higher-than-expected inflation, rather than high inflation per se , so the trade-off of higher inflation for lower unemployment could only be exploited over the limited period in which inflation expectations did not fully adjust to the new higher rate. In the longer run, when expectations had adjusted, high inflation would have no stimulatory impact. In Friedman's words, 'a rising rate of inflation may reduce unemployment, a high rate will of this principle had not previously been observable because inflation had never stayed high for long enough to be built into expectations. The second, and related, factor to be brought into the conventional model was the importance of supply shocks. These could be thought of as shocks which reduced the sustainable levels of output and employment consistent with steady inflation. For much of the world the quintessential supply shocks were rises in oil prices but, for Australia, the real wages shock of 1974 was probably at least as important. Recognition of the importance of supply shocks implied a corresponding recognition of the limitations of what could be achieved through conventional demandmanagement policies. Although economic thinking has advanced in a number of ways since the 1970s, these two basic lessons from the period remain relevant, and often need repeating. While the economics profession was quick to take up the stable Phillips curve, it was also quick in dropping it as a policy prescription. But there are still some in the policy debate - particularly among politicians, lobbyists and journalists - who think of the economy in terms of a stable Phillips curve, and who would like us to choose a higher inflation rate on the assumption that this would produce a sustained lift in growth and employment. But that is not the choice we face. Higher inflation can deliver at best only a temporary stimulus to growth and, in the longer run, is more likely to be detrimental. In the light of the early 1970s experience, economists stopped assuming a stable Phillips curve and started looking for ways to anchor monetary policy decisions. The Friedman suggestion of a steady growth of the money supply sufficient to accommodate normal economic growth and low inflation found favour in a number of countries. Several had been focusing on monetary aggregates since the early 1970s and, by 1975, a number, including the United States, Germany, the announcing monetary targets. Australia followed suit in 1976 by beginning to announce forecasts for the growth of M3. These were subsequently announced each year in the federal budget until the practice was discontinued in 1985. The nature of the targets was somewhat different to what is often assumed in the textbooks or in the somewhat idealised notions of monetary theorists. In no country were targets adhered to with the sort of mechanical precision envisaged in Friedman's , the classic statement of the case for monetary targeting. They were usually seen as guides to policy, and as vehicles for explaining the rationale of policy actions, rather than being binding constraints on the policy-maker. Monetary targeting regimes had a moderate degree of success in achieving their intermediate monetary objectives, and somewhat greater success in terms of the ultimate objective of reducing inflation. In the heyday of monetary targeting around the world, roughly from 1975 to 1985, some substantial reductions in inflation were achieved. Australia's inflation rate was reduced during this period, but was still a lot higher than the OECD average by the mid 1980s. It would be a mistake to attribute the differences in inflation performance across countries primarily to differing degrees of rigour in the pursuit of monetary targets. The countries that brought inflation under control most quickly were not particularly more successful in hitting their monetary targets than the rest. The general pattern, summarised in Table 1, was that countries achieved their targets about half the time. Australia's success rate was a bit less than that, about a third. On another measure - the average deviation from the target midpoint - Australia's record was quite similar to that of several other countries. The achievement of inflation reduction was a product not so much of the technical merits of monetary targeting as of the general shift in the policy-making consensus towards inflation control. What was critical was the willingness of the authorities to run policies that put a consistent downward pressure on inflation over a period of time. But, that said, the targets did serve a useful purpose. They focused policy on the need to anchor the nominal magnitudes in the economy, and they helped in communicating the anti-inflation strategy to the public and marshalling public acceptance of the required policy actions. The Volcker disinflation period in the United States was a good example of how useful targets could be in this role. Alan Blinder described the monetary target as a 'heat shield' which enabled the Fed to maintain a much tougher disinflationary stance than the public would normally have found acceptable. As a result the United States was able to make a definitive transition to low inflation at an early stage. Monetary targeting was always subject to two well-known problems, both of which were important in the Australian experience. The first was the problem of controllability. The fact that targets were often missed was an indication that close control was either not possible, or would have required undesirable movements in the policy instruments. The second was the instability of the relationship between money supply and the ultimate objective of policy such as inflation or nominal GDP. It was this second problem that was decisive in causing most countries to abandon monetary targeting as the basis of their monetary policies. By the mid 1980s, the problem of instability was coming to the fore. The relationship of money to ultimate objectives had always been imprecise, but had been judged to be sufficiently stable to serve as a useful guide to policy. But the structural changes in the financial system that followed deregulation were sufficiently large that this was no longer the case. In Australia, in the mid 1980s, the newly deregulated banks were able to win back market share from other institutions, and the financial system as a whole began to grow more rapidly. To some extent, this was to be expected, but it meant a lengthy period in which the behaviour of the monetary and financial aggregates diverged from inflation or reached 17.5 per cent, at a time when domestic inflation had been falling. The problem was not unique to Australia. By the time our targets were suspended in February 1985, many other countries had downgraded or abandoned them, for much the same reasons. In the words of Canadian central bank Governor Bouey, 'we didn't abandon the monetary aggregates, they abandoned us'. The move away from monetary targets was followed by a period of transition when policies became more pragmatic and there was a search for alternative guiding principles. Once again, Australia's experience was by no means unique. Virtually all countries were downgrading their monetary targets to one degree or another, and there was no immediately clear direction as to what should be put in their place. Theory offered little help. Some of the alternatives being put up by critics either had already proven unsatisfactory for us - like a return to fixed exchange rates or forms of monetary targeting - or were unrealistically radical. Most countries with floating exchange rates developed a pragmatic approach that, broadly speaking, tried to resist excessive inflation and to have some stabilising influence on economic activity in response to shorter-term shocks. Policy in Australia through this transitional period has been criticised for lacking a clear conceptual framework and allowing too much scope for central bank discretion, and there is some validity in these criticisms. In Australia, the policy 'checklist', which entered the discussion for a few years following the abandonment of monetary targets, comprised a wide range of variables which were to be consulted in assessing economic conditions and making policy decisions. The list of variables included interest rates, the exchange rate, the monetary aggregates, inflation, the external accounts, asset prices and the general economic outlook - in short, an amalgam of instruments, intermediate and final policy objectives, and general macroeconomic indicators. The checklist conveyed the idea - sensible as far as it goes - that policy needs to look at all relevant information. What was missing was some framework for evaluating that information and converting it into an operational guide for policy. Another way of expressing this is to say that monetary policy needed a 'nominal anchor'. Pure pragmatism was not enough because it could lead to monetary policy aiming to achieve a desired result for a 'real variable', which in the long run would be self-defeating. For example, if monetary policy was solely designed to achieve a given unemployment rate (as to some extent it was in the late 1960s/ early 1970s in many countries), it would be continually eased whilever the actual unemployment rate was above the desired rate. But if the desired rate was too ambitious, this would be a recipe for continued easing and, in time, continuously rising inflation. At the same time, there would be no guarantee that monetary policy alone would be able to achieve the desired unemployment rate if structural factors were important. Similarly, indeterminacy would arise if monetary policy was directed at the current account of the balance of payments, as a lot of discussion in the late 1980s seemed to suggest. If the current account was too large, should monetary policy be tightened to reduce domestic demand (and imports), or should it be loosened to lower the exchange rate and hence increase These sorts of discussion led policy-makers and academics to again ask the question about what monetary policy can achieve in the long run. The nearly unanimous answer was that it could achieve a desired rate of inflation, but could not, of itself, achieve desired outcomes for real variables like the unemployment rate, the rate of growth, or variables like the balance of payments. Monetary policy can have an influence for good or bad on real variables, particularly in the short run, but it was not appropriate to target it at these variables. As a long-run target, what was needed was a nominal variable like inflation, nominal GDP or the money supply. With the money demand function recognised as being unstable, and nominal GDP being too abstract a concept for easy public perception, attention turned to monetary policy regimes that centred on inflation. Two main alternatives presented * a system where the instrument of monetary policy was operated to achieve a desired result for inflation, without the need for an intermediate target; or * a system where the exchange rate was fixed to that of another country which had a good record of maintaining low inflation. In short, the two alternatives which satisfied the condition of providing a 'nominal anchor' were inflation targeting or fixing the exchange rate (sometimes called the hard currency option). Australia went down the first path, while most of Europe (including the United Kingdom for a time) went down the second path by tying their currencies to the Some would argue that this two-way classification of the options is too narrow and that monetary targeting remains a viable third option, at least for some countries. Germany is often cited as an example. This view ignores the reality that the Bundesbank has moved a long way away from strict monetary targeting in recent years, as is evident from the way they move their policy instrument. There is evidence to suggest that prospective inflationary developments are more likely to trigger a monetary policy move than is a deviation of money supply from its target. Unlike the experience in some other countries like the United Kingdom or New Zealand, where inflation targets came into force in dramatic regime shifts, the elements of Australia's inflation-targeting regime were put in place gradually. There were a number of reasons for this. While inflation targets had considerable conceptual appeal, the models adopted in the pioneering countries - New Zealand and Canada - seemed to us excessively rigid with their narrow bands and low target midpoints. The fact that these were the only working models available at the time tended to polarise debate, and it took some time for the Bank to develop its own more flexible version. Also important was the need to build public support, including political support, for a target, and again this happened gradually rather than in a single, decisive act. Some of the key elements of the inflationtargeting approach were in place quite early. The conceptual basis of such an approach, with a focus on inflation as the policy objective, no intermediate objective, interest rates as the instrument, and a transmission process that works via the effect of interest rates on private demand, had been analysed in a number of pieces that the Bank published in 1989, including its conference volume. What we now consider one of the key elements of the policy framework, the explicit announcements of cash rate changes, with explanations of the reasons for each change, began in January 1990. Over time, the Bank's published commentaries on monetary policy adopted target % and the economy became more detailed and developed a stronger inflation focus. The numerical objective of 2-3 per cent inflation began appearing in public statements by cumulative effect of all these developments was to establish an inflation-targeting regime broadly comparable to those being developed in a number of other countries around the same time. While there was no individual decisive event, international comparative tables such as those published by the BIS date the change in Australia from 1993. A final element was added with the joint statement on the conduct of monetary policy, made by myself and the Treasurer on my appointment as Governor. The statement gave the Government's formal endorsement to the independence of the Reserve Bank as contained in its Act and to the 2-3 per cent target. It also provided for enhanced accountability through semi-annual statements and parliamentary appearances. Several other countries adopted inflation targets around the same time as Australia. A recent survey by the BIS counts seven inflation targeters, making this currently the most numerically popular regime among mediumsized OECD countries (Table 2). As had been the case with previous regime changes, the immediate reason for change in many cases was either a breakdown of a previous regime or dissatisfaction with its performance. In the trigger was the collapse of fixed exchange rate commitments in 1992. New Zealand and Canada adopted their targets in a deliberate strategy of inflation reduction. Australia was somewhat different in that there was no crisis that needed to be responded to, and the target was developed to cement in place an inflation reduction that had already been achieved. The move to inflation targeting completed a significant conceptual leap from the regimes that had prevailed in the earlier decades. Instead of a focus on intermediate objectives, like the exchange rate or the money supply, the operational framework of policy was now built around a final objective, inflation. In describing inflation as the final objective in this context, I should make clear that inflation control is viewed as a means to an end rather than an end in itself. The reason monetary regimes have been set up to aim for low inflation is that this is the best contribution monetary policy can make in the longer run to growth in output, employment and living standards. In principle, this approach re-establishes a clear nominal anchor while avoiding the main problem of the intermediate-targeting regimes - namely, that the target variables did not have a sufficiently stable relationship with the final objectives. The approach also preserves, from the transitional period that I described earlier, the commonsense notion of using all relevant information: the difference is that there is now a clear criterion - the impact on the inflation outlook - for assessing what the information means for policy. Another property of inflation targets, not always well-recognised, is that they provide scope for counter-cyclical action. This is automatically built into the policy framework if a central bank takes seriously, as we do, both the upper and lower bounds of the target. When the inflation forecast is above the target, the framework requires policy to be tightened, as was the case a couple of years ago, and, when it is below target, policy has to be more expansionary, as at present. In this way the policy framework incorporates a systematic resistance to cyclical demand pressures. I have described this previously by saying that the policy aims to allow the economy to grow as fast as possible, consistent with low inflation, but no faster. Aside from these operational characteristics, an important dimension of the economic rationale for inflation targets is their role as a discipline on the policy process. The academic literature lays great store on this - particularly in the time inconsistency literature - although it tends to focus rather too narrowly on the idea of constraining the policy-makers. The targets are seen as correcting an inflationary bias that would otherwise arise from the temptation of central bankers to go for shortterm expansion. In this literature, rule-based regimes are said to be superior to discretion because they allow pre-commitment to noninflationary policies, and thereby overcome the assumed short-termism of the policymakers. Central bankers are very sceptical of this line of analysis because we do not see ourselves as inherently inflation-prone. But while I think this particular argument for a rule-based approach somewhat misses the point, the ability to specify policy in terms of a relatively simple rule does have some important advantages. In particular, simple rules provide a ready vehicle for accountability and for public communication: they require policy actions to be explained in terms of a clear target, and they help central banks to Also important is that, over time, a simple rule like an inflation target can provide a focal point for inflation expectations by making clear what the central bank is aiming at. One of the reasons that inflation targets have proven attractive to so many countries is that they seem to strike a workable balance, between having these advantages of a simple rule, and retaining a necessary degree of flexibility. The framework has simplicity in terms of an easily communicated objective, at the same time as having flexibility in the interpretation of information and operation of the policy instrument - a combination of characteristics that Mishkin refers to as While the essential characteristics of inflation targets are common to all the practitioners, there are some interesting variations across countries in the detailed design features. These involve characteristics like the target midpoint, the width of fluctuation bands and the timeframe for evaluating performance. Australia's system differs from the early models (particularly New Zealand) by focusing on a midpoint of 2-3 per cent (which really means 'about 2 rather than a range. The most common target midpoint is 2 per cent: Australia and the United Kingdom are slightly higher at 2 and (having originally been at 1). There is also a difference concerning the meaning of the upper and lower bounds. In the original New Zealand and Canadian models, inflation was meant to be always within the band, but in our variation that was never the intention. At this level of detail there is no single consensus model as to how an inflation target should be designed. To some extent, the variations reflect the different historical circumstances of each country. For example, New Zealand, which had the first and the most tightly specified system, also had one of the poorest track records on inflation and therefore the clearest need to signal a regime shift. Notwithstanding these differences, the essentials - a numerically specified target linked to procedures of public explanation and accountability - are common to all the inflation targets. To the best of my knowledge, inflation targeting was not seriously canvassed as a monetary policy option until the 1980s. By the end of that decade, however, as I have described earlier, there were only two monetary policy regimes that held out the promise of being achievable and of providing a nominal anchor - the first was the hard currency option and the second was an inflation target. It is my view that, as we approach the next century, the field will narrow further, and that inflation targeting will become the dominant monetary policy regime. This would be a remarkable change for a system that was virtually unheard of until the second half of the 1980s. The reason for this change is that the biggest group of countries that have chosen the hard currency option - the members of the scheduled on 1 January 1999 to achieve monetary union. On that date, there will be one European currency - the Euro - and one be the monetary policy regime pursued by the ECB? It cannot be the hard currency option because the Euro will be a floating currency. My guess is that, whatever the ECB chooses, it will rather closely resemble inflation targeting. An alternative view is that in order to impress markets that the Euro is as sound as the Deutschemark, the ECB may follow something akin to the German practice of monetary targeting. As I said earlier, this would not alter the picture very much as current German practice seems to be at least as much like inflation targeting as it is like monetary targeting. In this new world, there will be three major currencies, which will float against each other - the US dollar, the yen and the Euro. Of course, none of these are in the group of countries that has an explicit inflation target, but I have argued elsewhere that if you had to fit the United States into one or the other of the formal monetary policy regimes, the one that comes closest is inflation targeting. The target is not explicit, but the Fed makes no secret of the fact that it is its assessment of inflationary pressures and the outlook for inflation that is the major determinant of whether US monetary policy is adjusted. Fed's behaviour over the last month has made that abundantly clear. Japan is a more difficult case to classify, but the evidence is that with inflation virtually non-existent, interest rates have been reduced to about the lowest conceivable level (the cash rate is per cent). Thus, among the traditional OECD countries, we have a group of explicit inflation targeters and another group - the big three - who have systems which could most appropriately be called implicit inflation targeters. Outside the OECD area, there is still room for countries to choose the hard currency option - Hong Kong for the past 13 years and Argentina (for a considerably shorter time) - fit this description. But recent events in Asia as well as in other regions such as Eastern Europe may have made the fixed exchange rate option less attractive. If we take an even longer sweep of history, we can see that we entered this century with the most irrevocably fixed exchange rate system yet devised, namely the gold standard. As we enter the next century, we enter a world where floating exchange rates are the norm, and where the role of nominal anchor will be predominantly played by an inflation target, whether it is explicit, much as our own, or implicit as is the case in the United States.

r971106a_BOA

australia

macfarlane

Governor's appearance before the Committee. Thank you, Mr Chairman. It is a pleasure to be here in front of your Committee for the second time under the new arrangements set out in the Statement on the Conduct of Monetary . On the basis of the first hearing, we think the new arrangements are working very well. On that occasion, we received some very penetrating and constructive questioning from Committee members, and there seemed to be quite a lot of public interest in the proceedings. The main reason for these hearings is to improve the accountability of the Reserve Bank, both directly to Parliament, and via the press coverage to the public more generally. In the spirit of increased accountability, I should, I suppose, be accountable for what I said to this Committee at the previous hearing, as well as for what I am going to say today. I covered a number of subjects at the previous hearing which I thought were important for an understanding of how the economy was going to perform over coming years. I also mentioned a couple of outcomes we expected for 1997. It is those which will probably be of the most immediate interest. I said that, after a sluggish 1996 where GDP had grown at about 3 per cent - at one point, it got to not much more than 2 per cent on a 12-months-ended basis, we should expect it to pick up to about 4 per cent in 1997. I also said that I expected inflation to stay at the bottom of the 2-3 per cent range, with the possibility that it could go a little lower for a while. Now I think I could be excused for wanting to walk away from earlier forecasts as a result of the current turmoil in Asian and world financial markets. While I intend to say quite a lot about those events later on, I do not propose to invoke that excuse at this stage, because they have not had any effect on the economy to date. They have affected financial markets, but not the economy yet. Instead, I want to start by saying that the baseline we have to work from, i.e. the growth of the economy in the first three quarters of 1997, has been at least as good as I was pointing to in May, if not a little better. We now have the GDP growth rates for the first two quarters of 1997, which show the economy grew at an annual rate of nearly 4 per cent during that time. And we have further monthly figures for the September quarter which are somewhat stronger than those recorded during the first half of the year. This is true for the major monthly indicators such as retail trade, imports and exports. It is also true for the labour market, especially for vacancies, and to some extent also for employment. There is also evidence from the business surveys that confidence is picking up, but these surveys were generally compiled before the Asian headlines of a fortnight ago. * On inflation, the outlook changed a little. New figures brought underlying inflation below 2 per cent, and our on-going assessment caused us to lower our forecasts. As a result, we have had two further easings of monetary policy - one in May and one in July. An important reason for the lower inflation forecasts was the better outlook for wages. You may recall that shortly after the previous hearing in May we received revised figures on earnings from the ABS that suggested not only that they were lower in the quarter in question - the March quarter of 1997 - but that an upward trend had been revised away. This better picture was confirmed again in the June quarter figures, but the picture has been muddied somewhat by the recent September quarter figures which show an unexpectedly strong rise. On balance, therefore, we at the Bank judged that the information becoming available over the past six months was tending to confirm this relatively benign view of the future - GDP growth of about 4 per cent (enough for some further reduction in unemployment from the 8.8 per cent we had at the time of the last hearing) and inflation a little below 2 per cent (enough to justify the May and July easings in monetary policy). The picture was not all rosy - the slower output growth of 1996 was still making its presence felt in the form of sluggish employment growth in the first half of 1997, there were some doubts about the strength of investment, and the effects of El Nino were around the corner. But economies nearly always present a mixed picture, and this mixture was a lot better than most. In addition, financial conditions had become clearly easier than in May. The overnight cash rate had come down from 6 per cent to 5 per cent as a result of the two easings of monetary policy, and yields on 10-year bonds were down from 7 per cent to 6 per cent. The exchange rate against the US dollar has cents; against the trade-weighted index, it has I come now to the point where I should say a few things about what has been happening in Asia and the rest of the world. I will do my best to be specific, but you should bear in mind that the ground is constantly changing. The first thing I would like to say is that in the long run I am still very optimistic about Asian growth prospects. These countries still retain a set of characteristics that are conducive to long-run growth: * they can still achieve rapid productivity growth through technology transfer, i.e. they have started from a long way behind and have a fair way to go; * they are oriented towards international trade; * they have high savings rates and high investment and a relatively small government sector; * they have generally sound fiscal and monetary policies - although they have got some way to go in terms of the soundness of their banking and financial sectors; and * they have great respect for, and devote considerable effort to, education. I do not see the end of the Asian miracle, partly because I do not think it ever was a miracle; it was just the application of some tried and tested rules of good economic policy. It is still fortunate for our long-run prosperity that we have strong links to Asia. Having declared my optimism about the long run, I should now turn to the short run. Clearly, there are going to be difficulties here, in particular among four ASEAN countries - Philippines. From the moment the Thai baht was floated on 2 July, attention quickly broadened to encompass these four. Their currencies have fallen sharply, as have their stock markets and property prices. These countries are battening down the hatches - in two cases with the help of the IMF - to sort out their problems. The principal problem, it is now apparent, concerns how to handle the fall of previously over-inflated asset prices, undisciplined lending by local banks and foreigners, and some very opaque interrelationships between business and government which have obscured the true financial position of a lot of companies and banks. There also appears to have been over-investment in some areas. Property played its usual major role, but on this occasion there were also more contemporary avenues, particularly electronics and semiconductors, where there is clear over-capacity and intense competition among these course, these problems have been around for years - they did not just start on 2 July. A part of this adjustment must inevitably involve a sharp curtailment of growth in the short run and a contraction of credit. Imports will fall, and so the effects will be spread to other countries. The good news for Australia is that these four countries account for only 10 per cent of Australia's exports. If the difficulties remain confined to these four countries, the effect on Australia's exports, and hence our growth, would be modest. The rest of Asia is, in fact, a lot more important to Australia. Japan - our largest market - has been limping along at an average annual growth rate of about 1 per cent now for about five years. Our exports to Japan have virtually not increased at all during that period. The other big Asian markets for Kong. These are collectively much more important than the ASEAN four. Of course, some of the underlying problems that afflict the ASEAN four also apply, although more modestly, to some of these countries. For a time, it looked as though the ASEAN problems would spill over to these in a big way, but that seems less likely now, although we should not speak too soon. Even so, we should build in the assumption of some slowing in aggregate for these countries. To judge the effects on Australia, we should, in principle, have a view on how each country will fare in regard to economic growth, imports and the health of their banking systems (and we should look outside Asia, which I will do later). It is never easy and some sure bets turn out to be wrong. For example, virtually everyone thought the simultaneous share market crash of 1987 and associated company failures would presage at least a slowdown, if not a recession. In the event, 1988 turned out to be a boom year for the OECD economy and for Australia. Let us hope we can be a little closer to the mark this time. Most analysis to date has consisted of a relatively mechanical application of lower growth and lower imports among the ASEAN four to lower Australian exports and lower Australian GDP growth. The orders of magnitudes are quite small and the most commonly cited figure for GDP growth in Australia is a reduction of about a quarter of a percentage point. According to press reports, the OECD has recently suggested figures of 0.3 per cent for Australia in 1997 and 0.4 per cent in 1998. Quite how they got an effect on 1997, which we are already 80 per cent through, I do not know, but, as I said, I am only relying on newspaper reports. These sorts of figures can become considerably larger if we also bring in lower growth rates for Korea, China, etc., but we are getting into the realms of speculation if we do so. The only guide that we have is that this will not be the first time that it has happened. In 1984 and 1985 we saw a big drop in Asian currencies and a big drop in their growth rates. It had the predicted effect and our exports to Asia for a time were quite weak. Again, last year - in calendar 1996 - there was zero growth of imports in the ASEAN four, and our exports to them slowed. I think we will have to put up with a period of weakness again. Frustrating as this instability may be, it seems to be an inevitable part of an open competitive economic system which is the only type capable of achieving strong growth in the long run. So far I have only talked about Asia, but the outcome for the world economy will depend on more than Asia. We have to bring in two bigger regions - North America and Europe. but also including Canada and Mexico) is growing quite strongly. The recent disturbances in financial markets which were imported into North America from Asia do not seem to have had a lasting impact. If anything, their main effect seems to have been to hose down some overheated asset markets slightly, and hence to reduce the likelihood of an imminent tightening of US monetary policy. Such a tightening in the next six months cannot be ruled out, however. Europe is finally recording some gains after years of disappointingly slow recovery from the early 1990s recession. In fact, European growth has picked up to the point where six European central banks recently tightened monetary policy slightly to head off possible inflationary pressures down the track. So far, I have talked about Asian and world economic events as though their only effect on Australia was via our exports. Of course, that is only part of the story. The other important part is that we now have to face the possibility of further financial market instability. For better or for worse, through knowledge or through fear, the international investment community is taking a more sceptical look at things Asian, and that includes all countries in the Asian region, including Australia. That means they have become more risk-averse, and more likely to judge countries and their policies harshly. We have already seen some of the effects on * falling exchange rates; * falling share prices; * rising risk margins in interest rates; and * downgrades by rating agencies. We are in a better position to handle this financial instability than we have been at any stage in the last 30 years. We formerly had a reputation as a boom-bust economy, and investors used to build in quite a large premium for risk when holding Australian assets. We have come a long way in convincing investors that this is largely a thing of the past. A good example of this is that our bond yields are now virtually the same as US bond yields, whereas five years or 10 years ago it was not uncommon for the gap to be as high as five percentage points; some of this was a risk premium and some of it reflected our higher inflation. Another example is that the Australian dollar used to be one of the most volatile currencies in the world, whereas in the 1990s it has been no more volatile than the major currencies such as the US dollar, the yen or the mark. Over the past four or five months, this has served us well. While the Australian dollar has gone down a fair amount against the US dollar, it remained relatively steady in trade-weighted terms. It is true that over the last fortnight the Australian dollar has declined in trade-weighted terms, but it has done this in a relatively orderly fashion, and it is not an unreasonable market response given that our export markets have weakened. This new-found reputation for stability may surprise some people, because there is still a tendency to read so much into the small month-by-month or quarter-by-quarter variations in economic statistics. But if we take a longer sweep, we can see how many of the economic problems that used to concern us have now been eliminated, or are at least under some reasonable sort of control. The headlines are no longer full of stories about the current account deficit or the level of foreign debt. The budget deficit is small. High inflation and its inevitable twin, high interest rates, no longer fill the papers. This does not mean, of course, that we have solved all our economic problems, but we have clearly narrowed them down. This has also tended to concentrate minds on the one that remains - namely, the level of unemployment. This is a reasonable priority because less progress has been achieved on unemployment than on the other imbalances in the economy that came to the fore in the mid-70s and persisted through the 80s. It is not as though no progress has been made - the unemployment rate has come down from a peak of 11.2 per cent to its present 8.6 per cent - but it has been disappointing progress. With six years of the expansion now behind us at an average growth rate of 3.6 per cent per annum - the third highest in the OECD area - we could have hoped for more. I think some further progress can be made over the next year, although we have to accept that it will probably be slow, and monetary policy will only be part of the story - in the long run, only a small part. History suggests this will remain the case. Australia moved from 2 per cent unemployment to over 10 per cent in the decade from 1973 to 1983. The damage was really done during that period. Despite good output and employment growth in the 1980s expansion, the unemployment rate was back to 11 per cent following the 1990 recession. So in net terms no progress had been made in a decade. What we want this time is good growth in output and employment, with a difference - we want it to last a lot longer. The six-and-ahalf years that the previous two economic expansions lasted was not good enough. Although progress was made in reducing unemployment - particularly in the second one - it was all lost in the ensuing recession. This time around we must make sure we have a much longer expansion, reducing the likelihood and severity of any future slowdown as much as possible. I do not know how far that will be possible, but the surest way of ameliorating the business cycle in this way is to avoid the imbalances occurring during the later stages of the expansion. The main imbalance in Australia, as elsewhere, has always been the emergence of inflation. The story is never exactly the same - inflation can be accompanied by a wage push, an asset price boom or an external imbalance - but the result has been the same following each of the past three booms. That is why we need to have a more medium-term focus in our monetary policy and why the inflation target is such a central part of it. The inflation target is not anti-growth; low inflation is not an end in itself, we are interested in sustaining a good inflation performance because we are interested in growth and employment. Keeping inflation in check is the key to longer expansions. It has sometimes been said that we are too cautious in following this policy. I think that is a little unfair. Of course, we are cautious in that we like to look at a range of information and think carefully before we make a move on monetary policy. But we try to be forward looking and pre-emptive. For example, we did not wait till measured inflation was below 2 per cent before easing - in fact, it was 3.1 per cent when we first eased in July last year. Similarly, there have been suggestions that the Reserve Bank has a speed limit above which the economy cannot be allowed to grow (the figure usually cited was 3 per cent). Such a suggestion is, of course, incorrect and I have pointed this out on several occasions. In case there is still any doubt, you only have to look at our behaviour in 1997. As I said earlier, the economy has been growing at 4 per cent per annum so far in 1997, yet it did not stop us easing monetary policy twice this year. If we are getting reasonable news on inflation and our inflation forecasts are in good shape, we have no objection to the economy growing by 4 per cent or 4 per cent plus. When looking at the whole picture of employment and unemployment, monetary policy is only a small part of the story, and it mainly concerns the cyclical aspect of unemployment. If you look at the really big changes in employment or unemployment over decades, rather than years, monetary policy plays a very small role. The biggest change in employment performance of which I am aware is the contrast between the United States, the unemployment rate is back to its sixties level, whereas in Europe it is about five times as high as it was in the sixties. A few European countries have done better than that - including the United Kingdom - but others have done worse. If you try to explain the superior US employment result by faster economic growth you get nowhere. Europe has grown as fast as the United States over three decades - it just has not generated jobs. The explanations for the poor European performance on jobs all centre around various types of rigidities, especially in wages and conditions of employment, but also the social security system and the difficulties involved in starting businesses and the subsequent lack of entrepreneurship. I do not intend to go into this in any depth because it is a huge topic. I only raise it to point out that there is much more to the story than the growth of demand, and the role that monetary policy plays in it. In other words, even if we succeed in having good economic growth and sustaining it for a longer period than in earlier expansions, it will not solve all our unemployment problems. We will make some progress, but it is too optimistic to think that we will be able to emulate the Americans and return to the 1960s level of unemployment through macroeconomic policies alone. I saw in the paper yesterday someone from ACOSS saying that the big challenge for Australia was to achieve US-style economic growth and low unemployment without US-style inequality and poverty. I think this is a realistic way of looking at it. It shows an awareness of the current trade-off, and I suspect a hope that, with some ingenuity, we might be able to improve on it somewhat. My only quibble is that we already have achieved US growth rates - in fact, exceeded them - it is the US unemployment rate that has eluded us. This is something that people like myself, who studied economics in the sixties, find surprising. In the sixties it was the United States that was always criticised by countries like Australia and most of Europe for their high unemployment. Now the boot is on the other foot. There is a lot more that I could talk about, but I will confine myself to only one further topic. That is the subject of bank lending and bank margins, particularly bank lending to small business. This is a subject that this Committee has taken a particular interest in. In fact, the first large-scale inter-country study of Australian banks' margins and banks' profitability was undertaken by the Reserve Bank at the request of this Committee in August 1994. We did another study at the Committee's request recently which was published in our October 1997 . As Committee members also know, the Reserve Bank has been meeting with its Small Business the provision of finance to that sector. We formed this Panel because we were worried that banks had become excessively risk-averse and were reluctant to lend to small business in the early part of the recovery from the It has been a slow process, but competitive pressures have been gradually working their way into banks' margins, i.e. the difference between the average rate they earn on their loans and the average rate they pay on their deposits. These margins are now lower than at any time since we have been collecting the statistics, and the biggest fall has occurred over the past two years. Clearly, the entry of mortgage originators into the housing market was a very important development, and it led to the margin on housing lending falling from a level which was high by international standards to one which is about average. We are now beginning to see hotter competition in lending to small and medium-sized businesses. Partly this is a result of the need felt by many banks, particularly the regional ones, to reduce their reliance on the now much less profitable mortgage market. In this sense, it shows how competition slowly works its way through the system. I confess that it has taken longer than I expected, and longer than I hoped, but we are finally getting there. That brings me to the end of my introductory remarks. We have certainly had a very eventful period in the month leading up to this meeting and we have all been working hard to keep up with events, particularly in the international scene. We are happy to answer any questions you have, and I hope it leads to as good a discussion as we had together last time.

r971204a_BOA

australia

macfarlane

It is a pleasure to be here this evening to looked back over my files and I noted that this is only the second time I have addressed this group; the previous occasion was nearly seven years ago in February 1991. At that time, I spoke about asset price booms and busts, particularly the latter. You may think I have a one-track mind, but the same subject - only with a different location - is going to figure prominently in what I have to say tonight. I want to talk about the changing nature of economic crises, and then draw out some conclusions for Australia. At the risk of some oversimplification, I think there have been two basic types of economic crisis. The old-style economic crisis I will call Type I, and the new-style, which has come to prominence over the past decade, I will call Type II. Most of these crises occur in developing countries, but developed ones have not been immune from them. The standard way that countries - particularly developing countries - got into trouble in the past was that their governments did the wrong thing by running bad fiscal and monetary policy. Governments ran large budget deficits and did not finance them properly - they wrote cheques on the central bank, which is colloquially known as printing money. Interest rates were held artificially low (or negative in real terms) and money supply ballooned, resulting in accelerating inflation, a loss of competitiveness, large current account deficits and a collapsing currency. This was a Type I economic crisis, and the IMF has a standard set of arrangements for dealing with this problem. Just about every developing country ended up in this predicament at some time or other. Some of the Latin American countries did it again and again. We skirted perilously close to it in Australia, particularly in the mid seventies, but did not end up in the hands of It suffered a classic Type I economic crisis in 1976, and needed a support package from the IMF, with the usual conditionality requirements. The Type II problem is very different. Although it has become common in the past decade in a wide range of countries, the best examples at present are to be found in Asia. Type II economic crises are not caused primarily by bad fiscal policy or bad monetary policy. One of the reasons I have a lot of sympathy for the Asian countries at the moment is that they did not get into their present trouble through undisciplined fiscal policy, and their monetary policy in the conventional sense was quite good. This is shown by the fact that their budgetary positions are on average much better than OECD economies, and most have inflation rates that are quite low for developing countries. A Type II crisis is really financial in nature, rather than stemming from poor macroeconomic policies. Its central dynamic is the credit cycle and the main players are companies and banks, or financial institutions more generally. A Type II crisis usually traces its roots to a period when the economy was doing well, growing quickly and becoming popular with investors and lenders. Usually, but not always, an inflow of foreign capital is part of the process which bids up asset prices (and attracts more foreign capital). Domestic banks do not sit idly by - they join in to lend money for all sorts of promising projects and asset purchases. If the economy is growing strongly at the time, which it usually is, it looks as though everyone can make money. Some of the finance is invested wisely and makes a good return, but much of it is inevitably invested unwisely. A lot of it goes into property or is invested in industries which are already oversupplied. At some point, something happens and the whole process goes into reverse. In the case of South-East Asian countries, the event that triggered the reversal was the realisation that their currencies (initially the Thai baht) had become over-valued because they were tied to a strongly appreciating US dollar. The real exchange rate was also the trigger in Mexico in 1994. The mechanism by which the reversal occurs is usually capital outflow. Even without an external 'shock', a reversal would eventually occur, as it did in Japan's case. Domestic and foreign investors sell assets and take their funds out of the country. The early ones realise good profits in the process, the slow movers are motivated by a desire to cut their losses. In the process, the exchange rate falls sharply, and the initial diagnosis is that the country is suffering from a 'currency crisis'. Soon asset prices fall, with attention focusing on the most visible indicator of this - the share price index. Later it becomes apparent that businesses are going to fail, collateral values will fall, loans will go bad, and the inevitable glut of new property coming onto the market will not be able to attract buyers. If, as is usually the case, companies and banks have borrowed in foreign currency, servicing burdens become intolerable. Suspicion turns to the solvency of the banking system because its customers are failing and its capital is diminishing. It is usually not just a problem of an individual bank, but of a significant part of the banking system. Banks are reluctant to make new loans or rollover existing ones as they fight for survival. Compared with a Type I economic crisis - which was predominantly due to government failure - the Type II crisis is predominantly a private sector and banking failure. The government is, of course, still implicated, and there are usually Type I elements involved, but the solution to the problem mainly involves reforming the banking system. If the trigger for the crisis in the recent Asian episodes was an over-valued exchange rate, this can be counted as a macroeconomic policy error by the government. This is a complicated subject because for quite a while the currency fix seemed to be contributing to the good economic growth performance. But in the end, policy placed too much emphasis on international competitiveness and the current account of the balance of payments, and neglected financial stability and the capital account. The fixed exchange rate also affected the composition of capital inflow in that it encouraged borrowing in US dollars because US interest rates were lower and there was a perception of little or no currency risk. This contributed to serious Type II problems. The second way that governments often get involved is that they own or influence a lot of the banks and firms that get into trouble, and a lot of the physical investments that turn bad have been made at government direction. Finally, an important qualification to the view that Type II crises are predominantly private sector in origin is the recognition that the environment in which the private sector operates is largely determined by government policies. When the insolvencies emerge in the banking sector, people will ask 'Why did the government allow this to happen?', 'Why didn't the government have policies in place which prevented the build-up in this unsustainable situation?', 'What will the government do about resolving the crisis now that it has happened?' The truth is that the government cannot pass the buck. The best they can say is that it was not a failure of conventional demand management policies, it was a failure of a different set of policies altogether - the policies directed at financial system stability. There has been increased recognition in recent years that more attention should be devoted to policies directed at financial system stability. The two best examples of this are the Basle capital adequacy guidelines and, more recently, the Core Principles jointly promoted by the BIS and the IMF. One reason for this is that we now have a better understanding of the huge economic costs that are incurred whenever there is a systemic failure of the financial system. Systemic failure invariably results in a recession and can turn a probable recession into a depression. Modern scholarship now identifies a systemic banking system failure as the principal reason that the US economy experienced a depression in the 1930s, rather than a short-lived recession. The budgetary cost of resolving a systemic failure is also extremely high. Some people may say that one way to avoid this is to let the private sector sort it out. The drawback to this suggestion is that once the problem has reached systemic proportions, the intermediation process has broken down so badly that good borrowers will be hurt as well as bad ones. The government has to step in and close down the insolvent lenders, and take the bad loans off the remaining banks so they can start with a relatively clean slate. This solution is invariably costly and may not appeal to some on long-run moral hazard grounds, but the alternatives are so much worse. In practice, this is the only practical solution to a systemic failure of the financial system. Table 1 shows some recent examples of the budgetary cost of systemic failures. It covers only recent episodes in OECD countries; much higher figures could have been cited if the coverage had been extended to developing countries. The other reason for the recent emphasis on financial system stability is that economies appear to be more susceptible to instability as a result of the deregulated financial markets. Australia's experience in the late eighties points in this direction, but it is not an absolute rule. Just as Japan has shown that Type II episodes can occur without a lot of foreign capital flows (in fact, there were net outflows), there are many African and Latin American examples of it happening in a heavily regulated environment. The Asian countries, including Japan, which are now going through these difficulties could not be characterised as possessing highly deregulated financial sectors. The two Asian countries which most closely approximate the deregulated model are Hong Kong and, to a lesser extent, Singapore. To date, these countries have fared reasonably well. The link between deregulation of financial markets and instability is obviously more complicated than meets the eye. It would probably be better to say that the transition phase from regulation to deregulation is a dangerous period. This will be especially so if the transition is rapid, and if it is not accompanied by increased transparency and the enhancement of other policies directed at system stability. In essence, therefore, a Type II economic crisis is one which is centred around a failure of the financial intermediation process . The centrepiece of it is an environment which leads to excessive competition by banks to lend, resulting in a severe reduction in credit standards. The following features are normally * lending to related parties; * excessive concentration of lending to particular borrowers or areas, e.g. property; * excessively high loan to valuation ratios; * inadequate covenants to restrict the activities of borrowers; * lending based on asset values, rather than capacity to service from income; * failure to recognise and provide for deterioration in loan quality; and * lending to firms or individuals as a result of government directive, rather than on a commercial basis. All these developments often take place against a background of limited transparency, where investors and depositors have difficulty monitoring the capital adequacy of individual banks. There appear to be no problems during the initial phase of rapid economic growth and rising asset prices, but doubts begin to arise when asset prices fall. The recognition that some banks (and companies) have become insolvent is difficult enough in sophisticated capital markets, but is harder again where there is little necessity to revalue assets and disclose the results. Bank supervisors, as well as market participants, are thwarted by the lack of transparency. Inevitably, insolvent entities continue to operate, and there is widespread distrust of all banks because lenders and depositors cannot distinguish between creditworthy and insolvent institutions. As a result of the presence of Type II economic crises, it is now recognised that governments require improved policies directed at financial system stability. Within this general field of policy, the one that has the most direct relevance is the prudential regulation of banks. This includes both preventative measures and crisis resolution. But prudential supervision of banks is only one policy, although an extremely important one, among the range of policies that are required to achieve reasonable financial stability. Other important policies are those that pertain to the payments system and, of course, the whole field of securities regulation, including disclosure provisions and the enforcement of commercial and criminal law. In fact, it is possible to consider the whole body of law relating to claims over property and accountancy standards as being part of the necessary infrastructure for system stability. It is being increasingly recognised that, in the modern world, the most likely route to a self-inflicted economic crisis or, at its extreme, an economic collapse is through a systemic failure of the banking system. Therefore, in order to get good economic outcomes in terms of sustainable economic growth, we need more than just good monetary and fiscal policies. We need good policies directed at financial system stability, including, of course, good prudential supervision of banks. There is a close inter-relationship between monetary policy and policies that affect the stability of the financial system. While the principal aim of monetary policy should be to maintain low inflation as a pre-condition for sustainable growth, it cannot be conducted in isolation from developments in the financial system. For example, how far interest rates need to be raised to bring about a given slowing in the economy will depend partly upon how stretched asset markets are, and how exposed the banking system is to them. Similarly, the extent to which a currency depreciation can be accommodated will depend on banks' and businesses' exposure to short-term foreign currency borrowing. Having pointed out the close relationship between monetary policy and system stability policy, I expect some of you in the audience tonight will be thinking that my next step will be to put in a plea to keep bank supervision at the Reserve Bank, rather than to move it to the yet to be formed Australian Prudential disappoint you, but I am not going to do so; we did this in our submission to the Wallis Inquiry, but that chapter has ended. Although monetary policy and system stability policy are clearly related, we accept that this does not mean that bank supervision can only be carried out at the central bank. The Wallis Inquiry recommended against this, and cited a number of countries which had performed well under arrangements where monetary policy and bank supervision were carried out in separate institutions. The Government agreed with the Wallis Inquiry, as did the Opposition. We therefore accept that due process has been carried out, and that the umpire has made a ruling. We now want to get on with the job and help the Government put into place the arrangements recommended by the Inquiry. The Wallis Inquiry was well aware of the interconnectedness of monetary policy and system stability policy, and recommended that both of these responsibilities remain with the Reserve Bank. In common with many other observers of these matters, the Inquiry saw bank supervision as a clearly identifiable and separable sub-component of system stability policy. Even though bank supervision was to be carried out in APRA, the Inquiry recommended a number of mechanisms to ensure that there was close co-ordination between bank supervision and other aspects of system stability policy. These mechanisms involve Reserve Bank membership of the APRA Board, plus a number of arrangements for information sharing. I want to conclude my address tonight by covering two aspects of the proposed arrangements; first, I want to say something about what system stability policy involves once bank supervision is conducted elsewhere, and second I want to say something about the nature of APRA. With bank supervision being undertaken in APRA, what is left to be done by the Reserve Bank in carrying out its system stability responsibilities? The first and most obvious task remaining with the Reserve Bank is responsibility for the payments system. In fact, the Wallis recommendations increase our responsibilities in this area so much so that we are getting a separate Board to oversee payments system issues. As you will know, we already have a lot on our plate in this area, with the RTGS project nearing the operational stage and with the next major project likely to be in the area of reducing foreign exchange As well as specific responsibilities for the payments system, the Reserve Bank will also retain a capacity to contribute to the overall formulation of policies that impinge on system stability. The Reserve Bank will need to be able to evaluate the likely effects of prudential policy changes, particularly for banks but also for other financial institutions. It will have to keep abreast of the risks associated with the proliferation of new products and possibly new types of financial institutions. It will also need to form its own independent judgment of where the likely 'pressure points' are building up insofar as they may imperil system stability. The Reserve Bank's formal channel into the policy process will be through its membership of the APRA Board. It will also have to develop a close relationship with the be one vehicle for this. What we will no longer be doing is face-toface bank supervision. We will not be dealing with individual banks when they need help with licensing, interpretation of rules, statistical returns, etc. That will all be done by APRA. Inspections will also be the responsibility of APRA, but in the interests of information sharing, the Reserve Bank will be entitled to participate from time to time if it so desires. I do not imagine this would happen very often. Overall, it is APRA which will be setting and enforcing the rules designed to minimise the chances that financial institutions will fail. It will be APRA that has to make the judgment that an institution is in danger of failing, and to take the appropriate action. As you will see from this description of the division of responsibilities, the Reserve Bank will be relying on APRA doing a sound job. In fact, I think the whole country, and particularly the financial sector, has a big stake in ensuring that APRA is a first-rate institution. The ACFSC is also crucial to the long-run stability of the financial system, but it has the advantage that it already largely exists in the form of the ASC. APRA, on the other hand, has to be created almost from scratch. We should all support a speedy formation to make sure that the intellectual capital presently residing in its constituent parts in Sydney, Canberra and Brisbane is not lost, but is speedily brought together in one institution. It is also important that it have a high degree of budgetary independence so that it can augment its resources from private financial markets and so ensure a high degree of interaction between regulators and practitioners. I know that the Government is aware of these needs and is doing its best to bring about an early introduction for APRA. I want to finish tonight by assuring everyone that the Reserve Bank is doing everything it can to assist in the process.

r980311a_BOA

australia

macfarlane

This is my first opportunity to address such an important audience in New York, but I hope it will be the first of many such occasions. I have chosen as my topic the current Asian situation, which as you can well imagine is exercising a lot of our time and thought in Australia at the moment. We like to think that there is a lot of expertise in Asian affairs in Australia among our policy-makers, in our universities and in our press, and that therefore an Australian perspective could have interest for a wider audience. The events in Asia over the last 18 months have raised again the issue of whether it is possible to forecast economic crises. The international community went through the same self-examination after Mexico in 1994, and a large amount of research was done on the subject - much of it by the IMF. It sounds as though it should be easy. We can all point to obvious signs of trouble in particular countries - in Mexico, the overvaluation of the real exchange rate; in Thailand, declining exports and widening current account deficit; in Korea and Indonesia, the large amount of unhedged foreign borrowing. This type of casual empiricism, however, is not good enough; it tends to highlight a different factor for each country. To be a useful forecasting device, we need to identify a set of characteristics that is nearly always present in all countries that are about to experience an economic crisis. A number of economic studies have set out to do this, and have found a few useful regularities, but not much more. The results have disappointed those who hoped for a forecasting kit which would enable them to pick the timing of the next crisis and the countries involved. The private sector has not done any better as a forecaster, judged by interest rate spreads and credit ratings. The spreads between Asian interest rates and comparable US rates narrowed during the nineties to reach a low point in the first half of 1997 just as the problems were about to unfold. The ratings agencies made no downgrades in the first half of 1997, and compounded the problem by making a flurry of downgrades after Asian currencies had already fallen sharply. Notwithstanding the disappointing results of these forecasts, I intend to examine some of the characteristics that seem to lie behind the economic crises of the past decade. But before doing so, I should say a word or two about what is meant by an economic crisis - it could be something temporary and manageable, or, on the other hand, it could be an economic disaster. Most of the studies on this subject concentrate on a very specific subspecies of economic crisis, namely a currency crisis. This has the advantage that it can be measured by one variable - a currency crisis can be defined as any episode when the exchange rate falls by a large amount in a short period. A definition of this type would usually include, could add a much bigger list if I wanted to, but the above selection is sufficient to illustrate the points I want to make. The most important point is that a currency crisis need not be much of a crisis at all, in that it may not lead to a broader economic crisis. While it often does lead to a broader crisis - as in Asia today - there are examples in the above list where it was not the case. Few would argue that the United Kingdom's or Italy's departure from the ERM precipitated an economic crisis or led to any lasting hardship. I would make the same case for Australia in 1985. The depreciation of the exchange rate in these cases led to a beneficial policy response, had only short-term inflationary impact, and was soon followed by a significant appreciation. It seems to me that a fruitful approach would be to look at the factors which are likely to precipitate a currency crisis, and look elsewhere for another set of factors which would cause a currency crisis to lead to a full-blown economic crisis. By this, I mean a deep recession, high inflation and widespread corporate and banking collapses. There is a literature dating back to the 1980s which deals with speculative attacks on currencies. Not surprisingly, this points out that any country that has a combination of a fixed exchange rate and the free movement of international capital is particularly vulnerable to a successful speculative attack. The ERM departures of 1992 and the Asian currency crises of 1997 fit neatly into this pattern. But other countries with fixed exchange rates have been successful in avoiding depreciation. For example, France maintained its peg in 1992 and Hong Kong has done so for the past 13 years, despite the turmoil in its region. As well, some countries with floating exchange rates have experienced currency crises. All that can be concluded at this stage is that a fixed exchange rate is more likely to result in a currency crisis than a floating one. It is more 'brittle' - it allows speculators to build a position without turning the price against themselves. Also, it does not allow the monetary authorities a tactical retreat - they have to keep supplying foreign reserves at a fixed price. The situation described above becomes more marked if three other conditions apply: * if there is evidence that the currency is becoming overvalued, either because of domestic inflation (as in Mexico), or because it is fixed to an appreciating * if there have recently been other currency crises in countries with similar characteristics. Currency crises come in bunches; contagion is as good an indication of impending trouble as are any 'fundamental indicators'; * if there is evidence to suggest that the Government will not have the necessary support to be able to resist depreciation. Such resistance would normally involve tightenings of fiscal and monetary policy which would be hard if the economy is in or near recession, or where the balance sheets of the corporate sector are very weak. I have not mentioned the traditional villains - large budget deficits financed by central banks, and the resulting rapid monetary expansion and inflation. I do not want to suggest that these will not lead to a currency crisis - obviously, they will, but they have not been the main culprits in recent years. interesting situations - and the ones worth studying - are where currency crises occur in countries with reasonably responsible fiscal and monetary policies, as in most of the cases cited above. category of economic characteristics that are traditionally associated with currency crises are those pertaining to a country's external trade situation, such as its current account deficit or its accumulated external debts. Again, a large current account deficit is often associated with a currency crisis, but there are enough important exceptions to question whether this would be a useful indicator of an impending currency crisis. For example, neither Indonesia nor Korea had large current account deficits in the 1990s (including in 1997), nor did either celebrated case in the opposite direction is Singapore, which ran a current account deficit which averaged 15 per cent of GDP for the decade of the 1970s without a currency crisis. As you may have noticed, I have not mentioned any of the economic characteristics that have received so much attention in discussions of the current Asian situation. These include longstanding structural features such as soundness of the domestic banking system, the transparency of business relationships, the degree of government involvement in private investment decisions, or the quality of bank supervision. While these are important, they are important in a different way. Deficiencies in these areas clearly cannot be the cause of the recent currency crisis in Asia, because these deficiencies have been around for decades. They did not deter international capital from flowing in year after year and, therefore, could not be the cause of the change of direction in 1997. They are important, not because they cause a currency crisis, but because they provide an environment where a currency crisis can lead to a severe economic crisis. Whether a currency crisis leads to a severe economic crisis or not depends on two factors - how far the currency falls, and how resilient the economy is to a lower exchange rate and higher interest rates. The size of the depreciation This may sound as though it is a small diversion from the main theme, but it is not. It is quite possible that an exchange rate may fall by an amount much greater than anyone expected on the basis of ex ante information (anyone can always make up an ex post justification). This should not surprise us because no-one has yet been able to find a satisfactory explanation for movements in the exchange rate. That is, no-one has found an equation linking the exchange rate to various economic variables that is good enough to yield forecasts that outperform crude rules of thumb. We know that certain factors, such as those listed in the previous section, are associated with falls in the exchange rate, but we do not know whether the fall will occur this month or in two years, or whether it will be 10 per cent, 20 per cent or 80 per cent. One thing that seems clear is that in the early days of a floating exchange rate regime, we should expect some very large movements, particularly if the balance of forces is in the direction of depreciation. Markets are unfamiliar with the new system, they have no track record to guide them, there is often an atmosphere of panic among market participants or indecision among policy-makers, and reliable information is hard to come by. In these circumstances, overshooting is almost bound to occur. In Australia's case, the Australian dollar moved from a relatively fixed regime to a float in December 1983 because it was under upward pressure. Yet within 15 months the scene had changed and it began to depreciate sharply; in the space of 17 months it fell by 39 per cent in effective terms. This was a gross overshooting, as subsequent events proved (it regained two-thirds of its fall in the subsequent The situation in Asia involves an altogether higher order of uncertainty. Their currencies were floated because they could not resist downward pressure in 1997, and they had to give up their fixed rate regimes and move to a float before anyone was prepared for the new system. In these circumstances, floating rate regimes operate very badly and are extremely sensitive to confidence factors. Great skill is required in finding the right policies and managing the crisis. The countries concerned usually have no experience of it, and therefore often turn to the international community for help. It is an equally large challenge for the international institutions and the spirit of international co-operation. When an exchange rate falls quickly to half its former level, or a quarter (as in Indonesia), the strain on the economy becomes intense. Even in those countries with the most advanced banking systems, capital markets and regulatory regimes, such a fall is hard to handle. It is also clear that countries in this situation would have to attempt to reduce the size of the depreciation by raising interest rates, so that the economy would face a combination of a lower exchange rate and higher interest rates. Resilience of the financial sector A large, but not enormous, fall in the exchange rate - say, something between 20 and 40 per cent - could in some circumstances be absorbed without lasting damage, but in others it could lead to a major economic crisis. On the basis of recent experience, it now seems that the factors which are most likely to lead to an economic crisis are financial in nature, and pertain particularly to the structure of the banking system, the financial health of the corporate sector and the general financial infrastructure. A shortlist of the main factors that reduce an economy's resilience, and hence mean that a currency crisis will be translated into an economic crisis, is as follows: it recently experienced a debt-financed asset price boom, and thus become vulnerable to a large fall in asset prices? Have there been a large rise in the ratio of credit to GDP, an increase in corporate gearing, and, of course, large increases in property and equity prices? main thing to look for here is the quality of bank lending as indicated by the level of bad debts, the extent of lending that has been collateralised by over-priced assets, or more crudely, the proportion of lending to the property sector. It is bound to be difficult to get reliable figures, so an alternative would be to make an assessment of the quality of bank supervision. A starting point here would be to look for a good set of ownership rules; these should limit the extent of lending to related parties. (c) Have banks and commercial firms financed themselves by unhedged foreign borrowing? Every crisis focuses attention on at least one important cause, and this pattern of financing seems to be heavily implicated in each of the current Asian troublespots. (d) Is the financial infrastructure strong enough to handle a crisis? By this, I mean the accounting standards, commercial law, disclosure requirements and bankruptcy procedures. In current parlance, this is often discussed under the title of 'governance', and means an institutional framework that limits the extent of related party transactions (also known as 'crony capitalism'). A favourable score in this area is needed to help investors and lenders gauge whether they are dealing with a solvent or insolvent counterparty. A feature of all these underlying financial characteristics is that they are very slow to change. Just as deficiencies in this area cannot have been the cause of the recent currency crises, it is hard to believe that meaningful improvements to them can be made quickly enough to restore confidence to currency markets. A tax or an interest rate can be raised immediately, and so cause a rapid turnaround in fiscal or monetary policy. Domestic demand can fall sharply, leading to a quick move into surplus in the current account, as we have already seen in Asia. But improvements to financial infrastructure and the sorting out of a weakened banking sector inevitably take a long time, and any immediate measures are more in the nature of a 'promise' than an achievement. They will not quickly prevent capital outflow or restore inflow: the immediate solution lies elsewhere. Neither the financial markets, international organisations nor academic economists are good at predicting currency crises. In the past, they have happened in circumstances that appeared quite tranquil, for example mid 1997. The likelihood of crises happening is greatest for countries that have a relatively fixed exchange rate and are open to international capital flows. The speed with which these flows can turn around is astonishing. The five Asian countries at the centre of the current troubles - Thailand, received private capital inflows equivalent to 8 per cent of GDP in 1996, and outflows of nearly 2 per cent in 1997. Such a turnaround in capital flows, to quote Chairman Greenspan's understated style, 'do not appear to have resulted wholly from a measured judgment that fundamental forces have turned appreciably more adverse. More likely, its root is a process that is neither measured or rational...' It is not surprising that these countries' exchange rate regimes collapsed and they were forced into a rather hurried float. It should also not be surprising that the ensuing depreciations were extremely large, because that seems to be a common pattern. The smallest of the depreciations was still of the order of 40 per cent, and this plus the rise in interest rates was bound to put enormous pressure on domestic financial systems. In my analysis, I have distinguished between factors that are likely to cause a currency crisis and factors that are likely to mean it will become a general economic crisis. I have also said that I do not think the second set of factors - essentially deficiencies in the financial infrastructure - could have triggered the currency crisis, because they have been around for years. The problem, however, is that they can interact with the currency crisis once it has started. Market participants who may have been indifferent to deficiencies in the financial infrastructure at the old exchange rate start to voice disapproval of it once the exchange rate has fallen. But nothing may have changed with respect to financial infrastructure: the only new information on which the change in judgment could be based is the lower exchange rate itself. This could become self-reinforcing and lead to further capital outflow and a yet lower exchange rate. There has been a tendency for this to occur over the past 12 months. For this reason, and others, we have seen exchange rates in some Asian countries that have fallen to half of their level a year ago or, in Indonesia's case, a quarter. Falls of this size defy economic logic and serve no useful economic purpose. Indonesia was a successful trading nation a year ago at its former exchange rate, with a healthy growth of exports and a modest current account deficit. There is no value to Indonesia, to the region or the world in now having an exchange rate at a quarter of its former level. Any collective solution to the current troubles in Asia should have as a priority the aim of restoring exchange rates a fair way towards their former value. We should not lose sight of what we originally intended to do when the international support packages were put together for Thailand, Indonesia and Korea. Our aim was to allow an orderly economic adjustment and to minimise the risk of further contagion into other parts of Asia and the rest of the world. Our aim was not to capitalise on any of these countries' difficulties in order to bring about a political transformation. Some of the steps towards the restoration of a more realistic set of exchange rates are already occurring. Most, if not all, of the troubled Asian countries have returned to trade surplus and, probably, current account surplus. Although it would be a great help, it is not absolutely necessary to restore capital inflow; in the short term, all that is needed in order to provide some upward pressure on currencies is to prevent further capital outflow. The collective agreement among major banks to rollover Korean bank debt, and then to reschedule it, was a good example of what can be done. If there is insufficient initiative or cohesion among private lenders to Indonesia to follow the Korean lead, then a greater involvement of governments and the IMF is required. Whatever the details that are finally worked out, there can be little doubt that the overwhelming priority is to rollover, reschedule, restructure existing debt or do whatever else is necessary to prevent further capital outflow.

r980326a_BOA

australia

macfarlane

It is a pleasure to be here in Brisbane addressing the Australian Stock Exchange, the do not know whether I should nominate myself as a bull or a bear. Members of this audience will be able to make up their own minds after they have heard my story today. In the period since the collapse of Asian currencies - roughly since the floating of the Thai baht on 2 July 1997 - I have spent a fair amount of time, as have many others, trying to understand the reasons for that collapse. It has been a salutary experience, and it has caused many of us to re-examine some cherished views. I have already spoken twice on this subject, so I do not intend to cover the same material today. What I hope to do, however, is to draw some lessons from it, and to apply them to Australia. In a previous speech, I tried to identify the list of economic characteristics that would make a country vulnerable to a currency crisis or, worse, to a full-blown economic crisis. As you probably know, there is no definitive list that enables us to forecast these events with any precision, but there are about a dozen factors that seem to increase a country's vulnerability. If a country scores a very low mark on all of these factors, or at least most of these factors, there is a good chance that it would be subject to an international loss of confidence and ensuing economic problems. You will not be surprised to hear that Australia is not in this category; indeed, Australia scores a very high mark on most of these factors and thus should be in a very secure position. But we can never be complacent. Like all countries, we do not achieve a perfect score, and therefore it is worthwhile to go through a systematic examination of our strengths and weaknesses in light of the recent events. The list of factors identified from our research on the Asian crisis that pointed to the likelihood of a currency crisis or a wider economic crisis was as follows: Does the country have a fixed exchange rate and free movement of international Is the exchange rate overvalued? Has a country with similar economic characteristics recently experienced a currency crisis? Is there a large budget deficit and a lot of government debt outstanding? Are there loose monetary policy and high Is the domestic economy in, or at risk of, a recession? Is there a large current account deficit? Is there a large amount of foreign debt? Is there an asset price boom (especially Are there a lot of bad debts in the banking system, and a poor system of bank supervision? Has there been a lot of unhedged foreign currency borrowing? Are there poor accounting standards, few disclosure requirements, ambiguous bankruptcy procedures, etc.? A brief scan of this list should reassure people that Australia is in good shape. That is, it would receive a very favourable mark on the vast majority of these indicators, and so should be able to handle the current international turmoil without too much disruption. But we are not perfect, and there are two items on the list - the current account and external debt - where our score is low by international standards. In the remainder of my talk today I would like to set out in more detail how Australia stacks up against the above list, starting with the ten factors on which we receive a very high score, and following roughly the same order as in the list above. I will cover the factors where we receive a high score quite quickly in order to leave room for a closer examination of the two weak points. Australia allows the free movement of international capital, but we certainly do not have a fixed exchange rate. The Australian dollar was floated in December 1983, and after a few years of turbulence in the mid 1980s, has generally behaved as a floating rate should in the period since then. While it was more volatile in the 1980s than the major currencies such as the US dollar, yen and Deutsche Mark, in the nineties it has generally been less volatile than they have. It has varied cyclically over the past dozen years, but around a flat trend. There is no evidence to suggest that it is overvalued. Opinions will always differ on such a subject, but at the moment there are probably more, including some influential offshore institutions, inclining to the opposite view. Like most currencies, it has depreciated against the US dollar over the past 18 months, but against the Trade-Weighted Index it has been relatively stable. Judged by other measures of the exchange rate designed to capture competition with imports or against export competitors, it has shown a small increase in competitiveness. The issue of contagion can be addressed by asking whether another country with similar economic characteristics has recently experienced a currency crisis. The answer is in the negative: all the countries that have recently experienced a currency crisis have been at an earlier stage of economic development than Australia, particularly in respect of the depth of their financial infrastructure and the degree of prudence exercised by borrowers and lenders. The financial markets have made a clear distinction between troubled Asian economies like Thailand, Indonesia and Korea and countries like Australia. On fiscal policy, little needs to be said other than that Australia has a very low underlying budget deficit by world standards and is expecting a surplus next financial year. The stock of government debt to GDP (which effectively measures the extent of accumulated past deficits) is exceptionally low by international standards. On monetary policy, seven years of low inflation has finally received the international recognition it deserves. The international bond markets have expressed their confidence in Australia's fiscal and monetary policies by reducing the spread between Australian and US yields to the lowest margin in a generation. In the aftermath of the currency crisis which resulted in the partial breakdown of the developed that if a country was in or near recession, it would be particularly vulnerable to a currency crisis. This is because it would not be able to resist the currency crisis with tighter policies. (Whether it should, of course, would depend upon the circumstances.) Whatever the strength of this argument - and it is strongest for fixed exchange rate cases - it clearly does not apply to Australia, as we have a buoyant domestic economy. Furthermore, Australia is recognised internationally as having had one of the best growth records among OECD countries this decade. (Only Ireland and Norway - two very small economies - have done better.) I will delay discussion of the current account, the balance of payments and foreign debt until after I have completed the list of positive factors for the Australian economy. The next factor on my list was whether the country was in the midst of an asset price boom. The problem with asset price booms is that they are usually followed by asset price busts, which can give rise to company insolvencies and banking problems. Clearly, this is not the case in Australia at present, although we do have fresh in our memories the events of the late eighties and so cannot be too censorious of recent Asian events. While the Australian share market has risen over recent years, it has done so by a smaller amount than the United States or most of Europe. Commercial property prices have also been relatively restrained, and while house prices are rising, the large rises have been confined mainly to inner Sydney and I think we can be confident that our system of bank supervision is at world best practice, and the ratio of bad debts to total loans, at 0.9 per cent, is at its lowest level since statistics have been collected (admittedly, the collection only dates back to 1991). Of course, what currently seems to be a good loan can become a bad debt if circumstances change. Even so, I have a lot of confidence that our figures are a good guide to the health of our banking system. I think it is true to say that there has not been a lot of unhedged foreign currency borrowing occurring among Australian corporates since the days of the 'Swiss franc loans' of the mid-eighties, but I will postpone discussion of that topic until I deal with foreign debt in the second half of this talk. standards, disclosure requirements and bankruptcy procedures are what might be termed financial infrastructure. So is the existence of a large group of equity analysts and financial journalists, the ASC and stock market listing requirements. We tend to take a lot of this for granted, but it is very important that they be up to best international practice. Again, we should not feel too superior to our Asian neighbours in this respect; it takes decades or more to develop these, and as recently as the late eighties we still had some glaring deficiencies. I think we are now at international best practice, but it still involves continued improvement to stay there. While I am satisfied that the underlying structure of our economy, particularly its financial underpinning, is sound, there is no sensible way we can avoid a widening of our current account deficit in the short term. It is virtually inevitable because a significant number of the countries that make up our major export markets are likely to contract, or not grow as quickly, over the next 18 months. It is what economists call an 'external shock'. It is also true, of course, that if exports are weaker, then GDP growth will also be lower than it would have been without the 'external shock'. These 'real' effects on exports and growth are already occurring, though their full effects will take some time to be clear. In the case of financial prices, such as the exchange rate, bond yields, commodity prices and share prices, of course, the adjustments occur at once, as market participants can immediately adjust prices to reflect their expectations of what is to come. What I wish to do in the remainder of this talk is to try to address two questions. First, how will the Australian and international financial community accept the widening of the Australian current account? This is important because it has implications in the first instance for financial prices. Second, what are the prospects for our exports, and hence economic growth? I will not answer this question in a quantitative way, which may disappoint those who want numerical forecasts; in fact, I will be making a few criticisms of the simple models that are often employed for this purpose. Reaction in financial markets In the mid-eighties, Australian financial markets - particularly the foreign exchange and bond markets - experienced a major reaction to the widening current account deficit. The reason the reaction was so large was that doubts began to emerge about whether the economic situation was sustainable, particularly in view of the implications for foreign debt. There is always the possibility that the same or similar doubts will re-emerge over the next 18 months, but I am inclined to think that will not be the case. The reasons for my view are set out below. If we look at the history of the current apparent that the deficit has varied between about 3 per cent and 6 per cent of GDP, with an average of 4 per cent. Most importantly, there has been no on-going trend deterioration - the trade account has improved at a rate sufficient to offset the increase in net income payable abroad. The widening in the current account deficit that we expect in 1998/99 will be the fifth such cyclical widening in the past 20 years, and I think that people now accept this as a part of our economic cycle. You will note that I am only talking about cyclical movements in the current account. The broader issue of whether we should accept an average current account deficit of per cent of GDP in the long run would require another paper as long as the one I am presenting today. It would focus on our national savings performance, both in respect to governments and to the incentives that are provided to the private sector. But that is for another day. On previous occasions, the cyclical widening of the current account deficit usually reflected a mixture of external influences, such as a fall in the terms of trade, plus some significant internal imbalances or policy deficiencies. As examples of the latter, domestic demand in the earlier widenings ran at unsustainably fast rates, usually in excess of 7 per cent per annum for a time. Similarly, in all but one of the earlier widenings, Australia's inflation rate was higher than the world average, and again on two occasions, we were running a significant budget deficit. On this occasion, we have none of these imbalances. The widening of the current account deficit will be essentially the result of an external contraction of demand, with domestic demand running only slightly faster than trend. The foreign debt situation is not as threatening now as the most pessimistic people in the mid-eighties feared. Looking at a graph of the ratio of foreign debt to GDP (Graph 2) shows that it nearly tripled between 1982 and 1986 (from 12 per cent to 33 per cent). Many people feared that it would continue to rise at this rate, but it has not. In the nineties, it has averaged a little over 40 per cent, where it currently is. Another widely used measure of debt sustainability - the ratio of debt servicing to exports (Graph 3) - showed a somewhat similar pattern. It rose from 6 per cent to 22 per cent in the 1980s, but then reversed sharply in the early nineties, and is currently at about 12 per cent. The strong growth of Australian exports and the fall in world interest rates are largely responsible for this favourable development. In the 1980s, when the sharp rises in foreign debt and its servicing costs were occurring, the Australian economic debate was, not surprisingly, pre-occupied with these issues. At the time, there were no official statistics comparing foreign debt levels in developed countries, and in their absence there was a tendency for people to assume the worst - that is, to assume that Australia was the highest on the list. Now that the IMF and OECD publish official statistics on the subject (Table 1), we see that we should not have assumed the worst. While Australia is certainly in the top quartile of countries ranked by the net foreign debt to GDP ratio, it is not the are higher. Looking at the gross external debt to GDP ratio, Australia is in the bottom half of the table. The other aspect of foreign debt that has received a lot of attention in the light of recent Asian developments is the extent of unhedged foreign currency borrowing. Official figures only tell us that 60 per cent of Australian borrowing is denominated in foreign currency. Of that, a significant proportion has been borrowed by banks, and this is virtually all hedged. Our assessment is that major Australian corporates normally hedge their foreign currency borrowing unless they choose not to because they have a natural hedge through their exports. As I mentioned, financial markets tend to be forward looking, and it is likely that a significant deterioration in the current account is already factored into important financial prices. The reaction of financial markets to date has been more measured than was the case in the 1980s, no doubt reflecting their assessment of the much improved 'fundamentals' of the Australian economy. But we should not take this for granted. We have seen in Asia over the past year just how fast the international capital markets can react if they come to the judgment that a country is not being managed in a sustainable way. Slowdown in exports We would all like to know how large the current slowdown in exports will prove to be. But, because we have not been through this type of situation before, there is a lot of uncertainty about how to go about this. To date, those trying to be scientific and quantitative have tended to use a model which I would term a 'fixed co-efficient input-output model'. This approach starts by forecasting the fall in import volumes which each of our trading partners will experience and assumes that the volume of our exports to each country will fall by a similar amount. After adding together the results for each country, it arrives at a figure for Australian exports to the region. This is a time-honoured approach, but I am sceptical of how appropriate it is for a country in Australia's position. Despite Australia's impressive export diversification of the past decade, about 60 per cent of our exports are still essentially rural and resource commodities which are sold onto world markets. Most of these are fungible - they are sold to wherever the demand is. If Korean demand for base metals falls, Australia will still probably sell the same amount of base metals worldwide as before, but with more sales to countries other than Korea. Of course, if world demand has weakened, the price will have to fall to clear the market. That is what has been happening - commodity prices are now 9 per cent lower than at their March 1997 high in SDR terms. Thus, from Australia's perspective, the Asian slowdown may have its biggest effect not through lower export volumes, but through a fall in commodity prices, some (or, conceivably, a lot) of which has already happened because these markets are forward looking. There is still an effect on the economy, of course, since lower prices, other things being equal, mean lower export income, which in turn means lower demand and so on. It is important to note, however, that other things have not been equal: the Australian dollar has depreciated such that in $A terms, commodity prices are actually higher than a year ago. A good example of exporters seeking other markets is shown when we consider the recent history of our exports to Japan, by far our largest export market during the 1990s. As you know, the Japanese economy has been extremely weak over the past five years, and our exports to Japan have been flat over most of that period. But this has not stopped overall Australian export volumes growing strongly; they have risen at an average annual rate of 7 per cent in real terms over the past five years. Where has the growth come from? Just about everywhere but Japan, including, until recently, the other Asian countries that are currently in trouble. The most striking feature, however, has been the growth in a group of countries we have always called 'other'. As you can see from Graph 4, this is our fastest growing market in recent years. To satisfy your curiosity, 'other' is what we have left after we exclude Asia, the United States and Europe: that means it includes the Middle Another reason why the conventional approach to estimating the effects of Asia on Australian exports may overstate the slowdown is that a significant proportion of our exports are inputs into Asian exports, rather than final consumer or investment goods. This seems to be the case particularly for the two largest Asian markets - Japan and Korea. The situation is not as clear for some other countries, but as a general rule, we are probably better off in current circumstances than most suppliers because of the weight of commodities, foodstuffs and 'inputs into exports' in our mix. After the transitional export finance problems are solved, we should expect to see strong growth in Asian exports as a result of their large increase in competitiveness. I would be a lot more worried if Australian exports consisted of consumer products. Incidentally, this is one of the reasons why tourism has been hit so hard - it is probably our biggest export that is aimed directly at households, and is considered by them something of a luxury. I hope I have not gilded the lily too much in the above discussion. There is no doubt we will find the going tough on the export side, and we will not be able to repeat in the short term the sort of figures we have become used to over the past five years. But I think not enough account in popular discussions has been taken of our particular mix of exports and our capacity to find new markets. The events in Asia have confronted us with a challenge that was not foreseen a year ago. In deciding how to handle it, the first step is to recognise that the outlook for the economy is less favourable than it would have been in the absence of these events. The optimal policy response will be to accept that the effects should be spread across several economic variables, rather than attempting to adhere closely to earlier aspirations for any one variable, and letting the others do all the adjustment. It is clear that we should be prepared for a higher current account deficit in the short run - to try to avoid it would place intolerable strains on the rest of the economy. Similarly, we will have to accept a somewhat lower rate of economic growth and slightly higher inflation than seemed likely not so long ago. Notwithstanding these changes, we feel that over the next 12 months, Australia will continue to experience an economic outcome which will place it among the better performers in the OECD area. We also believe that our economic fundamentals will hold us in good stead, and that we will retain our hardwon reputation as a country with responsible economic and financial management.

r980507a_BOA

australia

macfarlane

Governor's appearance before the Committee. Mr Chairman, it is a pleasure to be here in front of your Committee for the third time under the new arrangements set out in the . I hope this meeting will be as successful as its predecessors in helping to lift the level of understanding of monetary policy, financial stability, the Australian economy and, of course, the region more generally. I also hope you have found our a useful source of information and a reasonably clear statement of our views. It is especially pleasing that we are meeting here in Melbourne for the first time. If you remember, Mr Chairman, the attempt to do so last November was foiled by a clash with Melbourne Cup week and the attendant shortage of hotel rooms. Fortunately, the Victorian Government has not been able to put on a sporting extravaganza to foil our plans this time. As on the previous occasion, I would like to start today by recognising that accountability includes being accountable for what was said last time. I will do this by reviewing how the past six months have turned out against the background of what I told the Committee we were expecting last November. At that time, I summarised our expectations by saying that I thought 1997 would prove to be a good year for economic growth, with GDP growing by about 4 per cent, that inflation would remain below 2 per cent for a while, but with a tendency to pick up as we went through 1998, and that there was a good chance that unemployment would decline. I said very little about the current account and balance of payments, as the outlook for Asia was still very unclear. We had only two quarters' data on economic growth in 1997 at the time of our previous meeting - now we have all four. The ABS records that GDP grew by 3.6 per cent over the four quarters, and non-farm GDP by 3.8 per cent, slightly less than the 4 per cent that I was expecting. I do not think there is any point in making much of this small difference. The other reason that I would not make much of this small difference is that the outcome for the labour market turned out to be a bit better than we expected. The average unemployment rate in the first half of 1997 was 8 per cent. When we met in November, the most recent figure we had was 8.6 per cent. The run of numbers we have received over the past few months have been either 8.2 per cent or 8.1 per cent. So if you look across the past 12 months, I think you could see a reduction in the unemployment rate of per cent or so. So over the course of 1997 a combination of good growth and moderate outcomes on wages made some inroads into our unemployment rate. On inflation, I have little to add to what I said last time. Underlying inflation has been per cent over the past 12 months. We are still expecting that it will rise over the next 12 months, largely because falling import prices, which were pushing inflation down, have given way to increasing import prices. In fact, the fall in the exchange rate has meant that wholesale import prices have risen by 7.7 per cent over the past 12 months, and import prices made their first positive contribution at the retail level to the CPI in the March quarter after seven quarters when they detracted from it. These changes are not alarming, but they do tend to suggest that we have passed the low point in the inflation cycle. So I feel reasonably comfortable with our earlier assessment, except in one respect - last time we met, the full extent of the Asian slowdown was still uncertain. In fact, it is quite interesting that as recently as six months ago, most discussions treated the ASEAN Four as being the known extent of the Asian slowdown. We did not know at that stage, although the possibility was flagged, that Korea would join them, that Indonesia would deteriorate significantly further, and that Japan would suffer a relapse into recession. When we take these developments into account, it is clear that a bigger external contractionary effect now has to be factored in. I will return to this subject in more detail later. the absence of the external shock from Asia, 1998 was shaping up to be, if anything, a stronger year than 1997. There was nothing in the internal dynamic of the economy which was pointing to a slowdown, and we had every reason to expect growth of 4 per cent plus. That will no longer be the case, and we are now looking at growth through 1998 of something more of the order of 3 per cent. This would probably mean that after a year in which the unemployment rate came down, we might be looking at a year in which it flattens out. I have already mentioned the outlook for inflation when I reviewed the previous year's results. Broadly speaking, we think that the trough in the inflation rate has passed, it is moving back again into the 2-3 per cent range, but it is not doing so in an alarming way. We expect it to be in that range by the end of this year, and it probably will rise a bit during next year. Balance of payments Another part of the economy which in Australia has always been closely watched is the current account of the balance of payments. With domestic demand in Australia growing at or above trend, but with a number of our major export markets declining, it is an arithmetical certainty that the current account has to widen, as it has. This is not a sign of an economic policy failure, and I trust markets will treat it accordingly. A number of people, including myself, have made the point that on this occasion the widening of the current account deficit is not the result of excessive growth in domestic demand, nor is it the result of declining competitiveness because of high Australian inflation, nor is it a counterpart to a large Budget deficit. For these reasons, we expect it will not arouse the same excitement as it has in the past, though you can never be sure. At present, our expectation is that the current account deficit in 1998 will be about 5 per cent of GDP, but if you look at the cyclical behaviour of the current account over the last two decades, you could not rule out it touching 6 per cent for a time. Imports are probably slowing from their very high growth rate in the second half of last year, but not by much according to the March quarter figures. Over the course of 1998, we still expect them to show their usual behaviour, that is to grow by a few percentage points faster than domestic demand. Exports, on the other hand, cannot hope to keep up last year's pace of 8 per cent, and a small positive figure is probably what we can expect. Most of our exports - our rural products and metals and minerals - are sold into worldwide, rather than country-specific, markets. If we cannot sell zinc or copper to Korea, we sell it to another country: the same goes for our rural exports. It means that for two-thirds of our exports, what we earn is a function of world demand, not of the demand from our specific (largely Asian) trading partners. At the end of the day, the prices for these commodities adjust to clear the market, and that has been happening. The prices of Australian commodity exports have fallen by 9 per cent over the past year when measured in terms of a neutral basket of currencies. At the same time, the Australian dollar has fallen against this neutral basket of currencies, so our commodity prices in Australian dollars - what our exporters actually receive - have gone up slightly. Even for our biggest exports - coal and iron ore - where prices are renegotiated annually, the Australian dollar prices in contracts which commenced in April this year were higher than in the contracts a year earlier. This is an example of the market adjusting - in this case, the foreign exchange market - to shield the export sector (but not the whole economy) from the worst of the Asian downturn. Having made these points, I do not want to give you the impression that I am downplaying the effects of Asia. To the contrary, the biggest difference between the way we view our immediate future today and the way we viewed it a year ago is clearly the external shock we have received from Asia. While it is true that the Australian business cycle is always affected by the world business cycle, the current Asian crisis is the first significant identifiable external shock we have had for a long time. The last time I can remember something as specific as this was OPEC II in 1979, but that was on a much bigger scale and affected the whole OECD area more evenly. The current Asian crisis is unusual in that Australia has a bigger exposure to it than any other OECD country (other than the two who are actually part of the crisis - Japan and Korea). We have always been very conscious of Australia's vulnerability to a sharp contraction in Asia. But it has always been our hope, and certainly the guiding principle behind Australia's policy, that the economic problems in Asia could be minimised by prompt action. It was this awareness of possible danger ahead that lay behind Australia's very quick response to the Thai crisis, and the Reserve Bank's willingness to put funds from its balance sheet at the Government's disposal to ensure that Australian participation was not delayed. It also explains why Australia is the only country other than Japan to be a part of all three Asian support packages - those for Thailand, Australia has done what it can to help minimise the Asian fallout, but clearly events have turned out worse than we had hoped for. The crisis has spread further than was at first thought likely, it is resulting in larger falls in output and employment in the countries concerned, and finally it has been compounded by the relapse of the biggest Asian economy - Japan - into recession. What started as a currency crisis in Thailand is leading to widespread suffering in a range of Asian countries. Of course, those countries have some deep-seated economic policy deficiencies - weak banking sectors, too much of what is called 'crony capitalism', too much government direction of investment (including implicit underwriting of loans) and insufficient disclosure, poor accounting standards, etc. These deficiencies are common to most countries at earlier stages of development than ours, and they have been around for decades. They did not deter massive capital inflow for most of this decade, and I suppose it must be galling for some of these countries to listen to sermons on their deficiencies delivered by international bankers who, until recently, were happy to ply them with loans. We all have to agree that these countries made policy errors; that is par for the course. Yet I agree with Paul Krugman who, when commenting on the current situation, said: 'Yet governments are no more stupid or irresponsible now than they used to be; how come the punishment has become so much more severe?' These countries have had to make a very rapid adjustment to their external positions to stop their exchange rates from falling below the extremely low levels they reached late in 1997. They could not rely on a resumption of capital inflow to stop the problem, so the only feasible way was to return their current accounts to surplus. This has involved very tight policies, a very large fall in domestic demand, and very large falls in imports. For the three countries in IMF programmes, we estimate that imports have already fallen by between 30 and 40 per cent. Even though there has not been enough time to expand exports in line with their improved competitiveness, their current accounts have already moved into surplus. Australia's exports to these countries appear to have already fallen roughly in line with their falling imports. Thus, we have received the effects on our trade flows quite early in the piece. In time, when their exports pick up, we should get some benefit from this even if their domestic demand remains weak. To date, we have coped quite well, largely because we were in good shape going into it with strong domestic demand and low inflation. This was in part due to the fact that we had taken expansionary monetary policy The other way in which we have coped well is that our financial markets have behaved very sensibly. It is true that our exchange rate has depreciated against the US dollar, and against major currencies in general, but this is an understandable market reaction to the deterioration in our international trading environment. Apart from a minor panic in January, the whole process has been very orderly. The bond market too has performed very well. International and domestic investors have clearly drawn a distinction between Australia and our Asian neighbours, and we have not seen any rise in risk premia on Australian bonds. Indeed, we have improved our position over the period, and Australian borrowers can now borrow in $A at or below the same rate as equally creditworthy US borrowers can borrow in US dollars. The Australian share market has also risen over the past six months and, even though it has not performed quite as well as some overseas markets, is higher than its former peak in mid What is the implication of Asia for the conduct of monetary policy? The simple answer is that it makes it more difficult. The Australian economy has suffered an external shock - a significant reduction in demand for our exports, which will lead to lower export volumes in some cases and lower export prices in others. This will show up in some combination of lower growth and a widening of the current account of the balance of payments. Because of the fall that has occurred in our exchange rate, it will also show up as higher inflation than otherwise. Even if we had perfect foresight, we cannot adjust policy in a way which would avoid these outcomes altogether. The best we can hope for is a combination which minimises the longer-run disruption to our economy. Choosing the monetary policy to achieve this is not an easy task. It involves constantly reviewing our position in the light of changes to the economy, and our forecasts of future events. Importantly, it will be heavily influenced by how the Asian situation develops. I repeat that the only reason we are foreseeing any slowdown in growth in 1998 is because of the Asian crisis - there was nothing in the domestic economy that pointed in that direction - in fact, it pointed to higher growth. I suspect that in the future evolution of our policy, Asia will be the major influence. As you know, the Board of the Reserve Bank met on Tuesday and did not make any change to the setting of monetary policy. There had been some speculation over the preceding month that we might ease, but the majority of observers expected no change. Our on-balance view is the same as the majority of outside observers: that is, we judged that the present setting is the right one. As we see it: * The present stance of monetary policy provides a low interest rate environment which is working to support, rather than restrain, growth. Credit is readily available, borrowers seem to regard current interest rates as attractive, financial wealth is rising, as is private sector leverage. * Developments in the exchange rate and interest rates charged by financial intermediaries since the last reduction in the cash rate in July last year have worked to magnify the effects of lower official rates. The exchange rate has come down against major currencies, and competition among banks has reduced interest rates to business and personal borrowers. * The most likely outcome over the next 12 months at the present policy setting is for inflation to return to its target range and for domestic demand to remain at or above trend growth. With a significant reduction in net exports, GDP will probably grow below its trend rate, but some growth slowdown in the short run is an unavoidable result of the external shock. * Our measured approach to date has served us well in that it has maintained confidence in Australian financial markets. That, of course, does not rule out further changes in policy, but it does impose a constraint in that it means monetary policy has to be adjusted credibly. We do not wish to jeopardise Australia's current good international standing or revive memories of when Australia was regarded as a 'boom and bust' economy. We gain a lot from our current reputation for stability - not only does it reduce our borrowing costs, but we can raise equity more cheaply, and we have become a more attractive place for direct foreign investment. Of course, we recognise that it would also be a mistake to stick too long to a setting of policy in the name of stability if there were good reasons to move. We have to be conscious of the risks to our current assessment, and constantly review them. The major downside risk which we can see is the possibility that the effect of the Asian and Japanese situations might produce a larger slowing in the Australian economy than our current expectations, perhaps indirectly by slowing growth substantially in other trading partners or by seriously dampening domestic demand through income or confidence effects. Such an outcome is not in our view the most likely one - but it has some probability. Mr Chairman, I think I have said enough for the time being, even though I have not covered a few topics that I know the Committee is interested in, for example: * the effect on aggregate earnings growth of the two Safety Net Review wage increases; * the contribution of increases in executive salaries to aggregate earnings growth; and * competition among banks to lend to small business. I am happy to answer questions on these subjects in the course of today's discussions, but I think it would be better to finish this monologue and get on with the questions and answers.

r980604a_BOA

australia

macfarlane

It is a pleasure to be here in London again, in front of such a distinguished audience. I was speaking to a similar group here last June, but the atmosphere was rather different. I was able to speak exclusively about Australia, but in todayOs climate I would be remiss if I was not also to spend some time talking about Asia. For this reason, I will cover both the Australian economy and some of its neighbours. With your indulgence, I will use a number of graphs, mainly in the form of international comparisons, to illustrate my points. As usual, I would like to start this presentation by emphasising the positive. The main positive factor is that Australia is completing the seventh year of an expansion that started in mid 1991. Over that period, our economy has grown at a rate which is very good by the standards of OECD countries. Diagram 1 shows the growth rate of OECD countries over this seven year period. The average growth rate for Australia of 3.7Eper cent put us near the top of this comparison. Only Ireland and Norway have grown faster but they are very small economies compared with Australia - adding their GDPs together, they are still about half the size of Australia. Of large economies, the United States has obviously done well, and the Netherlands, which is about the same GDP and population as Australia, has attracted widespread praise for its economic performance. At the same time, as we have put in this good growth performance, we have also maintained low inflation. This has helped us to live down the reputation we gained in the 70s and 80s as an inflation-prone country over the 90s this has definitely not been the case as you can see by my second diagram. Australian inflation has averaged 2.2 per cent per annum, which is a shade below the average for OECD countries over this period. More importantly for us, it has meant that we have achieved our inflation target, which is to average somewhere between 2-3 per cent in the medium run. Our current rate of inflation, i.e. over the last Emonths, has been 1 per cent, which is actually below the bottom of the range that we expect to be in in the medium run. As I said, I think our monetary policy is now getting the recognition it deserves. One good indicator of this is our bond yields. For as long as most people can remember, these were a lot higher than US yields, even 400 or 500 basis points higher. As you can see from Diagram 3, this margin has been gradually whittled away, and over the last three months it has disappeared. In fact, the yield on Australian bonds today is 13 basis points below US bonds and 25 basis points below gilts. Note that I am talking here about long-term interest rates. These are set by the markets and reflect the worldOs assessment of our future stability, particularly of our future price stability. I have not been talking about our short rates such as the overnight, or interbank interest rates, which are set by the Reserve Bank. At this point, I should say, however, that I am somewhat surprised by the tendency of the money market to price into these rates a possible easing in monetary policy. Well, I suppose anything is possible, but I would have thought this to be very unlikely. So much for monetary policy, what about fiscal policy? Australia has not had the difficulties that many European countries have had in getting fiscal policy back under control. For example, as you have probably heard from Australian policy-makers on previous occasions, we would have had no difficulty in meeting the Maastricht criteria at any stage over the last four years. Our budget deficit is low as a proportion of GDP and the stock of outstanding government debt is also very low by world standards. Let me illustrate this with another set of international comparisons: Diagram 4 shows the Australian budget position as a proportion of GDP compared with other countries in the last year. Our surplus of 0.2 per cent of GDP is again one of the better performances amongst OECD countries. The budget which has just been passed for 1998/99 will show a surplus of about 0.7 per cent of GDP. Note that the measure of the budgetary position we are using is an underlying one; if we had used a headline measure, which includes the proceeds of privatisation, the budget would have been in massive surplus in recent years. I mentioned the stock of government debt to GDP. This really measures the accumulated effects of all the past budget deficits. The Maastricht requirements here is for countries to be below EperEcent, although it is regarded as such a difficult task that the umpire is turning a blind eye to those countries that cannot meet it. In AustraliaOs case, our figure is 31 per cent and going down quite sharply because we are retiring debt. Some of you will be thinking that this all sounds too good to be true, and are asking yourselves - Owhat about the downside?O Yes there is a downside, and in AustraliaOs case it is called Asia. Whilst we have benefited in the past by our trade connection with Asia, and I believe we will benefit again in the long run, it is definitely hurting us at the moment. Australia will be affected more than Europe or North America by the sharp reduction in Asian imports. In fact, it is already happening on quite a big scale and showing up in some of our figures at the end of 1997 and particularly in the first quarter of 1998. I will spend the rest of this talk bringing out for you what I think the main effects are and will be. Again, I intend to start by emphasising the positive. As you will have realised from my introduction, the first thing that we have going for us is that we have entered this difficult period in very good shape. GDP has been growing at 4 per cent, which is enough to have lowered our unemployment rate by Eper cent or so over the past nine months, and as Inflation is below our medium-term target. Our financial institutions are also very sound. Our banking sector has overcome all its problems of the late 1980s and for the past several years has been in very good shape. Bad debt as a proportion of total loans outstanding are about as low as it is possible for them to Our corporate sector balance sheets are in good shape and gearing ratios are a lot lower than they were at the beginning of the decade. Our asset prices certainly do not show any sign of over-valuation. Although the share market has risen over the last couple of years, it has not risen to anywhere near as much as North American or European markets, and our commercial property prices have been quite restrained during the 1990s. Another factor that we have going for us is that we do not have the brittleness built into our system that the fixed-exchange rate countries of Asia had in theirs. Our exchange rate has already depreciated substantially - against G7 countries it has gone down by about 14 per cent over the past year as the market has factored in the problems of Asia and the resulting widening of our current account deficit. It has also depreciated against sterling by a similar amount. In the main, this depreciation was accomplished in an orderly fashion but on a few occasions, once in January, once in May, and again today, we judged that the market was over-reacting and we intervened. We are watching the situation closely. A significant fall in the exchange rate as we have had was always going to be part of the adjustment to this external shock, but an overshooting would be in no-oneOs interest. There is no doubt that the current account deficit is widening and that this will attract a lot of attention. This is, of course, not new for Australia. As Diagram 7 shows, this will be the fifth time in the last two decades that the current account deficit has pushed into the region of 6 per cent of GDP. My feeling is that the market is now beginning to realise this is the normal cyclical behaviour of the Australian economy. I also think that they recognise that on this occasion it is almost entirely due to the contraction in our trading partners. In the past, it has been possible to point to domestic imbalances and policy deficiencies in the Australian economy as important causes, but not on this occasion: the domestic economy is not overheating as it was on past occasions when the current account widened greatly; the fiscal position is not contributing to the widening of the current account as the Government is running a small surplus; and Australia is not losing competitiveness through having a higher inflation rate than its partners. To the contrary, we are gaining competitiveness because our inflation rate is slightly lower than our trading partners and our currency has depreciated substantially against our major competitors. The other thing that makes the situation different this time is that we have a lot more information on that favourite topic of the 1980s - foreign debt. It is clear from IMF data on the subject that Australia is not uniquely tarred with this particular brush. While our net debt to GDP level puts us in the most heavily indebted quartile of OECD countries, we are not at the top, as many people believed. New Zealand, Canada and Sweden all have a higher net foreign debt to GDP ratio than Australia. If we look at gross debt to GDP, which I think is a better measure of foreign exchange vulnerability, Australia is in the middle of the field. When I last spoke about this subject about three months ago, I talked about the effects of Asia as being something that was still going to happen. Now, it is clear that these effects have already shown up in a very big way. Since trade statistics are produced in the most timely way, the evidence has shown up there first, particularly in the imports figures for Asian countries. If you compare the average so far in 1998 with the quarterly average immediately before the crisis broke - the June quarter of 1997, the figures are as follows. % Even Singapore, which is not part of the problem but is affected by it, has seen its imports fall by 18.5 per cent over the same period. The figures on current account positions are not as timely, but if we make use of the IMF forecasts for 1998 we can see clearly how rapid the turnaround in these countriesO positions has been. For example, Thailand had a current account deficit of about 8 per cent of GDP before it entered the crisis; the latest IMF forecast for 1998 is that it will have a surplus of 7 per cent of GDP. This is a truly astonishing turnaround, but Korea has had a similar turnaround, and Indonesia has also returned to surplus. How have they done it so quickly? Basically, by savage contractions in domestic demand and GDP. Here the figures are not as timely or reliable as the trade statistics, but we can get some guidance by looking at Korea which does produce quarterly GDP statistics. When we seasonally adjust these, they show that GDP fell by around 6.5 per cent in the March quarter (after falling by EEperEcent in the previous quarter) - that is an actual rate, not an annual rate. I cannot remember any of the countries I am familiar with having an annual fall as big as this, let alone a quarterly fall. If that is not big enough to surprise you, gross domestic demand fell by 22 per cent in the March quarter of 1998. Indonesian GDP in the March quarter appears to have fallen by a similar amount to KoreaOs, and judging by the fall in Thai imports, I would not be surprised to hear that the Thai economy had contracted by a similar amount. I think it is probably true to say that we are already in the period of maximum contractionary impact in Asia. As you would expect, these events have already made their presence felt in Australia, where export volumes have already fallen by 3 per cent in the last quarter of 1997 and by 2.2 per cent in the first quarter of 1998. While we cannot get volume figures for Australian exports by country, our estimates suggest that: for a number of destinations - such as Thailand, Indonesia and Malaysia - our exports have fallen in line with their imports; for Korea and Japan, our exports have declined by less than their imports; for non-Asian destinations, particularly Europe and North America, our exports have grown faster than their imports. When we aggregate these effects, it is clear that our export volumes have fallen, but by a smaller amount than our export markets. An important reason for this is that most of our exports are sold into a worldwide market, rather than to country-specific markets. For example, if we cannot sell zinc to Thailand, we sell it somewhere else, rather than keeping it at home. Another factor, which we think will become increasingly important, is that many Australian exports are inputs into other countriesO exports. In time, when Asian exports pick up in line with their improved competitiveness, we should expect to benefit from this. Having said this, I do not wish to put too much of a gloss on it. We clearly are suffering a fall in exports, which combined with above-trend growth in imports has led to a significant widening in our current account deficit. Imports now appear to be slowing, but they will not (or should not) slow to anywhere near the extent of our exports. We have to accept this widening of the current account deficit, analyse its causes and explain these developments to the wider public. If there is a bright side, it is that the Asian adjustment is occurring so quickly and therefore the downward phase should finish earlier. As these countries have cut imports by a third in the past six months, it is hard to believe that they can do so again in the next six months. It is more likely that they are approaching the point where they will level out and start to rise, even if only modestly. That does not mean that we are out of the woods yet because we are still being affected by the slowdown in other parts of Asia, but the first wave may be close to having worked its way out. Although Australia is geographically an island, we recognise that we are not economically one. I should say two islands for fear of offending the Tasmanians. We cannot set ourselves economic aspirations that are independent of our international trading environment. What we can aim to do is to get through this difficult period with minimum disruption to the economy, but we cannot avoid the effects altogether. With good policies in place, there is no reason why we should suffer a sharp contraction in economic activity like some of our Asian neighbours, although some slowdown compared with 1997 is inevitable. Similarly, there is no reason why a relatively normal cyclical widening of the current account of the balance of payments should lead to an excessive depreciation of the Australian dollar, and a surge in inflation, as is happening in some of our Asian neighbours. But again some pick-up in inflation compared to our current very low results will undoubtedly occur. Some widening of the current account, some reduction in growth below last yearOs rate and some rise in inflation will all happen. No economic policy response, no matter how far-sighted or finely tuned, can prevent these changes. But there is no logical reason for these changes to be Olife threateningO; we should be able to adapt to the changed circumstances better than at any stage in the past quarter of a century. In the end, the result will depend very much on confidence, both domestically and internationally. That in turn will depend not only on the quality of our fiscal and monetary policy, but on a host of other attributes. It will depend on the soundness of our financial institutions, the depth of our markets, the basic fairness and transparency of the accounting and legal underpinning to our corporate sector, and the capacity to carry out business at armOs length and not to fear that vital information is being withheld. In short, it will depend on the worldOs judgment of the soundness of our institutional and political framework, and its assessment of whether Australia is a stable and safe place to do business. I am sure that we will pass that test.

r980702a_BOA

australia

macfarlane

Thank you for the opportunity of being present at the celebration of the Reserve Bank of Fiji's 25 Anniversary. The family of central banking certainly has a wide span of ages - from the Swedish Riksbank, which this year is 330 years old, all the way down to relatively young central banks, such as a number of us in the Pacific region. I would have to include the Reserve Bank of Australia as one of the younger ones - we have only been a separate entity for 39 years - not much older than the Reserve Bank of Fiji. Over the 25 years that the Reserve Bank of Fiji has been in existence, relations between it and the Reserve Bank of Australia have always been close. Many members of the staff of the Reserve Bank of Fiji have visited us in Australia for training, and in turn we have seconded a number of our people to the Reserve Bank of Fiji. Some of you may remember Paul Talbot who spent a few years here recently - he is now in charge of our Information Office. Our latest Reserve Bank of Australia export to Fiji is Steve Morling, who is finding the work so interesting and the lifestyle so congenial that we will have difficulty getting him back. Leaving that aside, I am sure the close relationship between our institutions will continue over the next 25 years and beyond. I should now turn to the more serious business of today's seminar. The topic I have been asked to speak on is actually a rather wide one - 'Globalisation, Liberalisation and Challenges for Small Island Central Banks'. I will be doing so from the perspective of a large island central bank - the Reserve Bank of Australia. A lot of the problems we all face are similar, but, as you know, the lessons learnt in developed countries may not always be entirely appropriate for other countries. I am conscious of that, and I will do my best to take into account the unique challenges facing small island economies in what I have to say today. The term globalisation is one which is in frequent use but is rarely strictly defined. In part, globalisation means the increasing tendency for enterprises to operate across national borders, thus generating trade in goods, services and flows of capital. Another part is the tremendous advances in the transmission of information, so that ideas, fashions and popular tastes move much more quickly between geographically distinct regions. This same capacity for transmission of information also means that capital markets, which are populated by large firms that are managed on a global basis, react literally instantaneously to changes in economic news - as well as to rumour and speculation. Liberalisation is easier to define - it means the freeing up of product, labour and financial markets to respond to price incentives. In some ways, this liberalisation is facilitating globalisation; they certainly seem to go together. The best example of liberalisation is the tendency for protection to decline for most products since the 1940s which has led to greatly increased trade flows. This is, in fact, a return to the trend seen before the outbreak of the First World War, which was sidelined by a retreat into protectionism during the 1930s. At the same time, pursuit of reasonably liberal policies is seen as the best way to extract value from globalisation. For economies, whether large or small, which start with a technological disadvantage, openness to foreign direct investment allows the accumulation of capital, technology transfer and the acquisition of new skills by the domestic workforce. Openness and liberal policies allow countries to move more quickly towards the productivity levels of the advanced countries. Since productivity is the ultimate source of wealth, with this trend come higher living standards. This approach, together with a commitment to upgrade education, explains the bulk of the growth in incomes per head in the east Asian countries over the past generation, which, recent severe problems notwithstanding, remains one of the most remarkable economic transformations in history. Fiji has been undergoing a process of gradual liberalisation and reform that is having an impact upon both the real and financial sectors of the economy. These reforms will affect the way in which the Government provides services and produces goods; the financial sector is already largely deregulated. As I understand it, the main aims are to improve the delivery of government services and to empower the private sector. The objective is to increase efficiency in key areas of the economy. This will ultimately reduce costs and increase the level of service provided to private businesses and individuals. Many government enterprises are in the process of being corporatised and privatised, and with time these measures will lead to greater competition and, hence, lower prices for private businesses and consumers. There are indeed many challenges which flow from these developments. The challenges are not only for central banks, of course: the implications of globalisation are profound for governments and business communities in all countries. Not least among these are the requirement for governments to explain to the general public the benefits which flow from these changes. Reforms associated with liberalisation typically imply a difficult transition period. The benefits of liberalisation take time to permeate through the economy, and in the intervening period some members of the community will experience economic hardship. Liberalisation can cause a significant, though temporary, dislocation of factors of production from old and inefficient enterprises (both public and private). Yet it takes time for new employment opportunities and more profitable enterprises to become apparent. All too often, the debate is captured by those who lose from the process - and, as with any evolutionary change, there always are losers. Since these tend to be concentrated, vocal and well organised, and the beneficiaries dispersed across the population, debate can be one-sided. There is also a tendency when the economy suffers a setback to blame the process of reform, when a moment's thought should remind us that setbacks happened in the past independently of whether reforms were occurring. Small island economies of the region are currently experiencing difficult economic times. For example, Fiji is simultaneously being affected by a severe drought which has reduced sugar production, a lower price of gold, and the Asian crisis which is causing difficulty for the tourism industry. In addition, the Asian crisis has created concerns of financial distress spreading to other countries in the region. It is inevitable that some will ask, therefore, whether this is an appropriate time to be undertaking further reforms. But there never seems to be a right time to reform - we are all like Saint Augustine who pleaded 'God, grant me purity, but not yet'. There is a common misconception that the trend towards liberalisation and globalisation means that policy authorities have to abdicate their role completely. To the contrary - they do not abdicate their role, they change the manner in which they perform their role. They have to give greater attention to establishing the general set of institutional arrangements within which the private sector operates, rather than to directing individual decisions. This is particularly so, in my view, in the case of the financial sector of the economy. I want to spend the rest of my time making some observations about these issues. A sound institutional framework is the cornerstone of sustainable and stable economic development. This is largely the responsibility of government and the public sector. An efficient legal structure combined with well-defined property rights are essential to creating the incentives needed to generate new job opportunities and encourage investment, particularly from overseas. Developing transparency in financial and business transactions is important. Transparency permits more rational decision making, particularly with regard to assessing the levels of risk associated with transactions. The adoption of internationally recognised accounting and auditing systems helps in this regard. Further, regulations are required to ensure the adequate provision and dissemination of information, either to the appropriate government organisation, or to the general public. Increasingly, governments are understanding the benefits of enhancing both transparency and credibility of public institutions. This has been especially evident in the worldwide trend towards greater independence of central banks from day-to-day political interference. In part, this move has been driven by the growing realisation that sustained easy monetary policy does not generate greater output in the long run. Instead, easy monetary policy leads to higher inflation; when inflation is very high, this can even detract from the long-run growth rate. Eventually, inflation has to be brought back into line, and this is always and everywhere a costly process. So it is better not to let it get away in the first place. In many developed economies, the move to greater central bank independence and more explicit recognition that the appropriate long run-goal for monetary policy is price stability, have gone hand in hand. In some instances, including Australia, this has meant the adoption of a numerical target for inflation. Central bank independence should always be counterbalanced by an appropriate degree of transparency and accountability - to Parliaments and the general public. In our case, and most others, this has been achieved. Greater transparency and, if the central bank does its job well, heightened credibility together make it easier to reach this inflation objective. One challenge, then, for central banks of the small island economies is to maintain and enhance their independence and to defend the case for sound monetary policy. No doubt, this cause will be helped by continuing to provide thorough and professional economic analysis, and by emphasising the benefits of good monetary policy - including low inflation and a more stable real economy - that can flow from an appropriate mix of independence and accountability. The primary operational goal of monetary policy in small island economies of the region has been, and continues to be, a stable exchange rate. Central banks in the region generally operate a fixed exchange rate, with the level of the exchange rate pegged either to a single major currency, or to a basket of currencies based on their major trading partners. Occasionally, the level of the exchange rate peg is adjusted in response to a major shock hitting the economy. In this area, Australia and New Zealand have taken a different route. For example, the Australian dollar was floated in the early 1980s as part of a broader package of ongoing liberalisation and reform. Our practical experience has been that this regime change has played an important role in helping to create macro-economic stability. However, like most other countries with floating exchange rates, we have found that the exchange rate can at times overshoot its fundamental level in response to large swings in market sentiment. The process of learning to live with this additional volatility has been lengthy, and at times difficult, but for Australia I believe that a floating exchange rate has been, for us, the only way to proceed. I have not come here, however, to try to convert you to floating exchange rates. Exchange rate regime is a choice each country must make in light of its own circumstances. Small economies often have a number of characteristics which make a fixed exchange rate the more attractive regime. Firstly, small island economies are often very specialised and rely on high levels of exports and imports (as a share of total production). This means that domestic prices move closely with the prices of traded goods, which in turn depend closely on the value of the exchange rate. In this way, the exchange rate acts as an anchor, helping to stabilise the behaviour of most wages and prices in these economies. Therefore, fixing the exchange rate can be an effective way of achieving low and stable inflation in these small island economies. The second point is that the size of these island economies tends to hinder the development of deep and liquid financial markets necessary to generate stability and reduce uncertainty. Illiquid financial markets can cause small volume transactions to result in substantial price changes. A freely floating exchange rate under these conditions could mean large and prolonged movements away from any fundamental level. For these reasons, choice of exchange rates has tended towards fixed rather than floating. Fixed exchange rates do mean that there are issues which have to be taken into account in monetary policy, especially in a climate of global capital flows and financial liberalisation. In the case of Fiji, capital controls, which are now being gradually unwound, have no doubt helped to simplify the central bank's task of fixing the exchange rate in the past. Against this must be set the fact that openness to beneficial international capital flows can better support the development of small island economies. I am referring here to foreign direct investment and long-term capital, as opposed to very short-term flows. Countries such as Fiji typically have many profitable investment opportunities and infrastructure needs, and yet they do not necessarily generate sufficient domestic savings to support this level of investment. Financial capital from overseas can help to realise these longer-term opportunities. More liberalised trade in financial capital can also benefit domestic savers through diversification. Because small island economies are subject to large shocks, there is likely to be a substantial benefit to domestic residents holding some foreign assets in their portfolios. At the same time, capital market opening - even for big economies - is a double-edged sword. The challenge for central bankers is to capture the benefits that come from openness to financial flows, while avoiding many of the risks associated with increased volatility caused by sharp changes in the direction of capital flows. I believe that developing countries should have the option to exclude short-term capital inflows if they think that the risk of volatility outweighs the benefits, or that these flows will place too great a strain on the balance sheets of banks or businesses. We have seen in Asia recently that large short-term capital flows into countries that have financial infrastructures that are still in the early stages of development can have devastating results. I do not know how any outside observer could look at these developments and not be uneasy about this lethal combination. In time, when the financial infrastructure has improved, short-term capital may become more attractive again. But it takes a long time to develop a resilient financial infrastructure - most developed countries took many decades to reach their present state. I know from Australia's experience that it took us a long time. We are happy with our present position whereby there are no restrictions on international capital flows, but that does not mean that we want to impose this on other countries in different circumstances. The banking system should play a central role in the growth of developing countries. An efficient banking system will help to channel limited domestic savings, as well as funds from overseas, into the most profitable and sustainable business opportunities. In other words, banks provide a valuable service by transferring funds from lenders to borrowers and assessing and managing risk. This service is pivotal in small developing countries - many small and unknown businesses rely on intermediated finance to undertake investment because they cannot obtain funds directly from investors (via either issuing equity or bonds). The process of financial deregulation is intended to improve the efficiency of the financial system by allowing banks and other institutions to set interest rates and make loans on a commercial basis. The problem is that banks and other financial institutions can and do fail, sometimes leading to instability across the whole financial system. This type of instability can cause severe downturns in macro-economic activity, and may require governments to undertake substantial bail-outs, at taxpayers' expense. The experience of many countries is that the financial system is particularly vulnerable to instability in periods following deregulation. In part, this is driven by competition for market share amongst financial institutions, which can lead to excessive risk taking. This can be exacerbated by a significant inflow of funds from overseas that typically results from capital market opening. Here the experience of Asia over the past decade or so is fresh in our minds, and it contains some important lessons. These countries saw very large inflows of foreign capital - in some cases, in excess of 10 per cent of GDP for years on end - which undoubtedly helped to fuel their rapid growth. But the quality of the lending and investment that those inflows supported was in many important instances found lacking. As asset prices rose and corporations and banks became more highly geared, the financial systems of these economies became fragile and were unable to withstand the panic when the footloose foreign capital wanted to leave in a hurry. The ensuing fallout has exposed inadequacies in the institutional structure in these financial systems very clearly. Unhedged foreign currency borrowings by banks and corporates; unduly close relationships between banks, corporations and governments, investment undertaken without due regard to likely return on capital - these provided an environment which, while certainly not causing the panic, did leave the system unable to cope once the panic came. The result has been a very costly adjustment for these societies, and loss of reputation for their policy authorities. Earlier experience in Australia also showed that the transition to a deregulated and open financial market is not without its difficulties. The knowledge and quality of staff are important, particularly those making lending decisions in the private sector and those working in the central bank as regulators and supervisors. Lack of experience is always going to be a constraint when a country first deregulates its financial system and opens itself up to financial capital flows. Attention to the strength of supervisory and regulatory systems is essential. A key challenge of central banks in small economies, therefore, is, as they seek to pursue the benefits of capital market liberalisation, at the same time to strengthen their capacity for maintaining financial system stability. Fortunately, a lot of international experience has gone into developing broad principles for supervision of financial systems, and we have the benefit of the so-called Basle Core Principles. For many small economies in the Pacific, of course, a significant share of the banking system is accounted for by foreign banks, whose global operations are subject to oversight by their home country regulators. There are, nonetheless, some domestically owned banks in the islands, and even where the entire banking system is foreign owned and supervised, the authorities have to satisfy themselves that the local operations of the banks are being run prudently. A foreign bank will probably not be allowed by its parent to fail, but it could still be a source of considerable instability in a small economy. There is not time to dwell at length on these questions, though we may mention a few. Issues such as the legal framework - making sure the central bank or other supervisor has the power to license the operations of banks (and possibly other financial institutions). This means being prepared to say no to some of the less reputable operators who try to obtain a banking licence from the island economies and to use this 'seal of approval' elsewhere. I regret to say that some of these operators have been known to come from Australia. The bank supervisor also needs the power to obtain information from individual financial institutions and the capacity to act in times of crisis. Minimum credit standards for banks making loans are needed, and some capacity to ensure that banks comply with these standards. One of the critical requirements, and one of the most difficult for small economies, is that staff who work for the central bank, and those who work in the private sector, be adequately trained, and upgrade their skills through time. Indeed, it is true to say that there is at present a worldwide shortage of bank supervisors. Foreign financial institutions locating domestically can help in this regard by bringing in their own expertise. The island central banks with which I am familiar have always seen the importance of developing staff skills, so I am saying nothing new here. In general, however, I simply offer the observation that in the past decade, it is in this area of supervision and financial stability that it seems central banks have most quickly suffered damage to their reputation. This is a risk which exists even in regulated financial systems, but it seems to me that the risks are heightened under conditions of globalised, and liberalised, markets. This risk is not a reason for not proceeding down the liberalisation path, but it is something central banks have to contend with. The challenges for all central banks, then, are many in the globalised world. We do not have, nor should we seek, the option of turning our backs on these trends - they will affect all of us whether we like it or not. The trends bring the odd pitfall, but they also bring tremendous opportunities for our citizens. We need to be careful to avoid the traps, so that we can enjoy the benefits. On behalf of all your colleagues at the Reserve Bank of Australia, I would like to congratulate the Reserve Bank of Fiji on its 25 Anniversary, and to wish you well in your next 25 years.

r980915a_BOA

australia

macfarlane

The following is the text of the Shann Memorial delivered by the It is an honour to be invited here tonight to deliver the Shann Lecture. As is customary when giving a memorial lecture, I have re-acquainted myself with the writings of the man whose memory we are honouring. It is noteworthy that for most of his working life he held a Chair at this University in History and Economics, as opposed to Economic History. This allowed him to range over a broad area, both as a scholar and as a polemicist. His scholarly reputation rests mainly on his economic histories, and I am pleased to record that he also wrote a fine piece on monetary policy in 1933 called 'National Control of His best known work, 'The Boom of 1890 - and Now', was not much more than a pamphlet, but was extremely important in establishing his reputation among the wider public. Written in 1927, it was an account of a period about 40 years earlier - a period that was recent enough to matter, but too long ago to have figured in people's working lives. I see a lot of value in this type of work, and have even tried my hand at a similar piece myself. Tonight, I would like to move to a more recent era and to a narrower topic, by examining the development of monetary policy over the last quarter of the twentieth century. In doing so, I intend to cover not only the institutional changes, but, where relevant, the intellectual cross-currents and the political influences that were at work. It may seem strange to give a prominent role to political influences, because the end point we have now reached in our monetary policy framework in Australia is not dissimilar to that of a number of countries that have had very different political developments. But even though the end points are similar, the sequence of events in the Australian development has been unique, and political influences have played a role in that sequence. Around the world, the mid-70s was a very unhappy period for macroeconomics - to find a worse period in terms of economic mismanagement, we would have to go back to the 1930s. In the 1930s a severe deflation was let loose on the world economy, while in the 1970s it was a severe inflation. To make matters worse, even though the inflation of the 1970s was initially tolerated because it was thought to be helpful in pushing unemployment down to very low levels, it ended up having the perverse effect of yielding a higher level of unemployment. The word stagflation was coined to describe this period. The experience of the Australian economy in the mid-70s reflected these unfortunate worldwide developments to the full. The underlying rate of inflation reached 20 per cent by early 1975 and was in double digits again in the early 1980s. Unemployment rose from 1.4 per cent at the start of the decade to 6.5 per cent by 1978. While the unemployment rate rose further in later decades, it was the 1970s that transformed Australia from a low to a high unemployment economy. All macroeconomic policies came in for severe and justifiable criticism at this time, monetary policy being no exception. A similar phase of self-examination occurred in all OECD countries, and there was intense debate about monetary policy in the economic literature. In this lecture, I would like to examine how this debate evolved in Australia and how it led to changes in our monetary institutions, our guiding economic principles, and the responsibility for decision-making. I intend to concentrate on these three main * First, changes to the institutional structures which formed the underpinnings of the money supply process - regulations on banks, methods of government debt financing and the exchange rate regime. Changes to these features amounted to fixing up the underlying 'engineering' of the monetary system. * Second, changes to the guiding economic principles which determined whether monetary policy was on the right course. * Third, changes to the 'governance' of the monetary policy decision-making process. From the above description it may still not be completely clear exactly what the difference is between these three main areas of change. Perhaps it will be a little clearer if I employ a metaphor. If we were to picture monetary policy as a ship, the first of these changes was to stop it leaking, the second was to equip it with a more reliable navigation system and the third was to work out who should be at the helm. I do not wish to spend a lot of time describing how the monetary ship was made seaworthy because there are already some very good accounts available. At our starting point in the mid-70s, most observers agreed that loose monetary policy had been a major factor behind the rise in inflation, and that it needed to be tightened. Unfortunately, there were significant structural deficiencies in the system which meant that no one could be confident that a tightening could be achieved with any reliability. The first deficiency was that the system relied heavily on direct controls on banks, including interest rate ceilings imposed on banks' deposit and lending rates. This meant that, even if monetary policy was successful in limiting the expansion of bank deposits and lending (and it was by no means clear that it would be), the tightening of conditions would not extend to the non-bank financial intermediaries. It was this group - merchant banks, building societies and finance companies (formerly called hire purchase companies) - which were usually the fastest growing providers of finance. The solution to this problem was to remove the interest rate ceilings and allow banks to compete on equal terms with other providers of finance. This meant that if banks were short of liquidity they could raise interest rates and compete for funds with other intermediaries who, in turn, would probably have to match them. In this way the tightening of conditions would be spread across the whole financial sector. Interest rate ceilings on deposits were removed in December 1980 and on smaller business loans in April 1985. With the removal of the ceiling on loans for owner-occupied housing in April 1986, the last of the interest rate ceilings was gone. The second deficiency in the system was that there was no mechanism in place to ensure that the budget deficit was financed entirely by borrowing from the public. Any shortfall in borrowing from the public was automatically met by the Government borrowing from the Reserve Bank, a method of financing which is colloquially known as 'printing money' or 'monetising the deficit'. In order to stop these unintentional monetary injections into the system, the Government needed to move from its existing system, where it set interest rates on government bonds and issued only the amount of bonds that the market wanted to buy (the 'Tap System'), to a new system where it sold the amount needed to finance the deficit at whatever interest rate the market demanded in 1979 for Treasury notes and in 1982 for government bonds. Finally, the fixed, quasi-fixed or occasionally changed exchange rate regimes that Australia had used over the post-war period introduced another element of unintended monetary injections or withdrawals into the system. Under all these systems, the Reserve Bank had to clear the foreign exchange market at the end of each day. If there were more buyers of Australian dollars than sellers, this effectively represented an injection into the Australian money supply. This meant that if monetary policy was tightened in Australia with a view to slowing the growth of the money supply, its effects could be offset through the foreign exchanges. This is because the tightening of monetary policy would raise Australian interest rates relative to other countries, and attract money into Australian dollars. In the first instance, this could be offset by Reserve Bank open market operations, but in the long run it could be self-defeating. This problem was overcome with the floating of the Australian dollar in December 1983. These three changes were effectively completed by the mid-1980s. Even though one of them - the float of the currency - was a massive change to Australia's economic structure, the three changes were seen by economists as largely technical in nature, and there was little dissent in the economic community. Also, there was no political polarisation with one party supporting and the other party resisting the change. The Campbell Committee, which reported in September 1981, had been an important influence in establishing a consensus for change. This Committee had been set up by a Coalition Government, but most of its recommendations were implemented by a The move to greater exchange rate flexibility, which, as explained above, had begun well before the float, meant that monetary policy needed a new guiding principle (or a new navigation system, to quote the metaphor used earlier in this Lecture). Instead of having an external guide (the fixed exchange rate), a satisfactory internal guide had to be found. This process, beginning in the mid-1970s, took Australian monetary policy from a system based on pure discretion, to monetary targeting, and ultimately to the present system of inflation targeting. The changes were not always smooth and there were some important gaps along the way which have never been satisfactorily explained. I would like to retrace some of this ground tonight. In doing so, I hope to skip lightly over the periods that have been covered fully before and concentrate on those that have been neglected. was pegged against the US dollar, and this effectively formed the centrepiece of Australian monetary policy. If our economic conditions got too far out of line with those in the United States it would imperil the exchange rate, and so fiscal and monetary policy would have to change in order to prevent it. It is a simple system, and one that still finds favour in a number of quarters around the world. The best known current example of this system is the Exchange Rate System, which is scheduled soon to go a step further into monetary union with a single currency (the Euro) and a single central bank Our link with the US dollar was broken in 1971, and thereafter the discipline exerted by a fixed exchange rate dissipated; once the link was broken the first time, it was no longer 'sacred' and could be broken again. Although we retained a pegged exchange rate system in one form or another until 1983, parity adjustments became increasingly frequent. We were effectively on our own with no clearly enunciated guiding principle behind our monetary policy until monetary targeting was introduced in 1976. This period of four-anda-half years could therefore be regarded as one where unconstrained discretion was the underlying basis of monetary policy. it was also the period when inflation accelerated most quickly and reached its highest level, it confirmed the general suspicion among monetary economists that something more than pure discretion was needed. Some guiding principle, or rule, that limited the capacity for discretion in monetary policy was essential to keep it from falling under the influence of expediency or succumbing to populist pressures for an excessively expansionary stance. The period of monetary targeting By January 1976 that guiding principle was found when Australia fell into line with a large number of other industrialised countries by introducing a monetary target. This move, which coincided with the election of the Fraser Government, had strong support from the Bank, the Research Department had been heavily influenced by academic monetarism, as evidenced by much of their research output in that period and the choice of visiting overseas scholars. At the top of the Bank, the Governor and Deputy Governor were supportive of the new regime, but retained a degree of scepticism and a recognition of the need for some flexibility. The Australian system of monetary targeting was based around an annual target for M3, which was not unusual by world standards. What was unusual was that it was set by the Treasurer on the joint advice of Treasury and the Bank. Another unusual feature was that the Bank always preferred to use the term 'conditional projection' rather than target. Its success, as measured by how often it was met, or by the size of over-runs, was not very different to experience elsewhere. This degree of success was somewhat surprising considering that for most of the period over which it operated the underlying monetary 'ship' contained all the leaks and distortions referred to in the previous section. The era of monetary targeting lasted for nearly nine years (from April 1976 to January 1985), which roughly coincided with the period which Goodhart describes as 'the high watermark of international monetarism'. I do not propose to examine its strengths and weaknesses at any length because I have done so elsewhere, as have others. Suffice to say that it did bring some order to Australian monetary policy and was a big improvement on its predecessor. Nevertheless, it had only limited success in its central task of reducing inflation, and as time went on its inherent weaknesses began to show. The logic of monetary targeting presupposes a stable statistical relationship - the demand for money - which implies that inflation is ultimately linked to the rate of growth of the money supply. This relationship, as in other countries, was never very precise over short periods, but that could be tolerated if it retained its long-run stability qualities. In time, particularly as a result of financial deregulation, the long-run relationship started to become unstable. At some point, M3 targeting had to be abandoned. The replacement for monetary targeting In the event, monetary targeting was discontinued in January 1985. The immediate reason for it was the extent of overshooting that was occurring during 1984, which seemed to indicate the effects of financial deregulation rather than a major rise in incipient inflation. Also of importance was the fact that Treasurer Keating had made no secret of his lack of enthusiasm for this approach to monetary policy. Even so, the decision to discontinue targeting was seen by some as precipitate, and many in financial markets were unprepared for the change. The Bank was criticised for not having produced a convincing body of work containing the evidence for the change in policy regime. Some of this criticism was justified, but to prove the breakdown in a long-run relationship always takes a long time. To allay the fears of those in financial markets who thought that the end of monetary targeting meant a return to unconstrained discretion, the Bank looked for an alternative framework which it could use as the basis for its monetary policy. As a result, the so-called 'checklist' was born. Its birth was announced in May 1985 by one of my predecessors, and its most detailed exposition was given in his In the event, it proved to have a short life and there was little further mention of it after that time. The checklist contained a number of economic variables that were to be taken into account in setting monetary policy. Up to a point, it was useful in conveying the sensible idea that monetary policy needed to look at a wide range of indicators, not just one. Its problem was that it did not have a sufficiently well-thought-out economic rationale or any criteria for determining which indicators were more important. In particular, it failed to distinguish between the instrument of monetary policy, intermediate targets and ultimate targets (an essential framework that is to be discussed in the next section). They were all in there, along with at least one variable that did not fit into any of these categories. The checklist was introduced in haste - barely four months after the end of monetary targeting. It had not undergone close economic analysis within the Bank, and had not been exposed to prior public scrutiny through research papers. In defence, it has to be said that the circumstances of the time were very turbulent; in 1985, the currency was plunging, bond yields were rising and there was a loss of confidence in Australian macroeconomic policy and serious doubts about the sustainability of our external position. There was a feeling something had to be done. Nevertheless, an important lesson was learnt from the episode - no central bank should commit itself to a new monetary policy regime until it has researched the subject thoroughly and established its credibility with reference to the economic literature and overseas practice. A new period of discretion? The With the short-lived 'checklist' period over, the Bank entered 1988 with no articulated framework for monetary policy, but a determination not to introduce a new one in haste. At first, there was little pressure from the markets, the press or the economic community to deliver a new framework because by 1988 the currency woes of 1985 and 1986 seemed well behind us. But that mood soon changed as critics began to focus on the fact that Australian inflation had not returned to relatively low rates as it had in most OECD countries. It is this period of intense criticism - roughly from 1989 to 1993 - that I would like to cover in some detail. I trust I can do this safely now because we are far enough past this period for it to have lost its political sensitivity, but close enough to still remember the details. The main charge of the critics was that Australia was still an inflation-prone economy, and that its central bank was never going to be able to improve the situation while-ever it relied on unconstrained discretion as the basis of its monetary policy. The critics also attacked the Reserve Bank for a lack of independence. Other high inflation countries such as the United Kingdom (which was opting for membership of the European Canada (which were opting for inflation targeting) were doing something about 'stiffening up' their monetary policy frameworks, but Australia appeared to be doing nothing. To make matters worse, in the eyes of the critics, the newly appointed Governor - Bernie Fraser - was known to be a close associate of Treasurer Keating, and they therefore assumed his appointment would result in a reduction in the Bank's independence, already perceived as being too little. This was another subject where they also had some suggestions, but I will save the discussion of central bank independence until the next section. For most of the critics, there was no alternative but radical reform of the legislation to create a new type of central bank subject to some form of binding monetary rule. Many of the critics were also influenced by academic thinking which held that discretionary monetary policy would inevitably fail. Discretion was held to be destabilising, and to have an inevitable inflationary bias which could only be corrected by the imposition of a rule on the central bank. These conclusions, deriving mainly from the writings of Friedman and other members of the monetarist school, received empirical support from the events of the 1970s and 1980s. This debate is usually called the 'rules versus discretion' debate, and those supporting a rule generally got the better of the argument. They were reinforced by the newer sophisticated writings of the rational expectations school, and in particular by its introduction of the concept of 'time inconsistency', which purported to show that there was a technical reason why only a rule could contain inflation. While there was a degree of agreement among the Australian critics about what was wrong with Australian monetary policy, there was less agreement about what rule should replace the existing system. The critics proposed a wide range of alternative models, including a currency board, monetary base targeting, a return to targeting broader monetary aggregates, various forms of commodity standards, and a combination of inflation targeting and central bank independence. Within the Reserve Bank there was some sympathy for an important part of the critics' case; it was conceded that monetary policy based entirely on discretion was intellectually and practically unsatisfactory, and it had been associated with high inflation in country after country. We also agreed that something better was needed, but most of the concrete proposals could be dismissed as impractical. There were no practical working models of strict monetary base control or commodity standards, and monetary targeting and fixed exchange rates had already been rejected as unsatisfactory for Australia. The difficulty arose with respect to the inflation targeting proposals. There was recognition within the Bank that this was the most promising approach, but political circumstances contrived to make our participation in the debate marginal at best. This was because from about late 1989 onwards the most vocal proponent of the view was John Hewson, first as shadow Treasurer, then as the Leader of the Opposition. This had the effect of forcing the Government into defending its record on monetary policy and hence the existing institutions and approach. It was a great disappointment for the Bank that this debate was politicised before the economics profession had time to explore it fully in an objective non-partisan way. But it would be unfair to criticise either of the two political protagonists for this - there is nothing wrong with them being quicker off the mark than the economics profession. The Bank had long agreed with its critics that Australia's high inflation rate was an obstacle to sustained economic development and that monetary policy would have to play the major role in remedying the situation. During 1988 and 1989, the Bank's research efforts were taking it towards a model that had a lot of similarities to those which underlay the New Zealand or Canadian style inflation targeting. Our research had taken us down a path that led to the same general framework as those models, (and of the model of inflation targeting we eventually adopted in 1993). It is summed up in the schematic framework in Table 1. In August 1989, which was just before the subject had become politically charged, I was able to summarise our views to an international audience of central bankers as follows: the cash rate is the instrument of monetary policy, there is no intermediate objective, and the ultimate objective has to be a nominal variable such as the rate of inflation or nominal GDP (the asterisked While we accepted some of the arguments of our critics, and we shared a common framework with the most practical of the alternative models put forward, there were still some major differences. First, and most importantly, we believed that we could achieve what our critics wanted - a return to a low inflation environment - without radical overhaul or a complete rewriting of the Reserve Bank Act. In a sense, we believed that reform from within was possible and that this would gradually return Australia to being a low inflation country. Secondly, we believed that the early overseas formulations of the inflation targeting/central bank independence model were too rigid in several ways: * There was a tendency to suggest that the single objective of low inflation meant that central banks should pay no attention at all to other economic variables. We felt that there are a number of circumstances where, even if primacy is given to maintaining low inflation, the effects on output and employment had to be taken into account and had to influence monetary policy actions. The best central banks overseas, moreover, clearly behaved in this fashion. * There was a tendency for proponents to understate the output and employment costs of the initial reduction in inflation. This was because they relied on the conclusion from the rational expectations school that credible disinflations would be relatively costless. * We were worried that if central banks were to be judged only by inflation results, there would be a tendency to over-achieve, i.e. they would be very reluctant to allow inflation to rise, even if only slightly and for short periods, but would readily accept circumstances that pushed the economy in the deflationary direction. chosen 0-2 per cent as their target, that had become the numerical norm in discussions of inflation targeting. We regarded this as probably too low, and certainly too narrow a range. No country had achieved this sort of inflation performance over any significant time interval in the past 50 years. We did not like the concept of a 'hard edged band', particularly the early formulations which suggested some decisive action occurring whenever the band was breached. During the early 1990s, particularly between the 1990 and 1993 elections, the Bank had to keep a pretty low profile in the debate because of the political constraint alluded to earlier. Governor Fraser made a number of speeches which defended the Bank and its monetary policy. In some of these he also questioned the more extreme versions of inflation as the single objective, and disputed the view that central bank independence meant that there should be an adversarial relationship between the central bank and the During this period, the lack of a monetary policy framework that could command widespread support had its costs. It meant that each of the monetary policy easings of 1990 and 1991 were met by the charge that they were only done for political reasons (lowering interest rates was presumed to make the Government more popular). There was clearly great distrust of monetary policy, the Government and the Reserve Bank - or, in modern parlance, a lack of credibility. It is interesting that virtually all of the serious criticism of the Bank in this period was coming from the perspective that it was too soft on inflation. Hence the proposals for reform were all aimed, in one way or another, at eliminating the supposed inflationist tendencies. Yet, while all the debate was going on, inflation was actually falling to its lowest level for a generation. In some senses, it was this that ultimately proved decisive in confirming that it was possible to return to a low inflation environment without radical change to the Reserve Bank or its Act. It was this economic development that ultimately ended the debate in our favour. Having said that, I do not want to suggest that we foresaw the whole development and were always confident of the result. We, like our counterparts in other countries, were surprised by how far and how quickly inflation came down at the beginning of the 1990s. We also did not forecast the depth of the 1990/91 recession. But once inflation had come down, we felt that there was a high likelihood that it would stay low during the subsequent phase of economic growth. We also felt that an inflation target would help to bring about that result. The introduction of inflation targeting As I have already suggested, much of the intellectual groundwork for the development of our inflation target had been laid well before its introduction. The crucial step required to turn this into reality was the adoption of a published numerical target. For reasons already alluded to, it was some time before this step was taken. Not only was the issue highly politicised, but there was a strong presumption (by both the critics and proponents of inflation targeting) that an inflation target had to be '0-2', which the Bank felt would have been too restrictive. Although we had a general aim of getting inflation down, we did not follow the New Zealand or Canadian sequence of announcing, in advance, a planned reduction to a particular range over a specific time period. As it turned out, that sequence was reversed in our case - inflation was reduced, and a commitment to keep it low as then put in place. The process of establishing that commitment in the public arena was itself a gradual one. Governor Fraser in 1993 referred in two speeches to the objective of keeping inflation around 2 to 3 per cent. The initial flavour of these remarks was that inflation had reached a trough in the early-1990s recession, and that the Bank wished to ensure that it did not rise appreciably during the recovery. This commitment was expressed increasingly firmly with time. In developing our inflation target, the Bank was encouraged by the examples of other countries such as the United Kingdom and Sweden, which adopted inflation targets in 1992 and 1993. These showed that alternative, less rigid inflation targeting models could gain acceptance. Both countries specified targets higher than the original '0-2' model. own choice of a 2-3 per cent figure was based partly on pragmatic considerations. had declined to a trough of 2 per cent, and the main priority was to stop it rising too much from there. There was also a respectable body of academic opinion to suggest that it was optimal to aim for something in the low positive range rather than too close to zero. The other unusual aspect of inflation targeting in Australia was that it was introduced by the central bank. In other countries such as New Zealand, Canada and the United Kingdom, it was from the outset a joint undertaking by both government and central bank, with the former setting the target and expecting the latter to achieve it. Usually, the agreement was formalised in a public document. The evolutionary nature of this process of change in Australia was no doubt unsatisfactory to some of the Bank's critics. They would have preferred a more decisive regime shift, and there were some who felt that the absence of such a shift meant that we did not have a 'proper' inflation target. But gradually, the Government began to recognise that the inflation target was helpful to good economic policy. They had not argued against it after it was introduced, but it was difficult for them to embrace it enthusiastically, given its chequered political history. Even so, by 1995 and 1996, Treasurer Willis was publicly giving the Government's endorsement to the Reserve VIII, the ACTU agreed to aim for wage increases that were compatible with an inflation outcome of 2 to 3 per cent. Thus, Australia was gradually arriving at a very satisfactory position whereby most of the monetary policy regime was now receiving bilateral support - a huge improvement on the situation in the early 1990s. This is the third and last of the areas of monetary policy that needed to be clarified and improved. Returning to the nautical analogy introduced in the first section - this area concerns the question of who should be at the helm now that the vessel has been made seaworthy and equipped with a reliable navigation system? Most listeners will recognise that this boils down to the much-discussed subject of central bank independence, to which I promised to return. Although there has been a worldwide movement towards greater central bank independence over the past decade, I propose only to talk about the aspects that have been unique to Australia. One of the peculiarities of the Australian debate on this subject is that the Reserve Bank, by virtue of its Act in 1959, was always given a high degree of general independence as an institution. The fact that it had been unable to exercise this independence in monetary policy for much of the post-war period was due to a practical impediment - it did not possess the instruments of monetary policy. In the heavily regulated financial world which characterised most of the post-war period, virtually all the instruments - in the form of interest rate controls on government debt and on bank lending and borrowing rates - were vested in the Treasurer. It was not until deregulation was largely completed in the mid-1980s that the Reserve Bank was in a position to exercise the monetary policy powers contained in its Act. Only when it became possible to use open market operations to 'set' the overnight cash rate, was the Reserve Bank in a position to adjust monetary policy in the same manner This development occurred at about the same time as the intellectual case for central bank independence was gaining momentum in major economies around the world. just as in the case of inflation targeting, the issue of central bank independence in Australia also got caught up in the political crossfire between the same two parties. It is perfectly reasonable that it should become a political issue, because it is about the optimal delegation of decision-making authority, a decision which rightly rests with the Government. While the Bank throughout the 1990s had independence, the political stand-off delayed its official recognition for a period longer than the delay of the Government's recognition of the inflation target. The final recognition was not achieved until after a change of government had occurred. In August 1996, the present Treasurer and I signed the Statement on the which set out the Government's recognition of the Reserve Bank's independence and support for the inflation target. There is still a lingering misconception in Australia that parties of the political right support central bank independence and that those of the left oppose it. This is a peculiarly Australian perspective based on our experience in the early 1990s; it is not true at present, was not at an earlier date and has not been the case in other countries. The two best known examples of countries adopting central bank independence are New Zealand, where the legislation was introduced by the where it was introduced by the Socialist Government resisted granting independence to the Bank of England to the end, but the introduced it as one of its first Acts. In all of these three cases, unlike Australia, new legislation was required because the existing Acts did not provide for independence. I have covered a full quarter of a century in this account, and have attempted to fill in some of the political, as well as the intellectual, background. It has been an eventful quarter of a century for monetary policy, but one where a lot of progress has been made. Some of this improvement has been easy because the starting point was so bad - the mid-seventies to late-seventies saw inflation peak at 20 per cent, while unemployment was rising and economic growth was going through its most sluggish phase in the post-war period. Today's economic environment is extremely benign in comparison to those days, even though, like then, we have the threat of an external shock hanging over us. When my account starts, not only were monetary institutions inadequate, but monetary policy was not held to be very important. Fiscal policy was given precedence, and monetary policy played a subsidiary role. In those circumstances, it is not surprising that the monetary framework was not well developed, and that little public attention was focused on it. By the time monetarism arrived on the Australian scene, this all changed. Monetary policy became regarded as extremely important and much attention was focused on it. As we have seen, this attention eventually increased so that by the late 1980s- early 1990s, monetary policy had become an intensely political subject. Not only was the conduct perceived as political, but the design of its institutions had become important enough to form a major part of the electoral platform of one of the major political parties. Finally, we have entered a phase where a measure of peace has returned. The day-today conduct of monetary policy is still closely scrutinised by the markets and the media, but attitudes to the underlying institutions and framework have reached a measure of bipartisan support. With the reduction in controversy, monetary policy has gained a degree of credibility that seemed out of the question a decade ago. Of course, it is not only the bipartisan acceptance of the framework that has contributed to the increase in credibility. The larger reason is that Australia has returned to the ranks of low inflation countries, so the underlying grievance of the majority of the Reserve Bank's critics has been removed. Economic historians who look back over the past quarter of a century may well be surprised by the huge role played by inflation in shaping our attitudes to monetary policy. They should not be surprised. Just as the deflation of the thirties was the dominant macroeconomic event of the first half of this century, the rise of inflation in the seventies was the dominant event of the second half of the century. So much of recent monetary policy thought has simply been a response to that event, just as Keynes provided the response to the earlier event. What will be the next challenge? Already, monetary thought is recognising that there are more things to central banking than a single-minded pre-occupation with inflation. The recent events in Asia have taught us that the avoidance of financial crises is as important. In Japan, we are confronting the spectre of deflation, which we all thought had been left behind after the war. It would be fascinating to know what the defining event will be in the next quarter of a century. ,

r981014a_BOA

australia

macfarlane

In my ten minutes here I will try and cover what I see as the main changes in perspective about what we formerly termed the Asian crisis, and then say a few words about future international financial architecture. The main change is that since August this year we no longer think of an Asian crisis but we now think of either an emerging markets crisis or a general world financial crisis. A second important change is that the western policy establishment can no longer believe that the root cause of the problem is the inadequacy of the financial infrastructure and governance of some formerly rapidly growing Asian countries. Of course, not everyone used to believe this, but there were some very influential institutions that thought this way. Everyone is now aware that contagion is a much stronger force than formerly thought. Contagion is an essentially irrational force which tars large groups of countries with the same brush, and causes fear to overrule reason. Given the bigger role for contagion, more and more people are asking whether the international financial system as it has operated for most of the 1990s is basically unstable. By now, I think the majority of observers have come to the conclusion that it is, and that some changes have to be made. With pretty well everyone now conceding that changes have to be made, you would think it would be a relatively simple matter to move on to the next step. But it will not be, because there are still big differences of opinion about how serious the problem is. One school of thought held that the main thing required to restore stability was to improve transparency, particularly the Government's transparency to the private sector - e.g. by more frequent and accurate publication of figures for international reserves. This school of thought also gave a fair bit of weight to improving the quality of bank supervision in emerging market countries. This explains the motivation behind two of the three working groups set up by the G22 in April. But an increasing majority think something more is required, and the most promising approach here goes under the general title of burden sharing with the private sector like to say a little more about this because I think it will be necessary if we are to make real progress. If we go back and think of the Thai, Korean or Indonesian crises, we can see the problem if there is no formal system of burden sharing. Once the currency doubts started, short-term lenders knew that if they could get their money out fast enough they would minimise currency losses and loan losses. So when each loan had to be rolled over it was not renewed, and capital flowed out. Each day this happened the exchange rate came under further downward pressure, which encouraged further capital flight. Everyone wanted to be out before the point was reached where the exchange rate was so low, interest rates were so high, and insolvencies were so rife, that those who could not get out of the door would be big losers. This process ensured the maximum fall in the exchange rate. Something clearly has to be done in terms of managing the crisis to reduce the incentives for everyone to try to be the first one out of the door. Some system of standfast followed by an orderly workout involving rollovers, reschedulings and, in extreme cases, debt equity swaps is clearly required. No country wants to be the first one to do this, and unilateral action could cause panic in other countries a la Russia. What is needed is a system that involves co-operation between the host country, private lenders and the IMF. We saw an example of how effective this can be for Korean bank-to-bank debt late last year. Ideally, this should not be on an ad hoc basis, as it was in Korea, but should be thought out well in advance, with the possibility of such workouts included in loan documentation. This, of course, would increase the cost of borrowing by emerging market economies, but that would be no bad thing. One of the problems over the past five years was that it became too cheap and too much of it was done. It would be better than excessive lending followed by capital flight as we have seen over the past few years. This is all becoming reasonably conventional thinking now and, as I said, it is contained in the third Working Party Report of the G22. But it was not that long ago that any suggestions along these lines was greeted with the response that it was out of the question because it involved interfering with the free movement of capital. I would like to conclude by mentioning two other things that have changed over the past year. First, hedge funds. As recently as three months ago if you complained about the activities of hedge funds you were regarded as paranoid and you received a sermon on the dangers of shooting the messenger, etc. Now, no one has got a good word to say for them, and they are likely to soon be brought into either: the disclosure net; or some form of supervision via their connections with banks. Second, I see a clear improvement in future crisis management in the way the IMF is talking with Brazil. Unlike the Asian crises, I don't see any country in future putting itself in the hands of the IMF without knowing pretty clearly beforehand what the IMF conditions will be. If it doesn't like the conditions, for example, because they are too wide ranging, it will not go to the Fund. If it is comfortable with the conditions, it will be able to sign up from day one. This way, we should be able to avoid the long periods of semi-public haggling over conditions that characterised the Asian crises and did so much to frighten the markets into pushing exchange rates down excessively. Address to the International Conference of in on I would like to start by adding my voice to those who have already welcomed you to this Conference and to the city of Sydney. It goes without saying that there could hardly be a more propitious time for the international leaders in the field of bank supervision to be meeting. When we first started planning this Conference a couple of years ago, we did not know whether it would attract a lot of interest or would be greeted with a yawn. We now know it is the former, and we in the Reserve Bank, and our colleagues at the with whom we are jointly hosting the Conference, are sure that you will be in for a couple of very interesting days. It is hard to pick up a newspaper these days without seeing the word 'crisis' prominently displayed in a headline somewhere. First, we had the Asian crisis, then it spread into being an emerging markets crisis, and now we hear so much talk of a world financial crisis. It is interesting that, so far, the focus is on the word financial and not on the more general word economic . It is also interesting that these troubling financial events are no longer confined to emerging market economies. One consequence of these two trends is that the contrast between economic health and concerns about the financial sector is as marked in the world's most powerful economy - the United States - as elsewhere. There is a big challenge, therefore, to the bank supervisors of the world, and it seems to be equally large whether they are dealing with the least, or the most, sophisticated of the world's banking systems. I see two main challenges for the world's economic policy-makers - one for the short term and one for the medium term. In the short run, the challenge is to get through the current crisis - to make sure no more dominoes fall through contagion. The region at risk is clearly Latin America, even though many of these countries are now running infinitely better macroeconomic policies than could have been imagined a decade ago. It would be tragic for them to be blown off course by the spread of financial turbulence that they had no significant part in the making of. It would lead more countries to question the wisdom of adopting sound macroeconomic policies and of opening their economies. One helpful recent development is the acceptance that there should be behind-the-scenes discussions between a potential borrower and the IMF. If an IMF package does prove to be necessary in the case of Brazil, for example, it will already have had its voice heard, and it will know exactly what the conditions are in advance. It thus should be able to sign up on Day One and so avoid the situation that occurred in Asia where countries put themselves in the hands of the IMF without knowing what the conditions would be. Thus, the handling of the Brazilian situation seems to be benefiting from one of the lessons of the Asian rescue packages. What can bank supervisors do to assist in the resolution of the present situation? Given that a major part of the problem is an increase in risk aversion by lenders and a possible 'credit crunch', it seems to me that bank supervisors will inevitably have a very big influence on the outcome. I would like to endorse the remarks I recently heard Bill McDonough make that bank supervisors will have to be extremely careful not to inadvertently encourage banks to become even more risk averse than they currently are. This will require great sensitivity on the part of supervisors, and I am sure you will all rise to the challenge. The second big challenge to all of us involved in international finance is to devise a better system for the long run. None of us should be happy about how events have unfolded over the past five years, and none of us could deny the claim that the international financial system is prone to periods of extreme financial turbulence that leave lasting economic costs. At first, this instability was attributed to deficiencies in the financial infrastructure in some emerging market economies. Soon, however, more thoughtful people saw the source of the instability as being the combination of two things - large movements of short-term capital taking place in countries that had small and not very well developed financial infrastructures. We now know that there is a third important factor at work as well - banks in developed countries (often in conjunction with hedge funds) have been taking much bigger risks than their supervisors or their shareholders thought. How do we go about devising a better system or, in current parlance, designing the new international financial architecture? Obviously, this will be a very large task, and I can only offer a few observations here this morning. First, we all recognise that access to the international capital market has, on balance, bestowed enormous benefits on participating countries, particularly developing countries. The world is a much better place when it is outward looking - historical epochs where large international transfers of capital were taking place were those where living standards around the world were rising fastest and where poverty declined most. I, for one, would be saddened if a number of countries responded to the current turmoil in international markets by cutting themselves off from the international market place thereby forgoing the benefits that the use of foreign savings can bring. It goes without saying that Australia is completely happy with its policy of permitting the free movement of international capital and sees no case for any change. On the other hand, it is simplistic to insist on the totally free movement of capital in all countries and in all circumstances. To do so would be to ignore the lesson from recent crises, to further risk the stability of the system and to invite a reaction which would make us all worse off. We need to devise a system for maximising the benefits to be gained from international capital while limiting the risks. For example, I think Chile was probably quite wise, and certainly within its rights, for a time to impose a tax on capital inflow which impinged most severely on very short-term flows. (Note, however, that Chile did not impose controls on outflow.) Like Chile, the world economy has to reach a proper balance, and I think there is increasing recognition that it will involve a few trade-offs. Within developed countries, a number of institutions have been designed to encourage investment and risk taking - the joint stock company, the concept of limited liability, bankruptcy laws and, of course, central banks as lenders of last resort. These are all accepted as necessary parts of a developed financial system, and help provide the right balance between encouraging enterprise while at the same time preventing individual financial distress from turning into widespread financial panic. All these things, by the way, have the by-product of creating an element of moral hazard. Internationally, on the other hand, despite all the talk of globalisation, a borderless world and the integration of financial markets, there has been a reluctance to go very far down the path of finding an international equivalent to the bankruptcy laws or the lender of last resort. The main objections have traditionally been that it would interfere with the free movement of capital and that it would create a moral hazard. That attitude now appears to be changing, and the recent discussions of private sector burden sharing can be viewed as, in some sense, an international equivalent to domestic bankruptcy arrangements. In a company bankruptcy, failure to follow the right approach results in a 'fire sale' of assets: in a national financial crisis, it results in a flight of capital and an excessive fall in the exchange rate. The third Working Party Report to the addresses the problem where, in a crisis, all individual creditors look after their own private interests and, in so doing, create a situation which is worse for them as a whole (and for the debtor country). This is the problem known colloquially as 'everyone rushing for the exit at once'. The Report makes a number of helpful suggestions, all of which revolve around the recognition that a tripartite agreement between creditors, debtors and probably the IMF would be the best way of resolving a crisis once it has begun. The agreement would involve some sort of standfast followed by a workout which would include rollovers of debt and rescheduling. This is a very promising approach, but as recently as last year in the Asian crisis was dismissed on the grounds that it represented an interference with the free of flow of capital I should take this opportunity of saying how For a group that has only been in existence for a little over six months and has only met twice at Ministerial level, it has achieved a lot. The three Working Party Reports are the most constructive effort to date in laying out some practical steps towards improving the international financial architecture. I have already said how useful I thought the third Report was, but there is also a lot of good sense in the first one which deals with transparency and disclosure, and in the second one which deals with an improved financial system supervision. Both these subjects - disclosure and supervision - have relevance for the very topical subject of hedge funds. In fact, the first Report recommends that ' a working party ... be formed as soon as possible to examine the modalities of compiling and publishing data on the international exposures of investment banks, hedge funds and other institutional investors '. We regard this cautiously worded recommendation as a big step forward, in that for the first time to my knowledge, an official international body has proposed bringing hedge funds into the disclosure net. But I wonder if it is still too cautious. The big macro hedge funds have become, to some extent, an extension of the proprietary trading arms of major banks. There is, in fact, a continuum running from commercial banks to investment banks to hedge funds, and it is hard to see why some of this should be within the supervisory net and some without. This alone would argue for some degree of supervision - for example, limits on gearing - rather than just disclosure. The case becomes stronger when we take into account the fact that the New York Fed has had to organise a support package for a large hedge fund on the grounds that its failure would have systemic consequences (both nationally and internationally). If, like banks, they are important enough to have systemic consequences, it is hard to see why they should escape supervision of some form or another. I want to conclude by sympathising with you as bank supervisors because of the inherent difficulty of the task you face. To some extent, the biggest challenge is to bring the countries furthest behind world best practice up to standard, and the Core Principles are a very useful step in this direction. But as recent events have reminded us, even in the countries with the most developed systems of bank supervision, we still continue to be surprised by the capacity of the best and the brightest to take risks the magnitude of which even they do not understand. This makes the task extremely hard for bank supervisors - you all have to run very hard just to keep up with developments in markets, and perhaps, the nature of risk itself.

r981021a_BOA

australia

macfarlane

I would like to start by adding my voice to those who have already welcomed you to this Conference and to the city of Sydney. It goes without saying that there could hardly be a more propitious time for the international leaders in the field of bank supervision to be meeting. When we first started planning this Conference a couple of years ago, we did not know whether it would attract a lot of interest or would be greeted with a yawn. We now know it is the former, and we in the Reserve Bank, and our colleagues at the Australian Prudential Regulation Authority, with whom we are jointly hosting the Conference, are sure that you will be in for a couple of very interesting days. It is hard to pick up a newspaper these days without seeing the word 'crisis' prominently displayed in a headline somewhere. First, we had the Asian crisis, then it spread into being an emerging markets crisis, and now we hear so much talk of a world financial crisis. It is interesting that, so far, the focus is on the word and not on the more general word . It is also interesting that these troubling financial events are no longer confined to emerging market economies. One consequence of these two trends is that the contrast between health and concerns about the sector is as marked in the world's most powerful economy - the United States - as elsewhere. There is a big challenge, therefore, to the bank supervisors of the world, and it seems to be equally large whether they are dealing with the least, or the most, sophisticated of the world's banking systems. I see two main challenges for the world's economic policy-makers - one for the short term and one for the medium term. In the short run, the challenge is to get through the current crisis - to make sure no more dominoes fall through contagion. The region at risk is clearly Latin America, even though many of these countries are now running infinitely better macroeconomic policies than could have been imagined a decade ago. It would be tragic for them to be blown off course by the spread of financial turbulence that they had no significant part in the making of. It would lead more countries to question the wisdom of adopting sound macroeconomic policies and of opening their economies. One helpful recent development is the acceptance that there should be behind-the-scenes discussions between a potential borrower and the IMF. If an IMF package does prove to be necessary in the case of Brazil, for example, it will already have had its voice heard, and it will know exactly what the conditions are in advance. It thus should be able to sign up on Day One and so avoid the situation that occurred in Asia where countries put themselves in the hands of the IMF without knowing what the conditions would be. Thus, the handling of the Brazilian situation seems to be benefiting from one of the lessons of the Asian rescue packages. What can bank supervisors do to assist in the resolution of the present situation? Given that a major part of the problem is an increase in risk aversion by lenders and a possible 'credit crunch', it seems to me that bank supervisors will inevitably have a very big influence on the outcome. I would like to endorse the remarks I recently heard Bill McDonough make that bank supervisors will have to be extremely careful not to inadvertently encourage banks to become even more risk averse than they currently are. This will require great sensitivity on the part of supervisors, and I am sure you will all rise to the challenge. The second big challenge to all of us involved in international finance is to devise a better system for the long run. None of us should be happy about how events have unfolded over the past five years, and none of us could deny the claim that the international financial system is prone to periods of extreme financial turbulence that leave lasting economic costs. How do we go about devising a better system or, in current parlance, designing the new international financial architecture? Obviously, this will be a very large task, and I can only offer a few observations here this morning. First, we all recognise that access to the international capital market has, on balance, bestowed enormous benefits on participating countries, particularly developing countries. The world is a much better place when it is outward looking - historical epochs where large international transfers of capital were taking place were those where living standards around the world were rising fastest and where poverty declined most. I, for one, would be saddened if a number of countries responded to the current turmoil in international markets by cutting themselves off from the international market place thereby forgoing the benefits that the use of foreign savings can bring. It goes without saying that Australia is completely happy with its policy of permitting the free movement of international capital and sees no case for any change. On the other hand, it is simplistic to insist on the totally free movement of capital in all countries and in all circumstances. To do so would be to ignore the lesson from recent crises, to further risk the stability of the system and to invite a reaction which would make us all worse off. We need to devise a system for maximising the benefits to be gained from international capital while limiting the risks. For example, I think Chile was probably quite wise, and certainly within its rights, for a time to impose a tax on capital inflow which impinged most severely on very short-term flows. (Note, however, that Chile did not impose controls on outflow.) Like Chile, the world economy has to reach a proper balance, and I think there is increasing recognition that it will involve a few trade-offs. Within developed countries, a number of institutions have been designed to encourage investment and risk taking - the joint stock company, the concept of limited liability, bankruptcy laws and, of course, central banks as lenders of last resort. These are all accepted as necessary parts of a developed financial system, and help provide the right balance between encouraging enterprise while at the same time preventing individual financial distress from turning into widespread financial panic. All these things, by the way, have the by-product of creating an element of moral hazard. Internationally, on the other hand, despite all the talk of globalisation, a borderless world and the integration of financial markets, there has been a reluctance to go very far down the path of finding an international equivalent to the bankruptcy laws or the lender of last resort. The main objections have traditionally been that it would interfere with the free movement of capital and that it would create a moral hazard. That attitude now appears to be changing, and the recent discussions of private sector burden sharing can be viewed as, in some sense, an international equivalent to domestic bankruptcy arrangements. In a company bankruptcy, failure to follow the right approach results in a 'fire sale' of assets: in a national financial crisis, it results in a flight of capital and an excessive fall in the exchange rate. The third Working Party Report to the G22 on International Financial Crises addresses the problem where, in a crisis, all individual creditors look after their own private interests and, in so doing, create a situation which is worse for them as a whole (and for the debtor country). This is the problem known colloquially as 'everyone rushing for the exit at once'. The Report makes a number of helpful suggestions, all of which revolve around the recognition that a tripartite agreement between creditors, debtors and probably the IMF would be the best way of resolving a crisis once it has begun. The agreement would involve some sort of standfast followed by a workout which would include rollovers of debt and rescheduling. This is a very promising approach, but as recently as last year in the Asian crisis was dismissed on the grounds that it represented an interference with the free of flow of capital (which it does). I should take this opportunity of saying how useful Australia has found the G22 Meetings. For a group that has only been in existence for a little over six months and has only met twice at Ministerial level, it has achieved a lot. The three Working Party Reports are the most constructive effort to date in laying out some practical steps towards improving the international financial architecture. I have already said how useful I thought the third Report was, but there is also a lot of good sense in the first one which deals with transparency and disclosure, and in the second one which deals with an improved financial system supervision. Both these subjects - disclosure and supervision - have relevance for the very topical subject of hedge funds. In fact, the first Report recommends that ' . We regard this cautiously worded recommendation as a big step forward, in that for the first time to my knowledge, an official international body has proposed bringing hedge funds into the disclosure net. But I wonder if it is still too cautious. The big macro hedge funds have become, to some extent, an extension of the proprietary trading arms of major banks. There is, in fact, a continuum running from commercial banks to investment banks to hedge funds, and it is hard to see why some of this should be within the supervisory net and some without. This alone would argue for some degree of supervision - for example, limits on gearing - rather than just disclosure. The case becomes stronger when we take into account the fact that the New York Fed has had to organise a support package for a large hedge fund on the grounds that its failure would have systemic consequences (both nationally and internationally). If, like banks, they are important enough to have systemic consequences, it is hard to see why they should escape supervision of some form or another. I want to conclude by sympathising with you as bank supervisors because of the inherent difficulty of the task you face. To some extent, the biggest challenge is to bring the countries furthest behind world best practice up to standard, and the Core Principles are a very useful step in this direction. But as recent events have reminded us, even in the countries with the most developed systems of bank supervision, we still continue to be surprised by the capacity of the best and the brightest to take risks the magnitude of which even they do not understand. This makes the task extremely hard for bank supervisors - you all have to run very hard just to keep up with developments in markets, and perhaps, the nature of risk itself.

r981125a_BOA

australia

macfarlane

It is a pleasure to be in Melbourne again time I addressed this group two years ago I spoke about the Australian economy, monetary policy and wages. Events have moved on a good deal since then, and I hope what I have to say tonight reflects this. The biggest change is that attention is now more focused on the international economy than on domestic events. This change can be dated from the start of the Asian crisis in the middle of 1997, and has continued through more recent episodes which have affected other emerging markets as well as financial institutions in developed countries. These events have led a number of participants in international markets, myself included, to question some aspects of the present international financial system, and to make suggestions for improvements. I have said a number of things recently that have sounded a bit out of character from a central banker. Both I and my deputy have shown a lot of sympathy for our Asian neighbours and felt that it is unfair to place the blame for their current plight solely on their own policy inadequacies. We have also said that the present international financial system is unstable, that hedge funds should be brought into the disclosure and supervision net, and that the western policy establishment was wrong to encourage emerging markets to embrace the free movement of international capital so early in their development. This has led some people to wonder what has come over us, and to question whether we have deserted orthodox economics to follow more populist creeds. I have been asked whether we no longer believe in markets, and whether we have become proponents of capital controls. These questions worry me because they suggest that, for some people, there are only the two polar positions, and that if you express some reservations about one, you are automatically placed in the other. For these reasons, I want to spend some time tonight trying to place the recent suggestions for improving the operation of the international financial system in some sort of perspective. From the perspective of the Australian economy, the move to financial deregulation, and to the lifting of restrictions on international capital movements, has been a success. We can date it approximately from the floating of the exchange rate, and the abolition of exchange controls, in 1983. Although we characterise this 15-year period as being an era of deregulation, that is only a very approximate description. While the authorities have stopped setting prices such as the exchange rate or the interest rates banks can charge on mortgages, there is still a large ever-evolving body of regulation in place aimed at ensuring financial stability and efficient and fair markets. The stock exchange and the futures exchange have a comprehensive set of rules that participants must adhere to, and, of course, they are also regulated by ASIC. The banks and insurance companies are regulated by APRA, the payments system by the Reserve Bank, and competition policy is enforced by the ACCC. Underlying all this, is the body of commercial law and the accounting standards. This approach to organising financial markets - which, in deference to common usage, I will call the deregulated approach - has not been without its critics. A common criticism is that international capital has forced the Australian Government to run macroeconomic policies that were not in the interests of the domestic economy. By this, the critics mean policies that are tighter than the ones they favour. I have never agreed with this proposition. There has been an ongoing struggle in Australia by governments of both sides to return fiscal and monetary policy to sustainable long-run settings after the turmoil of the 1970s. The influence of financial markets has been a helpful one in bringing this about. Now that policies are in a sustainable and responsible position, I am not aware of financial markets pushing for tighter policies. The other common criticism is that financial markets in Australia have been unstable. The simplest answer to this charge is to point out that they would have been more unstable over the past 15 years if we had tried to find a path through the ups and downs of the world economy with a managed exchange rate and a set of interest rate ceilings. We would not have had the daily movements as under the present system, but the pressure would have built up and when the dam broke, as it assuredly would have, the crisis would have been worse. While I am confident that the deregulated system performed better than a continuation of the old regulated one would have, I do not want to give the impression that it is without fault. We are already on record as accepting that the exchange rate went down too far in the mid-1980s, that asset prices such as shares and, later, commercial property underwent a boom and bust at the end of the 1980s and beginning of the 1990s, partly as a result of excessive lending by newly deregulated banks. Our whole approach to foreign exchange intervention is based on our view that the foreign exchange market is not 'efficient' in the academic sense, but that it is prone to overshooting in both directions from time to time. In other words, we do not have an idealised view of how deregulated asset markets behave - we have a realistic 'warts and all' view. But even holding that view, we are confident that a deregulated model with no obstacles to capital movements is the best one for Australia. It took us a long time to adopt it, but there is now wide support for it at the political, policy adviser and community level, and I hear no suggestions that we should change it. But that does not mean that we should be urging every other country to adopt this model regardless of their state of development. Eventually, I think it will be in the interest of emerging market economies to do so, but the sequencing of this and other policies is crucial. When we look at international capital movements from the perspective of an emerging market economy, the view can be very different. For a start, the size of the financial sector in an emerging market is often extremely small relative to the flows of capital that emanate from developed countries. As Paul Volcker has put it: What is a small adjustment of investment strategy for a few major banks or mutual funds may be a large injection or withdrawal of funds for an emerging market. Second, it is clear that for most of the Asian emerging markets, some of the capital inflow that occurred in the mid to late 1990s was not, in any sense, needed. It was more than the amount required to finance their current account deficit, and it certainly was not needed to support their exchange rate because these were under unwelcome upward pressure throughout the period. The purist would say that if they did not want the inflow they should have let their exchange rates float upwards. This would have eventually curtailed the short-term inflows that result when a fixed exchange rate tries to co-exist with a positive interest differential. But what we do not know is how high the exchange rate would have needed to rise in the process and the extent to which this would have added to the economic difficulties. Remember the Thai currency crisis was triggered by the perception that the baht had become overvalued because it was tied to a rising US dollar. In short, if capital flows are very large relative to the size of the economies, they are, one way or another, going to cause distortions. Of course, the above considerations would not matter if the international capital markets were a smoothly adjusting mechanism that constantly kept the exchange rate in line with the evolving fundamentals. But this is not what people observe - they see booms and busts and do not believe the proposition that the market is always right. Attempts by academic economists to persuade them that the free market always, or nearly always, gives the correct equilibrium price are unconvincing. The public's scepticism is well placed because the intellectual underpinning of the free market position in relation to asset price determination - the Efficient Markets Hypothesis - is very weak. In all the exchange rate tests of which I am aware, the hypothesis has been contradicted by the facts. The third difference from an emerging market viewpoint is their relatively underdeveloped financial infrastructures and regulatory frameworks. They do not have as strongly a based system of regulating stock markets or banks or the underlying body of commercial (including bankruptcy) law or accounting practices. They also have serious deficiencies in the allocation of investment which unduly favours those who are well-connected to the government, the banks or both (the so-called 'crony capitalism'). I have no intention of denying that these are serious shortcomings and that they should be rectified as quickly as possible if the countries concerned are going to achieve first world living standards. But we have to be realistic about how quickly these things can be achieved; in our own countries, some of these changes took decades or generations rather than years. Such problems are heightened by the phenomenon of contagion, a fourth element particularly strong among emerging markets. In cases of panic, financial markets are not very discriminating. When one country suffers a withdrawal of capital, others come under pressure. Partly, this can be geography, as physical proximity can often mean economic and financial linkages. But even economies on the other side of the globe, with few direct linkages, can be affected for no other reason than that they are classified as 'emerging markets'. Such countries might well have some weaknesses such as those noted above which, given time and a measure of economic and financial stability, might be adequately addressed. But under conditions of widespread desire to shed risk, they become immediate stumbling blocks for markets. This can put intense pressure on the policy authorities and economies of these countries - pressure which few countries can withstand easily. For these reasons, the picture looks different from the perspective of the emerging market economies. What is good for us after a long period of evolution need not be good for another country at a much earlier stage of that evolution. In modern parlance, it is essential to get the sequencing right. Countries have to attain a high standard of financial infrastructure and regulation before they can submit themselves to the potential instability inherent in the totally free movement of capital. In the meantime, they should integrate themselves as closely as they can into the international capital market and, as their markets evolve towards maturity, they can take additional steps progressively to liberalise their regulatory regimes. To expect them to do it in the other order is to ask them to run before they can walk. Fortunately, there is now a widespread agreement that something has to be done to improve the international financial system. The degree of instability, if it continues unchecked, could lead many participating countries to question the whole legitimacy of the system. The severity of the contractions in Asia is the most striking example, but so is the sudden recognition that a hedge fund can become so important that its failure could pose a systemic threat to the United States and international economy. The fact that the second most important exchange rate in the world - the US dollar-Yen rate - could move by 20 per cent in a month without there being a material change in fundamentals has also caused concern. I think there is now agreement that something has to be done, and it is heartening to see that the United States has taken a leadership role, including by convening the Group of 22 and its three working parties. I also think that the Australian Government has played a very useful role - first by its representations to the IMF urging more flexibility in its handling of the Indonesian crisis, and secondly by its attempt to keep the momentum of APEC heading in the direction of more liberal trade policies. Change is already occurring in that the western policy establishment is no longer pushing emerging market economies to move quickly to full capital account convertibility. As recently as October last year the IMF, at its Annual Meeting in Hong Kong, was hoping to get its members' endorsement of a change to its Articles to make it easier for it to encourage countries to adopt full convertibility. This proposal was not put forward at the 1998 Annual Meeting in Washington because it was clear that it would not get support. There also seems to be greater tolerance for countries which have a generally outward-looking policy framework, but which have in place some impediment to very short-term capital movements. I refer here to Chile's deposit requirement on foreign borrowing and to Singapore's and Taiwan's restrictions on their banks lending domestic currency offshore. The more important task is to get on with the job of improving the international monetary system, with the specific aim of reducing the degree of instability. Some of this is the job of the emerging market countries, and in the first instance involves increasing disclosure by these countries' governments, companies and banks. As well as making markets better informed, and better able to judge the risks they are taking, the aim here is to make some progress on reducing the previously opaque links between governments, banks and companies, or, in other words, to improve governance. In addition, there is a lot of work to be done to bring the supervision of financial institutions up to standard - a task which will take a lot of personnel, training and time. These changes are extremely important and require a lot of effort on the part of the emerging market countries. They also mean that a lot of time-honoured ways of doing things will have to be replaced. This is bound to meet opposition, and it will require political courage as well as economic expertise to achieve results. It will be made a lot easier if the developed economies are also seen to be examining whether there are aspects of their regulations that are contributing to the instability of the international system. The most obvious reform here is to do something about the extent to which current regulations allow excessive leverage in financial markets. The immediate focus should be the close inter-connections between hedge funds, investment banks and commercial banks. The hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities. Our reconstruction of the transactions that hedge funds undertook in Australia in June suggests that they could engage in almost infinite leverage in their off-balance sheet transactions if they so chose. One has to ask whether the Basle capital requirements are excessively generous in their treatment of financial market activities. A related problem is the weakness in banks' credit assessment processes that allowed them to build up some very large exposures to hedge funds and other financial institutions. No matter how effective the above changes turn out to be, no-one expects that they will eliminate economic crises altogether. There still will be a need for improved crisis management. Here, the most useful suggestion goes under the title of private sector burden sharing. This is designed to be used in a future crisis when a country's international reserves are exhausted and its exchange rate is plunging as a result of capital flight. In order to reassure markets, countries are often tempted to guarantee a variety of foreign borrowings, with the result that their taxpayers incur large losses while foreign lenders escape unscathed. Private sector burden sharing would stop the capital flight by bringing foreign creditors, the debtor country and the IMF together to work out a rescheduling, probably with a standfast arrangement to hold things together while negotiations take place. Thus, the burden would be shared more evenly, and the pressures on exchange rates could be reduced. Another way in which crises can be handled better is illustrated by the recent IMF package for Brazil. It was an improvement on the Asian packages in two respects. First, the conditions were agreed on in advance in behind-the-scenes negotiations between the IMF and Brazilian authorities. This was much better than the public tug-of-war between national authorities and the IMF that occurred in Thailand and Indonesia. Second, I also note that the conditions are not as wide-ranging as in Indonesia, for instance. I agree with Martin Feldstein that the IMF conditions should confine themselves to matters that bear directly on the currency crisis, namely fiscal, monetary and banking policy, rather than trying to reform the automobile, shipbuilding or clove industry, as in Indonesia. It is important that we find a way of reducing the present extreme variability in international capital flows. It is also important that we find a way of managing future crises in a way that reduces the cost to the crisis country and shares the burden more evenly, and so reduces the moral hazard to lenders. If we do not succeed in doing these things, we face the prospect of a significant number of countries losing faith in open, market-based economic systems. It would be tragic if our failure to reform an unstable international capital market resulted in a return to inward-looking policies in the international trade in goods and services. And that may yet happen. One reaction to the instability of the international financial system would be for countries to unilaterally impose quite restrictive controls on inward and outward capital movements, and thus miss out on the benefits that access to foreign capital can provide. We have already seen this starting, and it would be regrettable if it were to spread. Even if this does not happen, there is still a possibility of other reactions which may be equally, or more, unhelpful to the world economy. In particular, I fear that a number of emerging market countries will take another form of safety-first policy by building up large international reserves - a new type of mercantilism. The problem with this solution is that to build up the reserves they would have to run current account surpluses for the foreseeable future. How will they do this? Will they be tempted to restrict imports, subsidise exports or maintain undervalued exchange rates? All of these are what used to be called 'beggar thy neighbour' policies. The whole world cannot do this, so who will run the corresponding current account deficits? The final irony, if this situation eventuates, would be that we would have an international system in which the poor countries lend to the rich so they can spend more than their income.

r981127a_BOA

australia

macfarlane

First, I would like to add to what Mr Hawke has already said by extending my personal welcome to Australia for the 1998 Asia Pacific Forex Congress. I am glad to see that the Asian Pacific Congress is continuing to thrive. A regional association such as this is important because, according to the latest BIS world market survey, the Asian region accounts for about one quarter of global foreign exchange turnover. I am hopeful therefore, that, as the practitioners in this region, your discussions here over the next couple of days will make a contribution to resolving some of the issues that recent events have exposed. When this Congress last met in Hong Kong a year ago, the so-called "Asian crisis" had already started, but few could have anticipated the toll it would eventually take, not only on financial markets but also on these countries' economies more generally. None of us thought that most of the economies of Asia would be in recession by now, or that the effects would have spread to non-Asian emerging markets. I am sure the Congress this year will provide plenty of topics for lively discussion because foreign exchange markets are so central to all that has happened. If we cast our minds back to July last year, we will recall that initially the events in Thailand and elsewhere were seen as a "currency crisis" before they became a general economic crisis. I am pleased that the Australian Government has been able to play a constructive role in helping to understand the difficulties in the region, and then to assist in efforts to overcome them. Australia was, in fact, the only country apart from Japan which contributed to all three financial assistance packages in the region. The Australian authorities were able to play a useful role because they had been building an understanding of regional developments for many years, in part reflecting the strong trade links with the region, but also a more general interest on the part of our business and academic communities. Bureaucratic ties, including among central banks, had also been strengthened, particularly through EMEAP, the group of eleven regional central banks and monetary authorities that has been meeting regularly since 1991. This understanding led Australia to see more quickly than most other countries the difficulties with the Indonesian rescue package, and it used what influence it had with the IMF to argue for a more flexible approach. Recently, Australia has pressed for APEC to lend its support to the proposed reforms to the international financial system put forward by the three G22 working parties. We recognise that there is a danger that the momentum could be lost if governments in this region do not keep up the pressure. One of the areas in which the reshaping of ideas has already begun to occur is that of exchange rate systems. Until 1997, most countries in Asia maintained some form of pegged exchange rate. In the case of Hong Kong, this was a type of currency board, while other countries maintained exchange rates which although often referred to as floating, were managed within a tight range against the US dollar or some weighted index dominated by the US dollar. Most of the latter group of countries have had to abandon their systems under the pressure of recent events. Currency boards such as Hong Kong's (or Argentina's, for that matter) seem to have survived rather better (though at a high price in terms of lost GDP). As a result, it is commonplace to hear these days the view that countries can choose to have a fixed exchange rate by way of a currency board or a pure float, but not any of the possible systems in between. I confess to some misgivings about this conclusion. I think it is mainly attractive to people who like intellectually pure systems, but we live in a very impure world. I think a lot more analysis needs to be undertaken before we could be confident of such a conclusion. For a start, Hong Kong's version of a currency board is very different to Argentina's. Secondly, we need to examine countries like Singapore, Taiwan or Chile, which do not fall into either of the polar cases, but whose economies seem to have done relatively well in difficult circumstances. Whatever the solution is, it will involve making very difficult choices. I am reminded of this when I look back over the many meetings I attended with Asian central banks in the middle years of this decade. The ever-present topic of conversation was what to do about the large inflows of capital they were attracting. Everyone knew that they were "excessive" in the sense that they were much larger than needed to cover the relatively small current account deficits, were difficult for the economies to absorb productively, and were putting a lot of upward pressure on their relatively fixed exchange rates. There were basically three alternatives open to them: As we know, they chose the first alternative. We look at the result and say they made a mistake. But the second alternative capital controls was effectively ruled out by international pressure in anything other than a crisis situation. Remember, while the international debate has now reached some form of consensus that "Chilean" style controls on inflows can play a useful role, this is a very recent development. That leaves the third alternative - a move to a floating exchange rate and this looked rather daunting to them. I am not aware of any country, including developed countries, that have made the move without being forced to do so by some form of crisis. The reality is that, even though the theoretical benefits of floating are clear enough, the transition can be, and often is, difficult. Certainly, that was our experience in Australia in the mid 1980s. In the case of the Asian economies, a move to floating may have brought things to a head sooner in that it would have removed the exchange rate certainty that underpinned the capital inflows that were driven by interest rate differentials. But, exchange rates which were already seen as being over-valued would have risen further, compounding the subsequent correction. With the benefit of hindsight, it now seems clear to me that it would have been difficult to avoid some sort of crisis. With so much internationally mobile capital pouring into economies with relatively small financial sectors, there was virtually no prospect of a smooth return to normality. So far, I have talked about possible exchange rate regimes and how difficult it has been for Asian countries to come to terms with these - what of Australia's experience? As most of you will know, Australia spent the first 40 years of the post-war period trying just about every form of fixed exchange rate that was possible. First of all, the Australian dollar was fixed to the pound sterling, then fixed to the US dollar, then fixed to a trade-weighted basket, then a variable peg to a trade-weighted basket. Finally, we floated, and in two weeks' time we will mark the 15th anniversary of the float of the Australian dollar. We are very comfortable with the floating exchange rate, and I know of no serious body of opinion in Australia that would want it any other way now that we have come to terms with it. In fact, it is widely seen as being an important factor helping Australia put in a good economic performance during the Asian crisis. We certainly have allowed our exchange rate to adjust to reflect economic circumstances, most particularly the international cycle in economic activity and commodity prices. We have not resisted these broadly-based economic changes and the Australian economy has benefited as a result. Since 1986 the Australian dollar has fluctuated around a stationary average value, with the cycle being quite pronounced - peak-to-trough movements of around 30 per cent have been common. While we are prepared to accept significant moves in the exchange rate, we do not follow an approach of benign neglect. When the exchange rate moves, we ask ourselves if it is telling us anything about policy settings. With our inflation-targeting framework, the central issue is always what the exchange rate move means for inflation, not only in the near term but also in the longer term. There have been instances when monetary policy has been adjusted in response to exchange rate moves, but they have not been frequent. We have also used intervention to influence the exchange rate, finding it particularly useful in circumstances where market imperfections are resulting in overshooting, as markets tend to do from time to time. Judging when this tendency to overshooting exists is always difficult at the time, and like most things in life, including making the sorts of decisions you all make in foreign exchange trading - usually easier with at least some hindsight. As a rule of thumb, however, the exchange rate is not overshooting unless it has already moved a considerable way from its "normal" level, or at least a level that can be explained by what is happening in the economic and financial environment. As you know, there is considerable debate about the effectiveness of intervention, even among central bankers. Some of this stems from a lack of clarity about what it aims to do. Intervention should not be viewed as a substitute for necessary adjustments in monetary policy. It is also expecting a lot of it to think it can support a fixed exchange rate during times of crisis. But, in a floating exchange rate regime, intervention can play a useful role in limiting extreme movements in the exchange rate. This is the approach we have taken in Australia. The result is that our interventions tend to be infrequent, coming mainly at or near the peaks and troughs of the exchange rate cycle. By and large, judged against our aims, we believe our interventions have been successful. They have also been successful when judged against the test proposed by Milton Friedman - i.e. whether or not they are profitable. The Bank has fairly consistently made profits from its intervention throughout the post-float period. During the past year, the Bank intervened on three occasions. These occurred after the rate against the US dollar had already fallen by a considerable amount. In other words, our policy on intervention has not prevented the exchange rate from falling enough to do the job we expect a floating exchange rate to do. Australia has been able to maintain growth of about 4 per cent in the past year, at a time when most of our main trading partners in Asia have experienced negative growth. Our exchange rate system, and the robustness of our financial sector, have been two of the keys to this performance. I would hope that countries that have only recently entered the world of floating exchange rates can draw some hope from this. The move from pegged to floating exchange rates is never easy. Soon after the Australian dollar was floated, it fell by over 30 per cent, not dissimilar to the falls recently experienced by some of our Asian neighbours. There is no doubt that this caused considerable dislocation to the economy at the time, requiring strict and somewhat unpalatable policy decisions. But I think that businesses, markets and the authorities all learned from that experience, showing that it is possible to emerge from such disturbances with the economy and the financial system in much better shape. I hope that this will also be true for the countries currently experiencing difficulties. The very recent signs of greater stability in regional markets can give us some confidence that this will be the case.

r981215a_BOA

australia

macfarlane

Governor, in testimony to the House of was released on 9 November 1998. It is a pleasure to be here in front of your Committee again. As you mentioned, the need to make adjustments to the composition of the Committee after the October Federal election means that we are meeting about five weeks later than our normal timetable. Given the uncertainty about the timing of the hearing, and the importance we attach to regular communication with the public about the economy and the Bank's activities, we decided to keep to the regular timetable for releasing our , which came out in early So there is a substantial gap between the and this hearing. On the whole, we feel that our still represents a reasonable summary of our views on events that had taken place over the preceding six months. The world has not changed dramatically since the was issued. We have, however, made an adjustment to the stance of monetary policy, following the December Board meeting. This was as a result of our continual process of evaluating incoming information, and our assessment of the outlook for the year ahead, and the various risks attached to our forecasts. Our judgment was that, even though most of the data coming in were suggesting growth was running ahead of earlier expectations, the likelihood was that growth would decline in 1999. At the same time, the likelihood of overshooting the inflation target was judged to have declined. Hence, we viewed a small further easing of policy as a prudent measure. The good economic outcomes over the past year will, I suspect, be a recurring feature of our discussion today. It might be helpful, therefore, if I start by reviewing the forecasts I presented seven months ago and making some observations about how recent developments compare with them. What I said last time could be summarised GDP would grow by about 3 per cent during 1998; the unemployment rate would remain relatively stable; we had passed the trough of inflation and it would rise gradually, reaching about 2 per cent by the end of the year; and the current account deficit would average about 5 per cent of GDP for 1998. I also said that I thought this combination of events would be a reasonably good result for Australia in view of the difficult external situation we were facing, particularly among our Asian export markets. In the event, the external situation did not get any better, but Australia's economic performance has exceeded our expectations, and, to the best of my knowledge, the expectations of virtually all forecasters. It now looks as though GDP growth during 1998 will be about 4 per cent, rather than the 3 per cent that seemed likely in May. A good deal of the additional growth is attributable to stronger outcomes than we had expected in the June and September quarters. The remainder is a result of upward revision to earlier data across most of the recent quarters. Consistent with this stronger than expected growth, the rate of unemployment has continued to edge down, rather than staying flat. Over the past three months it has averaged 7.9 per cent, compared with 8.1 per cent in the first quarter of 1998 and 8.7 per cent in the first quarter of 1997. On inflation, it seems clear that the trough has passed, and our best guess for the rise in the CPI over the four quarters to December 1998 is, in round figures, still about 2 per cent. But it is also true to say that inflation shows signs of not increasing by as much as historical relationships might have led us to expect, given the fall in the exchange rate. On the current account deficit, it now looks as though it has averaged around 5 per cent of GDP in 1998 rather than the 5 per cent we expected at the last hearing. I would summarise the situation as being one where the forecast errors were within the normal ranges that occur with forecasts of this type. The thing we can take some comfort from, however, is that no-one can accuse us of being Pollyannas because in each case the outcome was slightly better than the forecast. Growth has been stronger, the widening in the current account deficit smaller and, at the margin, the rise in inflation slightly smaller than we had expected. I now propose to make a few general comments about how we are expecting future events to unfold. Over the course of the year before the Asian crisis commenced, that is 1996/97, the economy grew by 4 per cent. In the first year affected by the Asian crisis - 1997/98 - it grew by 4 per cent. Despite starting 1998/99 at a similar pace, we have to accept that we will not be able to continue at this rate. Growth through 1998/99 is more likely to be somewhere between 2 and 3 per cent. Implicit in this is that the coming quarterly growth rates will be noticeably lower than the ones we experienced over the past year. Some slowing seems to be inevitable, given the weaker outlook for the world economy. Since we last met in May, most forecasters have revised down expectations. The IMF, to take just one example, has revised down its forecast for world growth in 1998 from 3 per cent to 2 per cent, and for 1999 from per cent to 2 per cent. If these estimates are a reasonable guide, then the external environment will remain difficult, and income from external sources constrained. Of course, domestic demand has been, and remains, much stronger than external demand, and so Australia's expenditure has run ahead of national income over the past year. But that gap cannot be expected to continue to grow at the same pace indefinitely, and so both domestic demand and GDP growth must be expected to come down over coming quarters. With slower growth in the offing, we expect that the unemployment rate will flatten out. Of course, we said that last time; now we are suggesting it will occur at a slightly lower rate of unemployment than we formerly expected. We expect the four-quarter-ended increase in the CPI to be about 2 per cent by the end of the financial year - that is, in the short term, we expect inflation performance to be consistent with our target. Of course, any forecast of inflation beyond that period is only as good as its assumption about the future path of the exchange rate. Given the current tendency towards lower commodity prices, we are assuming some further widening in the current account deficit to about 5 per cent of GDP in 1998/99. With an annual figure of this size, it would not be surprising to see a quarter or two of it running at over 6 per cent of GDP. I made the same comment in March this year, and again in May at our previous hearing. I expected that it would have come to pass by now, but it has not. It would not surprise me, however, if it does happen some time in the next year. This set of outcomes, or something like it, would represent a good performance for an economy in its eighth year of expansion facing a difficult, but not disastrous, external environment. I expect that it would be well received by the domestic and international investment community, though one can never take this for granted. And, of course, if the assumptions we are making about the world economy turn out to be too optimistic, all bets would be off. I now come to the second part of my testimony in which I attempt to answer the question of why we have done better than most other countries in Asia or the Pacific Rim. In doing so, I am conscious that the story is not yet over, so this is really an interim report. I think a number of factors have been involved and I will list them in no particular order. As we go through them, it will become apparent that they are all intertwined. First, I think the Asian crisis hit at a time when the Australian economy was in good shape, partly for cyclical reasons. By mid 1997, the economy was growing strongly and inflation was lower than our target. Had we not received a contractionary impulse from the Asian crisis, we may have been facing the need to tighten policy because of a potential overheating. No-one will ever know, but it is a possibility. I am conscious that attributing our performance over the past 18 months to our good starting point is rather superficial because it does not explain why the starting point was so good. But I will come back to that later. Second, I think we have benefited from the flexibility of our exporters who have switched from the contracting Asian markets into the ones, and into a number of other markets we do not usually think of as being important to us. The nature of our exports - with so much of them being commodities - has helped, but the efforts of our marketing companies and authorities should not be ignored. Even so, it has not proved possible to prevent exports from falling, and over the year to the September quarter they fell by 2 per cent in volume. Third, Australia has benefited from a greatly improved perception of the soundness of its economic policies. The fact that the budget has moved back into surplus - where it should be in the mature phase of an economic expansion - has been important. So has nearly a decade of low inflation. Also important on this occasion has been the recognition that Australia scores well on such factors as its regulation of banks, other financial institutions and stock exchanges, and that its underlying body of commercial law and accounting practice is at or close to world best practice. Not only have the international capital markets taken a better view of Australia, but we also seem to have more confidence in ourselves. Business and consumer confidence initially fell as the Asian events unfolded, but they did not fall excessively - for the most part they fell from well above average to about average. In the past three months, they have tended to rise moderately again as figures about the economy have confirmed that it has performed better than most expected. The fourth explanation for why growth has held up is a catch-all one - the economy just seems to be more flexible and adaptable than before. The only clear evidence of this is that productivity - whether labour productivity or total-factor productivity - has increased faster in the 1990s than in earlier decades. For example, total-factor productivity has increased at an average annual rate of 1.7 per cent during the expansion of the 1990s, compared with 0.7 per cent in the 1980s and 1.2 per cent in the 1970s. To me, this suggests that the painful adjustments that have been made over the past decade or so are paying off. By this, I mean the changes that have been made to increase competition in previously sheltered industries. This, of course, includes greater export orientation, but also greater competition in utilities and transport which has reduced costs to other industries. It also includes the downsizing of the public sector which has released resources. Finally, our labour relations practices and wage-setting machinery now have a degree of flexibility that has surprised the sceptics. I now come to a fifth factor, which most commentators view as being important - namely, the fact that in response to a contractionary external shock, the Australian dollar was allowed to float down. This is the way the textbooks say the situation should be handled, and is in sharp contrast to the severe domestic squeeze that can result in the cases of countries with fixed or quasi-fixed exchange rates. The domestic economy has benefited from the lower exchange rate because exporters' incomes have been held up and the incentive to export maintained (while at the same time assisting those industries that are competing against imports). The domestic economy has also benefited because we have not had to put up interest rates in order to maintain our external parity (as in a fixed exchange rate) or to prop up a floating rate that threatened to fall so far that it would have undesirable inflationary consequences. Raising interest rates in response to an external contractionary shock is not something that you normally would want to do, although in extreme circumstances it may become necessary. I have heard people say that it is a good thing that, unlike some other countries, we were relaxed in the face of a falling exchange rate. I can assure you all that we were never relaxed. Having followed the Australian dollar on virtually a daily basis for 15 years, I know that you can never take it for granted. While the floating rate is the best system we have had, like all asset prices freely determined in unconstrained markets, the Australian dollar is prone to bouts of instability or overshooting. On three occasions - in January, June and August - a downward overshooting threatened and we responded with foreign exchange intervention. On each occasion, stability was re-established, and unlike the experience of the mid 1980s, we did not raise interest rates. But this does not mean that that option was not on the table. It was, and financial markets knew this; as a result, 90-day rates were well above cash rates in both June and August. Fortunately, things turned out well, and so the option did not have to be used. Thus the exchange rate was centre stage. The general direction of its movement was performing a very useful function, yet the short-term dynamics were such that it often threatened to go too far. It has been a delicate balancing act, but one with a favourable outcome. Over the past two years, the economy has been able to grow at over 4 per cent per annum without significant upward pressure on inflation (which has averaged 1.6 per cent over the same period). This is better than almost anyone expected. Another way of approaching the question is to ask why were we at the Reserve Bank able to accept this continuation of high growth and depreciating exchange rate without having to tighten monetary policy (in fact, being able to ease it slightly at the beginning of this month). The answer is that the combination has not to date seriously threatened our inflation target. Why has it turned out this way? The answer, I think, is that we are beginning to receive the big dividend that low inflation provides. The economy has gradually adjusted to nearly a decade of low inflation and, although the adjustment is still not complete, the benefits are becoming apparent. Inflationary expectations are much lower and more stable; wage contracts are now often two or three years in duration; loans, including housing mortgages, often have interest rates fixed for long periods; and businesses know that they can no longer automatically pass on any cost increase secure in the knowledge that it would get lost among the multitude of other price increases. This new less volatile environment allows the floating exchange rate to do its job of stabilising the domestic economy in the face of an external shock. It does so by reducing the tendency for the expansionary effects of a falling exchange rate to be dissipated in the form of rising inflation. It also goes without saying that the low inflation environment makes the task of monetary management a lot easier. I think we can take some satisfaction about how events have turned out over the past two years, but we should not become complacent. This particular episode, which started as a regional Asian crisis, is far from over. We should not think that we can see the end of it just because it has already been running for 18 months. For a start, the United States has only recently started its slowdown, and uncertainty about the US outlook seems greater at present than for some time. In addition, Japan remains gripped by powerful contractionary forces. That could put continued pressure on commodity prices. Much has been said recently about how Asia has passed the worst of its problems, and on many measures this is so. But the contractions have been very severe in many cases, and no-one is expecting a quick or strong recovery. I do not wish to say any more at this stage. You will note that I have dealt exclusively with the domestic economy, but I think that is appropriate since I have spoken so much recently in other places about Asia, the world economy, and international financial markets. My colleagues and I are, of course, happy to answer any questions you may have on the topics I have not covered, or for that matter, on the ones I have.

r990311a_BOA

australia

macfarlane

Last time I spoke to a group like this in Tokyo was in September 1997 when my hosts were Barclays de Zoete Wedd (BZW). The same people are hosting this Seminar, but thanks to the mergers and rationalisations that have become so common in the finance sector, I am now speaking under the auspices of ABN-AMRO. My aim today will be to give you an update on the Australian economy, but I do not wish to concentrate too much on the very short term. As many of you are investors with a medium and longer-term horizon, I would like to spend a fair bit of my time on matters relevant to this horizon. Not only will I talk about how Australia has weathered the Asian crisis, but I would also like to touch on some of the medium-term structural adjustments that have been going on for more than a decade. I will start with one of these longer-run comparisons - namely, economic growth. We have now nearly completed the decade of the 90s, with nine of the ten years already behind us. Over this period of nine years, which for each of the countries in my comparison includes some recessionary period, Australia has grown faster than other comparable OECD countries. Only Ireland and Norway, which taken together are only about half the size of Australia, have done better, and there are rather special reasons in each case. This is the first decade to my knowledge where Australia has put in such a strong growth performance relative to other OECD countries. Of course, these figures are averages over nine years - what about the current situation? My next table looks at the growth over the latest year (1998) for those countries in the Asia and Pacific Rim. It is not a pretty picture, with the majority of countries having experienced outright contraction in their levels of income. Apart from China, which is a relatively closed economy, Australia has recorded the highest growth. The figure of 4.7 per cent over the year to the December quarter 1998 was a good deal stronger than any of us had forecast, given the contractionary forces that were being felt from our trading partners. We had been expecting a noticeable slowdown, and we still are. But it will be a slowing off a much higher basis than we formerly thought. A companion piece to the comparison of economic growth over the decade of the 90s is a look at the rate of inflation of the same countries over the 90s (or at least the first nine years). Over that period, Australia had an average rate of inflation of 2.8 per cent per annum, which is slightly higher than the average of OECD countries, but within the range of 2 to 3 per cent as specified in our inflation target. If we deleted the first two years (1990 and 1991) from our comparison, our inflation rate would be about average for OECD countries. Of course, the other thing that stands out from this graph is just how low inflation has been over that period, with 14 of the 18 countries having averaged less than 3 per cent. There are many explanations that have been put forward for the return to a very low inflation environment. Macro-economic policy, particularly monetary policy, has played the major role, but micro-economic influences, such as heightened competition, have also been important. In Australia's case, these micro-economic influences have been quite important, not just in explaining lower inflation, but also in explaining the economy's growth and resilience in the face of external contraction. Among the changes made have been: These are all designed to make the economy more efficient and more competitive, but, of course, in the short run they also have costs. For example, there is always an increase in uncertainty in an economy where change is occurring, and there are often job losses involved, such as when a large over-staffed public utility is privatised. Of course, there are also enormous benefits which are often overlooked, such as cheaper electricity, cars, telephone calls and airline flights, new export industries, etc. The best quantitative sign that these changes are yielding good results is that the economy is now more productive than it ever was. This graph shows productivity growth in each of the three recent expansions. It is clear that the increase in productivity of 1.9 per cent per annum in the current expansion is a good deal better than the figures we had in the expansions of the 1970s or 1980s. The figure I am showing here is multi-factor productivity. This measure of productivity cannot be increased simply by shedding labour and replacing it with capital. It can only be increased by using both labour and capital more productively. While Australia has had good results on growth, inflation and productivity, our results on unemployment could only be described as average. Our unemployment rate has come down from the peak of 11.2 per cent in 1992 to its present level of 7.5 per cent. Such a result looks good by the standard of Continental Europe, but does not look good by other standards. Naturally, it does not look good by Japanese standards, where the unemployment rate has always been low relative to other countries. But it is also not good compared to the United States or the United Kingdom. We have done well in Australia in providing economic growth, but we have not turned it into jobs as well as we might have. I would now like to turn to public finance, which is another dimension in which the Australian performance looks good. On comparable OECD figures, our budget was in surplus to the tune of about 1/2 per cent of GDP in 1998, and a bigger surplus is expected next year. A better measure of the longer-run effect of fiscal policy can be obtained by looking at the ratio of general government debt to GDP. This effectively measures the accumulated deficits by the debt that is needed to finance them. On this measure, Australia's public finances have resulted in the smallest call on capital markets of all OECD countries. As well as our government finances being in reasonably healthy shape, our banking system is also very sound. I have tried to summarise this with one graph which shows banks' impaired assets (or bad loans) as a proportion of their total assets. This reached a peak of 6 per cent in 1992, but has come down pretty well continuously since that time. At present, the ratio is less than 1 per cent, which is about as low as it can conceivably ever get. In short, we did have some problems right at the beginning of this decade, as did a lot of other countries, but the bad loans were run off relatively quickly, new capital was raised, and the banks' balance sheets have returned to a very healthy state. I would now like to turn to a subject which tended to dominate economic discussion in the 1980s. That subject is the current account deficit and the level of external debt. In the mid 1980s, there were fears that Australia's current account position might be unsustainable. As a result, there was a large fall in the real exchange rate, and a number of other adjustments had to be made, including a substantial tightening of fiscal policy. Where has that left us when we look back a decade later? Looking back, it is clear that the situation was not unsustainable. When we look at the bottom line of this graph which shows the current account deficit as a percentage of GDP, we can see that it has oscillated between about 3 per cent and a bit over 6 per cent over the last two decades. There is a very strong cyclical element in the current account deficit, and on four occasions it has widened to a bit over 6 per cent of GDP. We have been expecting it to do the same on this occasion because of the contraction in our export markets and our own relatively buoyant domestic demand. Somewhat to our surprise, it has not happened, but we would not be surprised if it does happen soon. The only sure way of preventing such an eventuality would be to slow the Australian growth rate down to something like that of our Asian neighbours, and, quite rightly, no-one wants to do that. That would be very bad economic policy. Although things have turned out better than expected, it does not mean we have escaped completely from the contraction of demand in our trading partners. Obviously, we have suffered from a fall in commodity prices and we have also seen the volume of our exports fall to a level slightly below that which was prevailing in the middle of 1997. But the fall in exports has been nowhere as large as you would expect if you simply added up the falls in imports in our trading partners. The reason for this is that a large proportion of our exports, particularly the rural and resource exports, can be quickly shifted from those markets that are contracting to those markets which are expanding. If we look at what has happened since mid 1997, we can see that: One of the reasons that it has been possible to do this is that such a high proportion of our exports are commodities. We often bemoan this fact, but in a regional crisis like the one we have just seen, it can be an advantage. Let me return to the issue of sustainability of our external position. The other side of the worries about the Australian balance of payments in the mid 1980s was a concern about the level of foreign debt. It had risen from almost nothing to about 35 per cent of GDP in five years. This caused a lot of concern because people tended to assume that this sharp upward trend would continue, which would raise doubts about the sustainability of our external position. In the event, the sharp rise in this ratio flattened out. The present ratio is about the same as it was in 1992 and not a lot higher than the mid 1980s. The arithmetic is such that with a constant current account deficit as a proportion of GDP, the foreign debt ratio does not rise forever, it tends to flatten out at a new level, and this is what has been happening. Another way of looking at sustainability is to look at it from the side of debt servicing. Here, the story is somewhat similar. Debt servicing payments as a percentage of exports rose from 5 per cent to 20 per cent during the 1980s, again causing quite a bit of concern. But with the strong growth of Australian exports over recent years and the lower interest rates around the world, this ratio has fallen back to 10 per cent in the 1990s. What have these developments in the Australian economy and its external situation meant for financial prices such as the exchange rate, interest rates, share prices, etc.? Let me try and answer this from a medium-term perspective first and then turn to developments since the Asian crisis occurred. Starting with the exchange rate, the medium-term perspective is well summarised by a graph of the Australian dollar in trade weighted terms. As you can see, when we look back over the last nearly 20 years, there has been one major change, namely a downward shift in the real exchange rate in the 1985/86 period. Since then, while it has moved about quite a lot from quarter to quarter and from year to year, it has been around a basically flat trend. If we look at the Australian dollar against other individual major currencies, we get a similar picture. For example, the Australian dollar against the yen shows the same pattern, but the flat trend I have drawn in since 1986 should perhaps have a very slight downward slope. If we look at the Australian dollar against the US dollar, again we see the same pattern, and on this occasion I think the flat line is probably appropriate. If we now turn to recent developments, i.e. over the last two years, obviously the Australian dollar has depreciated. The depreciation against the US dollar looks quite pronounced because the US dollar itself has been quite strong; the depreciation in trade weighted terms looks more modest because the Australian dollar has gone up against some Asian countries that have quite a big weight in the index. Looking over the whole period of nearly two years, we think the currency has behaved in a reasonably exemplary fashion, although there were a couple of periods where it threatened to overshoot. One thing that gave us a fair bit of confidence throughout this period was that the international markets seemed to be comfortable buying Australian assets. Our share market has continued to rise, although nowhere as fast as the US. The bond market has also been well behaved. The margin between Australian and US bonds, which had been very high in the 1980s and early 1990s (often as high as 500 basis points), trended down so that by mid 1997 the margin was less than 100 basis points. Despite a very temporary blip in August last year, the margin has stayed quite low and is currently about 30 basis points. We regard this as not only a reflection of an acceptance that our inflation rate is low, but also general endorsement of the soundness of economic policy in Australia.

r990521a_BOA

australia

macfarlane

It is a pleasure to be in Hong Kong talking to the CLSA Investors' Forum. This conference has built up quite a reputation over the years and I am honoured to be invited to address such an impressive group of investors. I will try my best to avoid presenting you with a 'sales pitch', but that is easier said than done. If you think that I am concentrating too much on the favourable side of the Australian economy, you can always redress the balance when it comes to question time. The Australian economy has attracted a fair bit of favourable attention lately because it has performed so well during the Asian economic and financial crises. Whilst this favourable publicity is very gratifying for people like myself who have been around during the lean years as well as the good ones, I do not intend to spend much time today talking about recent economic events. This is because I think the good performance of the Australian economy is not just a recent event, but something that has been unfolding over the past decade. In other words, the recognition may be recent, but the underlying story has been around for a lot longer. We have now nearly completed the decade of the 1990s, with nine of the ten years already behind us. Over this period of nine years, Australia has grown faster than other comparable OECD countries (Table 1). Only Ireland and Norway, which taken together are only a little over half the size of Australia, have done better, and there are special reasons in each case. This is the first decade to my knowledge where Australia has put in such a strong growth performance relative to other OECD countries. While there have been other decades - such as the 1950s and 1960s - where Australia grew faster in absolute terms, we did not exceed OECD average growth rates in those periods. The 1990s stands out as the first decade of the post-war era where Australia's growth would put it in the first quartile of performers. I should also add, of course, that this economic growth was achieved against a background of very low inflation. Over the same nine-year period, Australia had an average rate of inflation of 2.8 per cent per annum. This is slightly higher than the average of OECD countries but within the range of 2-3 per cent as specified in our inflation target. If we deleted the first two years (1990 and 1991) from our comparison, our average inflation rate would fall to about the OECD average. Of course, the thing that stands out when we look at inflation in the 1990s is not the difference between the countries, but the uniformity in that they all have achieved very low inflation rates. The question I want to address today is this - why has Australia done so much better relative to other countries in the 1990s than it had in previous decades? I will attempt to answer this question by starting with those aspects of the economy I know most about, namely macro-economic policy, and then moving on to other areas which are a little more speculative. By doing it in this order, I do not wish to imply that improvements in macro-economic policy are the main explanation. They may be, but on the other hand, it is entirely possible that the biggest improvements have come from the structural side. Monetary policy has been put on a much sounder footing in the 1990s than in earlier decades. The inflation targeting regime has been a success in Australia, as it has in other countries that have adopted this approach. The Government's recognition of the independence of the Reserve Bank has also been an important factor. Monetary policy has, in effect, become depoliticised, and decisions can now be based more on medium-term considerations than in earlier decades. Low inflation, and the fact that it has been maintained without forgoing economic growth, is the clearest testimony to this improvement. Fiscal policy is also in much better shape. The Budget is in surplus and projected to stay there during the period covered by the forward estimates. Perhaps the best medium-term measure of a country's fiscal position is the ratio of government debt to GDP. Instead of showing one year's position, this measure summarises the effect of all previous years' surpluses or deficits. As you can see by the next slide, Australia has the lowest ratio of any OECD country, and it is still declining. One aspect of Australia's recent economic performance that has received favourable comment is the behaviour of the exchange rate. When the Asian crisis erupted, the exchange rate fell so that at its low point in August last year it had fallen by a very significant amount. Unlike a number of countries in the region, interest rates were not raised to defend the exchange rate. I would like to make two observations about the exchange rate: Recent events in Asia and elsewhere have highlighted how important financial stability is in determining macro-economic outcomes. Although there are many factors which underlie financial stability, one very important one is the prudential supervision of the banking system. In Australia, we learnt quite a lot about that in the late 1980s and early 1990s, and that learning experience has served us well over the past decade. The best single measure of this aspect of financial stability is shown by the level of bad debts of the banking sector. As you can see from Graph 3, these have fallen from their peak of 6 per cent in 1992 to less than 1 per cent at present. This is about as low as they can realistically be expected to go. Turning to structural policies, I would like to start by showing a graph of productivity. This graph shows the average increase in productivity in each of the last three economic expansions, i.e. the 1970s, the 1980s and the 1990s. The measure of productivity used is multi-factor productivity. This measure of productivity cannot be increased simply by shedding labour and replacing it with capital. It can only be increased by using both labour and capital more productively. As you can see from Graph 4, productivity growth has been much faster in the 1990s - nearly 2 per cent per annum - than the rates of increase achieved in earlier expansions - about 1 per cent per annum. Whilst we cannot draw very specific conclusions from this improvement, it seems to me that it tells us that we must have been doing something right. My guess is that the main things behind this improvement have been the various micro-economic reforms that have been aimed at increasing the competitiveness of the Australian economy. These include: I think we made a lot more progress in these areas than we were ever given credit for internationally. Each of these changes met with resistance, and in many cases compromises were made which would not please the purists. But taken together, along with the private sector restructuring that was occurring at the same time, they have amounted to a major set of reforms, and have made the Australian economy leaner, more flexible and more competitive. Whilst these measures make the economy more efficient and competitive in the longer run, they of course have short-run costs. There is always an increase in uncertainty in an economy where change is occurring, and there are often job losses involved, such as when a large over-staffed public utility is privatised. Of course, there are also enormous benefits which are often overlooked, such as cheaper electricity, cars, telephone calls, airline flights, new export industries, etc. But because the complaints and resistance tend to receive more publicity than the successes, the impression is given that there is a lot of resistance. I think this is a misleading impression and that Australians are actually very adaptable people. Some historical examples of this adaptability include: Another aspect of this adaptability is the speed with which Australians have taken up new technology, particularly computer-based communications technology. I have two graphs to illustrate this. The first on modem usage per head of population, and the second on electronic commerce servers per head of population. Both measures, not surprisingly, show the United States, at the top of the table, but Australia is also very highly placed, coming third in modem usage and second in electronic commerce servers. In particular, it is notable that Australia, along with Canada, makes considerably greater use of these technologies than European countries, for example. The picture I have painted is, not surprisingly, a very rosy one. This is partly because I am talking to a group of international investors, but it is mainly due to the fact that the numbers themselves have been very good ones. But the outlook cannot be perfect; every economy has some vulnerable points. Even the Americans, who have done so well over recent years, worry about the level of the stock market and the possibility of incipient inflationary pressures. What are the Australian equivalents? We think that our expansion is going to slow down at some point because that is what business cycles do. We are still forecasting a slowdown even though our previous forecasts of slowdowns have not eventuated. But I would hardly classify a mild slowing of the economy as being a major problem for us. The only way we could get into a major problem on this front is if there is an outright contraction in the world economy, and that does not seem to be a likely outcome. We do not think that our asset markets are over-heated, nor do we see inflationary pressures at present. Credit growth has been very strong, but it has not interacted with asset prices as it did in the 1980s. That could all change in the future, of course, but for the present this sort of over-heating seems a long way off. The usual area that people point to as a danger point for Australia is the balance of payments. Naturally, our current account deficit has widened over the past two years. This is what you would expect, given the buoyancy of the Australian economy and the contraction in so many of our major export markets. This widening is thus more a reflection of the strength of the Australian economy rather than its weakness. If you look back over the past 20 years, you will see that the Australian current account deficit has fluctuated between about 3 1/2 per cent and 6 1/2 per cent of GDP. On four occasions, it has exceeded 6 per cent, and it seems likely that when the final figures come in for the March quarter of 1999, this will have happened for the fifth time. In the past, this has often rung alarm bells, but it is not doing so on this occasion. Why is that so? I think there are basically two reasons for this: In Australia, we always have to keep a weather eye on the balance of payments, but it does not seem to represent quite the same constraint now that it did in the 1980s. Of course, it is not really up to me to make these judgments. It is really up to the market. It does seem, however, that the market is much more prepared to give the Australian economy the benefit of the doubt than it formerly was. To return to my earlier theme, I think that is because the totality of policies in Australia are now judged much more favourably than they were in earlier years. Virtue does seem to have its own rewards.

r990617a_BOA

australia

macfarlane

Governor, in testimony to the House of was released on 6 May 1999. Thank you, Mr Chairman. It is a pleasure to be here in Melbourne again appearing in front of the Committee. Like last time, the has already been released a month before the hearing. On this occasion, it was the Budget that caused the delay in the hearing, but I do not think this is a serious matter because the is still relevant. If anything, the advance release of the may have been helpful in giving more time to digest the material contained in it. We have more recently sent to the Committee some new material in the form of a paper on bank fees. I would now like to start off in my customary manner by comparing what I told you last time with what now appears to be the most likely outcome. I do this in the interests of accountability, but I also think it has the advantage of drawing out the limitations of economic forecasting and the necessity of seeing policy formulation as an iterative process. Last time, I indicated our expectation that our growth rate was likely to be lower in 1998/99 and that there would be some pick-up in inflation (though to a rate consistent with our target). I said that the current account deficit would expand, and would probably reach 6percent of GDP on a quarterly basis at some stage. I indicated that not much further progress could be expected in reducing unemployment from the rate of 7.9percent which had prevailed in the three months before the hearing. It is now well known that growth has not, as yet, declined. In all likelihood, growth for the 1998/99 year has been in excess of 4percent, measured either in year average terms or for the four quarters to June. This makes this expansion, which began in the middle of 1991, the longest continuous upswing since the 1960s. Nor is there any sign yet that the expansion will come to an end soon. We are still of the view, however, that some decline in growth is likely, but from a considerably stronger starting point (and, of course, more delayed) than earlier thought. The outcome for calendar 1999 will, in our judgment, be lower than the growth recorded in 1998 - something between 3 and 4 per cent. This is a fairly mild decline, given the size of the external shock to which we have been subject. More importantly, the risks of a sharp slump have lessened considerably since we last met. Last December, we had just been through a period in which confidence in the prospects for the global economy, including, of course, the US economy, had reached its lowest point. Behind this were concerns about extreme instability in global financial markets and the possibility of a 'credit crunch'. Since then, the US economy has continued its strong performance and concerns about credit crunches have disappeared. Indeed, there is now a widespread expectation that the strength of the US economy means that a tightening of US monetary policy is on the cards. Evidence has also continued to accumulate of a turn for the better in the countries in east Asia which slumped so sharply during 1997 and 1998. Inflation in Australia, meanwhile, has risen, but very slightly and considerably more slowly than our central forecast of six months ago had suggested. A possibility which we flagged in our November 1998 - that competitive pressures in international markets would have a dampening impact on the rises in prices for imported goods - has in fact turned out to be the case. In our latest , we have forecast inflation to be about 2 per cent in underlying terms by the end of 1999. In headline terms, the CPI also is likely to be about 2 per cent. This is a little higher than we suggested in the , as we have now taken full account of higher international oil prices, which roughly offset the effect of the health care changes. The current account deficit has turned out to be something like 5 per cent of GDP for 1998/99, and was almost 6 per cent in the March quarter. It is highly likely that a quarterly figure over 6 per cent will be recorded in the June quarter. It seems to us that numbers something like that might well be seen over the next few quarters, with the result that the outcome for 1999 as a whole will be about 6 per cent of GDP. The unemployment rate has fallen further, in line with the stronger than expected growth in the economy, and over the past three months has averaged 7.5 per cent, its lowest for about a decade. Given the amount of growth we have had over the past year, some further moderate decline in unemployment will probably be recorded, in net terms, over the remainder of this calendar year. Even though the outcome has turned out better than expected, if someone wanted to score a point, they could say we are not very good forecasters. I would concede that we have been a little conservative in our forecasts, but it has not led us astray in a policy sense, i.e. it has not jeopardised the achievement of a good economic outcome. As someone who has been involved in forecasting and economic policy in the lean years as well as the good, there is a more interesting question that has to be asked. It is this: How is it that the Australian economy has been able to grow at 4 per cent plus perannum in the seventh and eighth years of an economic expansion without generating significant wage and price pressures? It certainly was not able to do so in earlier expansions. I have already given part of the answer to this question in my December testimony, and in a couple of speeches since. It is that the economy has achieved improved productivity growth as a result of the microeconomic reforms of the past fifteen years. The main changes have been reductions in tariffs, privatisations, financial deregulation, competition policy and labour market reforms. Of course, businesses have also become much leaner and more adaptable as they have responded to increased competitive pressure. The key piece of evidence for this is the higher growth of multi-factor productivity in Australia in this expansion compared with previous ones. A lot more could be said about this subject, but I will leave it to others, and move on to a related subject. It seems to me to be quite possible to have higher productivity growth and yet to still encounter macroeconomic imbalances which would bring an economic expansion to a halt. In other words, higher productivity growth can explain why the economy's average growth rate is faster, but I do not think it can provide an adequate answer for why the expansion will last longer. To do this, I think a macroeconomic explanation is required. Here I have to come back to low inflation and low inflationary expectations, which have characterised the 1990s expansion, but were clearly absent from earlier expansions. As the earlier expansions matured, inflationary pressures built up which simultaneously pushed up prices (requiring a monetary policy response) and squeezed businesses and business confidence. In the mid seventies and early eighties the expansions came to an end with a wage explosion, while in the late eighties it was an asset price boom and bust. This time we have had neither of these. As I said, a recent history of low inflation has been crucial this time. It certainly has helped the wage bargaining process. Employees have seen that quite modest nominal wage increases have translated into decent real wage increases because inflation has been contained. They have not had to build anticipatory increases into their wage bargains to safeguard themselves against inflation getting away from them. Increased flexibility in industrial relations arrangements has also helped. Similarly, low inflation and low interest rates have had a favourable impact on business behaviour. An important reason for this is that with low interest rates, there is little or no scope for negative gearing. Most of the reckless schemes of the entrepreneurs of the 1980s were simply negative gearing writ large. This was the biggest contribution to the boom and bust in asset prices. It was not the only reason - I accept that the rapid increase in the number of lenders associated with the deregulation of the finance sector also played a role. We could argue about the relative weights of these two factors if we wish, but the relevant fact for today is that neither of these two factors is present in the current expansion. If we do not seem to be developing our usual ailments, as I have argued above, are there some new ailments that may bring our progress to a halt? A number of possibilities could be identified, but one that has attracted a fair bit of attention is the fall in the household saving ratio. In contrast to the business sector, which has become more cautious in the 1990s, the household sector has become less cautious, as shown by: The household saving ratio falling from 12percent in the first half of the 1980s to about 1 per cent at present. This has been Household borrowing rising as a percentage of annual income. This less cautious attitude by households is a surprise to many people because it seems to be at odds with the usual media depiction of a public worrying about its future, anxious about job security and generally insecure. If we were instead to judge the public by what they actually do, we would conclude the opposite. Unlike their parents and grandparents, who saw a great need to save for a rainy day and who had the privations of the Depression still in their minds, the spending and saving pattern of the current generation indicates a totally different attitude. Of course, developments on the supply side have made this a lot easier. At today's low interest rates, it is possible to service a much bigger loan than it was at the start of the decade. Also, banks and other financial intermediaries have found new ways of providing credit based on previously inaccessible collateral. The important issue is whether this trend change in household behaviour is going to cause problems for the economy, particularly whether it is going to endanger the present expansion. I think there are three possible problems that could arise, so I will discuss each one briefly. The first possible problem is that if inadequate household saving persists, it could mean inadequate provision for retirement. This, in turn, would put increased demands on future taxpayers. This is an issue of inter-generational equity. I do not want to suggest that this is not a problem - it may well be a big one, but the solution to it would be found in improvements to our policies regarding retirement income. The second possible problem is that any reduction in saving, other things equal, would lead to an increase in the current account deficit. Has the trend decline in household saving over the past decade caused the balance of payments to deteriorate? The answer seems to be no: the current account deficit has shown roughly the same cyclical movement that it has exhibited over the past twenty years reason for this is that there is not a one-for-one relationship between household saving and the current account deficit. We have to also take into account government sector saving, business sector saving and, of course, investment before we get to the current account of the balance of payments, and movements in some of these factors have offset the reduction in household saving. The third possible problem is that increased indebtedness makes the household sector more vulnerable when interest rates rise. This is probably true, but the main implication is that to achieve a given macroeconomic effect, interest rates would not have to be raised as much as formerly was the case. I now want to turn to a totally different subject, but one that will be very important over the next seven months. I refer, of course, to the issue of the end of century date change - or Y2K as it is colloquially known. The main point I want to make is that the Australian financial system is very well fixing and testing their systems began in the mid 1990s and it has been under the scrutiny of APRA and the Reserve Bank since early 1997. Financial intermediaries have devoted over a billion dollars and thousands of staff to checking and updating computer systems. Where problems have been found, they have been fixed. Outmoded ATMs and EFTPOS machines have been replaced, computer programs have been rewritten or new software has been installed. With all this effort, the Australian financial system rightly enjoys a world-class reputation for its high level of The Reserve Bank's own computer systems are, of course, Year 2000 ready. In particular, the systems that the Reserve Bank uses to distribute pensions and other government payments to banks, building societies and credit unions on behalf of Centrelink have been thoroughly tested. Pension payments will be made on time. So much work has now been completed to ensure that the system works, that the big issue facing us is no longer a technical one - it is instead an issue of public reaction. While I am very confident that the overwhelming majority of the Australian public will act sensibly, there are no doubt a few who are inclined to believe doomsday scenarios. With this in mind, there are a few preparations that we at the Reserve Bank have been putting into place to help reassure the community. An important step was to talk to the banks, building societies and credit unions to make sure that they were communicating with their customers in clear language to reassure them that their deposits were safe. Because the simple fact is that their deposits are safe and their records are not at risk from Y2K-related problems. All financial institutions have extensive back-up systems to ensure that each night they keep multiple physical records of all account information. While some members of the public have expressed concerns for the safety of their deposits because they think records might disappear, there is no basis for this type of concern. The safest place for people to keep their savings is in the financial institution that they are already with. Withdrawal and conversion to cash would expose them to a lot of unnecessary risks. The vast majority of people, I believe, do not have those concerns, but they probably still have a few uncertainties. Many will wish to take more cash out to tide them over the New Year period than they normally do. To this group, I just want to make a few points: Do not, for a minute, fear that you need to take out more cash because there may not be enough to go round. There will be. The Reserve Bank has printed, and is carrying in stock, a lot more notes than usual so that it can meet any increased demand. If you are worried about high-tech systems such as ATMs or EFTPOS letting you down, remember you are only dependent on them for the first three days of the new year. After that, the banks, building societies and credit unions open their doors again and you can go back to the old-fashioned ways of obtaining cash. You are really only dealing with a long weekend. Even in those three days, you are not completely dependent on cash - credit cards can, if necessary, still operate in their traditional paper-based mode and cheques can be used as normal. Overall, our view is that the system will be able to operate on a 'business as usual' basis and the public should view the new year as just another long weekend. That is what I will be doing. For those who want a little extra reassurance in the form of extra cash, they can be confident that it will be readily available. That is all I wish to say in general terms about Y2K at this stage, but I will be happy to answer any detailed questions you wish to put to me. I am also conscious that I have been talking for quite a while, so that I have not left any time to cover the subject of bank fees. But with a copy of our paper at your disposal, I am sure you will find plenty of material to supply you with questions on that subject also.

r990729a_BOA

australia

macfarlane

The following is the text of the R.C. Mills Memorial Lecture delivered by the Governor, It is an honour to be here today at the University of Sydney delivering the eighteenth to start a Memorial Lecture by paying homage to the person in whose memory the lecture is held, but I would like to break with tradition and do that a little later where it fits in more naturally. On nearly every occasion when I speak before an audience such as this, I talk about some aspect of monetary policy. That is what is expected of me because people - very naturally - associate central banks with monetary policy. Monetary policy's major task is to contribute to sustainable economic growth through maintaining low inflation, as we have been doing with some success during the 1990s. I have talked about this at length elsewhere, and I am sure that informed people are well acquainted with the current monetary policy regime in Australia, which is based on an inflation target, an independent central bank and a floating exchange rate. As a result, I do not wish to take up any more time going over old ground. The subject of financial stability does, however, call for some public explanation. For a start, a lot of people are unsure of exactly what it means. Additionally, there are those who are unsure of what its relation is to central banking, which, as I have just said, they usually associate with monetary policy. In the remainder of my lecture I would like to cover both these topics, plus two other issues: what does the Reserve Bank need to do to fulfil its financial stability responsibilities; and whether the changes we have seen in the structure of financial systems over recent decades have made the system more or less stable. Financial stability is the avoidance of a financial crisis. A financial crisis is a more modern term for describing what used to be called 'banking panics', 'bank runs' and 'banking collapses'. We use the broader term financial because, with today's more sophisticated financial systems, the source of the crisis could be the capital markets or a non-bank financial institution rather than a bank, although almost certainly banks would become involved. A well-functioning financial sector is critical to an economy's well-being because it is so intimately connected to every other sector of the economy through its role of providing credit. When large-scale failures occur among financial institutions, the supply of credit dries up and this quickly leads to cutbacks in other industries. Additionally, the finance sector is the part of the economy that is most susceptible to crises of public confidence. A problem that hits one part of the finance sector can quickly spread to the rest of the sector, and then to the economy more widely. Once it becomes widespread, it is termed a systemic financial crisis to distinguish it from one that is confined to a single institution or a very narrow part of the financial system. Another way of approaching financial stability is to look at it from the perspective of developments in the overall economy. There is widespread recognition in the community that the normal growth path of an economy is not smooth. We have all lived through a number of business cycles, and although we wish that the cycle could be abolished, most of us are resigned to the fact that expansions cannot go on forever, and they will be followed by a recession. Provided that these recessions are not very frequent and not very deep, public confidence in the legitimacy of the economic system remains intact. The problem with a serious bout of financial instability or a systemic crisis - inevitably involving a boom in asset prices, followed by a bust - is that it makes the recession much deeper and longer, and can even turn it into a depression. The best-known example of this is the Depression in the United States in the 1930s, the severity of which is now widely attributed by modern scholars to the collapse of the US banking system. Australia had a similar experience in the Depression of the 1890s, and some more recent examples, which I will cover later, contained some of the same elements, although fortunately on a smaller scale. Over the past three years, we have witnessed the Asian economic crisis, the depth of which is largely due to the collapse of financial systems in these countries. Although it is not well known in Australia, the Nordic went through a similar experience a decade ago. Cost as per cent of GDP In short, it is possible to have a normal business cycle where financial stability remains intact. These are usually quite mild cycles. It is also possible to have cycles where financial instability plays a large role. These are usually very severe. Thus, there are very good reasons for a country to do what it can to avoid financial instability. History shows that it does not happen very often, but when it does, its effects can be devastating. Another direct and measurable cost of financial crises is the cost to taxpayers of fixing them. When there is widespread failure of banks and other deposit-taking institutions, the government invariably pays out depositors in full or in part, whether or not there is a formal system of deposit insurance. Financial institutions also have to be recapitalised in order to allow them to start lending again. The cost to the budget of both these types of assistance can be enormous, as shown in Table 1. Note that the figures given for Asian countries are only estimates as the final bill has not yet come in. The outcome could be lower or higher, depending largely on how quickly Asian countries resume their growth path. The idea that a central bank should have responsibility for financial stability has roots deep in the history of central banking. Indeed, in many countries, financial stability considerations were the original reason for the formation of the central bank. Perhaps the best example is the United States. The establishment of the Federal Reserve System in 1913 was a direct response to the bank runs and financial panic of 1907. It was only later that an explicit monetary policy role was grafted onto the Federal Reserve's financial stability responsibility. Elsewhere too, financial stability issues played a significant role in central banking. By the end of the 19th century, the Bank of England was well practised in acting as the lender of last resort. In the 1850s and 1860s, following the bursting of speculative bubbles in the US and UK railroad sectors, it lent freely to institutions to prevent financial panic, as it did during the Barings crisis of the 1890s. In France, the unravelling of speculative positions in the stock market in 1882 led the Banque de France to provide secured loans to the Paris Bourse. In Italy, the collapse of a building boom in Rome and Naples in 1893, and the resulting failure of one of Italy's largest banks, prompted the creation of the central bank, the Banca d'Italia. Financial stability considerations also played a role in the development of central banking in Australia, although less explicitly than in the United States. In the early decades of this century, there were strong advocates for a central bank along the lines of the Bank of England. Progress, however, was hampered by ideological debates about the role of private banking, and by concern that a central bank would out-compete private banks. While the Commonwealth Bank did take on some central banking functions in the 1920s, including note issue and the provision of settlement accounts, the watershed was the It is here that we return to Professor R.C. Mills. In between establishing the economics department of the University of Sydney and Professor Mills played a prominent role as a member of the Royal Commission. As S.J. Butlin notes in his biography of Mills, the structure of the Commission's Report and its drafting owes much to Mills' hard work and his ability to argue and persuade. Mills was an advocate of a strong central bank with responsibility for ensuring the overall stability of the financial system and the economy. He, and his colleagues on the Royal Commission, argued that the private banks had intensified economic fluctuations by lending aggressively during the boom of the late 1920s and then contracting lending harshly during the Depression. This was seen to be a repeat, although on a smaller scale, of the situation argued that a strong central bank might have been able to limit the unhealthy expansion that eventually brought about the crisis. The idea that a central bank should seek to restrict those developments in the financial system that threaten the health of the economy strikes a strong resonance today. The difference between today's interpretation and that advocated by Mills and his colleagues is a subtle, but important, one. In the 1930s, banks dominated the financial system, and a framework of regulation on banks was seen as the best way to ensure financial stability (and to operate monetary policy). Today we realise that heavy regulation stifles competition and innovation, and is an ineffective mechanism for monetary policy - even though it can achieve a high degree of financial stability. We also recognise today that, while banks remain at the core of the financial system, financial markets - and by this I mean the money, debt, equity, derivative and foreign exchange markets - play a much bigger role than they did in the 1930s. Control of banks is no longer the same thing as ensuring financial stability - the issue is now much more complicated. Indeed, following the recommendations of the Wallis Report in 1997, the Government specifically separated the prudential supervision of banks from the Reserve Bank and vested it in a completely new institution, the Australian Prudential This sounds on the surface to be very different from the sort of world envisaged by Mills, but it is only so in a managerial sense, not in a fundamental economic sense. The Reserve Bank still has dual responsibilities for monetary policy and financial system stability, something of which Mills would have approved. And, of course, these two responsibilities were spelled out again in the Wallis Report, and in the speech by the Treasurer when introducing the Wallis reforms. What is different now is that the day-to-day face-to-face process of bank supervision, with its setting of standards, monitoring, interpretation and data collection, is carried out in a separate agency - APRA - which also has responsibility for the equivalent supervision of other deposit-taking institutions, insurance companies and the superannuation industry. APRA's role is an extremely important one. Recent events in Asia have reminded us that good supervision of financial institutions is the single biggest contribution that governments can make to ensuring financial stability, whether it is the central bank or another agency that carries out the actual work. While the present system is managerially a different arrangement to the one it replaces, it is not fundamentally different in kind. There are still very close relations between bank supervision and financial system stability through the close connections between the having two Board positions on the latter). In addition, there is the Council of Financial Regulators, which brings together the heads of the Reserve Bank, APRA and the Australian reinforces the point that the Reserve Bank has not vacated its responsibility for overall system stability, even if it no longer does the 'hands on' supervision of banks. I would now like to turn to the third issue: how the Reserve Bank meets its financial stability responsibility. Here it is useful to think about two broad sets of policies: those that help prevent financial disturbances and those that counteract the effects of disturbances if they occur. I will start with the first set. Policies that help to prevent crises Maintaining low inflation When listing policies that help to prevent financial crises, the first one we come to is the maintenance of low inflation. It stands to reason that a background of low inflation is less likely to underpin rapidly rising asset values, and the speculative excesses that go with them, than a background of high inflation. But we should not take too much comfort from this, as events in Japan remind us. A better formulation would be to say that low inflation is probably a necessary, but not a sufficient, condition for financial stability. The transition phase from high to low inflation and from high to low interest rates can actually raise some asset prices for very good reasons. Similarly, if the move to low inflation has coincided with the deregulation of financial markets, the first observed effect may be increased instability. As so often in economics, it takes a long time to observe changed behaviour in a new steady state, such as low inflation; most of our recent observations come from transition phases between one regime to another. Ensuring that the payments system is safe The Bank also has important responsibilities in the payments system. As part of last year's regulatory changes, a new Payments System Board was established within the Reserve Bank. This Board has explicit legislative responsibility for ensuring the stability and efficiency of the payments system. In the stability area much of the hard work has already been done. The introduction, last June, of our real-time gross settlement (RTGS) system for high-value payments greatly strengthened the payments system infrastructure, as did the passage of a number of technical pieces of legislation involving bankruptcy proceedings and the netting of obligations. Australia's payments system is now as robust as any in the world. Maintaining an influence on regulatory arrangements in Australia Before explaining this, I must emphasise again that the Bank has no intention of duplicating the work of APRA. We recognise that APRA is the policy-making body responsible for setting prudential standards in Australia. We also recognise that the responsibility for supervising individual institutions lies with APRA, and, as part of this division, the Bank has taken the decision not to receive confidential prudential data on individual institutions on an ongoing basis. It relies on APRA to monitor the health of these institutions, but it does receive aggregate data, and on occasions attends APRA's on-site visits as an observer to keep up to date with the changing nature of financial institutions. Where the Bank can make a real contribution to regulatory arrangements is through its knowledge of, and day-to-day dealing in, financial markets and through its broad macroeconomic responsibilities. Two examples should help to illustrate this. First, it was through our own dealings in the foreign exchange market that we became aware of the high level of activity of hedge funds in Australia in June last year. This was well ahead of the collapse of Long-Term Capital alerted the world's bank supervisors to the risks associated with large hedge funds. The second example comes from the macroeconomic studies we have undertaken of the Asian crisis. These reveal that the main contributor to the rapid inflow and outflow of capital to these countries was short-term bank-to-bank lending. One of the reasons that banks in Europe, Japan and the United States were so keen to lend short-term to banks in emerging markets was that the Basel capital weights favoured short-term lending over medium- or long-term lending. This is logical from the point of view of an individual bank - there is less risk associated with a short-term loan. But it is not helpful to international stability if banks as a whole show a disproportionate tendency to lend short-term. It is these flows which, with good reason, are often termed 'hot money'. The Bank and APRA are grappling with this conflict, and I for one hope that the Basel weights are adjusted to remove the incentive towards short-term international lending. Being able to participate in international fora on financial stability issues As a result of recent instability in international financial markets, there has been renewed interest in official circles in examining the causes, and seeing what can be done to improve the situation. Australia has taken quite a prominent role in these discussions, with a number of arms of the government involved. The Reserve Bank has contributed to Australia's efforts, particularly by focusing on two areas where we believe the incentive structure is leading to excessive risk-taking and heightened instability. The two areas are the activities of hedge funds, and the arrangements for handling a crisis once it has occurred - in particular, ensuring that at least some of the losses are borne by the lenders. An indication of the success of the Australian effort to date is that Australia is one of the four countries that has been added to the original Group of Seven to form the new representing Australia at the next meeting in Keeping abreast of developments in financial markets In carrying out its ordinary business, the Reserve Bank trades in the money, bond, foreign exchange and futures markets. This gives us a familiarity with financial instruments and market practices which can add value to the views of other regulators. I do not wish to suggest that this puts the Reserve Bank in a better position, only a different position. Regulators such as ASIC have a much better legal perspective than the Reserve Bank, while APRA is more knowledgeable on prudential standards and institutional practices. Taken together, therefore, there is a very broad range of skills among the members of the Council of Handling 'once-off' threats to stability These will arise from time to time and may be difficult to predict in advance. The clearest example of this to date is the challenge of the Year 2000. While the financial system is well prepared for the new year, the best-laid plans could be threatened if the public were to over-react to Year 2000 concerns. For this reason, given our mandate to maintain the stability of the financial system, we are directing a lot of resources to ensure a smooth transition. A lot of the work has been very technical - making sure that computer systems work, that the financial system has sufficient liquidity and that ample currency notes are printed. But in the final analysis, we have to ensure continued public confidence in the financial system, so it is a matter of public reassurance and communication. In each of these policy areas, the Bank needs to be mindful not only of the stability of the financial system, but also its efficiency. While in many cases, policies designed to improve the stability of the financial system also improve its efficiency, this is not always the case. A highly regulated system might well be very stable, but it is unlikely to be very competitive or innovative. The Bank's broad policy responsibilities require it to balance these various considerations. Handling of a financial crisis The other situation in which the Reserve Bank will be required to play an important role is if a financial disturbance actually occurs. It is unrealistic to expect that financial regulators will be able to prevent all financial disturbances. The Bank, therefore, needs to be able to respond to disturbances when they happen. The main way in which it would do this is through the use of its balance sheet to provide liquidity to the financial system. The Bank's preference would be to do this through its usual daily operations in the cash market, providing liquidity to the market as a whole, rather than to individual institutions. Nevertheless, in the highly unusual case in which a fundamentally sound institution was experiencing liquidity difficulties, and the potential failure of the institution to make its payments posed a threat to overall stability of the financial system, the Bank would be able to provide a lender-of-last-resort loan directly to that institution. In principle, a lender-oflast-resort loan could be made to any institution supervised by APRA. It is important, however, to make clear that the Reserve Bank's balance sheet is not available to prop up insolvent institutions. Put more plainly, the Reserve Bank does not guarantee the repayment of deposits in financial institutions. Indeed, the recent legislative changes have removed from the Bank the responsibility for protecting depositors. This is now APRA's responsibility, and APRA has the power to issue directives to institutions, to revoke licences and to arrange for the orderly exit of troubled institutions. Obviously, if it were necessary to undertake any of these actions, APRA and the Bank would consult closely in order to limit the flow-on effects to the rest of the financial system. From a purely Australian perspective, our biggest financial crisis was in the 1890s. Although the 1930s were comparable as an economic contraction, it was a lot smaller as a financial crisis. And for the first four post-war decades financial instability was rarely in the foreground. One could be excused for thinking that the problem of financial instability was fading away. The events from the mid 1980s to the early 1990s dispelled this illusion. A widely based asset price boom came to an end, and the ensuing asset price falls brought down many highly geared businesses and, more importantly for present purposes, a number of financial institutions. Two large State Government-owned banks failed, as did one of the largest building societies, as well as several merchant banks and fringe financial institutions. The effect on the real economy was profound, particularly in Victoria where a disproportionate share of the financial failures occurred. It was a salutary experience, but fortunately many lessons were learned both by the private-sector participants and by the regulators. From an international perspective, it would be easy to gain the impression that financial instability is on the rise. The past decade has included the banking collapses in the Nordic countries, the Mexican crisis of 1994, the Asian crisis of 1997, Russia in 1998 and Japan's problems stretching over much of the decade. During the same period, we have heard disturbing news of many individual companies and markets, the most celebrated ones being the demise of Barings and the near-demise of LTCM. Looking over the experience at home and abroad, I do not think it is possible to say that the risk of serious financial instability has either increased or decreased in the course of the past century. The only reasonable working assumption is that the risks of serious financial disturbance are about the same as they always have been. An important reason for this is the unchanging human propensity to go through periods of extreme optimism which pushes asset prices to great heights, followed by a reaction which causes prices to fall precipitously. What has changed over the course of the century, particularly in the past couple of decades, is the nature of the risks we face. The traditional financial crisis was triggered by the failure of one or more banks, often during a period of declining asset prices. The cause was usually a failure to correctly assess credit risk, for example by lending against temporarily inflated asset values. Fire sales of assets and contagion led to runs on other banks and the emergence of a full-scale financial crisis. Such a scenario is still possible today, particularly in an economy heading into recession, but it no longer represents the stereotype. For a start, bank supervision and banks' own control of credit risk have improved enormously over the past decade. Also, financial disturbances are now more likely to originate in, and be transmitted through, financial markets than has been the case in the past. Financial markets are now much larger and many transactions are much more complex, making the risks associated with them harder to understand. Derivatives - the biggest growth area - are a good illustration. While they enable many businesses to hedge risks which they formerly had to accept, they also allow others to take risks that they formerly could not. Notably, derivatives can make it easier for some participants to engage in leverage - an old-fashioned activity which can greatly increase risk. The recent LTCM episode brought this out clearly and its near-collapse illustrated how market risks can be large enough to be systemic. Recent events also reminded us that in a globalised market place, financial instability will often come from abroad. Last year, after the Russian and LTCM incidents, risk premia on loans to all but the best credits increased sharply. Even in the United States, lesser corporates found sharply higher borrowing costs, while in emerging markets even large stable companies could not roll over maturing debt at interest rates which would keep them solvent. Fortunately, this situation did not prevail for long, but action by the US Federal Reserve was required to end it. As an aside, I should add that Australia was only marginally affected in this episode, and our new-found reputation for financial stability was not questioned. Of course, the spread of financial problems across national boundaries is not new. A hundred years ago the default by the Argentinian Government on securities underwritten by Baring Brothers triggered financial turmoil in London, which led to Britain reducing its overseas investments. This, in turn, contributed to major contractions in economic activity in Australia, South Africa turnaround in capital flows was as dramatic as that recently experienced in some Asian countries, and the effects on the economy were just as severe. What is new today, however, is the speed with which events are transmitted around the world, and the role that markets, as opposed to institutions, play in the process. It is important that we maintain financial stability because of the contribution that it makes to ensuring a more prosperous and more fully employed economy. It is also important that we receive recognition as a country that has a world class financial infrastructure which is capable of maintaining this stability into the future. Our recent exemplary performance has helped in this regard. But the task of ensuring we have an acceptable degree of financial stability in the years and decades ahead is a never-ending one. No-one can or should guarantee that no financial institutions will fail, any more than no manufacturers or retailers will fail. In fact, in an ideal world there would be a scattering of small disturbances every year or two to keep everyone on their toes. Unfortunately, the real world is not like this: there are long periods of calm when virtually no financial disturbances take place and rising prosperity is taken for granted, creating a false sense of security and eventually leading to short periods which contain several failures and the threat of many more. The requirement for all those involved in ensuring financial stability is to be alert and proactive during the long periods of calm, just as an army must be during peacetime. There is a constant challenge to be found in identifying new risks, avoiding harmful incentives and adjusting the regulatory arrangements to keep pace with changes in financial technology. It is not an easy task, but I am confident that the major regulators - APRA, ASIC and the Reserve Bank - are up to it.

r991027a_BOA

australia

macfarlane

The following is the text of the Chris Higgins delivered by the of on It is an honour to be invited to deliver the Chris from 1970 till his death in 1990. He was, in my opinion, the best Australian applied macroeconomist of his era and a policy-maker of distinction. His views on economics would place him amongst those whom Alan Blinder identified as having hard heads but soft hearts. He could have held a Chair at any Australian university and many overseas ones of note if that had been his objective; instead, he had an outstanding career at the OECD and the Australian Treasury, where he rose to become Secretary in 1989. Chris was also an excellent companion - a man of taste, wide reading and wit. It is good to see so many of his friends in the audience tonight. Chris' death in 1990 robbed us of a good friend, and Australia of an outstanding public servant and economist. I also cannot help but think it was a great shame that Chris did not live to see the 1990s unfold. His professional life was concentrated in the 1970s and 1980s - two periods of relative turmoil - and he did not see many of the things he stood for bear fruit in the 1990s. I would like to take this observation as the theme for my lecture tonight. I would like to start by looking at economic growth in Australia over the past half-century do this, the variation in growth rates is not nearly as great as when we compare different phases of the cycle. This is largely because each of the decades contained a recession (or more than one by some estimates) as well as periods of growth. The 50s and 60s showed the strongest average growth at 4.2 per cent and 5.4 per cent per annum respectively, while I do not want to suggest that our recent economic performance means that we have returned to a golden age such as we had in the immediate post-war period. Nor do I wish to deny that there is still a backlog of remedial work to be done - our unemployment rate being an obvious example. But, on the other hand, we must be doing something right. Our expansion so far in the 1990s has outlasted its predecessors in the 1970s and 1980s, and it is still going strong. We have withstood a difficult external shock, and should be able to sustain the expansion a good deal longer. The fact that the annual growth in GDP per capita has increased in the 90s, and that it is now faster than in OECD countries, is a welcome development. The major reason for improvement in GDP per capita is that a closely-related variable, namely labour productivity, has also shown a clear improvement in the 1990s. In addition, multi-factor productivity - which is a little further removed from GDP per capita - has also shown a clear lift compared with earlier decades. Table 3 shows a comparison of these measures of productivity over the three most recent expansions. Average annual rate the 70s, 80s and 90s showed very similar growth rates in the 3.3 to 3.4 per cent range. It is disappointing that we could not keep up the 50s and 60s performance into the later decades, but nor could other countries. There was a trend slowdown in growth around the world as the period of post-war reconstruction passed into history. In fact, the fall-off in growth for OECD countries was considerably more pronounced than for Australia, so Australia's relative performance improved towards the end of this fifty-year period. While economic growth in Australia was lower than for the OECD on average over the 50s and 60s, it was higher in the 80s and 90s, with the biggest advantage in Australia's favour occurring in the 90s. This is a surprise to some people and one response is to query it on the grounds that our recent relatively buoyant economic growth could have been mainly the result of our faster population growth. Table 2 examines this issue by taking out the effect of population growth and looking at real GDP per capita over the same five decades. On this basis, the recent relative improvement is now more pronounced than in the earlier table. The 90s not only shows a pick-up in Australia's growth of real GDP per capita compared with the two previous decades, but it is the only decade in which Australian GDP per capita has grown faster than the OECD area, and by an appreciable amount. Average annual rate Per cent per annum The reason for the pronounced rise in productivity is essentially microeconomic . It is because labour is being used more efficiently, capital is being allocated to areas of the highest productivity and innovation is occurring more rapidly than before. Partly this may be due to increased managerial efficiency, but a more likely explanation is to be found in the policy changes designed to make the economy more flexible and competitive - in other words, policies designed to affect the supply side of the economy. Among these I include financial market deregulation, tariff reductions, privatisations, competition policy and decentralisation of the labour market. These have all made a contribution, but it is probably the interaction between them that is more important; in this sense, the total effect is more than the sum of the parts. I have talked on this subject on earlier occasions, so I will not repeat myself tonight, other than to observe that these have brought tangible benefits that are often overlooked by the beneficiaries. The other distinguishing feature of the 1990s is that the expansion has continued for longer . National accounts data up to the June quarter of 1999 show eight years of expansion at an average rate of 4 per cent per annum, already exceeding the length of the previous two expansions. All forecasters are expecting significant growth in the current financial year, so that, even on the most pessimistic assumptions, the present economic expansion will be a lot longer than its predecessors in the 70s and 80s. More importantly, in earlier expansions, serious imbalances had built up by this stage. In the early to mid 70s and the early 80s, inflation was in double digits, partly as a result of a surge in wages. In the late 80s, asset prices and credit growth were rising to unsustainably high levels, and consumer price inflation was still excessive. Both the dynamics of the business cycle itself, and the need for tough anti-inflationary monetary policy, pointed to an abrupt end of the expansion. On this occasion, the picture is different and no-one is expecting an abrupt end. I would now like to make a few comments on why the expansion of the 90s has been steadier and longer than its two predecessors. Here I think we have to look for essentially macroeconomic explanations. The first explanation is to be found in a comparison of the rates of inflation this time compared with the two previous expansions. It is curious now to look back to some of the economic debates of the 60s and 70s. In those times, there were many people who thought that you had to tolerate 'a little bit of extra inflation' to make sure the economy would grow. Many, if not the majority, thought that getting inflation down again would not be worth the price, because it would result in permanently lower growth. The short-term interpreted as being a summary of our medium-term choices. could be further from the truth. The low inflation decades - 50s, 60s and now the 90s - are the ones where we did well on growth in absolute terms, or in relative terms. The high inflation decades - the 70s and 80s - were the ones where our growth performance was at its poorest. Average annual rate of increase The most reasonable explanation for the lower inflation and hence steadier and longer expansion in the 1990s is the improvement in macroeconomic policies. By this I mean monetary and fiscal policies, or what used to be known as demand management policies. I will not say very much about fiscal policy, other than to note that medium-term considerations now play a much larger role, something that Chris Higgins consistently argued for. The improvement has occurred in two stages after the disaster of the 1970s. In the late 80s, and again in the mid 90s, the Budget was brought back into surplus where it remains at present. As a result of this fiscal consolidation, the medium-term health of the Government's accounts has improved greatly. One important indicator of this is the stock of government debt to GDP, which is now lower for Australia than for virtually any other OECD country. On monetary policy, I will say a little more. A similar realignment towards a medium-term approach has certainly occurred in the case of monetary policy. The centrepiece of this has been the inflation target and the Government's reaffirmation of the independence of the Reserve Bank as outlined in our Act. A similar realignment has occurred in a number of other countries, and a model of this type, whether explicit or implicit, is now the mainstream international approach to monetary policy. This approach has been a major factor behind the low inflation of the 1990s, both here and in most other OECD countries. A central channel through which this approach operates is through maintaining low inflationary expectations. Wage and price setters no longer need to engage in the defensive behaviour they formerly used to protect themselves against future rises in inflation. Similarly, opportunistic tactics aimed at profiting from inflation no longer make sense as a business strategy. And finally, the assumption by businesses that there is no need to resist increasing costs because they can simply be passed on to consumers by raising prices has had to be discarded. While the inflation target has played an important part in maintaining low inflation, there is more to monetary policy than just setting the target - there also has to be a willingness to act in a timely way. This is best illustrated by events in the period from 1994 economy was growing strongly and there were signs that inflation and wages would soon pick up (this expectation was reflected in a number of places including the yield curve). The first tightening of monetary policy occurred in August 1994 and was followed by two others before the end of the calendar year. It is important to note that at the time the tightening occurred, the current inflation rate was 2 per cent (four-quarter-ended underlying inflation). Thus the tightening was pre-emptive - it was based on an assessment of the outlook rather than current experience. In time, inflation did rise and peaked at 3.3 per cent per annum in the year to Pressures soon abated as the economy slowed and wage claims moderated. By July 1996, the first of a series of monetary policy easings occurred. Again this was pre-emptive because the inflation rate at the time was still above 3 per cent. But, because inflation was forecast to return to the middle of the band, the period of tighter monetary policy that had prevailed since end 1994 was no longer needed, and so interest rates could be taken back to more appropriate levels. The pre-emptive nature of these policy changes, plus the Government's affirmation of the inflation target and the independence of the Reserve Bank contained in the on the Conduct of Monetary Policy in August 1996, significantly increased the effectiveness of monetary policy and the credibility of the Reserve Bank. This put us in a good position later to handle the contractionary effects of the Asian crisis and the associated period of turbulence in financial markets. The textbook response to a contractionary external shock such as the Asian crisis is not, in our view, to tighten monetary policy. But the turmoil in financial markets, such as a plunging exchange rate and widening bond spreads (both indications of capital flight), can sometimes only be settled by such a show of forceful action. Most countries in the region, whether developed or emerging markets, chose to, or were forced to, raise interest rates at some stage during the Asian crisis, with subsequent detrimental effects on their economic growth and employment. The fact that we were able to withstand the pressures without doing so (in fact, reducing rates slightly in December last year) is a testimony to the increased credibility of monetary policy in Australia, and to the higher reputation that the Australian economy overall commands in the international market place. It is also an illustration of how timely action, such as in 1994, can ultimately contribute to a longer and more robust expansion. Before concluding, I would like to make a couple of other observations on this subject. The first is that pre-emptive monetary policy action only refers to being pre-emptive vis-a-vis actual developments in the economy; it does not mean being pre-emptive vis-a-vis the financial markets' assessments. Financial markets are looking at the same data as the Reserve Bank, are making forecasts and calculating the probabilities of monetary policy action. Interest rates on bills and bonds always move in anticipation of monetary policy action. To be pre-emptive vis-a-vis the market would be the same as taking the market by surprise. No-one should regard this as a worthwhile objective, although it will occur from time to time. In the modern world of greater transparency and accountability, such surprises should be rarer and rarer as the market becomes more aware of the central bank's objectives and modus operandi . The other implication of this new world of monetary policy is that policy changes will probably be a good deal smaller than in the past. Just as the tightening of 1994 was much smaller than its predecessors in the 1980s, it is reasonable to assume that this trend will continue. The past three years have hardly been a placid period for the world economy, yet in successful economies the movements in interest rates have been relatively small (for example, in the United States they have moved through a range of of a per cent). The other thing we are seeing is that financial factors are playing a larger role than before. The biggest move in US rates over the second half of the decade was the easing in late 1998 as a result of the 'credit crunch' which followed the Russian default and the demise of the hedge fund LTCM. At present, US monetary policy is, of necessity, partly operating through the medium of the stock market as that market moves in anticipation of Fed tightenings. Fortunately in Australia we do not have as highly valued a stock market to contend with, but we cannot ignore these considerations entirely. Our household sector is now a much larger holder of equities and, at the same time, is more highly leveraged than in the past. This is bound to affect the transmission mechanism for monetary policy. My final comment is that whatever monetary policy does, there will be those who disagree with the decision. This is inevitable and probably healthy. Everyone is entitled to their own view, and has a right to express it. That will always be the case. What has changed over recent years is that, by and large, those who disagree with a decision no longer reach for the ready excuse of claiming that it was 'only done for political reasons'. This change has been a long time in coming, but now that it has arrived, it is a huge advance. It makes it easier for monetary policy to do what it judges to be right and not be inhibited by fears of public misperception - whether that means temporarily higher interest rates or temporarily lower interest rates - than formerly. In the long run, however, it almost certainly means on average lower and less variable interest rates for the reasons I have outlined above.

r991111a_BOA

australia

macfarlane

I will say a few words on monetary policy tonight, but they are not intended to be very profound. This is partly because I have recently held forth on the subject in the Chris Higgins Lecture. You will also be aware that we have made a change to monetary policy, issued an accompanying press release, and also issued our regular half-yearly report within the past week or so. With so many public statements in such a short time, we should have got our point of view over to everyone by now. So my comments tonight are not intended to point to any new direction in monetary policy - they are meant only as an elaboration on a couple of points in what we have already said. We have just been through an exercise in which monetary policy was tightened for the first time in five years. History shows that interest rates have to go up as often as they go down, but although we all know this, Australia has had particular difficulty in handling these rises in the past. Not that the problem has been confined to Australia, many others have had the same experience. Tightenings have tended to be delayed for too long, and when they have finally occurred, they have often been quite abrupt and accompanied by heated political argument. This was certainly the pattern in the 70s and 80s, although we made a big step forward in the 1994 tightening as I emphasised in my recent lecture. On this occasion, I would maintain that the tightening was neither delayed nor abrupt, and it certainly took few people by surprise. But more importantly, the response to it by the economic community and by politicians was extremely civilised. Although some people expressed disagreement, I detected no heat or acrimony in their words. In the political sphere, the comments made by the Government, the Opposition and others showed that we have gone a long way down the path of de-politicising monetary policy. This is a very welcome development, and although there were a number of steps along the path, the most important one was the joint signing of the in 1996. Those who disagreed with our decision to tighten tended to point out that there were few signs that the economy was overheating, that inflation was not threatening to exceed the target over the forecast horizon, and that wages growth was not heading up (as in 1994). As a description of the economy, that assessment was essentially correct, and we have no desire to dispute it. But the implication for policy which was drawn from this assessment was not, in our view, correct. In our view, it reflected a rather dated approach to the application of monetary policy. The traditional view is that you only begin to tighten monetary policy when things have become, or clearly will become, overheated or, in other words, out of control. The tightening in those circumstances is a sign that something has gone wrong and is, in effect, an admission of policy failure. Hence, the ample scope it provides for criticism, particularly in the political arena. The unusual aspect of the recent tightening is that it occurred before things had become, or were about to become, out of control. If it is successful, it will mean that they do not get out of control in the foreseeable future. That is what is meant by the term 'pre-emptive'. But clearly we could not have just picked any period when the economy was performing well and chosen to tighten monetary policy and claimed it was done in order to be pre-emptive. There had to be good reasons why it was now - in the final quarter of 1999 - that we made this decision. Although we have explained this in our , I would like to spell out a couple of aspects of this in the time remaining tonight. Although it is only a year ago, most of us have forgotten how gloomy the prospects seemed in the second half of 1998. This was the time when the Asian problems had spread via Russia and Latin America to Wall Street itself. If you look back at the press release which accompanied our easing of monetary policy in December 1998, you will see it referred to the expectation by official and private forecasters that 1999 would be a worse year than 1998. As we now know, the world did not turn out that way - 1999 has turned out to be a stronger year than 1998, and both official and private forecasters are now expecting 2000 to be stronger again. I do not wish to quibble with this assessment. I merely wish to record that from about the middle of 1999, markets around the world began to recognise that the accommodative stance of monetary policy by major central banks that had been so appropriate for 1998 and early 1999 was starting to look less appropriate as 1999 progressed and strengthened. This reassessment happened first in the United States and was soon followed in other English-speaking countries and then in Europe. As usual, the markets were quicker off the mark to raise market interest rates than they needed to be, but they were broadly correct. Since mid-year, we have seen the United States, the United Kingdom, Australia and the ECB tighten monetary policy. I suspect there will be a few more countries to come in the not too distant future. Just as the weakness of the world economy did not come to pass, a similar expectation of weakness in Australia failed to materialise. Real GDP in Australia again grew by over 4 per cent in the 12 months to the June quarter and will probably still be showing a similar rate in the 12 months to the September quarter. This measure may slip for a time as we drop off some of the high quarterly growth rates from our calculations, but we think growth will remain robust over the next 12 months. Similarly, the quite lengthy period during which inflation was undershooting our target seems to have come to an end. The CPI inflation rate would already be a bit over 2 per cent apart from the Government's reduction in the Health Rebate Levy. Although some of this result has been due to rises in oil prices, measures of underlying or core inflation, which are largely unaffected by oil prices, have also risen by about 2 per cent over the past 12 months. Thus, the period where the Australian economy was experiencing a contractionary impact from abroad and where the outlook was for weaker growth and sub-2 per cent inflation has now well and truly passed. The monetary policy that was appropriate for that period is no longer appropriate to the new circumstances that we face. That is the main reason behind the tightening of monetary policy we undertook after our November Board Meeting. This move was what the flexible inflation targeting framework suggests should happen. There is some confusion, however, on this point and so it is worth spending some time to clarify it. Some interpretations of the target imply that the Bank is not supposed to contemplate any rise in interest rates until the upper end of the target is threatened. This is equivalent to saying that the most expansionary setting reached during the downward phase of the interest rate cycle should be maintained until such time as a move to a clearly restrictive setting is required, and only then should a move be made. (That virtually guarantees that such moves will be large.) It is as though policy has to operate only with settings of maximum 'go', and heavy braking. This is a reading of the framework we do not share. There is a range of settings of the instrument between 'maximum go' and 'heavy braking'. Most of the time we would expect interest rates to be in that range. Let us look at two possible situations where monetary policy should be changed: Now some may object that all this smacks of fine tuning. I agree that we should not delude ourselves that the economy can be precisely controlled so that inflation stays within or close to the band, even when there are no external shocks. The point remains, however, that even if the process is not precise, the instrument does not remain at its most extreme setting once that is no longer needed. As the outlook changes, and as the balance of risks shifts, it is appropriate also for the policy instrument to shift. Some people have not been convinced by the arguments I have used above. Some still cannot understand why you would tighten unless the economy was overheating, and assume that there must be a hidden agenda. Others are keen to play the old game of trying to find a political dimension to monetary policy. This has led some people to say that the real reason is our fear of the inflationary effects of the GST, but that we are too diplomatic to say so. I am sorry to disappoint the proponents of this view, but that is not the case. We have made a point of saying that the recent monetary policy tightening is designed to increase the length of the expansion. Again, this may not be universally accepted, as many people associate tightenings with the end of expansions. Our position may seem the wrong way round to those who have a more traditional view of monetary policy, but I want to make a few points of clarification: I was going to conclude by saying a few things about communicating with the public, or what is now known as transparency. But the more I think about this, the more complicated it gets. So the one thought I will conclude with is this. Sometimes it is possible to be reasonably direct when talking to the public, as I believe we have been over the past few weeks. That is because we had a clear view about what needed to be done. But more often than not, you find yourself in a grey area where there is not a strong case to do something, where all incoming data have to be evaluated on their merits and policy options weighed up. In such situations, you cannot give views about the direction of policy - you cannot say more than you honestly believe - and that will often disappoint people looking for a clear guide to future action.

r991129a_BOA

australia

macfarlane

Governor, in testimony to the House of was released on 8 November 1999. It is a pleasure to be here in these dignified surroundings to appear before the Committee again. As you know, we take these hearings very seriously because we regard them as an important channel for Parliament, through its representatives, to question the Reserve Bank in depth. It thus plays an important role in ensuring the Bank's accountability and in the democratic process. As usual, I would like to make an opening statement, but it will not be comprehensive because we have put out our earlier in the month. Its contents are still very current and I will refer to it from time to time during the hearing. Also following past practice, I would like to start by reviewing what I said to you in June about how we saw the economy developing. There was still a fair bit of uncertainty around at that stage as to the extent of the expected slowdown in GDP growth from the per cent plus that had occurred in 1997 and 1998. That is why we had a relatively wide range of projected outcomes from 3 to 4 per cent. The top of that range would indicate almost no slowdown, while the bottom would probably indicate we were heading still lower and would represent genuine weakness in economic activity. We think the position is a little clearer now - our forecast for growth through 1999 is per cent, and through the financial year growth rate of 4 per cent implies a year-on-year growth rate of 3 per cent, the same as the Treasury is forecasting in its mid-year review. Thus, these numbers do show a modest slowdown for the Australian economy, but most of it is behind us. It incorporates the low June quarter figure and reflects weakness in business investment, and particularly a decline in net exports in the first half of 1999. Because the latter is unlikely to be repeated, we expect to see growth of around 4 per cent through the year ahead. There has been no reason to change our view on inflation. We thought inflation in the year to the December quarter 1999 would be 2 per cent, whether measured by the CPI or some underlying measure. We still think 2 per cent for the CPI and a shade over 2 per cent in underlying terms. When we look out to June 2000, our guess for the CPI is per cent, with 2 per cent for underlying. On unemployment, we have also not changed our view. When we met last time, the unemployment rate had been averaging 7 per cent, and we expected it to edge down over the remainder of the year. This is what it has done, so that now it has averaged 7.2 per cent over the past three months. We expect that it will go down further so that we will see some numbers less than 7 by June next year. The balance of payments has also turned out very much as expected. For quite a while, we had been forecasting the quarterly current account deficit to reach 6 per cent of GDP, and it finally did so in the June quarter and will probably remain at about this level through this financial year. It was surprising that the current account did not deteriorate faster and further, given the disparity between our growth rate and that of our trading partners. While the slowness of the deterioration has been a pleasing development, we think that the improvement could be some time in coming. In summary, we are expecting that the current financial year will be another good one for the economy. Growth will be a little lower than its recent peak, but still good, and inflation should be within the average we aim for. Considering that this is the ninth year of the expansion, such a result would mean that no major imbalances had emerged. The aim, as usual, is to keep the expansion going and to avoid the emergence of problems that would threaten its continuation. This brings me to monetary policy. The most important development here was the tightening immediately after our November Board Meeting when the overnight cash rate was raised from 4.75 per cent to 5 per cent. While I think this adjustment has been quite well received by the community, it is still worth spelling out some aspects which lay behind the decision. I would like to start by putting it in the international context, not because we have to follow what other countries do, but because there are some international developments that are a common background to all countries. One such development was the changed perceptions about the world economic outlook in 1999 and 2000. If you remember, 1998 was a weak year for the world economy, largely because of the widespread fallout from the Asian crisis. At the beginning of this year, things looked as though they were getting worse, and most forecasters - public and private - expected 1999 to be weaker than 1998. In the event, it turned out the other way - 1999 has been better than 1998, and 2000 should be better again. As our 'This change has led to an increase in both short-term and long-term interest rates in most industrial countries, as markets questioned the continuation of the accommodative monetary stance central banks have generally been following over the past year or two. The upward pressure in interest rates began in the US, the country most advanced in its economic cycle, but quickly spread to other English-speaking countries and, more recently, to Europe'. The market reaction was a bit quicker than it needed to be, but it was broadly correct. The United States was the first to tighten, followed by the United Kingdom. Our tightening in early November was quickly followed by the European Central Bank, and central banks in Sweden, Canada and I would now like to turn to the Australian economy, where a similar expectation of weakness in 1999 did not come to pass. Real GDP grew by over 4 per cent in the 12 months to the June quarter (the latest data we have) and will probably still be showing a similar rate in the 12 months to the September quarter. This measure may slip for a time as we drop off some of the high quarterly growth rates from our calculations but, as explained earlier, we think growth will be about 4 per cent in the 12 months to June 2000. Similarly, the quite lengthy period during which inflation was undershooting our target seems to have come to an end. The CPI inflation rate would already be a bit over 2 per cent apart from the Government's reduction in the Health Insurance Rebate. Although some of this result has been due to rises in oil prices, measures of underlying or core inflation, which are largely unaffected by oil prices, have also risen by about 2 per cent over the past 12 months. Thus, the period where the Australian economy was experiencing a contractionary impact from abroad and where the outlook was for weaker growth and sub-2 per cent inflation has now passed. The monetary policy that was appropriate for that period is no longer appropriate to the new circumstances that we face. That is the reason behind the tightening of monetary policy we undertook At the risk of being overly technical, I would like to spell out some aspects of our flexible inflation-targeting regime a little more fully at this stage. In doing so, I want to distinguish between two types of situation: the first is where inflation has been comfortably averaging 2 point something per cent for some time and the economy is performing roughly in line with its potential so there is no obvious upward or downward pressure on the inflation rate. The second is where the starting point is either above or below the range we expect inflation to average. In the first case, where inflation is where we want it, monetary policy would be set to keep it there. The economy would be in a type of dynamic equilibrium and there would be no need for policy action. We then ask ourselves what are the circumstances under which we would wish to change monetary policy. Would we do it if our forecast for inflation rose from per cent to 2 per cent or fell to per cent? My answer is that we do not worry about small variations in inflation of that magnitude. To trigger a change in policy would require a forecast which had inflation going clearly above 3 per cent or below 2 per cent and likely to stay there for a while. Our flexible inflation-targeting framework does not aim for rigorous fine-tuning, and requires a significant variation in the inflation forecast to trigger monetary policy action. This brings me to the second type of situation. This is where we start from a position where inflation is above or below our desired target range. In this case, where the initial situation is one of dynamic disequilibrium, the prescription is a little more complex. Let us look at the situations defined by the two possible starting points. The first is when inflation is above the target. In this situation, the inflation-targeting framework would say to raise interest rates to a setting which would bring inflation back to the target. But once the higher rates had done their job, they should be gradually reduced to more normal levels. This is what happened in 1996. We did not wait until our forecast had inflation falling below 2 per cent before we started to ease. The second is when inflation is below the target. In this case, the framework would first call for a setting of interest rates which would, over time, allow inflation to go back up to the target. Once it is clear that such a setting had done its job, the framework calls for it to be replaced by one more likely to keep inflation at the target. The framework does not envisage the low interest rate setting being maintained until something goes wrong. It is this reasoning which lies behind the recent tightening of monetary policy and why we refer to it as pre-emptive. To argue against it on the grounds that we should not act until our inflation forecast clearly exceeded 3 per cent would be to argue for a very 'stop-go' approach to monetary policy. It would be equivalent to saying that the most expansionary setting reached during the downward phase of the interest rate cycle should be maintained until such time as a move to a clearly restrictive setting is required, and only then should a move be made. This would virtually guarantee that such a move would be a large one. Not everyone will be convinced by the arguments I have used above. Some people still cannot understand why you would tighten unless the economy was overheating, and assume that there must be a hidden agenda. Others are keen to play the old game of trying to find a political dimension to monetary policy. This has led to claims that the real reason is our fear of the inflationary effects of the GST, but that we are too diplomatic to say so. I am sorry to disappoint the proponents of this view, but that is not the case. If the GST was the reason for tightening monetary policy, why have the Fed, the Bank of England, the ECB, the Bank of Canada, the Reserve Bank of New Zealand, etc tightened monetary policy? As I have said elsewhere, I am not aware of the forthcoming introduction of a GST in any of these countries. Our starting point has always been that the imposition of the GST will affect the level of prices, but not the ongoing inflation rate. This will require that businesses do not engage in opportunistic pricing by raising their prices by more than is warranted by the net impact of the GST and reductions in indirect taxes. If that is the case, the GST should not have an effect on wages because wage-earners will gain more from the accompanying fall in income tax rates than they will lose from the introduction of the GST. The net effect of the tax changes will be to increase the disposable income of wage-earners by more than the increase in their expenditure, as is evidenced by the fact that the package involves a cost to the Monetary policy is based on a view that inflation will be within the target immediately before the GST is introduced and that it will be back within the target a year later. This view, in turn, is based on the assumption that there will be no second round effects due to higher wage outcomes or opportunistic price behaviour as outlined above. If we started to observe behaviour that indicates that this assumption was not correct, then monetary policy would act upon it. We are not acting at present on the expectation that this assumption will be violated - we are acting in the expectation that it will hold. I would now like to make a few comments about Y2K, which is very topical because there are now only 32 days to go to the new century. When I appeared before the Committee in June, I said that Australian banks, building societies and credit unions were very well all their final testing at that stage, but now they have, and everything has been done to make sure that their computer systems will be able to handle the change into the new century. This includes not only all their internal accounting and record-keeping systems, but also their ATM, EFTPOS and credit card systems. As well as making sure their systems are compliant, they have also been sending out very clear messages to their customers about the safety of their deposits. We are very pleased to see this because, as I said in June, the simple fact is that deposits are safe and records are not at risk from I should also say a few words about my own institution. You will not be surprised to know that we have also put a lot of effort into our own systems to make sure they are Y2K compliant. One of our most important is our electronic direct entry system which handles all of Australia's pension payments. You will be pleased to know that all these payments will be made on time. I mentioned last time that it is not just a matter of getting the technical side right, but it is also important that we do not run into a problem of public over-reaction. All the indications here are that the vast majority of the public are taking a sensible and calm approach and have not been influenced by alarmist stories or predictions of doom - not that there have been a lot of these anyhow. In our judgment, the Australian media coverage, with only a few exceptions, has been accurate and balanced. I am often asked by people whether they should take out extra cash to see them over the New Year period. My advice is generally along the following lines: don't take the risk of having too much cash on your person or in your home; the safest place for your savings is in the financial institution that they are presently in; don't fear that the country will run out of cash - we have printed enough notes to provide for any conceivable demand; and remember you are only really dealing with a long weekend - banks, building societies and credit unions will be open on the three days before New Year's Day, which is the Saturday, and will re-open on the Tuesday. New Year's Eve is going to be rather unusual this year in that a lot of people will not be out enjoying the festivities, but will be at work to make sure that nothing goes wrong. At the Reserve Bank, we will have a team in place, including myself, and a communications centre to receive up-to-date information from financial institutions on what is happening. This centre will be linked to the Co-ordination Centre in Canberra and to various international networks that have been established. be the first countries to enter the new millennium, there will be a lot of international attention focussed on us, including a fair bit of live television coverage to other countries about what is happening in Australia. Remember the United States will only be starting its working day on Friday when we cross over into the new millennium. I am confident that Australia will acquit itself well once again in the eyes of the world when the great day comes.

r000211a_BOA

australia

macfarlane

It is a great pleasure to be here speaking to I first spoke before the Society in 1986 and have been back a few times since. On each occasion I have appreciated the interest and attention you have afforded me. I hope that what I have to say today will again be of interest to you. I want to take the opportunity today to expand a little more on the role of monetary policy in managing an economic expansion. This is a subject that I have spoken on in the past, but clearly there is more to be said. On this occasion, I would not only like to restate the Reserve Bank's position, but also deal with some of the views that have been put forward following our recent raising of interest rates. The current expansion, as you will all probably be aware, has now lasted longer than its predecessors in the 1970s and 1980s, and has also reached a higher level relative to its starting point. This is shown by the accompanying graph, which puts the three expansions on a comparable basis. Another interesting aspect of our current expansion is how similar it is to the much better known expansion in the US economy. While the US expansion has been going for 36 quarters compared to 35 for our own (measured up to the present quarter), our average GDP growth rate of 4.1 per cent is higher than the 3.6 per cent recorded in the US. While it is satisfying to look back and see how far we have come, it is more useful to look ahead and see what we have to do if we are to continue on this path. For some time now, the task of monetary policy has been just that - to manage the expansion in such a way as to maximise its length. We do not want to repeat the experience of earlier expansions which ended so unhappily, and therefore we must ask ourselves what it is that we have to do this time to avoid that fate. This is the main subject of my talk today, but before I get into it, I would like to ask your indulgence to detour through the age-old subject of the business cycle. Economists have been analysing the business cycle for a century or more. From time to time after a long expansion, a few feel emboldened enough to suggest that perhaps we have seen the end of the business cycle. This happened in the very early 1970s, and a few people are canvassing the idea now as part of the concept known as the 'new economy' or 'new paradigm'. While there is undoubtedly substance in these ideas, some of you may be disappointed to know that I am not a member of the school that thinks the business cycle has been banished, although I am happy to recognise that increased productivity growth in the 1990s has made the task of macroeconomic management somewhat easier than formerly. The most obvious benefit of this from the monetary policy perspective is that the overall rise in interest rates needed to prevent a potential inflationary situation developing now seems to be a good deal smaller than previously. There are two main mechanisms that lie behind the business cycle: 1. A business cycle of some sort may be the inevitable result of interactions involved in a complex dynamic system such as an economy. We know that cycles are the norm for such natural phenomena as the weather and animal populations, and some tendency in this direction is also probably intrinsic to economic behaviour. The first Nobel Prize in Economics was awarded to Ragnar Frisch for work on how business cycles can be propagated in simple models of the economy, and others such as Samuelson and Hicks expanded on this. school of economists have taken this in a new direction by regarding all cycles as being a natural result of changes in the supply side of the economy. I do not want to take any of this too literally, but I would agree with one conclusion that comes out of all this work, namely that it is probably unrealistic to expect a dynamic system like a modern economy to expand in a smooth line; its natural progression is probably characterised by some element of cyclicality. 2. A business cycle may be viewed as resulting from policy mistakes. In this view, policy is kept expansionary for too long during the upswing, resulting in the build-up of serious distortions or imbalances - principally inflation. Eventually something has to be done, but in order to eliminate the by then well entrenched imbalances, the degree of tightening required is quite large. As a result, the economy is pushed into recession and unemployment rises sharply. This explanation essentially sees cycles as the result of a delayed monetary policy reaction function. In the popular discussion of economic developments over recent decades, it is the second type of cause - the tendency for monetary policy to contribute to booms and busts - that has been the focus of attention. Fortunately, it is also the type that we have most chance of avoiding if we play our cards right. This would not mean that all cyclical behaviour would be removed, but a significant part of it could be. The centrepiece of this approach is to act before the imbalances have had time to become entrenched. If you are seriously aiming to maximise the length of the expansion, the tightening of monetary policy comes earlier than if you are mainly interested in a high growth rate for the year ahead and less concerned with the length of the expansion. Of course, this can sometimes make the explanation of monetary policy moves more difficult, because those opposed to the move may be able to claim that there was not sufficient hard evidence of imbalances to justify it. It is instructive to look back over the past few decades to see how imbalances have built up towards the latter part of economic expansions. No two expansions or their demise have been the same, nor is it the case that a single imbalance was the cause of the problems. In all cases, there were several imbalances whose interaction led to the build-up of an unsustainable situation. Having said that, however, it must be recognised that the pre-eminent imbalance has been inflation. It is now almost universally acknowledged that the maintenance of low inflation is the sine qua non of a sustainable expansion. It was the rise of inflation, in one form or another, which spelled the death knell of our previous expansions. In the long expansion which began in the 1960s and ended in 1974, inflation had already risen to 10 per cent by the September quarter of 1973, which was before the effects of OPEC I had been felt. Following the rapid wage escalation of 1974, inflation then peaked at per cent early the following year. We had a rather weak expansion in the 1970s, which received a boost from the rises in commodity prices associated with wage escalation pushed inflation from a low point of 8 per cent in 1978 to a peak of 12 per cent in 1982. In the strong, but shorter-lived, expansion of the 1980s the story was rather different. Although the increases in prices and wages were a good deal higher than we have become accustomed to in the 90s, there was no sudden acceleration in the latter stages of the expansion as there had been in earlier episodes. It was a boom in credit-financed asset prices and the associated speculative activity that did the damage. At some stage the boom was bound to be followed by a bust, whether of its own accord, or as a result of monetary tightening. While asset price inflation is conceptually different to CPI inflation, and is further removed from the ordinary operation of monetary policy, it is nevertheless a classic case of the type of imbalance that can occur in the latter stage of an expansion and lead to its abrupt and painful ending. There are several other types of imbalances that often accompany the latter stages of an expansion and that can be a warning of danger. One is monetary excess, which is usually manifested as excessive provision of credit, and which often ends up financing speculative activity. I have already mentioned this in relation to the 1980s, when the credit expansion was primarily to business and resulted in the over-leveraging of that sector. It is also possible for the imbalance to show up as over-lending to households, as happened in the UK in the late 1980s. Another imbalance that can occur is in physical investment. We are accustomed to thinking of investment as a good thing and only ever worrying about it if it is too low. But over-investment can also be a problem at times in that it can lead to the build-up of over-capacity. This in turn can lead to a subsequent dearth of investment, especially if demand has not been as strong as had been expected by those who put the investment in place. Part of the severity of the recent Asian recession, and particularly the Japanese one, is due to the earlier period of over-investment. Some of that effect also occurred in Australia in the late 1970s/early 1980s during the so-called 'resources boom'. Looking back over the post-war years, particularly during the fixed exchange rate period, the imbalance that often played the decisive role was the current account of the balance of payments. If it widened markedly, private capital inflow risked being insufficient to cover it, and interest rates would have to be raised to attract more capital and to reduce the demand for imports. This would be a major cause of the subsequent contraction, such as the 'credit squeeze' of 1961. With a floating exchange rate, the current account is a less immediate constraint: it only becomes binding if the market begins to worry about an escalating external debt to GDP ratio, or about the country's capacity to service the debt. This brings me to the current expansion. We have now had two policy tightenings involving a net increase in the overnight cash rate of of a percentage point. The tightenings were pre-emptive in the sense that they occurred before imbalances developed - in other words, before there was clear evidence of the economy generally overheating. As the foregoing discussion makes clear, we regard these tightenings as an essential component of a strategy which is designed to allow this economic expansion to continue for as long as possible, and not be overwhelmed by the usual imbalances that bring an expansion to an end. This approach to monetary policy is not unique to the Reserve Bank of Australia; one can clearly see the same thinking behind the actions of other central banks. They too have been bruised by the failures of the 1970s and 1980s and are determined to do better this time. While I think this approach is generally well understood, there are obviously some who do not support it. There is nothing like a rise in interest rates to bring out critics of monetary policy who hitherto had been silent. Of course, everyone has a right to express their views, and I have no trouble with the recent debate. I can also see why the public expect explanations from bodies that make important decisions, and we are conscious of the need to meet that requirement. As well as the explanation contained in the media release that accompanied the monetary policy decision, we will be publishing a detailed quarterly report on the economy next week, and I appeared in public before a Parliamentary Committee two days ago. I will also take the opportunity in the remainder of this speech to address these issues. We have for some time been in a period characterised by good economic growth, low inflation and low interest rates. It has been one of the better periods for the Australian economy, especially in light of the turmoil among many of our trading partners. I think there has been a tendency for some observers to think this happy state of affairs could continue indefinitely provided we left it alone. A common theme has been 'don't meddle - just leave it alone', or a related one, 'are you afraid of growth?'. These views seem to us to be very short-sighted - in essence, they boil down to the view that the best way to manage an expansion is to keep interest rates at their low point for as long as possible, and only raise them when things have gone off-track. We think that if we did this, we would look back in a few years' time and regret it, even though we might have been more popular in the short run. We also think that this approach fails to recognise just how expansionary the stance of monetary policy was in 1999. In either nominal or real terms, interest rates faced by borrowers were very low, as was shown by their eagerness to borrow. This expansionary stance of monetary policy was designed to combat a specific set of circumstances - weak world economy, expected domestic slowdown, and undershooting of the inflation target. When these circumstances changed, it was only reasonable that monetary policy would also change. We have tried to encapsulate the two changes taken together as a return to 'neutrality' from a position that was clearly expansionary. Of course, there will always be considerable measurement uncertainties about the term neutrality - perhaps we should have referred to a return to the 'neutral zone'. Be that as it may, if you do not have some idea of the concept of neutrality, you run the dual risk of: being late by not changing monetary policy until overheating has actually occurred (or, in the opposite direction, until a recession is staring you in the face); then being forced into a large and abrupt adjustment to recover the situation. Both of these outcomes effectively describe a 'boom and bust' monetary policy, which is the approach we set out to avoid. Another variation of the argument that monetary policy should not have been tightened, or not by as much, is the appeal to US experience. Proponents of this view claim that Chairman Greenspan has been doing the right thing by letting the US expansion run on, and not being deflected by more conventional voices calling for monetary restraint to avoid future inflation. I certainly have no qualms about joining the chorus of praise for Chairman Greenspan's and the this expansion, but I would like to make two points. First, we should remember that the Australian economy has actually grown faster than the US economy during this expansion. Secondly, the Fed has been prepared to put interest rates up as well as down in its management of the expansion. Interest rates were raised in 1994, again, although by only a small amount, in 1997, and again in a third phase in 1999 and 2000. The US experience argues against a policy of leaving interest rates at their low point for long periods in order to achieve a long expansion. There is another argument I want to address before concluding. For various reasons, a number of people have been keen to put forward the view that monetary policy was tightened because of the impending GST. Some have done this for partisan political reasons, and others because they are still adhering to the view that monetary policy should only be tightened if general overheating is present. Since it is not present, they assume there must be some ulterior motive that has been hidden and therefore seize on the GST. I have said on a number of occasions and will say so again today - monetary policy was not tightened because of the GST. The tightening would have happened without the impending GST, just as it has in the Sweden, etc. We at the Reserve Bank are still operating on the assumption that the GST will affect prices only on a one-for-one basis, and that wages will not be raised to compensate for the GST. The second assumption reflects the fact that reductions in income taxes will more than offset the rise in prices due to the GST. To raise wages as well to cover the GST would be to expect 'double compensation'. There is no economic logic for this and, if it were to occur, it would be an example of the type of imbalance that could threaten the end of the expansion, and therefore threaten the downward trend in unemployment. Wage surges ended two of the past three expansions - it is important that it does not happen again this time. I think good sense will prevail, and that anyone who is encouraging 'double compensation' will think again. I think we have still got a long way to go in this expansion. It is already longer than its predecessors, and if we as a community are sensible and do not allow short-term thinking to overcome our long-term interests, it could rival in length the expansions of the 1950s and 1960s. As for monetary policy, we think it can play a very important part in achieving that end. Inevitably, there will be those who agree and those who disagree with what we are doing. We think, however, that monetary policy should be judged, not by any particular movement in interest rates, which will always be surrounded by some element of controversy, but by its performance over the whole of the expansion.

r000314a_BOA

australia

macfarlane

I would like to start by thanking Mr Brady for his introductory remarks, and his decision to schedule a conference Sydney. It recognises the significance and growth potential of our capital markets, and the generally improved prospects for this region. I see a very impressive list of speakers and participants before me and I am sure there will be a lot of fruitful discussion over the next two days. I would particularly like to extend a welcome to the overseas participants in this Forum. The timing of the Conference is interesting in that it comes at a time when we can safely say that the Asian crisis is behind us and that, with a couple of exceptions, the outlook for this region is good. Perhaps it was Australia's success in withstanding the contractionary effects of this crisis that encouraged to hold its Conference here at this time. Whether that is the case or not, I would like to take the Asian crisis and its spillover to other emerging markets as the starting point for my comments this morning. I do not wish to go over the macro-economic issues because I have already done this before. I would instead like to ask what did we learn from this crisis that was of immediate relevance to capital markets? What are the implications for developed economies such as Australia? My answer to the first question is that we learnt that, for a country to play in the international financial market place, it needs a very sound financial infrastructure. I do not wish to suggest that it was the lack of this which the Asian crisis (the cause lay elsewhere), but it was this deficiency which made the crisis so deep when it occurred. This is quite a demanding list for several reasons. First, it is quite broad and involves the legal system, the Government, regulatory bodies, financial market participants and the professions. Secondly, and more importantly in my view, the achievement of a high standard in each of the items on this list takes a very long time. In our case, some of these things took a century to achieve. In many cases, we look back to periods as recent as the 1980s and wonder why we ever thought that we had done enough. That is one of the reasons I have been sympathetic to our Asian neighbours. It is inevitable that at an early stage of development of a country, its financial infrastructure will be only partly formed. Furthermore, even with the best will in the world, it is going to take time to bring these things up to scratch. When people say that the recent financial and economic instability was the inevitable result of a combination of the free flow of international capital plus inadequate financial infrastructure, there is much truth in the statement. But if that is the case, we cannot expect a sudden return to stability because the second essential component - the adequate financial infrastructure - will take years, or possibly decades - to achieve. The second thing we learnt from the Asian crisis, and its spread to other countries, was the necessity of having deep and liquid financial markets. We also learnt it was an advantage to have a floating exchange rate, and to have a capital market that was diversified and not one that was too dependent on the commercial banking sector. This brings me to the Australian financial system, to the capital markets and to financial markets more generally. The Australian financial system has developed rapidly over the past 20 years or so, with deregulation being a major driver of change. Deregulation started in the late 1970s with the gradual removal of controls over bank interest rates. It picked up speed in the early 1980s, with the removal of other controls on banks, freeing up interest rates on government securities (by adopting tender arrangements for new issues), floating the exchange rate, abolishing exchange controls and opening up the banking system, in the mid 1980s, to foreign competition. Shortly thereafter, bank supervision was formalised, and the Basel framework for capital adequacy of banks was adopted in 1988. The development of the financial markets in Australia is not, of course, the result purely of regulatory change. Financial institutions themselves have taken the opportunity to develop new markets and introduce new products. For example, in 1979 the Sydney Futures Exchange was the first derivatives market outside of the United States to introduce a contract based on a financial instrument when it introduced the futures contract on 90-day bills. Australian financial markets have become larger and more diverse over time and are now regarded as both sophisticated and deep. Turnover in the major Australian markets - - has grown at average rates of more than 20 per cent a year since deregulation. The exception to this rule is the market for government securities, which has grown more slowly than other markets in recent years because of the Government's run of budget surpluses (something that is also happening now in the US). The relatively even pattern of development in Australia reflects both a lack of regulatory distortions or incentives, and the fact that, unlike the entrepot markets in Singapore and Hong Kong, Australian financial markets have a reasonably large domestic economy to serve. As in most countries, the foreign exchange market has the largest turnover, with about $75 billion a day, a little over half of which involves the Australian dollar. The Australian foreign exchange market is the ninth largest in the world and the Australian dollar is the seventh most actively traded, marginally behind the Canadian dollar. To put this in perspective, Australia ranks as the 14th largest economy in the world, so the Australian dollar trades more actively than might be expected given the size of the economy. Its relatively high position globally reflects the place the Australian dollar holds in portfolios of international funds managers because of the opportunities for diversification it affords. The standing of the Australian dollar as a world currency is recognised by its inclusion in the first wave of seven currencies in the CLS System or to give it its full name Continuous Linked Settlement System for foreign exchange settlement which is scheduled to come into operation in 2001. The other currencies are the US dollar, euro, yen, Swiss franc, pound and Canadian dollar. Australia's position in world financial markets was reinforced recently when it was one of four 'significant financial centres' invited to join the G7 countries in the Financial Stability Forum, an inter-governmental group which monitors risks in the international financial system. As a 'systemically significant economy', Australia is also a member of the G20, which has been charged with broadening the dialogue on key economic and financial policy issues globally. This may sound obscure but it is not. We want our voice to be heard in the international forums that make the rules. This was not always the case. Our exclusion from the Group of 10 in the late sixties still rankles. We are determined that it won't happen this time. A major gap in the development of Australian markets until recently was the domestic non-government bond market or corporate bond market. This market, however, has recently grown strongly, representing further welcome diversification for borrowers and lenders. With non-government bonds on issue now totalling about $66 billion, this market is now about as large as the market for Commonwealth Government securities. This development is beginning to produce a 'credit curve' in Australia. Now that bond yields in Australia have moved lower on the back of low inflation in recent years, the incremental pick-up for taking credit risk probably looks more attractive to investors than it might have a decade ago when bond yields were perennially double-digit numbers. The financial infrastructure in Australia has evolved to accommodate this growth of financial activity. Practitioners and the authorities have worked together to ensure that the 'plumbing' kept pace with the system it was serving. In the case of payments and settlements systems, Austraclear and the Reserve Bank's RITS system, which introduced delivery-versus-payment, and then the ASX's CHESS system for equities were important steps forward. They have been inter-linked through the RTGS system to provide a very efficient payments and settlements infrastructure. Australia's RTGS system is among the most advanced in the world because of the way it closely links to securities settlements, giving it a very high coverage of high-value transactions. (Over 90 per cent of transactions by value are settled on a real time gross basis.) We have recently witnessed a major reorganisation of our financial regulatory agencies with the formation of APRA and changing responsibilities for the RBA and ASIC. The reform process is, of course, ongoing. The main item on the agenda at present is the so-called CLERP initiative - Corporate Law Economic Reform Program - which aims to achieve best practice in fields such as - It also aims to facilitate the application of technology to the conduct of business and promote competition in financial markets, including in investment products. The expansion of financial activity in Australia has not been confined to market trading. Holdings of financial assets in general have expanded rapidly. In the early 1980s, holdings of financial assets were about the same size as GDP; these days, they are about 2 1/2 times the size of the economy. The development of financial markets and the financial system has not benefited only the 'big end of town' - if anything, the system has become more 'democratic'. One measure of this is the spread of ownership of equity, with share ownership by individuals increasing sharply in Australia in the 1990s. The Australian Stock Exchange in a multi country survey estimates that 54 per cent of adult Australians now hold shares directly (including through personally managed superannuation funds); in 1991, this figure was 22 per cent. This trend reflects the programs of privatisation and demutualisation in Australia in the 1990s. Another measure of the 'democratising' of the financial system is that practically all permanent employees now receive privately funded superannuation benefits, compared with less than half a decade ago. It is the investment of these funds which has provided such an important stimulus to the growth of the funds management industry over the past decade and a half. The growth in the size and diversity of financial markets makes life rewarding and profitable for market participants like yourselves. But from my perspective, the size, and particularly the diversity, of financial markets are also important. Representing an institution that is responsible not only for monetary policy, but also for financial stability more generally, I am conscious of the value of a strong and diverse set of financial markets and institutions. To illustrate this point, I want to conclude with a few words from Alan Greenspan. In a speech last September on Lessons from the Global Crisis, he went over the experience of a number of countries and attempted to draw some conclusions, which are of relevance to what I have been discussing. In his view (and I will quote): but I apologise for not being able to impersonate his delivery style. 'The mere existence of a diversified financial system may well insulate all aspects of a financial system from breakdown. Australia serves as an interesting test case in the most recent Asian financial turmoil. Despite its close trade and financial ties to Asia, the Australian economy exhibited few signs of contagion from contiguous economies, arguably because Australia already had well-developed capital markets as well as a sturdy banking system. But going further, it is plausible that dividends of financial diversity extend to more normal times as well.' On that note, I will conclude and once again wish you all well for a fruitful and stimulating Conference.

r000522a_BOA

australia

macfarlane

House of Representatives was released on 5 May 2000. It is a pleasure to be here in Melbourne again for our regular half-yearly appearance before the Committee. I know we met in March and touched upon monetary policy, but that meeting was mainly about Reform of occasion, we will no doubt have a lot more time to spend on monetary policy. I would now like to start this meeting in the traditional way by reviewing the forecasts I gave to the Committee last November, and then outlining our current views on likely developments over the year ahead. Last November, with half a year's data available, I said that we expected GDP growth through 1999 to be 3 per cent. In the event, it was 4.3 per cent, which continued our record of expecting a modest slowdown that did not arrive. I also said that we expected growth to be 4 per cent in the year to June 2000, and on present indications this still looks likely, even though the rate may well dip below 4 per cent in the year to March. Of course, it will be more difficult than usual to read the true trends this year, with expenditure being shifted between quarters because of the GST, and the boost from the Olympics. Most monthly indicators of economic activity point to a slowing so far in 2000. However, it is too early to know whether this merely represents the slowdown in domestic demand that we have all been waiting for, and we have had built into our forecasts for some time, or whether it represents something bigger - a significant slowing in GDP growth. Our judgment is that we are seeing mainly the former, namely a change in composition of GDP growth. In other words, the slowing in private domestic demand, which is undoubtedly occurring, will be largely offset by the boost that we are getting from net exports and will soon get from fiscal policy. While we expect some slowdown in GDP in the sense that we do not expect to repeat the 4 per cent average that we achieved in 1997, 1998 and 1999, we still see quite solid growth ahead. We have no quibble with the sort of figures that were contained in the Budget Papers showing growth in GDP of per cent over 2000/01. Such an outcome would be quite a remarkable achievement compared with the record of the past three decades, but I will return to that subject later. On inflation, in November we forecast that the CPI would rise by 2 per cent in the year to December 1999 and by 2 per cent in the year to June 2000. We got closer to the mark in these forecasts - the outcome for the year to December 1999 was a little lower, at 1.8 per cent, and we now think that the figure for the year to June 2000 will be a little higher, at 3 per cent. Some of the increase in the CPI is due to temporary factors, so that the 3 per cent for the CPI corresponds to about per cent for underlying inflation. Thus we have finished the period when inflation was below the bottom of our range - a period that lasted longer than any of us expected - and we have moved back to where the CPI is near the top of our range, but partly due to some temporary factors. Where to from now? This will be particularly hard to judge, given that for at least a year the year-ended figure for the CPI will be obscured by the once-off lift due to the GST, and then the effects of the abolition of wholesale sales tax. At present, we feel that the most likely outcome for inflation once all the dust has settled - i.e. once we are well into 2001/02 - is that it will be in the 2-3 per cent target range, probably in the upper half. As usual, there is a large margin of uncertainty attached to that forecast, but the adjustments to monetary policy which have been made over the past six months give us more confidence that inflation should be contained. I would now like to move away from the short term and turn to the medium term. Most developments in monetary policy can only be understood fully in this context although, by necessity, most commentary concerns short periods such as month to month, in line with our Board Meeting, or even shorter, such as day to day, reflecting deadlines of the daily press. I will start by restating the logic of the inflation-targeting framework, which is the underpinning of our whole medium-term approach. We have an inflation target that says inflation should average somewhere between 2 and 3 per cent in the medium to long run. We accept that at times it will be outside this range, but if we think this is going to happen more than briefly it calls for adjustments to monetary policy which will return inflation to the target and then keep it there. We have based our monetary policy on this framework not because we only care about inflation, but because we think it will give us the best result for the whole economy in the long run. In particular, if applied sensibly, it will enable the economy's average growth rate to reflect its potential growth rate and therefore deliver the maximum sustainable increase in employment and living standards. We have already seen nine years of expansion with growth averaging over 4 per cent, a considerably longer expansion than we were able to achieve in the 70s and 80s. And there is every prospect that the expansion will continue for a good deal longer. For the first time in my working life, Australia in the 90s has come near the top of the decade growth rates among developed countries. We grew faster than the United States, and only Ireland, among developed countries, recorded faster growth. This growth occurred at a time when our inflation rate averaged about 2 per cent, a good deal lower than in earlier decades, and comparable with international standards. There was also less variability from year to year in growth than in earlier expansions, although some variability is inevitable: we have had annual growth rates at over 5 per cent and at less than 3 per cent during this expansion, yet its fundamental momentum has remained intact. I think the system has proved itself to be a very good one, and I am confident that it is the best way to ensure that monetary policy makes sense in the medium term. It is also worth noting that during the course of the expansion, we have had one complete cycle in interest rates - rises in 1994, then falls in 1996-98. These played their part in sustaining the expansion. The increase in official interest rates of 125 basis points that has occurred over the past seven months has to be seen in this context. For the present expansion to continue as long as possible, monetary policy has to be adjusted as circumstances change. The economy has been undergoing a shift from a period when inflation had been below the target to one where it was going to be in the target range. Without policy adjustment, there was the prospect that it would, in time, rise above the desired range. Until relatively recently, we were receiving information on economic activity that indicated the economy could even have been accelerating beyond the per cent growth that had prevailed over the 1997 to 1999 period. From our perspective, the decisions to raise interest rates were relatively straightforward. The situation is not as straightforward now. Signs of a near-term acceleration in growth have gone. As discussed earlier, there are now signs of slowing domestic demand, some of which may be in response to the tightenings that have already occurred. Other things being equal, this should be helpful in containing inflationary pressures. Other developments, principally the lower exchange rate, will act in an expansionary direction, and potentially put upward pressure on inflation. It will be a difficult time for reading and forecasting the domestic economy, and all this will take place against the backdrop of an international economy dominated by the uncertainty of the unfolding events in the United States. Markets, as always, will be looking for guidance. The more thoughtful will appreciate the complexity of the situation, the less thoughtful will be expecting to be told the 'formula' that we are using. Unfortunately, there is no 'formula' other than the guiding principle of the inflation-targeting regime. This means that we will be assessing the outlook for inflation as judged by the factors which form the basis of our forward-looking approach to monetary policy. Growth in demand and output, and the extent to which that places pressure on the economy's capacity, are clearly important. We judge this by examining all the available monthly and quarterly time series data on economic activity, including those which give an impression of intangible factors like 'confidence'. We monitor trends in commodity prices, wholesale prices, and wages, as well as the CPI and the various measures of underlying inflation derived from it. The wages data may be particularly important in the year ahead, given the difficulties in interpreting price indexes. We have to allow for structural changes - such as the increased competitive pressure in goods markets. This has been an important ingredient in maintaining downward pressure on many prices, and should be helpful in negotiating the introduction of the GST. Inflation expectations are important - since it is the anticipation of price rises that drives many decisions. We need also to consider the financial side of the economy - the expansion of credit, trends in asset markets and the extent of risks which may be building up there. We then complement this essentially domestic analysis with an appreciation of what is happening in the international environment in which Australian producers and consumers make their decisions. We can not afford to ignore the world price level, world interest rates, or the variable which connects both of them to the Australian economy - the exchange rate. Changes in the price of imports in foreign currency terms can have a large impact on domestic inflation as the OPEC oil price rises of the 1970s showed. The recent oil price increases demonstrate the same principle, on a much smaller scale. Rises in a range of raw materials prices, driven mostly by global trends, are also having an impact on the cost of producing goods in Australia. In the opposite direction, the subdued world price environment of 1997 and 1998 helped contain any inflationary fallout from the lower exchange rate we experienced during the Asian crisis. Movements in the exchange rate clearly affect inflation and, as such, are an integral part of any inflation-targeting regime. That is why they are frequently mentioned by central banks which operate monetary policy in this way. But there is no mechanical relationship between the level of the most frequently quoted measure of the exchange rate - the rate against the US dollar - and the future domestic price level. For a start, the price effects are better approximated by the trade-weighted index. Second, a temporary movement in the exchange rate may have little or no effect on prices and so some attempt must be made at estimating medium-term developments, or at least market participants' expectations of medium-term developments. Finally, a change in the exchange rate may have different implications if it primarily represents international views about our economy and policies, or if it is because we are being swept along with other countries in an international adjustment process. All of these factors are relevant and have to be taken into account with due weight. But that is done under the unifying framework of the inflation-targeting approach to policy. As I have noted above, this approach has delivered tangible benefits. I am convinced that it will continue to do so. Mr Chairman, it is a difficult time to be making monetary policy. The world environment is changing. Most of these changes are for the better - our region is in recovery, as opposed to the severe recession of two years ago, and global growth is strong. Our terms of trade are improving. Some other changes - in world capital markets, for example - are rather less benign for Australia. Adapting to these changing circumstances presents a challenge. At such times, it is important to keep our eye on the main goals - to sustain a long expansion, and to address early potential imbalances which could impede the expansion's continuation. However, we cannot assume that we have a choice of outcomes for the Australian economy, in terms of growth and inflation, which is invariant to what happens in the rest of the world. While we are benefiting from the stronger world growth compared with recent years, we will also be affected by the contractionary effects of the lift in world interest rates. As the forecasts I mentioned in the beginning show, the year ahead will most likely be one of slightly reduced growth, and somewhat higher inflation, compared with the exceptional outcomes of recent years. But if we can sustain the economic expansion through a tenth and eleventh year, even if its pace moderates for a time, and at the same time keep inflation low, we will have achieved something which has eluded us for three decades. That is a very worthy goal. It is what we aim to do.

r000526a_BOA

australia

macfarlane

It is a great pleasure to be in London again speaking under the auspices of Australian Business in Europe. The last time I spoke to this group in London was in mid-1998, which was very close to the low point of the Asian crisis. My main purpose on that occasion was to reassure investors in the City that Australia would get through the Asian crisis in reasonable shape. As you are, no doubt, all aware, the results were better than any of us could have predicted at the time. The economy continued to grow at 4 per cent plus, inflation remained low and, although the balance of payments deteriorated, it was temporary and not all that different to what has occurred on a number of other occasions in the past 20 years. The international situation is a lot different now. Most of the Asian economies are growing again and world output growth is a good deal stronger than in 1998. At the same time, the structure of world interest rates has moved up, as has Australia's. Whereas two years ago the focus of attention was on Asia and other emerging markets, the focus now seems to be more on the United States than in any earlier stage I can remember. I would like to take the opportunity today to update some of the things I said two years ago, but to do so in a way which focuses on medium-term developments. I will take as my starting point a comparison of economic growth rates of developed countries over the most recent decade. These figures from the OECD show that except for Ireland, which everyone in this audience would know is a very special case, the Australian growth rate has been higher than for any comparable OECD country. (Incidentally, each of the countries in this list experienced a recession at some stage earlier in the decade, which helps explain why the decade averages look a bit lower than the growth rates that we have been accustomed to over the past few years.) For me, however, the interesting thing about this table is that this is the first decade in my working life where Australia has figured in the top half of the table, let alone being virtually in the top position. We must have been doing something right. One of the things that we are doing right is that we have kept the 1990s expansion going longer than the expansions of the 1970s or the 1980s. The 1980s expansion was quite a strong one but it turned down midway through its seventh year. The 1970s expansion was a much weaker one even though it lasted a bit longer. The 1990s expansion shown in the diagram covers the eight-and-a-half years to December 1999, but we are confident that it has continued through the ninth year, and by the time we reach the September quarter we will be in our tenth year. So, sustainability of the expansion is the first key to our improved performance. The second key is improvements in productivity. Here, if we use the simplest measure of productivity, which is labour productivity, the pattern in Australia is very similar to the pattern in the United States: strong growth in the 1960s, a flattening out in the 1970s and 1980s, followed by a pick-up in the 1990s. But the pick-up in the 1990s in Australia has been more pronounced than in the United States. We have gone from 1.7 per cent per annum to 2.9 per cent per annum, whereas the United States went from 1.5 per cent per annum to 2 per cent per annum. I do not want to suggest that this means we have higher productivity than the United States; remember we are only talking here about rates of change of productivity. The fact that we have been able to speed up more than they have is, in large part, because we were starting from a lower base. Whilst I am on the subject of productivity, I want to make two general points: The first is the obvious one which I have made on numerous occasions that the main reasons behind the pick-up in productivity growth have been structural changes made over the past 15 years in the Australian economy which have increased flexibility and competitive pressures. These changes include: It has not been easy to put these changes in place, even though there has been for most of the decade considerable bipartisan political support for change. Inevitably, compromises have had to be made and, viewed in isolation, some of the individual changes do not look to be all that thorough. But taken together, I think the total is larger than the sum of the individual parts. Of course, one aspect of the economy that was not reformed during this period was the tax system. But that will change in about a month's time when a Goods and Services Tax is introduced to replace the old wholesale sales tax and to take some of the weight off income taxes. The second point about productivity I want to make concerns the new economy/old economy divide. Some people tend to judge a country's technological sophistication by, for example, the number of listed companies in the IT sector. Although Australia has a number of companies that fit this description, about 70 or so in fact, their combined share of the stock market is not large by international standards. But that is only one measure of technological sophistication. Another equally important one is the country's or the business sector's willingness to embrace new technology. This may be a better guide to productivity improvements than focusing only on the IT sector. I have two measures of the spread of technology: So, in terms of willingness to adapt to new information technology, Australia would get a very high score. This, along with the measures I mentioned earlier, helps to explain why there has been such a significant lift in the rate of growth of productivity over the last decade. A big lift in productivity growth has a beneficial effect on many areas of the economy. A lot of it is passed through to consumers and, in the process, this makes it easier to maintain low inflation. Some of it can also make businesses more profitable, which is, after all, the incentive that drives much of the efforts towards improving productivity in the first place. The two broadest measures of corporate profits as a percentage of GDP in Australia have been trending up over the past decade, with profits after interest showing a much sharper rise than profits before interest, again another indirect benefit of low inflation. You will note that this measure of corporate profits is adjusted for privatisations. If that had not been done, the lines would have trended up more sharply because of the significant number of privatisations that have occurred over the last decade. Largely as a result of these privatisations, the percentage of the population in Australia who are now direct shareholders has risen sharply and is exceptionally high by world standards. The proportion who hold shares directly is 41 per cent. I have not got a table of comparisons with me, but I believe this figure is now about as high as in the United States. If we added to the number who directly hold shares, the number of people who voluntarily hold shares through equity unit trusts (or mutual funds, to use US terminology), the number would go to about 54 per cent. And, of course, if we added in those who contribute to an accumulation pension fund, exposure to shares would be almost universal. Can I turn now to inflation? If we look at an international ranking of inflation rates over the past decade comparable to the one I showed for real GDP growth, Australia finishes in the middle of the field with an average inflation rate of 2.3 per cent per annum. This is a huge improvement on previous decades, but, of course, virtually every country has also shown a significant improvement. There are a number of factors behind this improvement, but the one I would like to mention today is our monetary policy regime. Like a number of English-speaking countries - the UK, Canada, New Zealand - Australia has a monetary policy regime which is based on the trilogy of an inflation target, an independent central bank and a floating exchange rate. Our inflation target is not all that different from that of the UK in that we aim for an average inflation rate of somewhere between 2 and 3 per cent over the long term, recognising that it could go above or below that range from to time, but like the UK, it is the average that matters. One consequence of lower inflation in Australia is the convergence of our bond yields to international norms, or at least the US norm. Some of you may have been able to remember that as recently as a decade ago, Australian government bonds were 400 basis points higher than US government bonds. We think of that as the bad old days, but if you were an international funds manager, you may look back on it as the good old days. Another factor that has contributed to the improved acceptance of Australian government paper is the recognition that our fiscal policy is very responsible by international standards. The Budget has been in surplus for some time now. This, together with the proceeds of the privatisations I referred to earlier, has meant that the outstanding stock of government debt has fallen in absolute terms, and as a percentage of GDP is now the lowest among developed countries. I am not sure how fully aware international investors are of these excellent figures on growth, inflation, productivity, public debt, etc., so I have taken the liberty today of indulging in a bit of trumpet blowing. One economic fact, however, that markets are aware of is that Australia always runs a substantial current account deficit and, therefore, is a net importer of capital. I have nothing very new to say on this subject other than to point out that it is the result of private agents' decisions rather than government's demands on capital markets, and that its magnitude has not changed very much in the last 20 years. It has varied cyclically, of course, but around a basically flat trend. At its cyclical low points it tends to be about 3 per cent of GDP, and at its high points a bit over 6 per cent. In this cycle, which was heavily influenced by the contraction of our Asian markets, the deficit touched 6.1 per cent of GDP in the September quarter of 1999, but has since fallen noticeably. The conditions are right for further falls over the next year, given that exports are now growing rapidly again (up 19 per cent over the last 12 months). The medium-term issue, of course, is whether the capital we are importing is being put to good use. The output growth, the productivity growth and corporate profit story suggest that it is. So far this year, exchange rates have been in the forefront of attention. For the first few months of this year, the Australian dollar declined quite sharply against the US dollar, more so than other major currencies. More recently, it has been a bit steadier, while a number of other currencies have weakened more noticeably against the US dollar. With firstly the euro, then the pound, then some other smaller currencies joining in, the position of the Australian dollar is now not so lonely. With the United States being perceived as the country most likely to need higher interest rates, we should not be surprised by an international adjustment mechanism which has seen other currencies all falling by a somewhat similar amount against a rising US dollar. Turning to the medium term, these developments have meant a fall in the Australian Trade-Weighted Index or effective exchange rate over the course of 2000. The more noticeable thing, however, is that since about the second year of the period of floating in Australia, i.e. since about 1985, the Australian dollar in effective terms has fluctuated around an essentially flat trend, with its present value being near the low end of this range. I think I have taken enough of your time on the medium term. Turning briefly to the period ahead, we expect that the current expansion will continue into a tenth and eleventh year, i.e. for the length of our current forecasts. Beyond that, the outlook is too distant for us to forecast. We are conscious that the reason we have done so much better this time than in previous expansions is that we did not let the usual late-cycle imbalances develop. The most common of these, of course, is inflation. We are confident that our early action on monetary policy, plus our adherence to the discipline of the inflation targeting regime, will mean that we continue to maintain low inflation in the years ahead.

r000810a_BOA

australia

macfarlane

It is a pleasure to be here in Brisbane to not sure that I will have much to say about leadership, but I hope that my comments will be of interest and relevance to those attending today. I would also like to thank the is to be congratulated for running this excellent series of lectures. I would like to take the opportunity today to restate the underlying logic behind our approach to monetary policy. My reason for doing so is not that it is intrinsically difficult, and therefore in need of repetition in order to aid understanding. It is because the logic is essentially medium to long-term in nature, and hence tends to get lost in the day-to-day welter of economic statistics and associated commentary. For those whose interest is in the details of the current economic statistics, we will be publishing our quarterly review, , next week. Our approach to monetary policy, like that of a number of other countries in similar positions, is based on the achievement of an inflation target. This says that over the medium term, inflation should average somewhere between 2 and 3 per cent. We recognise that it will not always stay in this range - that is why it is expressed as an average over the medium term. The actual adjustment of interest rates, of course, is done on the basis of our assessment of the outlook for inflation, including a central forecast and a judgment about the balance of risks. But if we have done the job well, we should be able to look back and see that over a reasonable run of years inflation has averaged 2 point something per cent per annum. So far in stating our approach I have not mentioned economic growth or employment, but there is a reason for approaching things in this order. It is not because we downplay the importance of growth and employment - we certainly do not, and in any case our Act makes it clear that to do so would be contrary to our mandate. We approach monetary policy in this order because there is overwhelming evidence to suggest that countries can only have sustained expansions if they are accompanied by low inflation. It is the sustainability of the expansion which is the key to maximising economic growth and employment. Thus, another way of expressing the aims of a monetary policy based on inflation-targeting is to say that its aim is to maximise the length of the economic expansion. A cynical observer might say that it is all very well to emphasise the length of the expansion as the crucial test now that we all know that the current expansion has been a long one. But this is an approach which we have had for quite a long time. I remember explaining it to a Parliamentary Committee in early September 1996 immediately before I took up my present position. I think there is a reasonable consensus forming in Australia, as there is in a number of other countries, that inflation-targeting is a good approach to monetary policy. The most persuasive argument in its favour is that the results achieved so far have been very good. The current economic expansion, which started in the September quarter of 1991, has already lasted longer than its two predecessors and, on current indications, still has a fair way to go. Graph 1 shows the expansions which started in the 1970s, 1980s and 1990s. For the current expansion, the figures only go up to the length of our expansion is very similar to the much better known US expansion - ours has lasted for 36 completed quarters 37 completed quarters. During this time, economic growth has averaged 4.1 per cent per annum, with inflation averaging in the low two's. So the good result on inflation was not achieved by sacrificing our growth performance. While a lot of countries have done well over the past decade, the Australian performance stands out. We have grown faster than other comparable countries inflation rate puts us in the middle of the field. Table 1 shows that only Ireland, which had very special circumstances, grew faster than Australia. In short, the results suggest that the inflation-targeting approach to monetary policy has been successful in achieving its aim. Also, the fact that Australia has been virtually at the top of the international growth league, while achieving a respectable middle order ranking on inflation, shows that we have not over-emphasised inflation control at the expense of economic growth. While I think there is now a consensus that the inflation-targeting approach to monetary policy makes sense, there is always room for disagreement about how it is applied in practice. Such differences of view are part and parcel of the normal policy debate, and we of course participate in it and listen to other views. In passing, I should say that I think the debate is carried out in a much more civilised way these days, compared with a number of earlier periods I can remember. I attribute this improvement to the fact that there is now wider agreement on the underlying model than in earlier periods. Nevertheless, differences of view remain, and I would like to say a few words about some of them today. The first area where there is always room for differences of view is on how to interpret the many individual pieces of economic data that come in virtually every day. How important is any particular statistic? Is it indicating strength or weakness? Are there special factors that have to be taken into account before it can be interpreted? Does it have any implications for monetary policy? This 'bottom-up' approach is widely used and it means that there is almost daily discussion in the media and elsewhere of the current and future strength of the economy. My observation over the past four years is that the bulk of people expressing a view on this subject invariably argue that the economy is weaker than the Reserve Bank judges it to be. There are very few on the other side to act as a balance. The majority of people who present a view think that the Reserve Bank has a recurring tendency to over-estimate the strength of the economy. This view is quite wrong: the fact is that we have consistently under-estimated its strength. You only have to consult my half-yearly appearances before the Parliamentary Committee to see that on every occasion I have had to explain to them why the modest slowdown in growth that we forecast did not arrive. The correct way of summarising the various views is to say that the Reserve Bank has under-estimated the strength of the Australian economy, while its critics have under-estimated by a larger margin. This is not unusual. There is a tendency during the expansionary phase of the business cycle to be unduly influenced by the inevitable signs of weakness in some of the individual indicators and hence to lose sight of its underlying strength. There is a tendency for people to not be able to see the wood for the trees. This is true of most economists, bureaucrats, politicians, the press and, as I pointed out above, central bankers are not immune from it. It is one of the reasons why historically there has been a tendency to leave the tightening of monetary policy till too late in the cycle. By then, various imbalances - particularly, but not only, inflation - have become established and policy has had to be tightened by a larger amount than if it had been done in a more timely manner. This has been an important contributor in many countries to shortening the expansion phase or to making the contraction deeper and so producing a boom-bust cycle. That is why if the central bank wants to have any hope of getting its timing right it has to move ahead of public opinion. This will mean that the tightening phase will inevitably attract criticism from various quarters and will be labelled by some as unnecessary or, at least, premature. That is why governments have entrusted monetary policy to independent Average annual rate since 1990 central banks - in order to ensure that monetary policy is insulated from day-to-day political pressures, and to make it clear to the public that this is the case. A second area where differences of opinion are often expressed is on how to reduce the level of unemployment. Now, in my opinion, there are a lot of policies that have a role to play in this task, one of which is monetary policy. There was a time not so long ago when economic purists, including some central bankers, often denied that monetary policy could affect unemployment - in their view, monetary policy only affected inflation. You will be pleased to know that I am not a member of that school. Bad monetary policy can certainly make unemployment worse, so it follows that good monetary policy can make it better than it would otherwise have been. What is the best contribution that monetary policy can make to lowering unemployment? My answer is that the best thing it can do in the long run is to provide the conditions which maximise the length of economic expansions. We do not want a seven or eight year expansion followed by a serious recession as we have had in the past. The damage to unemployment occurs during recessions. The significant rise in unemployment that occurred in Australia from the early 1970s to the early 1990s was not due to a prolonged period of weak economic growth, it was due to the fact that we had three relatively short periods of recession, each of which resulted in a big lift in the unemployment rate. To repeat, it is not the insufficiency of growth during the expansions which accounts for Australia's current rate of unemployment - it is due to the sharp rises that occurred during the recessions. To illustrate by reference to the US again: during our current expansion GDP has grown at a rate of 4.1 per cent per annum in Australia, compared with 3.7 per cent in the US; over the same period, we have reduced our unemployment rate from its peak by 4.6 percentage points compared with 3.8 percentage points for the US. The fact that their rate at 4.0 per cent is lower than ours at 6.6 per cent is entirely due to their lower starting point, which was due to the relatively mild nature of their early 1990s recession. In short, it is clear that the best thing that monetary policy can do to reduce unemployment is to prolong the expansion and delay and reduce the size of any subsequent recession. On occasion, that means tightening monetary policy early to forestall inflationary pressures, as an alternative to more vigorous application of the brakes when inflation has built more momentum. A third question which could be asked about our approach concerns Australia's potential growth rate. We are, I think, rightly proud of our growth performance during the current expansion, especially of our average of per cent per annum since mid 1997 when we were hit by the Asian crisis. But some may ask why we think 4 per cent is a good result - maybe the economy was capable of growing a good deal faster without pushing up inflation by much. We have all heard of Australia's improved productivity performance in the 1990s, so why can't this allow us even more There are two answers to these questions - a mechanical one and a policy one: The mechanical one is that the potential growth rate is determined on the supply side of the economy by the growth of the labour force and the rate of labour productivity. While the second of these is now about 1 per cent per annum higher than in the 1980s, the first - the growth of the labour force - is 1 per cent per annum lower. This is largely due to lower growth in the working-age population, and a much smaller rise in the participation rate as the female participation rate is now already quite high and the male participation rate is declining. So the improved productivity trend has contributed to higher living standards, but its effect on total GDP growth has not been as marked. The more important answer is the policy response; it is one that I gave three years ago at a time when a number of critics were claiming that the RBA would not permit the Australian economy to grow by more than 3 per cent per annum. The answer then, as it is now, is that we do not have firm views about a speed limit. Our tightenings or loosenings of monetary policy are determined by the inflation outlook. If the economy wants to grow faster than it currently is, and inflation is not showing any tendency to rise to the point where it could threaten our medium-term objective, then we would not restrict the economy's growth. That was true three years ago, and it is still true: the difference is that now inflation has moved up, whereas three years ago it was moving down. The rise in inflation over the past year, though a little larger than forecasters had expected, is not an alarming event. But it is a reminder to us that it would have been unwise to continue with the stance of monetary policy we had in mid 1999. Monetary policy at that time was at its 'maximum-expansionary' setting for the decade, and in our view some degree of tightening was going to be needed if we were to successfully manage further progress in the expansion. A number of other countries reached a similar conclusion over the past 18 months for reasons not very different to the ones I have outlined above. I have tried to give an outline of how the inflation-targeting approach operates and how it contributes to improved performance, not only on inflation, but also on output and employment growth. The outline is necessarily broad and I am afraid it will disappoint those who wish to have answers to specific questions such as why did we raise rates in one month rather than the next? - or why did we raise rates by 50 basis points rather than 25? Inevitably, the answers to these questions involve an element of judgment. But the truth is that the answers are not very important in the medium term. Rather, it is the average level of interest rates that matters. Have we allowed them to stay too low and so encouraged the build-up of an inflationary process, or have we raised them too high and so set in train a contractionary or deflationary process? These are the important questions, and any judgment on them must be based on the medium-term performance of the Australian economy. This may not be a simple task, but I would suggest that a favourable judgment would require that the macroeconomic performance of the Australian economy be better than in earlier decades, and that it stand up well in comparisons with the experience of other countries over the same period.

r000911a_BOA

australia

macfarlane

Ian, just taking you up on the reasons for the fall in the Australian dollar I'd like you to elaborate a little bit more if you could, and could it be that the world looks at Australia and says you are facing a very big technology import bill in the next ten years because you are not generating enough technology yourself and technology development yourself and to maintain the standard in this new economy will require huge imports of technology and we are being marked back accordingly? The first thing to say is no-one can really explain or forecast the exchange rate with any element of accuracy. No-one has ever produced a model that can explain month-to-month or quarter-to-quarter or even, I would probably suggest, year-to-year. You can explain very big movements over cycles but it is very difficult to explain small ones. There is a tendency, I think, when the exchange rate falls, for people to say first of all that they think they can't explain it, and then the second reaction is to go back and say well it must have been caused by a number of things which they have always thought was a shortcoming of the economy. But, in nearly every case, they are shortcomings that have been around for nearly twenty or thirty years and that's why one of the common explanations we heard about a month ago was "oh, it's the current account". Well, if it was the current account, why wasn't it happening last year when we had a bigger current account than we've got this year. I think some of these other structural ones, like that one Bob mentioned, are things that have been with us for a long time. We have always been an importer of technology and I don't really think that that particular characteristic of the economy has changed quickly enough or recently enough to explain the fall in the exchange rate in the year 2000. Although, I suspect there is one aspect in which that explanation does have some content in that I think there has been a change of preferences where people, because of the success of the US economy, probably now place a greater weight on technological factors than they did before. The aim of the game really is - the reason you have technology - is to improve productivity and we have been doing that; we have been improving productivity at a faster rate than just about anyone. I think what matters at the end of the day is how fast you improve productivity and how fast profitability goes up with employment and all those other good things. It's unlikely that there's a huge range of countries that can be really at the cutting edge of all forms of technology and I think maybe we should do better than we've been doing. We have had some successes, we've got some areas where we have been quite good, maybe we should do better. I'm not suggesting for a minute that we shouldn't do better and that we shouldn't put more resources into innovation and science and what have you. But I do have trouble in thinking that's the explanation for the fall in the exchange rate in the year 2000. You mentioned in your speech that for whatever reason, if you have a lower dollar, it can cause damaging effects. What will the lower Australian dollar mean to monetary policy? I was wondering when someone would ask that. Bob, you recognise of course, that I really can't give a very precise answer to a question like that. We're just among friends here, we won't tell anyone. Well I can tell you the sign of the co-efficient we are talking about. Well good. Well I think we all know that a weakening currency tends to put upward pressure on inflation, and also puts upward pressure on domestic activity. So we know that, other things being equal, there will be some pressure on inflation, but we don't know whether we are talking about a situation which is important enough or big enough to warrant a response. Although we would know what direction the response would be in. In order for us to get a better feel to really be able to give a firm answer on that, we really have to get some understanding of how the exchange rate would pass through into final goods and service prices. And of course this depends on a variety of things; it depends very much on how strong are competitive pressures and what is happening to the price of domestically produced goods for example, that are competing with imports. The most important one of all, I suppose is, we need to know whether the movement in the exchange rate is short lived or long lived. We have to make some assessment of what will be the reaction of wages; that has to be a forecast of course, you can't wait until you've found out what's happened there. And of course there's a heap of other things that are influencing inflation, as well as the exchange rate. For example there are other external factors, the price of oil being an example. And there's a whole host of domestic factors. But, I am not sure I can really say a lot more than that at this stage. Well we have been very specific about the GST and our view on that has not changed. Our view on the GST was that we will assume that it will lead to a once off lift of a specified amount and that once that lift has occurred, inflation will go back to its normal rate because people who are setting prices and wages will not try and build that into ongoing inflation. We still believe that is a sensible assumption and as far as we can see everything that's happened in the two and a bit months since the implementation of the GST suggests to us that that assumption is probably firmer now than when we first made it. I'm now going to throw the questions to you. I might say that anyone who asks a question to give me their name and organisation and I'm going to loose a lot of friends over this but first preference will go to the delegates and not the press. So, first To what extent, if any, do you think the outward investment flows by perhaps portfolio managers or unit trust managers in particular into the US market in recent years has been an influence on your exchange rate? It is a concern that several other countries in the region have had in terms of the way the rampant Nasdaq market, until recently, has sucked in capital from overseas and helped subsidise their current account deficit. I don't know whether I can give a firm answer to that other than to say I think this is an influence that all non-US markets have experienced to a greater or lesser extent and I don't know that I could hazard a guess as to whether we have experienced it to a greater or lesser extent than every other country. I don't think there is any reason to believe that it has happened on a bigger scale here than has happened elsewhere. That's the best I can come up with. There has been over the whole period of the float, if we go back to 1983, there has been in Australia a long term movement towards international diversification of portfolios by funds managers and so as each year has gone by they have held, I suspect, a slightly higher proportion in offshore assets than domestic assets, and that has no doubt had some long term influence. But I don't know that we have had any special propensity to suddenly diversify towards US tech stocks to an extent greater than any other country. We've seen some comment coming out of New Zealand recently about the longer term viability of them retaining their own currency. Would you care to speculate as to whether there is a long term future for the currencies of relatively small economies like Australia, Singapore, you could nominate any number, or do you think that there's a possibility that there will be a growing convergence into currency blocks? It's definitely true that there are a number of countries which have tried to operate a floating exchange rate system unsuccessfully who are now very attracted towards currency boards or dollarisation. This is a widespread view in Latin America and, of course, we've seen in Europe the European Monetary Union have the same effect. By and large, countries that have successfully run a floating exchange rate regime are comfortable with keeping it. Now, I think the New Zealand case is interesting because I think the debate in New Zealand is not specifically about their exchange rate regime. It ends up getting back to that, but I think the debate in New Zealand is really on a much broader issue of can a country of 3 3/4 million people have a whole lot of independent features. Is it worth having them when there is another country which is nearly six times as big next door - in GDP terms six or seven times as big. So I think in my understanding of the New Zealand debate, the centre piece of it is this worry about them being small and being peripheral; about their best people, the brain drain to Australia; about their stock market about to be absorbed by you, Maurice. I think that this is the essence of the debate in New Zealand. And when they start thinking that way, one of the manifestations where it comes out is - "well perhaps we are already integrating more and more with Australia, why don't we just go the whole hog and have the same currency". I think that that's the way the debate has gone there. It hasn't started with their unhappiness about a floating exchange rate, which is where it started in Latin America. It's really about size and viability and that's what's dragged the exchange rate into the discussion. Ian, do you think we have got enough size and viability? And talk about brain drains and things. Yeah. This is always the next question when you look at New Zealand very sympathetically. And you start to see the way they're thinking and the advantages that they see. Then someone comes along and says, well, what's the next step, does that mean Australia should do the same. Well, I don't think that - certainly in terms where Maurice's question started from which is exchange rates - I don't think there is a very strong case there at all. The US is a very different economy to ours, it has a very different structure of its economy and has different external shocks. There's no case at all in my view. And in fact you only have to think how we would have performed over the last three years if we had had the US dollar as our exchange rate. I think we wouldn't be talking about the economic growth I am talking about, or a 28 per cent increase in exports. We would be talking about something that was pretty sick. I think in terms of exchange rate you can't make the jump from the New Zealand/Australia debate to Australia/US debate but in terms of other aspects of the economy, where everyone around the world people are worrying or wondering about a world where all the best and brightest (not all but a lot of people are to go where the big money is). I don't know if I can answer that but I know that monetary policy is not going to solve that problem. : While the recent weakness in the Aussie dollar has baffled most observers including most of us here, it has been explained widely as the Australian dollar being caught up in the downdraft consequent upon the sell-off of the Euro. Given that we were, until recently, linked to the currencies of our major trading partners in the region this connection with the Euro is even more baffling than the weakness in the Aussie dollar. I was wondering whether you could comment on that? I started by saying that no-one has a model or an equation that can forecast the exchange rate. The irony is that the Australian dollar was one of the few that was more forecastable than the others. There was more medium-term predictability in the Australian dollar than in the US dollar or the yen or the deutschemark. But even there, as I said, you cannot forecast on a quarter-to-quarter basis or even a year-to-year basis. And one of the reasons is that these markets become attracted to a particular rule of thumb and run with it for a while and then, when no-one can predict, drop that one and get attached to another rule of thumb. For a long period, the Australia dollar was regarded as being a "dollar bloc" currency and there was a tendency for people to think it would move relatively closely with the US dollar. And over most of its life as a floating exchange rate currency, if you graph the Australian dollar against the US, against the Euro (and we have to create a synthetic Euro if you go back against the US), there was some similarity. We did have this characteristic and we were often referred to as a "dollar bloc" currency. There was a period not that long ago when, for some reason, we went for a year very close to the yen. If you graph the Australian dollar/yen rate there was very small deviation. People were actually saying we were working on a yen standard. In the Asian crisis, we got judged, probably quite fairly and logically by the international community as being a country which was dependent on Asia. And so our exchange rate went down, to nowhere near the same extent as the crisis troubled Asian economies, but there was similarity in movement. And now we have got this situation where, in terms of day-to-day movements and within day movements, in fact hour-to-hour movements, we have this unusual situation of whenever the Euro weakens we tend to weaken with it, although not to the same degree recently. Over the last couple of days the Euro has been a good deal weaker than we have, but we have tended to weaken with the Euro. I'm afraid I can't provide a logical explanation for that any better than anyone in this room can provide a logical explanation for that. This is a question about Australia's monetary relations with New Zealand. At the end of last week, the Prime Minister, Helen Clark, announced at a press conference in New York, that as a result of her country's currency weakness and recent other developments, she has had a change of mind and is now advocating a monetary union of Australia and New Zealand and the introduction of a common currency. What is the feeling right now on this subject in Australia? New Zealand ...(not audible)... took a great debate, is this country ready to consider a monetary union with New Zealand? As to the New Zealand attitude, all I know is from one newspaper cutting. I have just got back from Switzerland this morning, so I haven't really been following local events closely for about the last four days. So all I know about the New Zealand position is one newspaper cutting that was sent to me, which is the one I think you are referring to David - the Prime Minister, Helen Clark, saying this is something that should be seriously looked at. Whereas in the past, I think that she has tended to dismiss it. Our attitude has always been that it is essentially a New Zealand decision. I think the benefits or the costs are going to be borne almost exclusively by the small member of the partnership, particularly if the ratio of the partnership is, as it is in our case, 1 to 7. I think that we would be cooperative but we would see it as being predominantly a decision for New Zealand to make. And I think that's been our attitude all the way along. I wish to ask the Governor, because we have a Currency Board in Argentina, I would say the behaviour of the current account is showing that, for example, with a currency board exports of goods, merchandise exports have doubled from 1994 so far. And this year they are increasing at 14 per cent with the fixed rate back to the US dollar. I see a difference with factorial movements and the situation is very similar to Australia. So the current account deficit is mostly explained in Australia and Argentina by the factorial movements that to say interest payments, profit remittances and intellectual property rights and so on. In my view, there is a reflection of the long term savings performance of the economy. I believe there is not enough savings in the domestic economy (not audible) that in the long term run you have this deficit in the factorial movements and perhaps, in the case of Argentina you have, I would say how you would we have a higher risk premium, because we have a ...(not audible)... board and perhaps in the long term performance in the case of Australia you have the depreciation of the dollar. I wish a comment by the Governor about this. We do have a low household savings ratio in Australia. That's a feature of most of the Anglo Saxon economies, the US has even a lower one; Canada, New Zealand, the UK have highly deregulated financial systems and low household savings ratio. I don't think it's a function of the exchange rate regime. I think it is either cultural or a function of the sophistication of the financial systems. That would be my answer to that. Thanks Ian. Our time has elapsed. It has been a fascinating discussion. Ian started by reminding us some features of the Australian economy that you tend to forget but then in the end we had a discussion as to why the dollar had fallen. We have canvassed a vast number of reasons and probably have not got to the conclusion as to why it has fallen. I guess everybody has their views many of you would know my views about the matter which I write in The Australian each day but, very clearly, there are different views. There is one thing that Ian said very definitely though. There is not going to be a fall in interest rates. It's very clear that if our inflation was to rise as a result of the falling dollar, Ian would be under considerable pressure. Thank you Ian for being frank about your views. We appreciate it very much and could you put your hands together in the normal way. Thank you.

r001109a_BOA

australia

macfarlane

I am very pleased to have been asked to the third time in Melbourne. When deciding on a topic for tonight, I realised that it would be very difficult to discuss the Australian economy without spending some time on the exchange rate and the various reasons advanced for its recent fall. So I have decided to plunge in and devote the whole speech to this topic. Obviously, we have been doing a lot of thinking about it, and I will see if I can say something useful about it in the 20 minutes I have available tonight. The exchange rate has behaved during 2000 in a way that no-one predicted. There used to be some elements of predictability for the Australian dollar in that its broad movements could usually be explained by changes in our terms of trade (or its close relative, commodity prices) and the difference between domestic and foreign interest rates. The relationship was not close on a month-to-month or quarter-to-quarter basis, but it could explain the large swings. This broad relationship is shown in Graph 1 which compares the predicted exchange rate and the actual exchange rate using an equation which has been used in the Bank over the years. (By the way, there is nothing unique about this equation as several of the large banks active in the foreign exchange market have also used is that, on the basis of previous experience during the floating rate period, we could have expected a rise in the exchange rate in 2000. Instead, we have seen a fall and the gap between actual and predicted is over three standard deviations - the largest in the past fifteen years. Something therefore has changed, at least for the present. Another way of making the same point is to say that the Australian dollar has never previously shown a significant fall with economic conditions as they presently are. Over the course of 2000, we have had a strong world economy, improving Australian terms of trade (rising commodity prices), a buoyant domestic economy, a declining current account deficit, a fiscal surplus and rising domestic interest rates. In the past, a significant fall in the Australian dollar has coincided with the opposite - a weak domestic economy and world economy, and falling commodity prices. It has also usually occurred against a background where there has been widespread public criticism of fiscal and monetary policy for being too expansionary. None of these elements is present on this occasion. The comments I have made so far have treated the year as a single development, but I think it is possible to distinguish two phases. For the first seven months or so, the biggest influence on the exchange rate was the expectation of what was going to happen to Australian and US interest rates. The predominant view was that the strong US economy would mean that US interest rates would rise more than those in other countries (including Australia), and this contributed to a strong US dollar and falling Australian dollar. Any suggestion that the Australian economy was weakening (or the US economy strengthening) led to a fall in the Australian dollar. In the first seven months of the year, virtually all of the large movements in the Australian dollar could be explained this way. For example, on two occasions, a weak monthly retail trade figure caused the Australian dollar to fall by more than one US cent in a day. Our forthcoming examines this in detail. The irony of this situation was that this process actually involved a misinterpretation of the Australian economy. The signs of weakness that were seized upon were anomalies; the underlying economy remained very strong, incipient inflationary pressures were starting to appear, and during this period our interest rates were raised, as it turned out, more or less by the same amount as those in misinterpretation prevailed and the currency fell. Over the six months from late January, the Australian dollar fell by 11 per cent against the US dollar and 8 per cent in trade-weighted terms. The second phase occurred from around mid year, when it became widely expected by the market that the US economy was going to have a soft landing, and that no further increases in US interest rates were likely. As a result, the market's expectation of future interest differentials moved in a direction favourable to Australia. Had the foreign exchange market continued to behave as it did in the first half of the year, the Australian dollar would have risen, but it did not. It steadied for a while, and then fell appreciably from mid August. It was this period that convinced a lot of people that some new factor must be at work, which was overwhelming the normal determinants of the exchange rate. It was also in this period that the alternative explanations were put forward most volubly. Before getting on to some of the newer explanations for the currency's movements, it is worth looking at some more conventional explanations. The first of these is the strength of the US dollar itself, which has been the biggest reason behind our recent experience. This has affected us in a mechanical sense in that if the US dollar is rising, the currency on the other side of the bilateral exchange rate must fall. We have been part of this, as is shown by the fact that the Australian dollar has fallen more against the US dollar than in trade-weighted terms. There has also been an indirect effect in that the rising US dollar has affected the investment preferences of many market participants in an extrapolative way which I will discuss later. The US dollar in 2000 has risen against the currencies of all other industrial countries, although its rise against the yen has been relatively small. These two currencies - the US dollar and the yen - have been the strongest currencies in 2000, and they happen to be our largest trading partners and so have the largest weights in our trade-weighted index. Interestingly, the newer explanations for currency movements are largely based on the assumption that countries with strong currencies will have characteristics similar to almost the opposite to the United States - weak economy, barely positive interest rates, massive fiscal deficit, trade surplus and an economic culture based on conventional manufacturing. I do not wish to dwell on these differences, other than to note that they show the dangers of coming up with a general explanation of exchange rate movements which turns out to be only applicable to one country or one period of time. The second explanation relies on the well-known tendency for exchange rates to be driven by momentum. That is - once a trend has been established, for example, by the events in the first half of the year - it tends to continue and thereby to overshoot the level implied by fundamentals. There have been many documented examples of this, and market participants often place weight on this factor when explaining movements in exchange rates. I have no doubt that this has been an important factor over recent months, as it has been on several earlier occasions in our past. A related market rule of thumb that has appeared this year, but was entirely absent last year, is the one which relates movements in the Australian dollar to movements in the euro. The good thing is that these trends and rules of thumb do not continue indefinitely, and the further the exchange rate departs from fundamentals, the more likely it is that some unforeseen event will come along to jolt the rate into a new direction. The third conventional explanation gives prominence to Australia's external position - the current account deficit and the accumulation of foreign debt and other liabilities. This explanation emerges whenever the Australian dollar is falling, and then goes into hibernation whenever it is rising. The problem with this explanation is that our external position has been relatively stable over the past decade or more, and so it is difficult to use it as the explanation for an event that only occurred as recently as this year. Over the past decade, the current account deficit has cycled around an average of about per cent of GDP, and our foreign debt has stayed a little over 40 per cent of GDP. It is true that total external liabilities to GDP has risen, but against this, the ratio of debt servicing to exports has halved over the past decade, and the current account deficit itself has been declining during the period of the falling Australian dollar. I think it is very difficult to make the case that our external position has recently deteriorated, or that it is the explanation for the falling Australian dollar in 2000. While I am generally sceptical that this year's events can be explained by a sudden focus on trends in the current account position, it may be more promising to think about developments from the perspective of capital flows. If, for one reason or another, investors found Australia a relatively less attractive destination for their funds, compared with some other destination - e.g. the United States - we would expect that this will have implications for the exchange rate. Some will want to assert that this occurred because people suddenly focused on Australia's current account, but this seems unsatisfactory because the recipient of the flows - the United States - is seeing its current account deficit expand to unprecedented size. In fact, as a share of GDP, Australia's current account deficit is well on the way to being smaller than its US counterpart, yet the US dollar has been rising, and the Australian dollar falling. So to make sense of what has been happening, it is necessary to think in terms of capital flows being driven by changes in the perceived returns in the different countries. In the remainder of this talk, I would like to examine this apparent shift in capital flows, and to think about whether it is temporary or permanent. There are two reasons put forward for why overseas investors may now have a smaller appetite for investing in Australian assets - the first applies to debt and the second to equity. On Australian debt, whether at the short or long end or whether private or public, current interest rates are now lower than formerly was the case. For a good part of the past two decades, Australian interest rates were well above US rates, as we struggled to get Australian inflation back to a respectably low rate. Even when inflation fell, a number of years passed before the fall was finally reflected in inflationary expectations and interest rates. As a result, it was only over the past three or so years that Australian interest rates lost their longer contain a premium, investors' appetite for them has declined, and so the demand for Australian dollars to buy them has fallen. On the surface, this sounds plausible, but we should ask why have rates fallen. Surely they fell because Australian debt became more attractive to investors. Whereas in 1994 rates of 300 basis points above US rates were required to get investors to hold our bonds, they now do so willingly at rates only slightly above US rates. Clearly, the simple form of this argument has a few logical gaps. However, there does seem to be something at work here - perhaps due to differing appetites for Australian bonds on behalf of local compared with foreign investors - because there has been a reversal in recent years of the former high levels of capital inflow into Australian bonds. In the five years between June 1992 and June 1997, these inflows averaged $4.3 billion per year, whereas over the past two years there have been outflows of $5.2 billion per year. The second argument, namely that there has been a change in preference by equity investors, is a relatively recent one, but it has been put forward very forcefully. It essentially says that equity investment (direct and portfolio) is less attracted to Australia than formerly since we are viewed as an 'old economy' because we do not have a big enough exposure to the new growth areas, particularly the information and The contrast is drawn between the United States, which is seen as the 'new economy', and other countries, including Australia and Europe, which are seen as the 'old economy'. Let me say at the outset, there are two questions at issue - first, do a substantial number of providers of capital think this way? - and second, is there economic substance to the contrast between the two types of economy? There can be little doubt that the answer to the first question is in the affirmative - this line of thinking is very widespread at present, and therefore has no doubt been an important recent influence on our exchange The argument essentially says that, since Australian interest-bearing securities no rate. The answer to the second is, in my view, in the negative - the differences between the two types of economy - 'old' as applied to Australia and 'new' as applied to the United States - have been greatly exaggerated and the similarities ignored. This is important because if there is not fundamental economic substance to the view, it will not last - it will be seen as a phase through which capital markets passed. I would like to spend the remainder of my time tonight explaining why I believe this is so. The thing that stands out about the economic performance of Australia and the United States over the past decade or the past few years is not the contrast, but the remarkable similarity. For an investor, the most likely place to make money is where there is strong growth and a rapid increase in productivity. The United States is justly proud of its performance in these two areas, but the one comparable country in the OECD area that can match it - in fact, exceed it - has been Australia. I have shown the growth and productivity figures before, so I will not repeat them again, but will rely on a US source to make my point. October Bulletin sets out to explain the remarkable recent pick-up in US productivity and to contrast it with 16 other OECD countries. It is an excellent and thoroughly researched article which broadly achieves its objectives, but it keeps finding an irritating exception. Whether it is growth of labour productivity, growth of multi-factor productivity or the extent of capital deepening, Australia matches or exceeds the excellent US performance, rather than sharing the lacklustre performance of the majority of other countries. But proponents of the 'new economy' view would reply that they are not interested in the whole economy, they are interested primarily in the ICT part where the United States unquestionably is the world leader. But only 3.9 per cent of the US workforce is employed in the ICT sector (the comparable figure for make an assessment of a country by concentrating on the 3.9 per cent and ignoring the other 96.1 per cent is a question I cannot answer. On a similar note, the willingness to adopt new technology is surely the key to improving productivity, and here there are a number of indicators that place Australia very high in the world rankings. A recent OECD publication on this subject finds that, among the 27 or so OECD countries, Australia is: third highest in ICT expenditure as a percentage of GDP; sixth highest in PC penetration; eighth highest in internet hosts per 1000 population; third best in internet access cost; and third best in secure web-servers for electronic commerce. Not surprisingly, we do not match the United States in most of these measures, but we are almost always in the top quartile or higher, suggesting that among OECD countries we should be regarded as being towards the top end of the range in willingness to embrace new technology. Again, the proponents of the 'new economy' view find this reasoning unconvincing. They tend to concentrate on the production of the ICT sector, and give Australia low marks for not having more resources in this area. While there is no doubt that the very sophisticated fringe of ICT, as exemplified by Silicon Valley, would be an asset to any country, most of the production side of ICT is much more humdrum. In fact, the country with the highest share of GDP derived from ICT is for example, both have higher shares. The United States has outsourced a good deal of the production to less sophisticated countries with lower cost structures, with the result that the United States now has the largest deficit in trade in ICT of all countries. helps make the point that a policy of trying to direct resources into ICT, particularly its production at the expense of other aspects of the economy, could be self-defeating. It would be all the more disappointing if such a policy were sold on the grounds that it would be a constructive response to the current fall in the exchange rate. Perhaps the biggest weakness with the 'new economy' argument as an explanation of exchange rate movements can be found in the recent behaviour of the US dollar and US investments. It is frequently asserted that the reason the US dollar is rising is because everyone wants to buy US equities, particularly tech stocks, because that is where the high returns are. In fact, anyone who followed this approach this year would have been disappointed. Not only were they buying into something with an already high price and low yield, they would have seen the prices fall noticeably over the year - the Dow by 5 per cent and the NASDAQ by 16 per cent. the same period.) To the extent that the US investments made positive returns, it would have been only due to the appreciation of the US dollar itself, not to the assets purchased, which turns the underlying reasoning on its head. The Australian dollar has shown some big swings in both directions since it was floated in 1983. This is the fourth time in that era that the Australian dollar has fallen by more than 10 per cent in trade-weighted terms in a year. On each of the earlier occasions, it seemed at the time that the fall would go on forever, and there were plenty of people who had explanations to support its continuation. However, on each occasion, it recovered and it will do so again this time. The principal reason for the fall over recent months has been the rising US dollar, which has affected us directly and indirectly. Another reason is to be found in the interaction between the early fall based on expectations of interest differentials plus the intrinsic tendency for foreign exchange markets to continue to go in one direction, i.e. to overshoot, and to come up with explanations to justify the overshooting. Finally, over recent months, there has been a tendency for markets to judge countries and their exchange rates by the 'new economy model'. Ironically, this is exactly the period when US technology stocks have languished. I should now conclude by saying something about the implications for monetary policy. Monetary policy will continue to be conducted according to the medium-term principles contained in our inflation-targeting approach. This means that the exchange rate will be taken into account, along with the other variables that contribute to our inflation outlook (where this is appropriately defined to exclude once-off factors such as petroleum prices and the GST). On the other hand, as can be seen from our current behaviour, we have no intention of departing from our medium-term approach in an ad hoc attempt to push up the exchange rate for its own sake. The period ahead will contain many uncertainties, both here and abroad, but we have coped with uncertainty before. Over the past year, we have had the unusual combination of strong domestic growth, a falling current account deficit and a declining exchange rate, all of which are conducive to future growth. We still have to ensure that the medium-term outlook for inflation stays on track - which means making sure that several temporary factors have only a 'once-off' effect and are not reflected in the ongoing inflation rate. If we succeed in doing that, we will be in a good position to continue the expansion we have had since 1991.

r001201a_BOA

australia

macfarlane

Governor, in testimony to the House of was released on I would like to start by endorsing the remarks of the Chairman and saying what a pleasure it is to be in Wagga Wagga for the first hearing to be conducted outside Sydney, Mr Chairman, I think it sets a good precedent for future meetings, even if it does represent a cautious start, given that Wagga Wagga is half-way between Melbourne and Sydney and not that far from Canberra. Perhaps the Committee will be more adventurous in its future choices. I would also like to record our thanks to the Mayor of Wagga Wagga and his colleagues and to Kay Hull (a member of this Committee) for their hospitality earlier this morning. As usual, I would like to start by reviewing the forecasts I put before the Committee at the previous meeting in Melbourne in May. Starting with economic growth , you may recall that the Australian economy grew by about per cent per annum in 1997, 1998 and 1999, and, as usual, we were expecting a modest slowdown in the year to June 2000. The forecast I put forward for that period was 4 per cent, and the outcome was 4.7 per cent, continuing our tradition of modest underestimates of economic growth. For the year to June 2001, I said that we had no quibble with the figure of 3 per cent contained in the Budget Papers, nor would we quibble with the recent update which puts it at about 4 per cent. It is largely a matter of rounding, and not much should be made of small differences: the figure is meant to suggest again some modest slowing from past growth rates. I would note that the number for GDP growth involves a substantial slowdown in final domestic demand - from about 6 per cent growth to about 3 per cent - which is mostly offset by a further swing in net exports into positive territory and the assumption that the inventory rundown recorded over the past year does not occur again. inflation , the story is a little more complicated. Last time we met, I said I expected the CPI to rise by 3 per cent in the year to June 2000 - the actual outcome was 3.2 per cent. Not a very big difference, but the first time for quite a while that the outcome was higher than forecast. The reason for this was the higher-than-expected oil prices. When we look ahead, we should make sure our forecast goes beyond June 2001 in order to avoid the 'once-off' lift to the price level attributable to the GST. At the last hearing, I suggested that inflation could be in the upper half of the 2 to 3 per cent range once we are , which was released about two weeks ago, forecasts that inflation would be around 3 per cent by that time. This small increase is primarily due to the lower exchange rate now prevailing compared with the middle of the year. You are probably tired of being reminded that we are still in the longest expansion we have had for three decades, but that fact has to be the starting point for any economic discussion. When we receive the September quarter national accounts in a couple of weeks time, I expect to see them confirm that the expansion has continued unabated into its tenth year. During this period, the growth rate has averaged 4.2 per cent per annum, and most of the annual rates have been between 3 per cent and 5 per cent, with a few outliers above and below this. Over the whole period, inflation has remained low, which, of course, has been a major factor behind the expansion's longevity. And, in turn, this has contributed to a fall in the unemployment rate of nearly 5 percentage points to 6.3 per cent. Despite this record, we should not become complacent - we should always be looking ahead to see where the risks to the outlook are likely to come from. Not surprisingly for an economy like ours, which is in reasonable balance, the risks are on both sides. That is, while we are comfortable with our present forecast, there are circumstances which could lead to a stronger economy and hence a speed-up in inflation, and others that could lead to a greater slowdown in economic activity than our current numbers indicate. I will start with the risks to the inflation outlook. Obviously, the current year has not been an easy one in this respect. In addition to the GST-induced lift in the price level - which was easily foreseeable and appears to have gone according to plan or better - we have experienced two upward 'shocks' in the form of the rise in oil prices and the fall in the exchange rate. It is never easy to digest three such events in one year, so we have to be especially vigilant to make sure that any rise in prices is 'once-off', and ongoing inflation does not rise to the point where it threatens our medium-term objectives. So far, we seem to be on track to pass this test. The GST caused a smaller rise in the September quarter CPI than expected and, on balance, the data on wages suggest that wages are growing in a way consistent with our inflation target. But there is still some way to go before we can be confident that these temporary factors do not push us off course. If it turned out that the economy was more buoyant than we think, the chances of the shocks feeding into higher ongoing inflation would rise. I will now talk about risks that the outlook for economic activity could be weaker than we currently envisage. But before doing so, I should remind you that our forecasts already embody a slowing in GDP growth compared with last year, and a more pronounced slowing in domestic demand. So we are not oblivious to the presence of some factors which point to a less buoyant outlook than we have had over recent years. The first of these risks is the world economy, and the United States in particular. For some time now, most observers have expected lower growth in 2001 than in 2000 for both the world economy and the United States, but there is always the risk that the turnaround could be sharper, particularly if there is a shake-out in asset prices. No-one can be sure that, after such a long expansion, the United States can achieve a soft landing, but at present the odds point to this result. On the domestic front, the area of weakness that many people point to is in housing construction. There is no doubt that there will be a big contraction here, but we should remember that it was predictable (and has been predicted by virtually all forecasters for some time). We have just gone through a period when activity in the housing sector was really quite frenzied. At its peak in the June quarter, investment in dwellings was at its highest level ever as a percentage of GDP. A lot of activity in the housing sector that would normally have taken place this financial year was brought forward into last financial year in order to get in before the GST, so the cycle in housing is likely to be more pronounced than normal. The rises in interest rates, no doubt, also played a role, but they were small compared to the GST effect. The third risk that some people have focused on is business confidence. We have to be careful here because we have over a dozen surveys of business confidence and they do not all show the same results. Even so, it is true to say that business confidence is not as high as it was a year ago and that it has fallen in recent months. I think the recent fall owes a lot to the realisation that the housing and construction sector will be weak, to the fact that a number of businesses have only recently had to face up to the practical implementation of paying the GST, and to rising petrol prices. What does the foregoing mean for the economy and for monetary policy? Starting with monetary policy, our main message is that it will continue to be conducted according to the medium-term principles contained in our inflation-targeting approach. We think this approach has served the economy extremely well, not only in the direct sense that it has maintained low inflation, but in the wider sense that it has provided the preconditions for sustainable growth. We will be looking closely at all the influences on inflation over the coming year - including the demand pressures in the economy, the growth of wages, and the level of the exchange rate - in order to judge how they will collectively influence the outlook. Monetary policy will then be set accordingly. We will also, of course, be closely watching developments in the real economy, the labour market, financial markets and our exports and imports. There is a wide range of statistics available on an almost daily basis, from the Bureau of Statistics and from other sources, which chart the course of these economic variables. You only have to read the daily press to see how much attention is paid to these statistics. We at the Reserve Bank, of course, follow them in great detail, something we are able to do because we have a good staff and a lot of experience at examining them. But I want to suggest to you that this sort of data gazing, important though it is, is only one aspect of assessing likely developments in the economy and, on its own, can at times give misleading signals. The problem with statistics is that, as well as containing systematic information, they also contain a fair bit of random variation and sampling error. Sometimes this means that we get a group of strong statistics arriving together or a group of weak ones, which may signify nothing more than the statistical anomalies referred to above. If we rely only on these statistics to form our view of the outlook, we run the risk of regularly swinging from optimism to pessimism and back again, depending on relatively short-term variation in the data. Obviously, other approaches are needed to augment exclusive reliance on statistical observation and so help to identify the underlying direction of the economy. There are many advocates of approaches such as sophisticated econometric modelling, extensive industry liaison, and examination of leading and lagging indicators or the forecasts embodied in financial prices. All of these have their merits and can provide a broader perspective. But there are two other approaches that I would like to remind you of. The first is to go back and examine previous expansions and ask what were the imbalances that brought about their demise, and then to see whether those imbalances exist at present. I did this earlier this year in a speech in where I identified a number of domestic imbalances in previous cycles: high inflation, a wage surge, overvalued asset prices, excessive physical investment and excessive credit growth. Not all of these were present towards the end of earlier expansions, but usually two or more were. In looking at the Australian economy at present, it is hard to see evidence of any of these imbalances. Underlying inflation is about 2 per cent, rising to 3 per cent over the forecast horizon. Wages are growing at somewhere between 3 and 4 per cent. The share market has risen over the year, but does not seem overvalued compared with many overseas markets. House prices have risen over recent years, but appear to be stabilising at present; rises in commercial property prices have been quite restrained. There has been no evidence of over-investment or over-capacity in plant and equipment or construction. Credit to households is still growing strongly, but appears to be moderating. Credit growth to businesses has not been unduly strong at any stage in recent years. Overall, I think it is hard to find signs of the type of imbalances that occurred in the early which led to such unhappy results. Many people would add the current account of the balance of payments to my list, and point out that in the later stages of previous expansions, fast economic growth led to a widening in the current account deficit. Again, we are different this time in that the buoyant domestic demand growth we have experienced over the past year has been accompanied by a decline in the current account deficit. Of course, I have only listed domestic factors that give rise to imbalances and imperil the expansion. As I said earlier in my introduction, the world economy plays an equally important role, but we have no control, or even influence, over that. It is possible to construct disaster scenarios for the world economy, and no doubt some will, but I am comfortable sticking with the majority in assuming a modest slowdown in world growth or, in current parlance, a soft landing. No two economic expansions are the same; each of the previous ones differed, and the present one has its own unique features. As a result, we cannot rely only on cyclical comparisons such as I have just presented, but they are a helpful part of any overall assessment. A second approach, which I think is a useful reality check, is to look at how the present setting of policies is affecting the economy. On monetary policy, there is a tendency for attention to be focused on changes in interest rates, even when each change is quite small. It is at least as important to look at the level of interest rates in nominal and real terms, and ask whether their present setting involves a significant risk that the economy will overheat or contract. As you know, a year ago we thought that the continuation of the then setting of interest rates would risk the former outcome. That is why we moved to our present setting, which we would characterise as being in the neutral zone, i.e. not presenting either of the two risks to any substantial extent. Because it is in this zone, there is no overwhelming case to move it in a particular direction at present. Overall, the main point for present purposes is that you could not claim that the current setting of interest rates is inhibiting the growth of the economy. Another important influence on the economy which is often put under the heading of monetary policy is the level of the exchange rate. I do not wish to spend much time on this subject today because I devoted a whole speech to it less than a month ago. Suffice to say that I do not think there is anyone who would deny that the current level of the Australian dollar makes our exporting and import-competing industries super-competitive, and hence it is exerting an expansionary influence on the economy. On fiscal policy, the need to more than compensate consumers for the imposition of the GST ensured that it moved in an expansionary direction between last financial year and the present one. Again, I think we can all agree that, even though the budgetary position will remain in surplus for medium-term purposes, the current stance of fiscal policy is not imposing a contractionary influence on the economy. Overall, therefore, I conclude that because the economy has not developed the imbalances of the past, it has not been necessary to attempt to remedy them with the sort of counter measures in the fiscal and monetary areas that were often needed in the past. This is another way of saying that we have, in my opinion, avoided the boom-bust cycle in economic policy, and hence have an excellent outlook for the coming year. I have no further comments to make on the economy at this stage, but will be happy to answer your questions. The only other point I would like to make concerns the economics of banking. In the past, we have often provided to the Committee a paper on some banking subject, such as bank margins or bank fees and charges. On this occasion, there is no special paper, but we have recently finished a major study, in conjunction with the ACCC, on interchange fees in credit and debit card schemes. We will be happy to answer any questions on that study.

r010410a_BOA

australia

macfarlane

It is a pleasure to be here in Melbourne speaking to the Economic Society again at this very interesting time in the evolution of the world economy, the Australian economy and our monetary policy. With so much happening, I trust you will find what I have to say about our current economic circumstances and monetary policy of interest. There has certainly been a remarkable change over the past four or five months in virtually everyone's view of the economic outlook. I think the biggest change is at the global level, where forecasts for economic growth in major countries have been lowered. The most important economy, and the one that has been leading this reassessment, is the the rest of Asia is also feeling some chill trade winds. The process of monetary policy easing that began in the United States in early January has now spread to Canada, the Japan, many other Asian economies, and, of course, Australia. The Euro area is the exception. In a medium-term sense, we should not be surprised that after such a long global expansion, some aspects of the business cycle are reasserting themselves, or that developments in the US economy are playing such a leading role and attracting so much attention. As always, the evolution of the international business cycle and international financial markets has a major bearing on economic developments in Australia and therefore for Australian monetary policy. But there have been some very unusual developments in Australia which call for explanation, and which also have had implications for our monetary policy. Before returning to the bigger picture, I would like to spend some time on these unusual developments. I have frequently said that under the inflation-targeting approach to monetary policy, our aim was to maximise the length of the economic expansion and, as a corollary, to delay and minimise the severity of any downturn. Over the past decade, monetary policy, helped by other policies, has been relatively successful in this endeavour in that the current expansion has been longer than its predecessors in the 1970s and the 1980s. And when I last spoke publicly on this subject towards the end of last year, I expected this state of affairs to continue. Like virtually everyone else who follows economic developments in Australia, I was surprised and disappointed to learn what the national accounts had to say about our growth performance in the second half of 2000. The grounds for optimism about our growth prospects, which were shared by most private sector forecasters, have been spelled out on a number of occasions, but let me recap briefly: the Australian economy had strong momentum - it had been growing at about per cent for a number of years, yet it had not built up any of the imbalances that are common late in an expansion; inflation, although rising slightly, was moderate, as was the growth of wages; asset prices, although on a rising trend, were not obviously overheated and the balance sheets of the corporate and financial sectors were in good shape; a similar situation applied to physical investment, which meant the risk of excess capacity developing was minimal; the current account of the balance of payments was being reduced under the influence of rapid export growth; the fiscal impact of the various tax measures associated with the introduction of the GST was expansionary by all the conventional measures; and although monetary policy had been tightened, the level of real interest rates was not high by historical standards, credit was easily available, and the exchange rate had fallen to a point where it was very competitive. Of course, there were some worrying signs, but they seemed less significant than the factors listed above. Households in particular had taken on a lot of debt by their past standards, though not by international standards; they were also having to cope with higher oil prices. There were a few rumblings from falls in the US share market which had been going on since March 2000 but, other than that, the mood in the United States was still confident. Business surveys showed substantial falls in confidence in the second half of 2000, just as they had in 1998, and employment fell for a time, but these things were consistent with a slowdown, not a contraction. There was also the inevitable uncertainty surrounding the GST and the So the question is: Why was there such a sudden reversal in the second half of the year, particularly the December quarter? Economies as well balanced as the Australian economy was at mid 2000 do not just run out of steam: there has to be a reason, or perhaps several reasons. I think it is now generally recognised that there was one overwhelming reason for the change in direction. The feature of the national accounts that leaps out is the extraordinary role of house-building in explaining the weakness of GDP. This was surprising in one sense, because house-building only accounts for 5 per cent of the economy. But its decline in the second half of 2000 was so pronounced that it meant that the figure for the total economy showed a decline of 0.4 per cent at an annual rate. If we take out house-building and look at how the other 95 per cent of GDP performed, we see that it rose at an annual rate of over 4 per cent. This is much the same as its rate of growth in the previous year. Now I do not want to suggest that there was no slowing in some other sectors of the economy, but if it was not for the extraordinary behaviour of house-building, the story would be in line with most observers' previous expectations. Similarly, the behaviour of aggregate employment in the second half of 2000 can largely be explained by the construction sector and those parts of manufacturing supplying it. Why did house-building have this extraordinary pattern? I do not think there is anyone who doubts that it was due to the bringing forward of house-building pre 1 July 2000 to beat the GST, and the subsequent dearth of house-building in following quarters. We all knew this transition effect was occurring, and our forecasts showed substantial falls in house-building in the second half of 2000, but not falls big enough to outweigh everything else that was going on in the economy. The size of these falls was truly outside the range of previous recorded experience, and that is always difficult to forecast. Incidentally, similar large shifts in expenditure on housing did not happen in the other countries we had looked at that Let me make a disclaimer before I go any further, lest anyone think I am trying to blacken the name of the GST and imply it was all a horrible mistake. I have always thought that a GST is a good thing for the economy, principally because it could take some of the weight off the high marginal tax rates on middle incomes in Australia. I still do support it and note that it will still form an important part of the Australian tax system beyond the next election. My only point is that when making a major reform, such as a tax reform, the transition effects associated with implementing such a large change are nearly always unpredictable and cause short-term dislocation. But that is not a reason not to do them, otherwise we would never get any reform. I will now turn to monetary policy. Since early February, the Reserve Bank has reduced the overnight cash rate by 125 basis points to 5 per cent. A number of people have pointed out that this is an uncharacteristically large reduction over such a relatively short period of time. Why have we seen the need for such a My response revolves around two points. First, even though the outlook for the economy remains positive, the risks on the downside have increased this year. Second, the continuing good inflation performance of the economy provides scope for the Bank to be pro-active in trying to minimise these risks. Let me begin with the risks. The principal circumstance that has changed in recent months has been international, not domestic. All countries, at about the turn of the year, started to revise down their expectations relatively quickly for the year ahead. The reductions in forecasts for growth were not drastic, but they applied to most countries, and hence to the world economy in aggregate. The reassessment was centred on the United States, with Japan and other parts of Asia prominent. It cannot be denied that the fall in share prices in the United States, which was largely matched by falls in European and Asian exchanges, played a significant role in this reassessment, just as their earlier buoyancy had held up economic activity. As a quarters quarters to to result of the reassessment, the year 2001 so far has been one of monetary policy easings around the world, just as its predecessor had been one of monetary policy tightenings. The reduction in forecasts for world growth is not alarming - for example, the IMF is forecasting growth of 3.4 per cent in 2001, compared with growth of 4.8 per cent in 2000. But forecasts are still probably being revised down and the balance of risks has definitely shifted to worries about a larger downturn. This is seen most clearly in the capital markets, where investors are moving out of equities into bonds, and some banks are becoming more cautious in their lending behaviour. On the other hand, labour markets around the world have so far shown very little deterioration. The second risk relates to the domestic situation. I have already explained that the major change to our circumstances was that we now needed to factor in the 2.2 percentage point subtraction from GDP that was caused by the fall in housing in the second half of last year. Why should this be important if it has already happened? Indeed, you could make a case to say that if the world economy had continued to grow at the same pace that it did in 2000, the housing effect would have been purely transitory, even if it was much bigger than we or anyone else expected. But the world economy has slowed, which makes this reasoning somewhat academic. It is unlikely that such a large contraction in housing, and attendant falls in demand for those industries supplying the housing sector, could occur without some wider ramifications. I pointed out in my testimony to Parliament in December last year that I thought the contraction in housing (even though I did not know how big it was at the time) was the major reason for the fall in business confidence. We saw a similar setback to expectations recently when consumer confidence, which had held at above-average levels until March, fell sharply in the latest survey, which unfortunately was taken a few days after the release of the December accounts and was heavily influenced by the publicity surrounding it. The other domestic change that influenced our thinking on monetary policy was the lower outlook for inflation. The December quarter CPI followed the pattern set in the September quarter in showing a level of inflation well below our expectation, and implied that our forecasts for inflation would need to be revised downwards. As I have noted earlier, this gave scope for monetary policy to be eased more quickly than would have been possible on earlier occasions. Over most of the past 30 years, the classic dilemma for monetary policy was that, even when there was a need to ease on domestic activity grounds, there were often still strong inflationary pressures which cautioned against doing so. One of the many benefits of a low-inflation environment is that it restores to monetary policy a degree of freedom that is denied in a high-inflation environment. With inflation not imposing a constraint, it has been possible for the Bank to respond quickly to the need for a significantly lower level of interest rates. That is, we needed a level of real interest rates that was unambiguously expansionary, just as it had been in the period from mid 1997 to end 1999. The actual mechanics of getting from one level to another is a secondary issue. Whether to move by 25 points or 50 points, whether to move between meetings or not, or whether to have a pause or not, are essentially tactical issues related to market perception, rather than fundamental economic ones. It is the medium-term effect of the level of real interest rates, not the number or size of individual changes, that matters for the development of the economy. So once we realised that a significantly lower level was required, our aim was to move there as quickly as was practicable, without unduly unsettling markets. We have traversed a very difficult period. We knew well before we entered it that the second half of 2000, which included the introduction of the GST and the Olympics, was going to be difficult to forecast. We also knew that, even while we were living through it, it was difficult to assess developments, especially as we had the added complications of rising oil prices and a falling exchange rate. A great range of surprises was possible, but now that the period has passed, we know what the surprise was, and it is now part of history. We also know with reasonable confidence that housing should pick up strongly through the remainder of the year. Looking at the broader picture, the major influence on our outlook is the world economy and, inevitably, the biggest influence on this will be the US economy. Obviously, there is nothing we can do to influence world economic developments, but what we need to try to do is to foster as much resilience in the Australian economy vis-a-vis the world economy as we can. For a start, we can move to a stance more supportive of growth, and we have done so over recent months with monetary policy, using the scope to do so provided by good inflation performance. More fundamentally, we should have some resilience given that, in several respects, we have a better starting point than the United States. We did not have the extent of share price appreciation over the past couple of years that the United States had, and therefore we have not seen the unwinding of this that they have recently experienced. The United States has had an investment boom which has created some excess capacity in some sectors, whereas in Australia there is no such problem. In Australia the current account deficit has been falling, and is back at the low points seen over the past 20 years, whereas in the United States it is at a 20-year high. The Australian dollar is low, and hence supporting economic activity, whereas the US dollar is high, and hence dampening US growth prospects. This inevitably brings me to the exchange rate. The behaviour of the Australian dollar over the past 15 months has been difficult to explain, and those attempting to do so have moved from explanation to explanation as developments have changed. There has been no doubt, however, that over the past month much of the fall has been due to the general gloom that accompanied the release of the December quarter accounts, and this should fade as they are put into perspective. Of course, the other explanation has been the strength of the US dollar, which is in itself a bigger puzzle than the Australian dollar. We were told last year that the US dollar strength was due to the strength of the US economy, the high returns from investing in US equities, and the rising interest rates. In 2001, all three of these factors have gone into reverse, yet the US dollar is over 5 per cent higher than at the end of last year. There is not much doubt that a lower US dollar would be better for the United States and the world economy in general. The fall in the Australian dollar has been, in my view, an overshoot. It is not something I look upon with any comfort. But it is also something which we could not hope to prevent in the short term, short of drastic measures which in our judgement were not in the best interests of the economy, especially given the risks to growth from abroad. At its present level, or even one appreciably higher, the Australian dollar confers a major competitive advantage to Australian producers and has contributed to an exceptional performance by the traded sector. Although exports may not be able to keep up this growth rate over the next 12 months, they should still help to underpin the economy. To conclude, developments in the world economy obviously pose a risk to economic performance in the near term. Since there is little we can do to change that, we must focus on managing our own affairs in Australia in the best possible fashion. Monetary policy has been eased, in recognition of the changing circumstances, and should prove to have some expansionary influence over the period ahead. Domestically, the major risk we face is that public confidence over-reacts to the fact that we are not going to be doing as well as we did a year ago, or, somewhat perversely, to the lower exchange rate itself. But, in order to put these things into perspective, we should remember that the large list of positive factors I gave above still applies - we still have strong export growth, sound balance sheets in the corporate and financial sectors, asset markets which are not overheated, no over-capacity in physical investment, low inflation and macroeconomic policies that are exerting an expansionary influence on the economy.

r010511a_BOA

australia

macfarlane

Governor, in testimony to the House of was released Mr Chairman, a lot has happened in the economy since we last met in Wagga Wagga at the beginning of December. This has resulted in a significant shift in the stance of monetary policy. I think I owe it to the Committee to give a full account of these developments and the thinking behind our reactions. There were two major changes to the economic landscape that occurred shortly after we met in December. The first was that the outlook for the world economy changed rather sharply in a downward direction at the turn of the year. This was mainly a result of developments in the United States, but it was widespread enough to cause significant downward revisions to world growth prospects. The second major change was that it became apparent that the Australian economy had been a lot weaker in the second half of 2000 than we had formerly thought. Although this was information about a period that had by then passed, and was mainly due to a transitory factor, it had significant implications for the development of the economy in the period ahead. I would now like to explain these two developments more fully, then move on to our monetary policy reaction, before concluding with some comments on the current outlook. The slowdown in the US economy is something that had been widely expected for a few years, but the economy kept surprising everyone by powering ahead. Almost six months ago, it became apparent that the slowdown was in process, and had the potential to be very pronounced. The United States had several economic imbalances that, fortunately, we do not have. Their share prices were (and still are) very high by historical standards, there had been an investment boom in plant and equipment which was probably unsustainable, and the US dollar was high and rising. The US Fed moved very quickly to lower interest rates. Such action could not be expected to prevent a slowing in the economy, but it would reduce the chances of something more serious, such as a recession occurring. The first Fed easing on 3 January was a clear recognition that the world business cycle had entered a new phase, and this had implications for all countries. We soon saw easings of monetary policy in Canada, the Sweden and most Asian countries - and, of course, Australia - the Euro area was the exception. The slowing US economy, and particularly the cutbacks in investment in computing and electronics, also has had an impact on exports from Asia, with the result that aggregate east Asian GDP growth in the final quarter of 2000 seems to have been about zero (leaving aside the special case of China). The Euro area has been less affected, but there is evidence from the manufacturing sector and from business surveys that growth is edging down nevertheless. I turn now to the second factor, namely the weakness in the Australian economy in the second half of 2000, and its flow-on effects to the first part of this year. As I have conceded before, we did not foresee the extent of this weakness, and I am not aware of anyone who did, although some probably got closer than us. If you had told me before the event that the fall in house-building, a sector which only accounts for 5 per cent of the economy, would be large enough to outweigh reasonable growth in the other 95 per cent of the economy, I would not have believed you. Our analysis of other countries' GST experience had suggested a much smaller fall than actually occurred. I am not saying that the housing contraction was the only thing that happened to the economy; other things have also clearly slowed. But it was the thing that turned a relatively unexceptional slowdown into a small contraction. Of course, what we were witnessing was not the normal cyclical development of an economy, but the transitional effects of a once-in-a-generation structural change to the tax system. The fact that it led to a negative number for the change in GDP had a big effect on people's confidence. We saw this most clearly in the reaction to the release of the December quarter national accounts in early March. The Australian dollar lost 3 US cents over the next ten days to fall below 50 US cents for the first time. At about the same time, consumer confidence, which had until then held above its long-term average, fell sharply to well below that average. The reaction was so large that a number of commentators raised the possibility that the country could 'talk itself into a recession'. I am pleased to say that the mood has improved somewhat since that time. There were some other signs of weakness during the second half of last year, such as the fall in business confidence. This was something we spoke about at the December hearing, when I suggested it could be largely due to the fall in house-building and resulting reductions in sales by those parts of the manufacturing sector which service the housing sector. It was difficult for a while to discern the trend in consumption behaviour because of shifts in spending patterns caused by the introduction of the GST and the Olympic Games. But now that the dust has settled, it is clear that consumption, while doing quite well over recent months, is no longer growing at the heady rates it was a year or 18 months ago. Employment also fell for a few months in the second half of 2000, and there is no doubt that the labour market has softened following the strong growth recorded in the middle two quarters of 2000. Again, however, the construction sector is the main explanation for the weakness in the second half of last year. Over the period from August last year to February this year, construction employment fell by 48 000, while employment other than in construction rose by 41 000. At the same time as we were receiving this information on business confidence, spending and employment, we were also receiving news on inflation. Here the most important data were the CPIs for the September and December quarters, both of which were below our expectation. They suggested that inflation was well under control - in fact, we lowered our estimate of underlying inflation after receipt of the December quarter figure in late January - and they also pointed to the possibility that business profit margins were being squeezed. They thus reinforced the impression that was building of an economy that was slowing more than expected, in a world that was slowing more than expected, and where current inflation and future inflation were within the target zone we aim for under our inflation-targeting regime for monetary policy. The decision to ease monetary policy at our first meeting this year was a relatively easy one, and as you know, we eased again at the following two meetings so that the cash rate fell by 125 basis points in a little over two months. Collectively, this represented an uncharacteristically large move and deserves some explanation. Basically, we realised that a significantly lower level of real interest rates was required so that the stance of monetary policy would be clearly expansionary in that it would be supportive of economic activity. We felt we should, and could, get to such a position relatively quickly for two main (i) We had undergone a relatively abrupt change in our view of the world. As I said before, it became clear that the world was entering a new phase of its business cycle - a fact that was recognised in most countries. The fall in house-building, because it brought forward our own slowdown, reinforced the message from the world. (ii) Because inflation was not threatening to rise above our target, we had no conflict of objectives, and so could act quickly. In view of the foregoing, you will not be surprised to hear that the forecast of GDP growth that I put before the Committee six months ago has been well and truly overtaken by events. I said that I would not quibble with Treasury's figure of 4 per cent for year-on-year growth in the 2000/01 financial year. It now looks like being about half of that figure, but we would expect considerably stronger growth in the following year, probably somewhere between 3 and 3 per cent. Incidentally, this is only the second time out of the eight occasions that I have been putting these reviews of forecasts before you that we have over-estimated the outlook for growth; all the others have been small under-estimates. On inflation, I said last time that it could be approaching 3 per cent by the second half of 2001, that is after the impact of the GST has dropped out of the four-quarter-ended growth rate. Our current guess, now that we have two quarters more of CPI data, is about per cent for the same period. So far, I have spent most of my time covering events leading up to our decision to ease monetary policy, so it is time I moved on to more recent events. As I said before, March was a bad month for the economy, mainly because people received the news that there had been a decline in GDP in the December quarter. This was a great disappointment to most people, and they could not easily understand how such an outcome could have happened so soon after the buoyant conditions of mid-year. Inevitably, it affected people's confidence, and their views of the future. The area where this lack of confidence showed up most visibly was in the exchange rate. On 6 March, the day before the release of the national accounts data, the Australian dollar was worth 52.2 cents and was 49.1 in trade-weighted terms. By 3 April, it had fallen to an intra-day low of 47.75 US cents and 46.6 in trade-weighted terms - a fall of 9 per cent against the US dollar and 5 per cent against the TWI. In the process, the Australian dollar set new low points on both these measures, although against the TWI it was only by a tiny margin. I mention these details because I want to make two points. The first is that at a very detached and macroeconomic level, we all know that a low, and hence competitive, real exchange rate helps a country cope more easily with external adversity. Indeed, a floating exchange rate has as one of its virtues its capacity to automatically bring this about. This is one reason why our exports have been so strong, and why there is a widespread opinion that the exchange rate is a factor supporting future growth in the Australian economy. The second point is that when you already have a low exchange rate, further falls can be very unsettling, especially if they are accompanied by headlines about new lows being reached and new barriers being breached. People inevitably see this as a loss of international confidence in their country, and they in turn lose confidence. The falling Australian dollar was a widely cited reason by respondents to the consumer sentiment survey for why their confidence had fallen. The fall in the Australian dollar in March did not do the country any good, and it is pleasing to see that it has been reversed. April was a much better month than March, and it is possible to discern some signs that confidence is returning. Internationally, all eyes are still on the United States, where financial markets have gained confidence over the past month. All US share indices have risen appreciably, as have bond yields, consumers have continued to spend, and the first quarter GDP figure was better than expected. These developments are good news for Australia, at least in the short term. On the other hand, US employment has fallen over the past two months and businesses do not seem to be as cheerful as financial markets. There is still a lot of uncertainty overhanging the outlook for the US economy. Domestically, we have also had some developments indicating greater confidence in the outlook. The stock market has risen by 7 per cent since late March and is again close to record levels, bond yields have risen, and we have also had the recovery in the exchange rate I referred to earlier. Here, as in the United States, greater confidence returned to financial markets, even if wider measures of business confidence have not shown it. There are also some indications from banks and house-building - which had been the chief contractionary force - is in the process of turning around, and that its upswing could be very pronounced. Under these circumstances, it was perhaps not altogether surprising that financial markets' expectations about monetary policy began to change. They became less sure that we would ease again in May and, in fact, by the time of the meeting the majority of economists surveyed expected no change in interest rates. In our own thinking, we asked the question 'what behaviour of ours can most contribute to building confidence?' At the April meeting, knowing that we still had some more work to do to get interest rates down to levels that were clearly expansionary, we had decided that a move larger than some people expected would probably be preferred to a more cautious approach, and might foster confidence. By May, we had three moves in quick time under our belt. We knew that interest rates were not acting as a constraint on the economy, but rather were at levels likely to assist growth. With financial markets slightly more upbeat about the outlook, we felt that a steady setting of monetary policy would help confidence. We were also sensitive to the possibility that, on this occasion, a surprise fall in interest rates could easily cause people to think that 'things must be worse than we thought' and prompt the question 'what does the Reserve Bank know that we don't?' Such a reaction, had it occurred, would have been counter-productive. What can we say about the future? Inevitably, we can say less, I suspect, than you would like! has been returned to an expansionary setting, with the easing 'front-loaded'. Interest rates are close to the low points reached in the two most recent episodes of monetary policy easing. Given that fact, and given that we see some promising signs in the economy and financial markets, there is a reasonable chance that the current stance of policy will turn out to be easy enough to achieve the desired results. But equally, while it is reasonable to expect that the promising trends of late will develop into stronger momentum for growth, we cannot as yet be confident. This, in turn, means that we cannot be sure that further monetary policy easing will not be required. The growth outlook rests on various assumptions, not least that international conditions stabilise before too long, and improve somewhat during 2002. That is a reasonable assumption on which to make a central forecast, but we need to be, and are, alert to the possibility of a weaker outcome, which would have implications for the Australian economy. We will continue to evaluate new information as it arrives, particularly as it bears on the outlook for growth and, of course, inflation as compared with our target. We remain prepared to adjust monetary policy in response to changes in the balance of risks.

r010710a_BOA

australia

macfarlane

It is a pleasure to be here again talking to the Australian Business Economists and the often feel it would be nice to be able to speak in a detached way on some interesting public policy or historical topic. But in periods where the domestic and world economies are evolving quite quickly, current economic developments keep pushing their way to the front. So I will have to save my more scholarly piece for another day, and confine my remarks tonight to some observations on recent economic events here and abroad. I would like to take as my starting point the way we viewed the economic outlook for Australia about a year ago, that is, as we were entering the 2000/01 financial year. At that time, there were two main components to our view of the economic outlook. The first was a view on the medium-term cyclical development of the economy, which was predominantly optimistic. The second was a view about the effect of 'once-off' events such as the introduction of the GST and the Sydney Olympics on the financial year 2000/01; here, the tone was one of uncertainty. I would now like to spell out how these two overlapping views have fared in the light of unfolding developments. For some years now, we have pointed to the prospect of achieving a longer economic expansion if the economy can be managed in a way which avoids the type of imbalances that have brought about our downfall in the past. By the middle of last year, we were able to point out that it had already happened, in that the present expansion was already longer than its predecessors. But we were saying more than this - we were saying that, even though it was longer, it still had not shown any of the imbalances that characterised the latter stages of earlier expansions: although inflation of goods and services prices had risen, it was not by enough to threaten our medium-term objective; asset price inflation of either shares or property had not become a problem; wages growth remained moderate; there had not been excessive physical investment with its attendant risk of over-capacity; and the current account deficit was not high by the standards of the past 20 years, and falling quickly. For these reasons (and for others that I will come to later), we always felt optimistic about our medium-term economic prospects. This does not mean that we felt that the strong expansion of the 1990s could continue indefinitely at the average growth rate we were then recording. We were conscious that the business cycle, whether domestic or international, has not been eliminated, even though it may have been ameliorated. This meant that slower growth was to be expected as the cycle unfolded. But we did feel that there was no domestic reason why the economy should undergo anything more serious than a moderate slowing phase within the general context of continued expansion. Of course, we recognised that we were not immune to developments in the rest of the world. To the extent that there was a risk of something more serious than a moderate slowing of the Australian economy, we identified that risk as coming from overseas. But even here there was an element of optimism in that we felt that in the event of a world downturn, we would be affected less and later than most other countries because of the resilience of our economy I have just outlined. I now turn to the second component of our view referred to earlier. Everyone knew that developments in 2000/01, particularly the first half, were going to be difficult to forecast and interpret. This was because economic statistics would be very 'lumpy' as they reflected the introduction of the GST on 1 July, and the holding of the Olympic Games at the end of the September quarter. The introduction of the GST, and associated changes to other taxes, was a major event - structural changes of this type are likely to occur only once in a decade, or even once in a generation, and so are always difficult to forecast. Economists had very little to go on in assessing the likely effects, but we all tried to do so by looking at the experience of other countries that had made a similar change. This was not a lot of help, and no-one could be confident what the main effect would be. Judging from the questioning I received during this period, the most likely effect was thought to be on inflation, with shifts in consumption being the other factor most often mentioned. I am not aware of anyone who thought that house-building would be the main area affected, although everyone expected a decline. In the event, the major transition effect of the GST was to bring about a fall in house-building in the second half of 2000 that was much bigger than anyone had forecast or While house-building only comprises 5 per cent of GDP, its fall of 37 per cent in two quarters was enough to outweigh reasonably healthy growth in the other 95 per cent of the economy, and so produce a contraction in GDP for the half-year. There were other factors at work as well, for example, the rising oil price, and there were other parts of the economy that were affected, for example, the labour market. But the figures clearly show that the fall in house-building subtracted 2.2 percentage points from the half-year's GDP growth, and hence accounted for the overall contraction in economic activity GST, which would soon reverse, and therefore should, in principle, have no effect on our average prospects over the medium term. The problem with transition effects, however, is that they can affect people's confidence and their expectations because at the time no-one can be sure they are transitory. This happened on this occasion as business confidence fell, although not precipitously, over the second half of 2000. When the decline in GDP was revealed in early March, confidence took a sharper turn for the worse. Not only did business confidence fall further, but consumer confidence and the exchange rate joined in, and the share market did not escape without damage. This was a period of considerable gloom, when some observers went so far as to suggest that Australia might talk itself into recession. In terms of the two components of our view, the second seemed to have completely eclipsed the first, and you could be forgiven for believing that there was no longer any substance to the first view. What we now know is that at precisely the time that confidence was reaching its low point - the March quarter of 2001 - the transitional effects were dropping out of the calculations and the economy was returning to reasonable growth. The March quarter national accounts show this clearly, and a range of other indicators show a distinct improvement from Consumer sentiment, although declining in the second half of 2000, had remained above its long-term average until it fell sharply in March. It has now regained a level above its long-term average. The share market has been generally very buoyant by world standards, but fell by 6 per cent in March before recovering in The exchange rate reacted to the weak economic activity news and reached a low point in early April. It subsequently rose by 7 per cent against the US dollar and in trade-weighted terms. There is evidence from a number of business survey responses to questions about the economic outlook that confidence has improved. My assessment is that we are now back in a position where the first view represents a good summary of our position. The major threat to our future growth prospects now comes from the international economy, not from domestic factors. The list of domestic factors which provided underlying resilience a year ago still applies. And we could add to that list the fact that monetary policy and fiscal policy have both moved in an expansionary direction since then, and that the exchange rate continues to provide stimulus to the internationally traded sector. Before moving on to discuss the world economy, I would like to touch on one further question pertaining to the domestic economy. The question is the following: Does the fact that we had such a poor second half of 2000 put us in a worse or a better position to handle any future weakness in the world economy? On the surface of it, you might be inclined to say that it has made things more difficult for us because it has given us a weaker starting point. On the other hand, you could mount a defensible case that it may help us in the medium term. First, we have now got some of the usual cyclical contractionary forces behind us, which in a more normal business cycle we might still be facing. The housing contraction is the most obvious of these, but the inventory cycle has also been probably brought forward and therefore may be already half completed. Second, the greater and earlier-than-expected weakening of the domestic economy focused the attention of policy-makers on the need for easing somewhat earlier in the process than if the cycle had had a more normal shape. On monetary policy it is hard to be definite on this point, because other important factors were also at work - for example, the recognition that the international cycle was turning and that inflation remained low - but, at the margin, the weakness in the second half of 2000 contributed to an earlier easing. On fiscal policy, the increase in the first home buyers' grant is an example. Finally, the perception of weakness in the Australian economy probably contributed to holding down the value of the Australian dollar. I do not want to make too much out of these arguments, other than to point out that some clouds do have silver linings. When we think of the international economy, or its leading member - the US economy - we tend to remember that there has been a reasonably pronounced business cycle over recent decades. Recessions occurred in the mid seventies, the early eighties and the early nineties. A lot of people think in terms of a relatively regular cycle, and hence think we are due for another US and world recession now. We cannot summarily dismiss this simple approach, and I find it hard to argue against the view that economies contain some unavoidable element of cyclicality in their path of development. The issues are: Does a cycle necessarily involve a recession, and are there characteristics of the current cycle that make it different to its predecessors? I think these can be answered together. The current international cycle is different to its predecessors in one extremely important respect - the expansion phase did not culminate in an excessive rise in inflation. In fact, the rise in inflation was quite modest. This had two important consequences. First, because the rise in inflation was small, interest rates did not need to rise by very much during the relatively short period that they had to perform their anti-inflationary task. (Table 1 looks at the peak in inflation and interest rates at the end of various expansions.) Second, monetary policy could be eased much earlier in the slowing phase of the cycle than in the past. Thus, to the extent that the cycle is the result of changes in monetary conditions and monetary policy, it should unambiguously be more muted on this occasion. Similarly, to the extent that major downturns are the result of financial fragility, the situation should be better on this occasion as financial intermediaries in virtually all western countries are in much sounder shape than a decade ago. Thus, in the areas dear to a central banker's heart - monetary and financial stability - the situation is appreciably better on this occasion than earlier ones. capital expenditure, particularly in technology. It is worth looking a little more closely at them. When share prices were on the way up, and setting new highs for the price-earning-ratio, many people were expecting that this would eventually be followed by a crash like 1987, if not one of 1929 proportions. That scenario seems less likely now that we have about 15 months of correction behind us. While the fall in the NASDAQ was large enough (70 per cent) to warrant the term 'crash', and its preceding rise the term 'bubble', the share market as a whole has retreated in a more orderly fashion. The fall in the broad indices such as the S&P 500 or the Wilshire has been about 20 per cent over the past 15 months, and the price-earning-ratio has come down from a peak of 36 to 26. Now, I do not want to get into the business of forecasting future share prices - the only point I wish to make is that the risk of a fall severe enough to frighten people into stopping spending must be smaller now that we have some of the correction behind us, than when we had none. The high level of the US dollar, and the fact that it is still tending to rise, cannot be helpful to the US economy. It must be harming US exporters and those who compete with imports, and no doubt is one of the reasons why US manufacturing output has fallen for each of the past eight months. But these effects on trade flows, while unhelpful to the United States, must be helpful to its trading partners including ourselves. So it is hard to see the trade effects of the strong US dollar being harmful to the world economy as a whole. Where the rising dollar is harmful is in reinforcing the widely held view that you cannot go wrong in buying US assets - if their value goes down, at least you will gain on the exchange rate. This sort of thinking does distort capital flows and can lead to misalignments in asset markets. The area where I think a US imbalance is having unfortunate consequences both inside and outside the United States is in physical investment. In the year to June 1999, equipment investment grew by 13 per cent, and by 16 per cent in the year to June 2000. In the same two years, investment in It would be very reassuring if this were the end of the story for the world economy, but it would be too simple. There clearly are some important imbalances we still have to contend with, particularly in the United States. The most often mentioned of these are high share prices, the high US dollar and an overhang of high-technology products grew by over 23 per cent and 27 per cent. Whenever there is an extremely fast growth of investment, there is always the danger that excess capacity has been put in place and that the necessary correction will involve a period of sharply declining investment. That is happening now with US equipment investment declining by 2.3 per cent in the most recent quarter, and investment in technology by 10 per cent. These cutbacks have had a big effect on Asia where exports of electronic equipment have fallen by 25 per cent, which helps explain why Asian GDP growth has flattened out over recent quarters. Of course, this is a purely cyclical event, and will reverse in time, but it is an important channel whereby a US imbalance transmits itself to the world economy. While there are obvious imbalances in the US economy as outlined above, I would judge them to be smaller in aggregate than at a similar stage of earlier cycles, particularly if we give a lot of weight to inflation and financial stability. Japan is in a weak state as it has been on several occasions over the past decade and its outlook is not improving. Europe has also slowed, but no obvious imbalances of the US type have emerged. We are presently in a period of sub-par growth for all three areas, and this is inevitably a time of great uncertainty. Even though I expect the world economy to do better than it did a decade ago, we can probably expect to hear some more bad news before the better news arrives. I hope what I have said tonight has been reasonably even-handed. While I note that money markets have recently become more optimistic about our outlook, I think for most people the main unanswered question is still whether the world economy is going to face something materially worse than a period of slow growth over the coming year. The substance of what I have said tonight is that, while such an outcome cannot be ruled out, its likelihood is lower than it appeared at the turn of the year, or as recently as March this year. When these downside risks were mounting earlier in the year, we were prepared to ease monetary policy reasonably quickly and by a significant amount. If the outlook I have sketched comes to pass, further such decisive action may not be necessary. If the alternative occurs and significant downside risks re-emerge, we will not hold back from further action.

r010918a_BOA

australia

macfarlane

The following is the text of the Giblin Lecture delivered by the Governor, Mr IJ Macfarlane, to Let me start by thanking the University of Tasmania for inviting me to give this lecture, which commemorates one of Australia's truly remarkable men. My choice of topic tonight was made long before the tragic events in the United States last week. Before moving on to the main body of my speech, a few comments are in order about recent events. The first order of business for central banks at times such as this is to ensure that the financial markets and the payments system can operate effectively. This has been accomplished. The Federal Reserve was open and the US payments system operating on the day of the attack. Central banks around the world operated to assure market participants that there would be ample liquidity. We here in Australia did likewise, and have added substantial additional funds into the cash market, and are continuing to ensure that additional liquidity is available as required. Assessing the lasting economic impacts of the events will take longer. Much will hinge, obviously, on the extent to which investors and consumers in the United States respond to the tragedy by scaling back their activities and plans. That is almost impossible to predict. In the United States, where economic conditions were deteriorating and confidence waning prior to the attack, the Federal Reserve has brought forward an easing of monetary policy. Some other countries already directly affected unexpected weakness of their own monetary policy. These moves themselves will help, of course, to address the risks to global growth which already existed and those - as yet almost impossible to assess - which may result from the reaction to the attacks themselves. I know there were some who speculated about whether Australia might join this action today, easing further the already expansionary setting of monetary policy currently in place. We have, as usual, closely monitored events abroad and at home on a continuous basis. We have had better economic data in Australia lately than observed in the United States or Europe. The weakness of global conditions in the short term will affect Australia, as we said in our statement announcing an easing of policy just two weeks ago. But we have not seen, in the past week, anything relating to Australian monetary policy's field of operation which was so urgent that it warranted the suspension of the normal timetable of the deliberative processes of our Board. With that said, let me now return to the main body of my speech. Sometimes it requires an effort to find the complimentary remarks that usually preface a lecture such as this. But not so in the case of Giblin. While he is remembered principally as an economist, he did not take up this calling on a full-time basis until he was 47 years old, by which time he had already done so much in other areas. After graduating from Cambridge, during which time he played rugby for England, he spent some time prospecting for gold in Canada, became a merchant seaman, a plantation manager in the Solomon Islands, an orchardist in Tasmania, a Member of the Tasmanian Parliament, and was decorated for bravery in World War I. As an economist, he made contributions in a number of areas and had a close association with central banking through his membership of the Board of the Commonwealth Bank. But it is another aspect of this extraordinarily gifted man that I would like to commemorate tonight - his willingness to communicate difficult economic ideas to the broader public. Giblin wrote a series of articles in 1930 called in which he set out the economic issues facing Australia at the start of the Depression. This series faced economic issues head on, but did not talk down to its readers. I will try to follow his example this evening. What I intend to do is to answer three questions that are sometimes put to me by members of the public, rather than by regular participants in monetary policy debates. Because the questions are from 'lay' people, they may appear naive to a professional audience, but I often find that blunt untutored questions are the hardest to answer, and they can often force a re-examination of previously unquestioned assumptions. They can also open up some interesting historical and academic issues. I should also add that my choice of topic tonight is not prompted by any current economic events, but is the outcome of some reflections going back a decade or two. The three questions are the following: 1. Why does the Reserve Bank have to change interest rates at all: why can't they be left constant 2. Why does the Reserve Bank have to be involved in the first place: why can't the determination of interest rates be left to the market 3. Why do we need to set our own interest rates in Australia: why can't we just accept the rates of another country , e.g. the United Obviously these three questions come from quite different perspectives, and the people who ask them are making very different assumptions about how an alternative system for setting interest rates should work. But there is, I think, a common thread that connects them. That is the view that it would be desirable to take away the element of discretion from interest rate setting, whether by making them constant, by 'leaving it to the market' in some sense, or by ceding the discretion to another country. In other words, the questions arise out of a certain scepticism as to whether interest rate setting really requires an active decision making role for the central bank. One preliminary point to be dealt with before going to the substance of these issues is what we mean by 'the interest rate'. There are, in fact, many interest rates - short-term, long-term, private, government, on loans or on securities, etc - so which one do we mean? In this discussion, it makes most sense to focus on the short-term interbank rate that is typically set by a central bank - in Australia, the overnight cash rate (usually referred to as just the cash rate). The rest of the rate structure can be thought of as keying off current and expected cash rates, and it is the cash rate that is the main driver of movements in the interest rates that borrowers actually pay. So questions about the appropriate system of interest rate setting in this context really amount, in essence, to questions about how the cash rate should be determined. Let me turn now to the three questions I have just outlined. A lot of people are unhappy about changes in interest rates. When rates rise, there are always a lot of complaints in the media drawing attention to the plight of people with mortgages. When rates fall, the media usually treat this as good news, but I get a lot of letters from retirees who take the opposite view. One solution would be to instruct the open market desk at the Reserve Bank to operate in a way which kept interest rates at their current level indefinitely. Why would we not wish to do this? There are two answers to this question: one which is historical, the other more theoretical. The historical approach is to ask whether there has ever been a monetary system that did not involve variations in interest rates. The answer is no. Interest rates have always moved up and down under all the monetary regimes that have existed, whether the regime was a gold standard, a currency board, a normal fixed exchange rate, a monetary target, an inflation target, or a regime of pure discretion by the central bank. If someone can think of an example of a successful monetary system where interest rates never had to change, I would be very interested to hear of it. But while most people can instinctively appreciate this point, there are, no doubt, some who would like to know what would be wrong with trying to hold interest rates permanently fixed, even if it has not been done before. This brings me to the second part of the answer, based on economics: a fixed interest rate policy would be unsustainable because it would inevitably lead to either an inflationary or a deflationary spiral. This conclusion is well established in the theoretical literature, but it does not require any great familiarity with monetary theory to appreciate how it is arrived at. Suppose, for example, that a central bank attempted to set the interest rate at a low level which imparted a strong stimulus to demand and activity. Over time, if that were maintained, it would cause inflation to rise, and, with a fixed nominal interest rate, the real interest rate would decline, thus leading to further increases in demand and inflation. This process would continue through successive rounds resulting in an inflationary spiral. By a similar logic, if the initial level of the interest rate were set too high, a self-reinforcing process in the opposite direction would ensue, culminating in a deflationary spiral and rising unemployment. Only if the interest rate could be set at an exact equilibrium point would these two extremes be avoided, and, even then, the equilibrium would be temporary. Any economic event that pushed the economy slightly away from its equilibrium would set off one of the two self-reinforcing processes I have just described. One response to this line of argument might be to suggest that the central bank try to stabilise the real rather than the nominal interest rate, but this already concedes the main point: that the nominal rate has to be adjusted in response to information about current and prospective inflation. Having made this point, I have to concede that there are not many people who would advocate that interest rates should literally be kept permanently fixed. But there is a more subtle version of this viewpoint which is much more widely held: that is the view that policy should always aim to keep interest rates as stable as possible. Expressed in this way, the idea sounds more reasonable, and I think it is fair to say that it pervades some of the commentary that follows interest rate adjustments - the idea that changes in interest rates (and especially increases) should be avoided if possible. We need to be clear that this is an incorrect view, for the same reasons I have just outlined. If policy were to give too great a weight to stabilising interest rates, as an end in itself, it would risk destabilising the economy, because it would fail to keep up with inflationary or deflationary pressures as they emerge. Of course, it would also be a fallacy to jump to the opposite conclusion, that more interest rate variation is always better. Obviously, a policy which made large and hastily-decided changes in interest rates would also be a destabilising force, so it has to be recognised that interest rates can be moved by too much as well as too little. How much variation, then, is the right amount? This is not the sort of question that is open to a precise quantitative answer, but it is certainly possible to give some general principles. First, it depends on the size of the shocks that the economy experiences. Bigger interest rate adjustments will probably be needed the bigger the shocks to which you are responding. When the shocks and imbalances are small, interest rates do not need to move as much. Second, it depends on how responsive the economy is to a given change in interest rates. Arguably in the 1970s and 1980s, when inflation was high and variable, the economy was less responsive to a given change in interest rates than it has been subsequently. Hence, larger changes in interest rates were needed to achieve a given effect. Since the early 1990s, interest rate changes have generally been much smaller than in the earlier period. Third, it depends on how much uncertainty there is. When you are very sure about your reading of the economy and about the likely effects of a change in interest rates, it may be possible to move rates very quickly in response to an important piece of information. But when you are highly uncertain about how to interpret events, it pays to be more cautious and gradual in your approach. To use an analogy with driving - you should slow down in a fog. It follows from this that the 'right' amount of movement in interest rates depends very much on the circumstances. Sometimes rates will be highly variable, as they were in the 1980s, and sometimes they will be quite stable, as they have been in the most recent decade. In all of this, interest rate stability should be seen not as a goal in itself, but as a by-product of a stable macroeconomic environment. Let me turn now to the second of my three questions. This question, again, is based on a plausible-sounding premise, but the proponents of this view are often rather unclear about what 'leaving it to the market' would really mean in an operational sense. It might mean several things. In its simplest form, leaving interest rates to the market would mean simply telling the Reserve Bank to cease all open market operations. It is worth exploring what would be the consequences of such a policy. In a world where the Reserve Bank was undertaking no open market operations, the amount of cash that underpins the money market (exchange settlement funds, or what the academics call 'high-powered money') would depend on the Government's fiscal balance, and it is not hard to see that this would be likely to result in monetary instability. Any government deficits not financed by an exactly coincident issue of debt to the public, for example, would mean a rise in cash and a fall in interest rates. Similarly, a surplus not exactly matched by debt retirement would lead to a shrinkage of the amount of cash and an escalation of interest rates. In both cases, there would be much more short-run volatility in interest rates than exists at present. This is because the day-to-day fluctuations in the Government's position, which can be quite large, would no longer be smoothed out by Reserve Bank open market operations. A further point to add here is that even maintaining a balanced fiscal position on a daily basis would not ensure these effects would be avoided. Even with the fiscal position in balance, the system could be destabilised by changes in the public's demand for currency. Because the public's demand for currency expands with the growth of the economy, it could only be accommodated in this regime by some other source of cash such as provided by RBA open market operations. Failing this, there would be continuing upward pressure on interest rates and economic contraction. I have spelled this out in some detail because proponents of the 'leave it to the market' view often do not have a clear idea of what their position really means. But if they mean simply ceasing Reserve Bank operations, and leaving interest rates to the market in that sense, then it is clear that such a system would not be workable. It would be a recipe for more interest rate volatility, not less. To be fair to those saying rates should be left to the market, there are some who have a more sophisticated view. They would argue that I have made two assumptions that could easily be changed. First, if the Government did not bank with the central bank, then its fiscal position would not affect high-powered money. And second, if the central bank did not issue bank notes, but bank notes were instead issued by commercial banks, then it would not involve the central bank having to provide cash to the system. These changes would eliminate the central bank from the picture entirely, and bring us to the world of 'free banking' so beloved of a small group of academics. Among supporters of the free banking ideal, there are at least two schools of thought as to how such a system should work. One view is that money should be ultimately linked to a commodity such as gold, so that bank notes issued by commercial banks would essentially be 'gold certificates' redeemable in gold on demand. Therefore, the supply of gold would act as a discipline against over-issue of notes and the system would ensure that interest rates were determined by the supply and demand for funds. While examples that resemble this outline do exist in early banking systems such as Australia before 1910, they all eventually gave way to what are now conventional systems based around a central bank. The reason was that such 'free' banking systems were found to be prone to instability without a central bank to manage liquidity and provide last-resort funding in a crisis. Banking systems tied to a commodity standard were simply not flexible enough to cope with periodic bank runs and liquidity crises. No doubt, the true believers in free banking would argue that the theory was never properly tried, and that, if it were, the market would find a solution to the apparent problems. But that is to make the theory unassailable by pure assumption. The other school of thought on free banking is an even more radical one. It proposes a system of competing private currencies that would not have to be linked to any standard of value. The banks operating in such a system would compete with one another to offer sound currencies on terms that were attractive to the public. In effect, a country operating such a system would depend upon competition between commercial banks to ensure stability in the financial system and low inflation. To my mind, these free-banking proposals really belong in the world of technical curiosities. They can be argued to work in theory, but the fact is that there is no working example of such a system anywhere in the modern world. So I have to conclude that those who say interest rates should be left to the market are proposing something that is either not workable (if they mean simply shutting down central bank operations) or something that is much more radical than most people would be prepared to accept. This brings me to my third question. The premise behind this question is that we could do away with the discretionary role of the Reserve Bank by having a rule that interest rates would always be equal to those set by the US Fed. My first comment on this is that it is hard to see why anyone would see this as a particularly attractive goal. It certainly would not do away with central bank discretion, but only replace the discretion of one central bank with that of another. And it would be a discretion tailored to meet US conditions, not to policy requirements in Australia. But leaving aside the question of whether it would be desirable, the main question I want to focus on is: is it feasible? The answer is, it depends on how it is done. If the mechanism for achieving equal interest rates with the United States was that we adopt the US dollar, or establish a fixed exchange rate, then it should be technically achievable. Interest rate convergence would then be a by-product of fixing our currency to the US dollar, and, the more credible the exchange rate peg, the more closely our interest rates would shadow those in the United States. That was how interest rate convergence was achieved within Europe, though the same process is proving extremely difficult in Argentina. So if the people asking us to adopt US interest rates are really arguing for a change of exchange rate regime, then there is no dispute that it could probably technically be done. But this is really a different debate from the one about how to set interest rates. If, on the other hand, someone is arguing for adopting US interest rates under the existing exchange rate regime, I would have to say that such a strategy would not be workable. The reasons for this are quite similar to those I outlined earlier under Question 1. Suppose we began such a regime in a position of equilibrium, in which Australia and the United States had the same inflation rates and there were no imbalances tending to push the exchange rate in one direction or the other. In these conditions, we could expect the level of interest rates in the two countries to be the same. But if we then established a rule that Australian interest rates would always be equal to those in the United States, the system would be extremely vulnerable to any event that affected the relative performance of the two economies. For example, if there were contractionary forces operating on Australia, but not the United States, the level of interest rates would not be able to respond, and the result would be a downturn in the Australian economy, and in extremis , deflation. An expansionary shock would likewise destabilise the economy in the other direction. The strategy could only be maintained if, by a fluke, economic conditions in the two countries remained perfectly synchronised. Having made this point, it is interesting to note that interest rates in Australia and the United States have at times moved quite closely together in recent years. There is nothing wrong with that. We just need to be clear that when this occurs, it is a result of the two countries experiencing similar economic conditions, not something that has been set up as an end in itself. In the history of monetary economics there has been no shortage of proposals to make the system automatic, and thereby to eliminate the need for central banks to be involved in setting interest rates. I have looked at three simple proposals of this sort, and tried to show why they would not be viable or would have very different consequences from those imagined by their proponents. In a modern monetary system, it is not possible to have interest rates on automatic pilot, and so a discretionary role for the central bank in setting interest rates cannot sensibly be avoided. All of this is a long way from saying how the decision-making process should work: what should be the objectives and how the process should be governed. I have given my views on these matters in public on many occasions, as have a number of my colleagues, so I will not go over the same ground again tonight. Here, I would just note that the most important modern advance is to ensure the decision-making takes place within a framework of well-defined objectives and clear accountability. This is indeed one of the strengths of the inflation- targeting regimes that have been adopted in so many countries during the past decade. They recognise the need for a decision-maker, so that interest rates can be adjusted in response to unfolding events, but they also place the process within a framework of clear objectives and accountability. , Cheshire, presented at New Zealand Association of , paper presented at Federal Reserve Bank of An Enquiry into the ,

r011206a_BOA

australia

macfarlane

I last spoke at this Conference Dinner two years ago, and a lot has happened to the Australian and world economies since that time. I am pleased to be invited back and given a platform from which to share a few thoughts with you tonight. In keeping with the theme of the Conference - which is about forecasting - I will address the issue of how well placed the Australian economy is to handle the challenges of the next year, particularly the international challenge. In a sense, the talk will also be a replacement for my regular half-yearly report to the Parliamentary month's election, there has not been time to re-form the Committee and schedule a hearing date in the current half year. I will start tonight by showing a graph which compares Australia's current economic expansion with its predecessors in the 1970s may think I am tempting fate by showing this graph at this particular juncture, but I have been doing so, from time to time, over the past three years without ill effect. What the graph shows is that the current expansion is a good deal longer and smoother than its predecessors. One of the most important reasons for this is that inflation has been a lot lower on average and less variable than in the earlier expansions. Monetary policy, therefore, has been able to play a different role than formerly - one that involves earlier movements in interest rates, but with smaller amplitudes of movement. The inflation-targeting framework has been a crucial element in bringing about this result. For most of the period of the current expansion, the international background has been benign. The exception until recently was the period between mid 1997 and the beginning of 1999, when the Asian crisis confronted us with a pronounced fall in the demand for our exports and some pretty skittish international capital markets. We survived - indeed, prospered - in that period, much better than any of us thought likely at the time. Now we are confronted with another period of weak international demand, and this time the United States - the former powerhouse of the world economy - is the principal source of the weakness. This time we confront a problem that is global rather than specific to our region. The current problems did not, of course, start on 11 September, and I think there has been a tendency to exaggerate the economic consequences of that event, and under-estimate the underlying weakness that preceded it. If I had to give a date when it became clear that the international economy was in for a rough ride, I would nominate 3 January, when the Fed surprised everyone with the first reduction in interest rates in this phase only a fortnight after their previous meeting at which they had kept rates constant. After a flurry of interest rate reductions around the world in the next few months, the situation then settled down for a while. In Australia, after our three initial reductions, we paused for four months while we evaluated the incoming information. By mid August, we had concluded that the international situation was worsening again, and we began a second round of easings in early September, about a week before the fateful events in New York. Thus, taking these events together, we have been in a situation where we were conscious of a weakening world economy for virtually a full year. During that time - or for the three quarters covered by the national accounts - the Australian economy has grown at an annual rate of 4 per have also done better than other comparable economies. This is a very encouraging result for us, but success so far does not guarantee success in the future. Indeed, there is a large body of opinion that says we are destined to follow where others have led. Per cent, year-to-date annualised I suppose that is the question that has been on everyone's lips for quite a few months - if the world economy goes into a recession, as the United States and Japan have done and much of the rest of the world seems to be doing, does that mean that Australia has to follow? People who would answer yes to this question would point out that we have done so in the past, for example, in the mid 1970s, the early 1980s and the early 1990s. Why should this time be any different? This is a view of the world that I would call historical determinism, and it may or may not be a good guide. But before we accept such a prediction, it should be challenged by a close examination of the circumstances then and now. What such an examination reveals is that present domestic circumstances are very different to those prevailing in the earlier episodes. To put it bluntly, we brought a lot of the problems on ourselves in the previous episodes, whereas this time we have not done so. On the previous occasions, we could not in all honesty make the claim that it was mainly the fault of the rest of the world - much of the fault was clearly of our own making. In other words, Australia had a lot of serious domestic imbalances that contributed to the downturns. For a start, each of the earlier downturns was preceded by an episode of high inflation. In the 1970s and 1980s, the CPI was rising in double digits; in the 1990s, although this measure peaked at a lower rate - about 8 per cent - it was accompanied by unsustainably high asset price inflation. Accordingly, monetary policy had to be tightened on all three occasions to combat these imbalances, and short-term interest rates reached very high levels - either a little above or below 20 per cent on each occasion. Nothing remotely like that has happened this time to either inflation or to interest rates. Perhaps more importantly, monetary policy this time has been able to be eased much earlier than on previous occasions - interest rates have been successively lowered for nearly a year now, during which the economy has been growing at a good rate. While I think the different behaviour of inflation and interest rates is the biggest change between then and now, there are a number of other factors that contributed to our difficulties in earlier times that are not present now. I have listed these before, but there is no harm in doing so again: There were large rises in real wages that squeezed the business sector in the 1970s and 1980s. This time wages have grown at a reasonably steady 3 per cent per annum over the past year or two. There was an investment boom that led to over-capacity in the early 1980s. Investment has been quite subdued over the past two years, and, in more normal circumstances, we should be due for a pick-up. Even in current circumstances, a straightforward reading of last week's Capex Survey suggests a rise in the current financial year, though it is concentrated mostly in one sector (mining). In the early 1990s, the exchange rate appreciated sharply in the period ahead of the downturn. On this occasion, it goes without saying that the exchange rate is exerting an expansionary influence. On each earlier occasion, the deficit on current account of the balance of payments widened by an amount that alarmed many people. On this occasion, it has fallen to a level not seen in more than 20 years. I will return to some of these subjects later, but before I do so, I would like to address another form of historical determinism. The macroeconomic performances of Australia and the United States in terms of output growth and inflation were very similar over the 1990s. It would therefore not be unreasonable to ask the question of why they should not also be similar in the first few years of the new century. Again, I think there is a reasonably straightforward answer to that question which stresses some very big differences between the two economies. The US economy exhibited in the late stages of its expansion two or three developments which arguably warranted the use of the term The US stock market, particularly the technology sector as measured by the NASDAQ, rose to exceptional heights and has since fallen. The broad indices such as about 25 per cent from their peak, whereas in Australia the ASX 200 is only down about 4 per cent. In the United States, there was a burst of physical investment towards the end of the expansion, mainly in high-technology equipment. We are now seeing the reaction to this and the consequent excess capacity, in the form of sharp falls in investment. As explained earlier, this pattern of action and reaction is absent in Australia. The trade-weighted value of the US dollar has risen appreciably over recent years and, despite lowering interest rates faster than any other country this year, the currency remains at a very high level. These three factors were really a manifestation of the excessive euphoria associated with the widely held view that the secret of economic success was to pour resources into the 'high tech' sector. In the event, the countries that were most exposed to that sector are the ones that are showing the largest falls in output. So far, I have emphasised the strong points about the Australian economy, and the differences between us and other more vulnerable economies. But it would be foolish to deny that a fall, or even a pronounced slowdown, in the world economy and world trade would have a significant contractionary effect on the Australian economy. Clearly, such an effect will occur, some of which is already showing up. The two classical channels are through a fall in the volume of exports and through a lower terms of trade, but there may also be other channels. The remainder of my presentation will look at the probable size of these channels. It is true that during world recessions, the volume of Australian exports usually falls. Table 3 shows that at the time of previous world recessions, Australia has experienced periods of falling or weak exports roughly coincident with these recessions. But the negative contributions to GDP in any one year are not large; the biggest we can identify is the 1.4 percentage points in the year to March 1974. Clearly, if the rest of the economy was growing at a reasonable rate, this would not be enough to induce a recession. Traditionally, the Australian economy has had a reputation for doing better than most other economies in the good times and suffering more in the bad times. One reflection of this was that the Australian dollar was seen as a 'commodity currency' because it was heavily influenced by our terms of trade. Again, it is true that during previous world recessions, Australia experienced periods of falling terms of trade that coincided roughly with the recessions. The biggest negative contribution of 1.7 percentage points of GDI was in the year to March 1975 (following a massive positive contribution the previous two effects is such that, although they have made a noticeable contribution to slowing the economy, they would not be enough to cause a recession. Even if we add the export volume effects and the terms of trade effects together (noting that they usually cover different, but roughly adjacent, periods), the combined effect in any one year would not be enough to turn a reasonable positive growth rate into a negative one. The other conclusion that can be drawn from this table is that the contributions tend to be getting smaller, particularly for the most recent recession in the early 1990s. I would like to say a little more about the terms of trade before I leave that subject. As I said earlier, there has been a tendency to see Australia as being some sort of 'loser' in the international economic competition because of our vulnerability to terms of trade movements. There is an assumption that our terms of trade are subject to a long-term downward trend, that they are also cyclically sensitive, and that both of these characteristics stem from an unfortunate export mix, with its over-representation of 'commodities'. I think this is a somewhat dated view for the following reasons: On the question of long-run trends, it should be noted that the low point in our terms of trade was as far back as 1986/87 have been at successively higher levels. On the question of cyclical sensitivity, we have had conflicting signals over recent years. Our terms of trade fell between mid 1997 and mid 1998 as a result of the Asian crisis, but since that time, i.e. over the past three years, they have risen, even though the last of those three years has been a very weak one for the world economy. They are now above the peak they reached immediately before the Asian crisis. The focus on our export prices is misplaced because the really interesting action seems to be taking place on import prices. They are not as cyclical as export prices, but they have shown a more pronounced downward trend over the 1990s, particularly over the past five years. We know that a lot of this is due to the sharp falls in the prices of telecommunications and computing equipment, but it is more widespread than this. Of the 29 categories of goods for which the ABS publishes import prices, 26 fell in SDR terms between 1996 and the present. Nearly all of them are categories of manufactured goods. Whether the trend in the price of a particular category of internationally-traded goods is up or down depends to a large extent on long-run supply elasticities. It now seems likely that the highest supply elasticities are to be found in large-scale manufacturing rather than resource-based goods. Semi-conductors are an obvious example, as are less sophisticated products such as clothing, textiles and footwear, but it also seems to be true for electrical equipment, automobiles, and for many types of industrial equipment. In some senses, these are now the 'commodities' of international trade. I am not suggesting that all manufactured goods have this characteristic, but it seems that most of them do. My conclusion from this discussion of movements in exports, imports and the terms of trade is that they are not big enough by themselves to transmit a world recession into a domestic recession. A fall in domestic spending would be required to bring about that result. Why should domestic spending fall if the domestic economy was in reasonably good shape? One possible explanation is multiplier effects from the export sector, but most econometric estimates suggest that these would not be large enough to tip the balance. Another channel is through confidence effects - perhaps business and consumer confidence are influenced, not only by domestic developments, but also by international ones. Given the massive amount of information about the US economy that is routinely transmitted to Australians, it would not be surprising if this were the case. It is clear that some international events show up in measures of confidence among Australian consumers and business, September 11 being an obvious example. But, on the other hand, consumer confidence is still above its long-term average, and like most measures of business confidence, its recent trough was in the March/April period of 2001 - about nine months ago. At that time, we were getting bad news on the domestic front, particularly the temporary decline in GDP in the December quarter of 2000. The level of confidence recovered from this temporary trough, and on average over the past six months, has been a good deal higher than earlier in the year, and has held up reasonably well through the recent international turmoil. There is one thing about recent business behaviour that has worried me a little, but so far it seems to be mainly confined to the United States. I am referring to the practice by companies of announcing large lay-offs of employment whenever a downward earnings revision occurs. This practice is no doubt designed to please investors and therefore to prop up the company's share price. If these lay-offs are occurring as announced, it suggests a more rapid employment response than in previous downturns. While the practice may help one company when viewed in isolation, it is a serious error to think that companies in general can protect their earnings in this way. Earnings are meant to decline cyclically in circumstances such as the present because it is impossible to cut costs as fast as revenue is declining. The more the cyclical fall in earnings is resisted in this way, the more it is transferred to employment, and the more pronounced the cycle becomes. Calendar year 2001 has been a difficult one for the world economy, and the first half of 2002 looks like remaining weak before a recovery gets underway. This would mean 18 months of economic weakness for the world economy, and be classified as a recession like those of the mid 1970s, early 1980s and early 1990s. The Australian economy has got through the first half of it in reasonably good shape considering the circumstances. Can we keep up our present performance until we are again in an environment of reasonable world growth? Can we span the valley? I have given a number of reasons why I think we can, even though we will experience falling exports, falling earnings and the usual inventory adjustments. These are examples of externally-induced contractionary effects that cannot be avoided, but which are not big enough by themselves to cause a recession. For that to occur, we would have to see an over-reaction by domestic consumers and businesses. The evidence to date from surveys of confidence, from household spending and from business investment intentions is that they are holding up reasonably well. Far from over-reacting, they are exerting a generally stabilising influence. If this changes for the worse, or if it appears that the outlook for the world economy is weaker than currently assumed, we will be prepared to adjust monetary policy accordingly.

r020322a_BOA

australia

macfarlane

The following is the text of the Inaugural Sir Leslie Melville Lecture delivered by the Governor, I would like to start by thanking the me to give this address. We at the Reserve Bank were wondering what we could do to so the invitation now gives the two institutions - the Reserve Bank and the opportunity to pay tribute jointly to Sir Leslie in his home city, and most importantly in his presence. My address today will not be a biography of Sir Leslie because there are already several excellent biographical essays available and, I am pleased to say, a full-length book is currently being written. Instead, I hope this address will be seen as a general celebration of Sir Leslie Melville's contribution to public life in Australia and a vote of thanks from his successors for his outstanding and under-appreciated achievements. But, notwithstanding this intention, a very brief biographical sketch should help to set the scene. 1902, studied economics at Sydney University (while also studying as an actuary), and obtained his first job in 1924 as Public Actuary twenty-seven, he was appointed Inaugural as the Economist to the Commonwealth Bank, a position he held until 1950 when he became Australia's Executive Director at the Bank. During his central banking years he was a prolific writer on economic matters, both academic and practical, and contributed significantly to economic debate in Australia and overseas. In 1953, he left the Commonwealth Bank to take up an appointment as Vice-Chancellor of the was appointed Chairman of the Tariff Board, but resigned after two years due to disagreements with the Minister for Trade, Commission for eight years until the early served three different terms as a Board Member of the Commonwealth, and later In assessing Sir Leslie's contribution to Australian public life, pride of place must inevitably be given to his contribution to central banking. He was wholly occupied with this from the age of twenty-nine till his early fifties, and if we add in his years as a board member, he has an association with central banking stretching over forty-five years. I think the Vice-Chancellor recognised the centrality of this aspect of Sir Leslie's life by choosing me to be the speaker here today, so it will figure prominently in the remainder of my address. I have another motive for doing so because I want to use Sir Leslie's career to help answer a difficult question - how old is central banking in Australia? This is something that has perplexed us at the Reserve Bank, and has not been definitively answered by the several economic historians that have covered the field. In a strictly formal sense, the present Reserve Bank is the continuing legal entity that survives from the old Commonwealth Bank set up in 1912. It would be tempting, then, to claim that central banking started at that time and the central bank is ninety years old. the original Commonwealth Bank was a savings and trading bank with no central banking responsibilities, and so this legal continuity argument will not lead us to the right answer. At the other extreme we could say that, since the Reserve Bank as a separate organisation only dates from 1960, at the time of the separation of the Commonwealth Bank, central banking is only forty-two years old. Clearly this is also false - the start of central banking clearly pre-dates separation as is evidenced by, among many other things, , which was published in 1951. So at what date between 1912 and 1960 did the old Commonwealth Bank start to engage in what we would clearly define as central banking functions? There are two candidates that can be put forward as the correct date. The first is 1924, when the Commonwealth Bank took over the note issue function (clearly a central banking activity) from the Notes Board, who had in turn taken it over from Treasury. The second is around 1930, when the Commonwealth Bank became an important player in economic policy debates (in this case debates about the exchange rate). If we are to rely on Professor Giblin, who wrote the definitive history of the subject which I cited above, it is this latter date which marks the start of true central banking in Australia. And, of course, it was at about this date that a twenty-nine year old Leslie Melville joined the Commonwealth Bank. The history of central banking in Australia and the history of Sir Leslie Melville are therefore largely coterminous. If you read through the correspondence files in the archives of the Reserve Bank in the thirties and forties you could be forgiven for thinking that Melville was the central bank. I will say more of that later. The world was very different when Melville joined the Commonwealth Bank. To the best of my knowledge, he was the first economist that they had ever employed, and I believe the first economist to be employed full-time anywhere in the Australian public sector. In those days the central bank was composed entirely of bankers, and the Treasury entirely of accountants. There were good economists in Australia at the time - Giblin, Copland, Shann, Mills etc but they were largely confined to the universities. The exception was when a few months before Melville was appointed to the Commonwealth Bank. Commonwealth Bank had resisted appointing an economist for several years despite the urgings of the Bank of England to do so. The fact that it finally felt the need to do so, and to such an important position, adds weight to the view that this point in time, or somewhere near it, should be viewed as the start of professional central banking in Australia. And what a time for Melville to be thrown into the fray. The depression had started, the Australian pound had depreciated against sterling and there was intense public debate on economic matters. Melville had already played an important and public role in these debates in the two years before his appointment, but henceforth he would be a policy-maker with responsibility rather than a critic without responsibility. It is interesting that Melville, who publicly supported the devaluation and hence was considered as an expansionist, was appointed by an institution whose Chairman - Sir Robert Gibson - was the leading deflationist of the day (and opponent of devaluation). created and led the Economist's Department, which advised the Board on monetary policy, just as the present day Economic Group of the Reserve Bank does seventy years later. As he built up his team he looked out for young economists to add to his staff - one was HC Coombs, whom Melville recruited in 1935. Virtually from the beginning Melville's position was an extremely senior one despite his relative youth. Much of what he did would more appropriately be done by a Governor or today. correspondence files reveal that he was dealing directly with Prime Ministers and Treasurers. He was the principal economic advisor to the in 1933. On the eve of the Second World War, Melville was appointed - together with Giblin and Roland Wilson - to the Advisory Policy, a body whose job was to plan Australia's war economy during its early stages. During the twenty or so years that Melville headed the Economist's Department, he must have been conscious of the fact that, while central banking was undoubtedly important, it was dwarfed in size by the commercial banking activities of the Commonwealth Bank. It is doubtful how much time the Governor and Deputy Governor of the day had left over for central banking matters, given the huge number of commercial bank branches and staff they had to oversee. In these circumstances, it must have been comforting to be able to turn to someone of Melville's knowledge and experience. The next aspect of Sir Leslie's career that I would like to look at is his association with the setting up of the Bretton Woods institutions - the IMF and the World Bank (and, but with a long delay, the World Trade Organisation). It is hard for recent generations to understand, but this whole venture was undertaken for the most idealistic and public-spirited of reasons. It was an exercise in international cooperation designed to ensure that the post-war world did not degenerate into the isolationism and 'beggar-thy-neighbour' policy-making that had characterised the previous twenty years and had contributed so much to the depression and the Second World War. Australia was an enthusiastic participant in these negotiations at first and it is no surprise lead the Australian delegation. Melville had already been in correspondence with Keynes and others about international monetary reform from about 1942. This gave him the necessary background to lead the Australian delegation to preliminary meetings in London in 1944 and then to the United Nations year. Melville threw himself into the task and was extremely effective. The towering intellectual presence behind these meetings was Keynes, and there is a letter from him attesting to Melville's effectiveness. Keynes said of Melville's performance at the Commonwealth Conference that 'he upheld the dignity and integrity of Australia with the most marked success ... He handled himself most impressively, was clear cogent and never unreasonable, put his point forcibly yet moderately, and achieved in my judgement, as much as was humanly possible to move matters in the direction he desired. He had quite a difficult task and accomplished it supremely well'. Despite some later backsliding on Australia's part, we became important members of these institutions and it was fitting that in 1950, Melville was In view of my earlier comment that in the 1930's and 1940's you could be forgiven for thinking Melville was the central bank, it comes as a surprise that he was not appointed Governor in 1948. Instead the position went to his central banking protege, Coombs. A number of good judges, such as Giblin, thought the best man had been passed over. Even Coombs thought so too. In a letter to Giblin after being appointed Governor, Coombs said 'Many thanks for your letter of congratulations. As you know, I, too, have always thought that Melville should have had this job and have given that advice in the appropriate quarter'. Coombs retained the highest regard for Melville and wrote effusively, but no doubt honestly, to him on his retirement saying 'in the years you were with the Bank, you made a contribution to the theory and practice of central banking which is without equal in the world'. Sir Leslie succeeded another economist - Sir Douglas Copland - in becoming the National University. He was ideally suited to this role as he was both a genuine intellectual and an experienced administrator and negotiator. He was also devoted to the ideal of the Australian National University as a world-class centre of research. It is interesting that, without any conscious direction, a close relationship seems to have been formed between the Bank and the University. The former has provided a Vice-Chancellor the latter has provided virtually all of the university economists who have been appointed to the Reserve Bank Board I have commented on a number of aspects of Sir Leslie Melville's life, but not on the aspect which explains why we are meeting here today. I refer, of course, to his remarkable longevity. It is not just that he has lived for such a long time - it is that he was prominent in public life from such an early age. He was already a well-known and influential economist in his twenties. When you read the early correspondence in our archives that I consulted in preparation for this talk - the yellowing foolscap pages with their uneven typewritten contents and the annotations in immaculate copperplate handwriting - you are transported back to a different era. It is hard for me to imagine that Sir Leslie actually talked to and corresponded with Keynes, who was already a long-dead historical figure when I was a student. And there are many more - White. Not only did he meet these people, he still remembers them and can talk lucidly about them and their times. I think Sir Leslie has made a remarkable contribution to public life in Australia. It is hard to believe that one man could have done so many things in the general areas of economics, education and public policy-making. I could not see it happening today. I also find it hard to see how someone who has achieved so much is not better known. This I attribute to his natural modesty, and to the fact that he was so busy doing things that he didn't have any time left over to push himself forward. But it seems to me that any objective assessment of achievements would place Sir Leslie among the most distinguished Australians of the past century. If this were Japan, and we had a serious practice of interview', declaring our most distinguished citizens as national treasures, I have no doubt that Sir Leslie should be one of the first people chosen. History of , Melbourne

r020404a_BOA

australia

macfarlane

Dinner sponsored by the Melbourne Institute and newspaper, Melbourne, It is an honour to be invited here this evening to give this address, although I must confess I am somewhat daunted by the task. We have heard so much in this conference on such a broad range of economic subjects by such a distinguished group of speakers that I have been presented with a difficult act to follow. I have also been given a very broad topic, so I will have to confine myself to making only a few comments on each part of it. I would like to start with the proposition that Australians, on the whole, tend to be pessimists about the country's economic situation and about its future. This is not always the case as there are occasions, such as the present, where a degree of optimism breaks out, but these are the exceptions rather than the rule. While Australians are often optimistic about their personal economic prospects, they are seldom so about the economy's prospects. I have spoken about this before and produced various pieces of anecdotal evidence to support my view. More objective evidence is available in the form of answers to surveys , which show a clear propensity for respondents to judge the economy more harshly than their own economic prospects (about which they presumably know more). Why is there such low confidence in our economic situation, even by people who are reasonably confident about their own economic circumstances and prospects? The usual answer is to blame the press, but I think this is a bit superficial. The allegation is true in only one sense: there are a lot more economic stories on the front pages of newspapers in Australia than in other countries. And since there is a natural tendency for the press to give more prominence to bad news than good - just as we hear more about war-torn countries than peaceful ones - this tends to increase people's exposure to bad economic news. I think a deeper answer to why we tend to be pessimistic is to be found in our attitude to our economic past, which tends to be dominated by a strong element of nostalgia. While in other areas of our political and social history we may be revising downwards our assessment of our forebears' achievements, this is not so in the economic sphere. There is still a tendency to look back favourably on the economic peace and certainty of the past and contrast it with the perception of insecurity and instability that surrounds the present economy. Why is this so? (a) Those who know a little bit of history are aware of the fact that in about 1900 we were probably the richest country in the world in terms of income per head. Now we are in the middle of the pack of developed OECD economies. So this gives the impression of a country in long-run decline, but from a somewhat artificial starting point. We were the 'Kuwait of 1900': a country with a very small population and a large resource endowment producing commodities which were very highly priced at the time. But like any prosperity based on scarcity prices it could not last , as the decline in our terms of trade during the century showed. I will return to this theme when I discuss the future. (b) For others, the nostalgia is directed at the 1950s and 1960s. There is no doubt that around the world this period of post-war reconstruction was a 'golden era' for economic growth that had not been seen before or been equalled since. But we should remember that the Australian economy did not keep up with the rest of the world during this period: the growth in GDP per capita was lower than the OECD average in the 1950s and 1960s. We also tend to underestimate just how poor we were compared with what we take for granted now. Much of the post-war housing expansion into the newer suburbs involved building two-bedroom-one-bathroom houses with external toilets: sealed roads, sewerage and telephones came years later. There are many other examples of the difference in living standards I could quote. By the present I mean the economic expansion over the past decade which we are currently still experiencing. Fortunately we do not view the 1970s and 1980s with much nostalgia, so most people are willing to accept that the current expansion represents an improvement compared with those earlier decades. This can be seen in that: (a) The current expansion is longer. So far it has lasted for 41 quarters compared with 31 and 28 respectively for the expansions in the 1970s and 1980s. (b) Our rate of growth of productivity has picked up compared with earlier decades. We are one of a very small group (about five) of OECD countries to have achieved this. (c) We have weathered two quite large contractionary external shocks without significant adverse effects. I am referring here to the Asian crisis of 1997-98 and the world slowdown/recession of 2001. (d) There is evidence to suggest that some economic distortions that seemed to be entrenched have been removed or at least improved. The most obvious of these is the reduction in inflation from the very high rates of the 1970s and the quite high rates of the 1980s. Indeed, if we had not succeeded in regaining low inflation in the 1990s, we would have had no hope of achieving the long economic expansion we have had. There has also been some success on the balance of payments. It is now clear that the pronounced deterioration in the external accounts occurred during the 1970s, reached a plateau from the early 1980s to the present, and may have shown its first, although tentative, sign of improvement over the past few years. There is also evidence that progress is finally being made on unemployment, a subject I would like to cover in a little more detail. There were international recessions in the early 1970s, 1980s and 1990s. We have also just been through one in the early 2000s, although economists are still debating whether it was deep enough to be added to the list of its three predecessors. In the 1970s, 80s and 90s, Australia also experienced recessions roughly co-incident with the international ones. On each occasion our unemployment rate rose sharply - to 6.5 per cent in the 1970s, to 10.3 per cent in the 1980s and to 10.8 per cent in the 1990s. While we were able to reduce the unemployment rate during the later expansionary phases, each recession pushed it up again to a new peak (see Table 1). The real story behind the upward trend in unemployment was the shakeouts that occurred during the recessions, not the insufficiency of the growth rate during the expansions. During the international downturn/ recession of 2001, Australia was able to avoid a recession so our expansion is still proceeding. Nevertheless, there was some slowing in the pace of economic growth and the unemployment rate rose by about 1 percentage point. Although I am always wary of counting chickens before they hatch, it now appears that over the past six months the unemployment rate may have peaked at, or a little above, 7 per cent. If this is the outcome, it will be the first time for three decades that we have been through an international downturn that has resulted in the peak unemployment rate in Australia being lower than its predecessor. I hope that I am not premature in making this assessment, and am aware that it could all be unwound if we encountered a recession in the near future. But that is not likely in my view, at least not in the forecasting horizon. If my assessment is correct it will reinforce the view that the principal contribution that macroeconomic policy can make to reducing unemployment is to have the longest expansion possible (but not the fastest), and to have the mildest slowdown. It also suggests that the reduction in unemployment to an acceptable rate is a task that was always going to take longer than the timeframe encompassed by a typical economic expansion. As you can see from the foregoing, I think Australians have tended to be quite hard on themselves when making judgements about the economy. This has its good side of course, because it has meant we have been more prepared to take tough decisions than many other countries, particularly European ones, when it comes to reducing government debt, opening up the economy, privatising, deregulating the labour market and imposing stricter competition standards. When we look to the future, I see no need for us to retain our long-held pessimism about our country's economic future. For a start, we should gain some comfort from the fact that in economic terms, there was a clear improvement from the 1970s to the 1980s and an even bigger one to the 1990s. This is true in absolute terms and even more so in relative terms: the 1990s was the first decade that we clearly grew faster in income per head terms than the OECD average. We should not be looking at ourselves as one of the laggards, but as one of the few pacesetters among developed OECD countries. What about the longer-run trends? There is still a feeling in many quarters that 'we were dealt a good hand to play in the world economy of 1900, but a bad hand for the world economy a century later'. This is tied up with the view that we are mainly good at exporting resource-based goods (in which I include mining, metals and agriculture), and hence our terms of trade are bound to continue the deterioration that started a century ago. I think this fatalism is misplaced for two main reasons. The first and conventional response to this charge is to point out how the economy is changing, and in particular, how we are diversifying our export mix. Over the past sixteen years, the fastest growing categories of exports in real terms have been manufactured exports and exports of services. The annual growth rates of each category of exports is shown in Table 2. We all know of some success stories, but each one is relatively small in itself. What we don't tend to realise, is just how many there are, and how widespread they are. There is a second and more interesting response, however, than the conventional one, and it is one I would like to spend a bit of time on. It concedes that even with export diversification occurring, we are still going to be a country with a high proportion of our exports coming from the resource sector. In twenty years of diversification, the proportion of exports, which is resource-based, has fallen from nearly 80 per cent of the total to 60 per cent of the total at present. This is still very high by the standards of an OECD country, and even if it goes down to 50 per cent in another fifteen years, it will still be high by the standards of developed countries. Is this something we should worry A lot of people would say yes, because resource-based goods are 'commodities', and this means their prices will fluctuate widely in a cyclical sense, but more disturbingly, their trend will continue to show a long-run decline. This is the same assumption I have referred to a few times in my talk, namely, our terms of trade will continue to decline. But I think we have to doubt this assumption. The products whose prices will show long-run declines are likely to be those whose production can be expanded most easily. And nothing fits this description better than large areas of manufacturing. Governments around the world, particularly in Asia, are competing to build larger and larger plants, and companies from developed countries are assisting them through private direct investment. We all know how far the price of computer chips has fallen, but this is only one example of many. Large areas of manufacturing, such as textiles, clothing, footwear, electrical equipment and even automobiles have shown downward trends in prices. These are precisely the sorts of things that we in Australia import, and increasingly what developing countries export. In a recent study, the World Bank pointed out that manufactures now make up 80 per cent of developing country exports, compared with only 25 per cent as recently as 1980. 1985 to 2001, % pa Over the past three years the prices of 26 out of 29 categories of our imports have fallen (when adjusted for exchange rate effects). In other words the stigma of the word 'commodity' could now be more appropriately applied to our imports than to our exports. This may be the reason that for the first time in memory, our terms of trade actually rose during a world recession (i.e. over the past three years). It is also consistent with the fact that the low point in our terms of trade was in 1986: there have been cyclical lows since, but they have been at successively higher levels old growth shiraz) and get into something more promising. We have had a history of being told that we have the wrong model for our economy, and that we should change it to the one currently in vogue. I can remember in the 1970s when model was seen as the way forward. In the 1980s there were numerous books and articles predicting that Japan would soon overtake the US as the world's largest economy, and by implication that its corporatist approach was superior to more market-based approaches. In the first half of the 1990s Australia was regularly criticised for lacking the vigour of the emerging-market Asian economies (the Tigers) with their activist government-led development approach. In the past few years, it has been American triumphalism. The extreme expression of this was the recent infatuation with the 'New Economy' and denigration of activities regarded as 'Old Economy'. Two years ago at the World Economic Forum meeting in Melbourne, Australia was being heavily criticised for not making enough of the IT and telecommunications investments that are currently being written off by the former stars of the NASDAQ. As you can gather from the above, I am extremely sceptical that we can identify a 'new economic model' and have the government move us to it. But, on the other hand, I recognise that as a country we have to be continually adapting in order to exploit emerging economic opportunities, including at the more sophisticated and high-value added end of the spectrum. This is a job not just for the private sector, but a challenge for public policy-making. Among the purely economic policies with which I am familiar, such as monetary policy, fiscal policy and financial supervision, I think there has been enormous improvement over the past decade or two, and we can claim membership of the relatively small group of countries that represent world best practice. But good economic performance as we move into the future will depend on more than purely economic policies; it will depend on the incentives provided by our whole political, Now I don't want to get into an argument about whether it is better to put our scarce investment resources into the resource sector or into the manufacturing sector. In fact, I would strongly resist the government setting out to decide the answer to this question. All I am saying is that we shouldn't assume that our future is unfavourable just because we happen to have started with the industry mix we have. A corollary of my view, of course, is that it would be very unwise for the government to provide incentives for the private sector to move out of one activity into the other. It could easily end up being seen the same way as the decision of the South Australian authorities in 1986 to pay grape growers to pull up their red wine vines (some of which were the now highly-prized legal, social and educational environment. It is somewhat disturbing therefore to read the recent assessment by the Vice-Chancellor of Melbourne University that Australia no longer has a university that could be ranked in the top one hundred in the world. I have no reason to dispute his opinion as I have heard similar views from other academics. What it suggests is that, although we have made great progress in the breadth of our education system, we cannot make the same claim about the depth. At the highest level of higher education we are not keeping up. I am usually reluctant to stray into areas of public policy outside my immediate area of expertise, but I am prepared to do so tonight in keeping with the broad range of issues discussed at this conference. I do not have a shopping list of suggestions, but I am happy to conclude my address tonight with a plea to all those involved in higher education - governments, bureaucrats, academics and their spokespersons, taxpayers and businesses to do something about this situation. The remedy will almost certainly involve the overthrow of some long-held conventions that attempt to impose uniformity. It will probably also elicit the old catchcry of 'elitism', but far better that, than the complacency which accepts that our higher education can slip further behind world best standard.

r020531a_BOA

australia

macfarlane

Governor, in testimony to the House of was released on Mr Chairman, with the normal timetable interrupted by last November's election, it is slightly over a year since we appeared before this Committee. Since it has been an extremely eventful year, I will have a fair bit of work to do today to fill the gap. Looking back over the Hansard of the last meeting in May 2001, I see that I was explaining why we had lowered interest rates At the time of our meeting, I was pretty confident that the Australian economy was on a recovery path after a short housing-induced setback in the second half of 2000, but none of us were sure about what was going to happen in the United States and the rest of the world. External events were seen to be crucial to our fortunes and to the evolution of our monetary policy. As it turned out, these events unfolded in two distinct phases: Over the rest of 2001, the world economy continued to weaken. The United States had a mild recession, with consumer spending holding up and so preventing it from being as deep as earlier ones. On the other hand, the business sector had a pronounced recession judging from the fall in industrial production, business investment and corporate earnings. Most other major countries had negligible growth during the year, so that for the G7 countries as a whole, growth was virtually zero over the year. Even so, it looked for a time that it could have been much worse. For most of last year, therefore, we were receiving gloomy news on the world economy. After a brief respite in mid year, bad news began to re-emerge in July-August, so much so that we in Australia eased monetary policy on September. Then the events of September induced a new bout of gloom, and there was a real fear that the world economy would weaken further in 2002 and so experience a prolonged and deep recession. Monetary policy was eased virtually everywhere. In our case, even though our own economy remained in good shape, we eased in anticipation that the weakening prospects for the world economy would eventually flow through to the domestic economy. The second phase began in the early months of this year, when it became increasingly clear that our earlier fears about 2002 were not going to be realised. The US economy grew more quickly in the final months of 2001 and the first quarter of 2002 than anyone had expected. In addition, we received better news from pretty clear that 2002 will be a year of recovery for the world economy, and the IMF is forecasting good growth through the year. The debate is no longer about whether there will be a recovery, but about whether it will be an average or below-average recovery. There is still a good deal of uncertainty about how robust the US recovery will be once the inventory correction has passed, i.e. in the second half of the year. Some of the bubble-type distortions have not been fully unwound so there is still a fair bit of caution around, including in the Federal Reserve Board. So we are in a world economy with a more comfortable outlook than a year ago, but with still some uncertainties remaining. What of the Australian economy? The story here has been much less exciting, but the results a lot more satisfying. As you know, GDP grew by 4.1 per cent over 2001, which was the highest among comparable OECD countries. We can now safely claim that the Australian economy has weathered a world recession without itself experiencing one. This is the first time in my experience that such an outcome has occurred, and it must give us confidence in the soundness of our economy. But before getting carried away, we should concede: By the standards of earlier world recessions, last year's was a mild and short one, and some observers may be reluctant to classify it as a fully-fledged recession. We did not escape scot-free. If you average our growth in 2000 and 2001, it comes out at 3 per cent so we did experience a modest slowing. As well as good GDP growth, we have experienced quite good employment growth over the past year. It appears that the slowdown in our economic activity resulted in a trough-to-peak rise in unemployment from 6 to 7 per cent, and that half of the rise has already been whittled away so far in 2002. This is extremely good news because it is the first time for three decades that we have been through an international downturn that has resulted in the peak unemployment rate in Australia being lower than its predecessor. At this point in proceedings, I usually review the previous set of forecasts I gave the Committee and then present a new set for the period ahead. I will continue that tradition, but we should bear in mind there is a full year of new data available to us so there is more to review. Last May, when we had only two of the four quarters of 2000/01 available to us, I said we expected year-on-year GDP growth in that year to be about 2 per cent; in the event, it came in at 1.9 per cent. My forecast for year-on-year GDP growth in 2001/02 was per cent, and our current forecast (still with two quarters yet to come) is 3.6 per cent. So, even though there have been big swings in the international outlook in the meantime, the last 18 months seem to have turned out much as we expected (unlike the previous six months where the extent of the housing-induced setback took us largely by On the prices front, we still had not seen the GST bulge pass through the system when we met last May. The forecast I presented at the time was that when it had passed through, the rate of inflation measured by the CPI would settle at 2 per cent. In fact, that was 'spot on' for the four quarters to the September quarter of 2001, but by the December quarter inflation had risen to 3.1 per cent, and by the March quarter 2002 it was 2.9 per cent. So, on average, we slightly underestimated the rise in inflation. For the year ahead, i.e. 2002/03, we are forecasting the economy to continue growing at 3 to 4 per cent as it completes the eleventh year of its expansion and enters the twelfth. The outlook for inflation over the same period could best be summarised as remaining near the top of our target range, although we expect it to go down slightly for a time, and then to come back up. This was the view expressed in our quarterly released earlier this month. In short, the outlook for economic growth and inflation is such that the economy no longer needs the boost provided by an expansionary stance of monetary policy. We took the first step towards returning monetary policy to a more neutral setting earlier this month, and, unless unforeseen developments intrude, we should continue the process as we go ahead, while all the time carefully examining incoming data, both from here and abroad, to ensure that developments remain on track. I will return to this theme later in my presentation, but before doing so I should examine the economic outlook in a little more detail. In looking ahead, we always have to ask ourselves where the balance of risks lies. Another way of expressing this is to ask: what is the main risk for the economy if we did not adjust monetary policy? In our view, the most important risk would be that the expansionary forces in the economy would increase to an excessive degree, bringing with it the likelihood that inflation would rise from its present position at the top of our target range to something in excess of it. In the process, we would also expect other imbalances to emerge which would ultimately bring the current expansion to an end. Of course, we cannot entirely rule out the alternative outcome whereby the economy slows and puts sufficient downward pressure on inflation that it threatens to fall below the bottom of our range, but we would put a low probability on that outcome. As has been the case now for some time, to the extent we can identify risks on the downside, they come mainly from abroad. Even though the US economy grew quickly in the first quarter of the year, the strength of its recovery is still uncertain, and there are risks to the world economy from the unstable political situations in the Middle East and Indian sub-continent. On the domestic front, the most easily identifiable area of spending that will exert a dampening influence later in the year is likely to be house-building, largely because so many houses will have been built that construction will not be able to continue at its former rate. But overall, barring some unforeseen international event, we find it hard to see serious risks on the downside for the Australian economy. We cannot rule out slightly below-average growth, but we would regard anything significantly more adverse as unlikely. Instead, conditions are much more conducive to stronger economic growth than last year. The turnaround in the world economy will mean that it will be a positive force for growth over the year ahead rather than a dampening influence. This should be good for exports, investment and confidence in general. As well, both consumer and business confidence have returned to quite high levels after a couple of setbacks last year. Business investment has been quite restrained over the past couple of years but is about to pick up according to the plans businesses supply to the ABS's Capex Survey. This is not surprising given the relatively healthy profit situation, the high level of business confidence and the expected growth in spending. These more buoyant conditions may also encourage businesses to attempt to rebuild profit margins, which will be a factor underpinning inflation over the next year or so. Thus, we believe that if monetary policy maintained its present stance for too much longer, there is little risk of a serious slowdown, but a high risk that the economy in time would overheat. This provides the basis for our view that monetary policy should be returned to a more neutral setting. I think there is widespread agreement with this assessment of the situation, but inevitably there will be people who do not agree. One doubt you sometimes see expressed is the fear that any rise in interest rates will 'choke off the expansion'. Not surprisingly, we feel that this fear is misplaced. At one level, it amounts to saying that the expansion is so fragile that it can only be continued if monetary policy is kept permanently at an expansionary setting. We also care about continuing the expansion, but feel that the least risky way of doing so is with a more neutral interest rate setting. At another level, the fear may be that we at the Reserve Bank will err on the tight side. Of course, that is possible, but our track record does not support this view. Over the past decade or so, the thing that stands out about our monetary policy is the fast rate of economic growth it has permitted compared with other comparable countries, not any tendency to over-achieve with inflation reduction. Where we differ from some observers is that we are mainly interested in the medium run, i.e. we want to sustain the expansion rather than to maximise its speed over the next year. We have been consistent in this approach for the best part of a decade, and it has served us well. I would now like to change to a subject that was highlighted by this Committee in its press release announcing today's hearing, namely credit card reform. The Reserve Bank released its consultation document in December last year. In it, we proposed, subject to further consultation, three major changes to the four-party credit card schemes that operate in Australia: first, a new and transparent standard for setting the interchange fees on credit card transactions which would lead to a reduction in those fees, and thus in the merchant service fees paid by businesses; second, the ending of the prohibition imposed by the card schemes that prevents merchants from passing the cost of accepting credit cards on to cardholders; and third, the elimination of the restriction on entry to the credit card schemes that keeps out potential competitors that are not deposit-taking institutions. After we released our document, we allowed interested parties till mid March to prepare submissions, and we have been going through those submissions thoroughly with them since then. We want to give each party every opportunity to put their view forward, even if it involves multiple meetings. We are still in this process and, when we have finished, we will release our findings sometime after the end of June. During this period, we at the Reserve Bank have not engaged in public debate on this subject, even though some of the other participants in the credit card industry have been quite vocal. We see our role during this stage essentially as the umpire adjudicating between the competing views of the financial institutions and card schemes on one side, and the consumers, retailers, billers, etc on the other side. Of course, our umpire role should not inhibit the Committee from asking any questions it wishes to.

r020625a_BOA

australia

macfarlane

Roundtable with the Government of Australia, I would like to start by thanking for inviting me to be the guest speaker at the 7 Roundtables have served a very useful purpose since their inception in the late 1960s, and I am sure this one will be just as productive. When I was invited to give this address, I was told that it would be part of a session entitled significantly different, or in relative decline'. From this, I assumed that I was required to speak on medium-term issues, which I am always very happy to do. But since I have a couple of difficulties with the session title above, I may not stick to the script expected of me. My first difficulty is that I am wary of forecasts going out as far as 2020. These have a tendency to be not much more than projections of current short-term trends and can be quite misleading; this was the case with those produced by the Club of Rome in the seventies showing the world running out of commodities, and those made in the eighties showing the level of GDP in Japan exceeding that of the United States. My other difficulty is with the inclusion of the phrase 'relative decline' as a possibility, without specifically mentioning the possibility of 'relative advance'. This may be nothing more than a 'Freudian slip', but nevertheless, I will use it as the theme for my talk tonight. It is a theme I have touched on before - the tendency for Australians to be pessimistic about their economic future. The reasons for this pessimism have varied from decade to decade, and there have been a few new ones added in recent years, but the overall tone seems to be relatively constant, and relatively impervious to changes in our actual economic condition. I would have thought that, after a decade in which our growth performance has been the best in the OECD area (with a couple of minor exceptions), most of the pessimism should have receded, but I doubt that it has. In order to assist in this process, I would like to recall some facts before moving on to discuss the arguments. I have already mentioned our growth performance in the past decade. The actual numbers are shown in Table 1, which uses calendar year 1990 as the base and shows the average growth rate up to the most recent using 1990 as the base, we include the early nineties recession for all countries in the average, as well as the later expansion. Part of our stronger growth can be explained by faster population growth, but we also have put in an excellent productivity performance over the decade as well. In the work done by and by the OECD in Paris , Australia is identified as one of the group of countries that has increased its rate of productivity growth (whether measured by labour or multi-factor productivity) in the nineties compared with the eighties. Graph 1, which is reproduced from the OECD, shows Australia is second only to Finland in its acceleration in multi-factor productivity. The trends I have mentioned are not confined to the 1990s, although that was clearly our best decade in terms of relative Annual rate, per cent advance. If we look at the broader picture over the past 20 years, Australia is still in the very small group of advanced countries to have increased its share of world output. Using the IMF's annual database, it is possible to discern some interesting longer-term trends from developments over the past 20 years. This is a useful exercise because it is an antidote to the type of thinking which concentrates on very recent developments, some of which I will cover later. The two main trends that are of relevance for tonight's topic are as follows: (1)Our region - which is mainly the developing countries of Asia - has grown a lot quicker than the world as a whole and so its share of world output has risen from 10 per cent in 1980 to 24 per cent in 2001. Not only has the total risen, but each country, with the exception of the Philippines, has been able to increase its reminding ourselves of this major trend, because it tends to be overshadowed by our more recent memory of the Asian crisis of 1997 and 1998. (2)In contrast, the developed countries of the OECD area have grown less rapidly than the world average and their share of world output has fallen from 57.5 per cent in Within the group of developed countries, only three have managed to increase their share of world output - the United States, Australia and Ireland. If we leave out Ireland because of its small size and its exceptional circumstances, Australia and the United States are the only two developed countries of reasonable size and reasonable initial income per head to have increased their share of world output. Some people would discount our achievement by pointing out that a fair bit of our increase in share was due to higher population growth resulting from higher levels of immigration. But that should be seen as a strength rather than a weakness if we are interested in which areas are growing and which are declining in relative importance. Also, it points to favourable developments in the future, as high-immigration countries are less susceptible to the strains imposed by an ageing population. I have presented enough statistics for the time being. The purpose of highlighting these 20-year trends was not to imply that they must continue - they may not. My purpose was to ask the question 'given this has happened over the past 20 years, why would you start with the presumption for Australia of relative decline - why wouldn't you start from the expectation of relative advance?' Another way of viewing these statistics is to observe that, while there may have been some influences running against us, they have obviously been outweighed by influences acting in our favour. What are these influences that are generally cited as acting against our long-term interests? Per cent Per cent I will start with the familiar, then move on to some of the more recently-cited ones. The time-honoured reason for pessimism was the belief that there would be an inevitable long-run decline in Australia's terms of trade, i.e. that our export prices would stagnate, while our import prices would rise inexorably. This was tied up with the general lament that we had too small a manufacturing base, and were too dependent on 'commodities' produced by the rural and resource sector. There certainly was a lot of substance to this argument until recently, so I do not wish to belittle it, or declare it dead prematurely. But events over the past two decades or so have cast a lot of doubt on its future applicability. (a) Australia's terms of trade bottomed in 1986 and have risen since. It has not been an even rise, but each subsequent trough has been at a higher level than its predecessor. The main reason for this is not that export prices have been particularly buoyant, but that import prices, predominantly manufactures, have been weaker. (b)This should come as no surprise since the nature of the world's manufacturing sector has undergone an enormous transformation over the past two decades. In 1980, only 25 per cent of the world's manufactured exports came from developing countries: by 2000, 80 per cent did so. There has been a role reversal, and this has been accompanied by a loss of pricing power by exporters of manufactures that has effectively shifted real income to importing countries. It is hard to see how this process could not continue, with China and India still having so much capacity for further expansion. The more recent sources of pessimism are of a very different nature, and very hard to analyse in simple economic terms. Let me start with a frequently-heard complaint in financial markets, and work from there. The complaint is summarised by the phrase 'we (meaning Australia) are just not on the radar screen'. By this is meant the tendency for investors around the world to concentrate their efforts in the big markets, such as the United States and Europe, and to ignore us because of our small size and lack of strategic importance. There is no doubt that this tendency can be important at times, but we should not assume that it is permanent. Recently, we suffered from its effects, but there is no reason why it should continue, and it has not continued. Graph 2 on recent international capital flows into and out of Australia tells an interesting story. First, it is certainly true that inward portfolio investment into Australian equities dried up for a time in 2000 and early 2001. This was consistent with the 'we are off the radar screen' explanation, which itself was part of the international investment community's infatuation with the 'new economy' and its disdain for the rest, including us. But the important thing is that it seems to be a phase that has passed into history with the rest of the 'tech bubble' - inward portfolio investment has resumed again in recent quarters. Incidentally, inward direct investment continued at a relatively steady pace over recent years, and was largely unaffected by the tendency described above. In the past, it was inward direct investment that attracted unfavourable comment. Foreign investment and multinational corporations were viewed with suspicion and accused of buying our best companies (in some sense, the opposite of the 'we are off the radar screen' argument). Now the interesting tendency is in the opposite direction - Australian direct investment abroad is greater than foreign direct investment in Australia. Also, Australian portfolio investment abroad has risen strongly. What does this mean? Does it support another often-heard view that there are no good investment opportunities in Australia, and firms and investors are forced to go abroad? The first thing to note is that Australia is still an overall net importer of capital, i.e. more is invested in and lent to Australia from abroad than we lend to or invest in other countries (a necessary corollary of running a current account deficit). Since the Government has little or no role in these investment flows, it is the world and Australia's private sector players that have chosen this outcome. Notwithstanding this consideration, some people are still troubled by the amount of portfolio investment abroad by Australian institutions and direct investment abroad by Australian companies, accusing them of turning their backs on Australia. I think the situation is a bit better than this. My guess is that the bulk of the portfolio investment abroad is just a sensible diversification of assets by Australian investors and institutions. In 1983, before exchange controls were abolished, Australian portfolios had zero international diversification, and in time we will reach a level that is appropriate to our circumstances. In the meantime, we will see outflows as we move from zero to the optimal level. In addition, we should not forget that other countries are also diversifying their portfolios, and in the process purchasing Australian equities and bonds. On direct investment, we are going through the second phase of Australian companies buying overseas assets. In the first phase in the late eighties, it was done rather indiscriminately with a lot of investment outside the investor's normal area of expertise. The results were not very good. More recently, however, most of it has been done by successful Australian firms that have reached their limit of expansion in their own industry locally, but are good enough to compete in other markets in their area of expertise. Thus, we have seen them expanding directly into overseas markets in transport, packaging, building supplies, shopping malls, property services, etc, mainly activities that cannot be serviced via exports, but require direct investment. I think this trend is to be applauded, and is a sign of the success of Australian business rather than its inadequacy. Although we are nowhere near as far down this path as, say, the Netherlands or Switzerland, their success shows that it is not only the major countries that can create viable international companies. So far, I have not mentioned the other catchphrase - the 'branch economy' - the belief that the companies in the peripheral countries will be swallowed up by larger companies centred mainly in the United States (and, to a lesser extent, Europe), leaving only branch operations behind. This is a more difficult concept to pin down, although I do not wish to dismiss it as a concern. There certainly are powerful forces towards centralisation that operate within economies, and between economies. These centripetal forces are primarily the result of improved technology, particularly in communications, media and transport. They are best analysed within the framework of 'winner-take-all markets' rather than in the more conventional discussion on globalisation. If this is our concern, i.e. our best companies are falling into foreign hands, the thing we should mainly worry about would be a big rise in inward direct investment, but we have not seen this - we have seen a reasonably steady trend over recent years. Again, if this is our concern, we should applaud the success of Australian companies operating abroad, as shown by the recent strength of outward direct investment - although there will inevitably be tensions about where these companies will be listed and headquartered. It will take a long time before we can put these issues into perspective. We are still too heavily influenced by the events of recent years whereby everyone seemed to be comparing themselves unfavourably against the US economy, and finding that they were losing out in the investment community's esteem. That situation is changing and, when the dust settles, I suppose some of the more extreme views about the magnetic pull of investment to the United States will recede. As explained, we have already seen this happening in the Australian figures on foreign investment and it is also showing up elsewhere, including in the US figures on capital movements, where net capital movements have returned to outflows after a few years of heavy inflows This is the note on which I think I should finish. We cannot predict the future: all we can do as a country is to try and make sure that we have an economy that is resilient enough to handle the shocks that it will inevitably face. We have done so successfully twice in recent years when we faced the Asian crisis of 1997/98 and the world recession of 2001. This should give us some confidence that we can handle the next one - whatever it is - as successfully.

r020821a_BOA

australia

macfarlane

The following is the text of the Colin Clark Memorial Lecture delivered by the Governor, Mr IJ Macfarlane, at the invitation of the University of Queensland, Brisbane on I would like to start by thanking the University of Queensland for inviting me to deliver the 12 It is an honour that I very much appreciate. I met very briefly at Monash University in the late 1960s when I was starting my professional career and he was finishing his and easing into retirement. He was a remarkable man who was widely respected by the world's economics profession, but who received less recognition in Australia than he deserved. Previous speakers in the series have given accounts of his career so I will confine myself to two anecdotes. The first is based on something I spotted quite recently. Out of nothing more than idle curiosity, I looked up the journal for 1950 to see one of John Nash's original articles. While searching for it, I came across a list of the eleven members of the Council of the Econometric Society at that time. It was the cream of the economics profession, five of whom subsequently won Nobel Prizes, and all but one from prestigious universities. The exception was Colin Clark, who won acceptance into this august company yet listed his affiliation as the Queensland Bureau of The second anecdote is based on my memory of an article on India he wrote in the more than 30 years ago. It provoked an angry response from a local Indian academic, the essence of which could be summed up as 'what would you know about the subject?' In his reply, Clark listed the people with whom he had discussed the subject over the previous 40 years - the list started with Gandhi, Nehru and Mountbatten and continued from there. To some, it might seem to be a case of name-dropping, but to people who knew him it was just another illustration of his extraordinary breadth of experience and his endless search for knowledge. Let me now turn to the topic of my address today which, not surprisingly, is about monetary policy. I want to start with the apparently simple question, 'what would good monetary policy in a healthy economy look like?' Usually, when people answer such a question, they end up by giving an account of what monetary policy should set out to do. They point out that its primary focus should be on a nominal variable such as inflation because this maximises the chances of achieving sustainable economic growth. Sustainability is the key concept here; attempting to maximise growth in the short run is counter-productive, as is exclusive concentration on trying to smooth the business cycle, or the attempt to get the economy on to a trend growth path higher than its potential. I have no wish to argue with any of these propositions, and indeed they are all encompassed within our inflation-targeting approach to monetary policy. They are admirable statements of the aims of monetary policy, but they are not descriptions of what good monetary policy in a healthy economy would look like, i.e. they do not tell us how the instrument of monetary policy would behave. Perhaps it is best to start at a very simple level. Most people do not like very high interest rates and associate them with bad monetary policy. Of course, if the country is already experiencing high inflation, the high interest rates may be a necessary evil, and the alternative would probably be a lot worse in the long run. Be that as it may, we can hardly say that such a situation could be described as good monetary policy in a healthy economy, because the economy is not healthy - it is suffering from high inflation. This all seems pretty obvious, but the obverse is not so obvious. I sometimes hear people say 'why don't we have lower interest rates like country X?' as though the lower the interest rate, the better off we would be. On closer examination, we see that very low interest rates, although they may also be a necessary evil in the circumstances, usually indicate an unhealthy economy - one that is in recession or, even worse, deflation. We do not have to look very far to see examples of this over the past few years. So if very high is bad, and very low is bad, is there not a happy medium somewhere? Is this how we would recognise good monetary policy in a healthy economy? The answer is yes - that is certainly part of the story, but only part. I would now like to go on and tell the rest. Twenty or thirty years ago if we had asked my simple question, the answer would have been something like the following. If the potential growth rate of the economy is, say, per cent per annum and the desired rate of inflation is 2 per cent, then the long-term trend rate of growth of nominal GDP will be about 6 per cent per annum. We should, therefore, aim to make sure that the supply of money grows at a constant rate which is consistent with this. The actual rate will depend on the trend in the velocity of circulation, but the important thing is that when we find the right rate, we stick to it. In this world, interest rates are determined as the residual - they rise or fall enough to ensure that the growth of money supply stays on its constant path. Note, of course, that economic growth will not be constant: its annual growth will fluctuate around the long-term trend. This is a very simple model and a very appealing one. Unfortunately, things were never really able to work out this way. The assumed stable long-term relationship between money and nominal GDP broke down because of changes brought about by financial innovation and deregulation. But it is still a very good starting point for discussions, and many of its characteristics still hold good in a world without a stable demand for money. In the modern monetary policy framework as practised around the world, we cannot, and should not, directly 'control' the supply of money and wait for interest rates to drop out as the residual. We now control the very shortest interest rate (the cash rate) directly, and so it acts as our instrument of monetary policy. So how should its average level and its short-term movement behave in a healthy economy? The answer: very much as they would in the earlier example I gave with a stable demand for money. For example: Nominal interest rates would not show either a rising or falling long-run trend. Their fluctuations would be around a stable average - in technical terms, they would have the statistical characteristic known as stationarity. * The numerical value of this long-run average would be the level that was consistent with a low-inflation sustainable growth path for the economy. For a healthy economy, the inflation rate would neither rise nor fall in trend terms, and so the long-run average real interest rate would also be stable. It is this rate which is often referred to as the 'neutral rate of interest'. * The actual real rate of interest would rise and fall as it responded to increasing and decreasing inflationary pressures in the economy. If the real rate of interest did not go up and down in response to these changing pressures, the underlying dynamics of the economy would be unstable for the reasons I outlined in my The actual time path of real interest rates would closely resemble the time path that would occur in the stable money demand example I gave earlier. The difference is that it would result from a sequence of deliberate monetary policy decisions, rather than occurring as a residual. This is the sort of behaviour of interest rates that has been observed in Australia over the past decade. A stable rate of inflation, a stable average growth rate, a stable average short-term interest rate whether measured in nominal or real terms, but some variation in actual interest rates as monetary policy responds to alternating periods of inflationary or disinflationary pressures. That is, a stabilising monetary policy involves interest rates moving. It is entirely consistent with the inflation-targeting framework we employ, and it is employed either explicitly or implicitly by virtually all other major countries. What is the relevance of the foregoing for what is happening now? If we look around the world, we see some examples which illustrate some of these points. It is very hard to find examples of countries with very high interest rates, other than a few emerging-market countries trying to stave off a currency crisis. Examples of very low interest rates come more readily to hand. The best example is Japan where the cash rate is zero; this is obviously a result of an economy experiencing deflation and a closely spaced series of recessions. In the United States the cash rate is 1.75 per cent, the lowest since the early 1960s. Again, this is an economy which has just been through a recession and is still experiencing the unwinding of the equity price bubble. In the case of the Euro area, the situation is closer to normality, but growth over the past year has been negligible; not surprisingly, the cash rate is still only Then we come to a few countries like United Kingdom where conditions are relatively normal and the cash rate is in the range of 4 per cent to 5.75 per cent. I should also mention in passing that this group of countries all employ inflation targeting as their monetary policy regime. Most of the countries in this group have raised interest rates this year, because there has been a good case to do so on domestic grounds. But, at the same time, they have been keeping a close watch on the global economy and global financial markets to see whether these developments could outweigh the domestic influences. That has clearly been our case over the past two months. In May, I told a Parliamentary Committee that, since the Australian economy was behaving normally, and the world economy was getting back to normal, our interest rates should also be moved up to normal (or neutral). That is still a good general guide to policy, and is consistent with what was said in the first part of this lecture. But policy always has to retain the capacity to respond to unexpected events, and hence I did include a qualification to this guide in that I said that 'as long as nothing intruded'. Also, I did not specify a timetable. As a result, the financial markets were not surprised when monetary policy was not tightened at the July and August Reserve Bank intruded, as was obvious to anyone who kept abreast of world economic and financial developments. The expected development of the domestic economy was still on track, but for the world economy, and particularly the US economy, some serious doubts had arisen. Whatever guiding principle underlies a monetary policy strategy, it has to contain the flexibility to absorb incoming information and be adjusted accordingly. So if unforeseen events intrude, they should correctly be allowed to delay the return to normality, or if the events were severe enough, they could in extremis overturn the direction of movement. Although the latter possibility has to be recognised, we think it is very unlikely. There has been more focus on equity markets over the past two years than any other time I can recall in the post-war period. Most of the focus is on the United States, but European markets have fallen just as far. Falls in equity prices are principally a concern to us because of the risk they pose to global economic recovery. The most obvious channel is through wealth effects to consumers, but business spending is also vulnerable to the rising cost of equity capital, and to the cost of debt as credit spreads widen. There may also be an increase in general uncertainty and less preparedness to invest as a result of community disillusionment with some recent business practices. I want to stress that these risks come from international markets, not the domestic ones. Even though Australian share prices have fallen, compared with others they have done so by a smaller amount, from a much lower peak, and the fall has been much more recent. Most importantly, we did not have a 'bubble' in our stock market as Graph 1 attests. Nor have we had anywhere near the widening of credit spreads in debt markets that has business environment has not been without incident, as several prominent failures show, but with the exception of One.Tel, they have not been the result of a boom and bust in the share markets. The other thing I would like to mention before I close is another aspect of asset prices. We in Australia have been very fortunate in the current expansion in not having a boom or a bust in asset prices - the closest we come to such a situation would, I suppose, be the large rises that have occurred over the past five years in house prices. Now, many of you may be aware that this situation is one that we at the Reserve Bank are not entirely comfortable with. While it may give home owners a happy feeling, we cannot help but also think of the people - mainly in the younger age groups - who aspire to own a home, but are finding it increasingly difficult to do so because rising prices are putting home ownership out of their reach. But since this is mainly a wealth distributional issue, rather than something that directly affects the economy's ability to continue its low-inflation economic expansion, it is not something that can or should be directly addressed by monetary policy. As always, monetary policy has to be directed towards how the average of the whole economy is evolving, not to what a particular sector is doing. Although we should not allow our perceptions of developments in the housing sector to determine our stance on monetary policy, in our view that does not mean we should remain silent on the subject, and we have not. The situation over the past 18 months, where more than half of the total increase in housing loan approvals has gone into the investor market, is a very unusual one. When we see that this is occurring against a background where vacancy rates are rising, rents are stagnant or falling, and a large increase in new supply is coming on stream, it suggests to us a mis-allocation of investment, and the likelihood of a shakeout in the market, at least in the major cities. If that is to occur, it is better that it occur sooner rather than later. My main conclusion is that in assessing monetary policy, it is important to see it in a medium or long-term perspective. It is also important not to get the impression that monetary policy is only exerting an influence if it is changing. It is true that monetary policy only makes news when it is changing, but its influence is really the result of what the level of interest rates is. It is quite easy to conceive of situations where monetary policy has not been changed for a considerable time, but where the level of interest rates is exerting a strong expansionary or contractionary effect on the economy. Once we recognise that the level is important, we inevitably have to ask what we should compare the current level with, and this leads us to think of the concept of normality or neutrality. Of course, we only expect interest rates to be normal in periods when the economy is operating in a normal or healthy way. In situations where it is under either sustained inflationary or disinflationary pressure, there are more important matters at hand than to ponder such theoretical concepts as the neutral level of interest rates. Fortunately, the Australian economy is in that small group of countries that can rightly be described as operating in a normal or healthy way; in fact, in many ways, we are the best example around at present.

r021113a_BOA

australia

macfarlane

This is the fourth time I have addressed Melbourne, and following the practice adopted on earlier occasions, I would like to focus on a topic of current interest. Last time I was here two years ago, I devoted the whole speech to the exchange rate. This time I have found no need to mention it, as there are other more important things on our mind and, I think, of more interest to you. Last year - that is, calendar 2001 - was a difficult year for the world economy, in particular for the G7 countries, where over the course of the year output declined. So for the developed world it was a recession year, although a mild one by past standards. Monetary policy was eased virtually everywhere, particularly towards the end of the year when confidence about the future course of the world economy declined further following the events of September 11. As you know, the Australian economy grew very well during the international contraction of 2001, although we looked abroad and to the future with some apprehension. As the year 2002 began, it appeared that the worst fears for the future had evaporated. The US economy was always likely to enjoy only a relatively modest recovery, but appeared to be making a pretty quick turnaround, exceeding even the most optimistic forecasts, and confidence picked up - not only there, but in Europe, and even for a time in Japan. Those countries with strong domestic fundamentals - such as Australia, Canada, Sweden and New Zealand - began the process of getting their interest rates back to levels that were more commensurate with their domestic needs. But in about the middle of the year this confidence about the recovery of the world economy began to wane, and one of the consequences was that the upward adjustment of interest rates by the countries with strong domestic fundamentals was discontinued. I would like to spend some time examining this period from the middle of the year in more detail to see what it tells us about the future of the world economy. A good way of illustrating the change in outlook is to see how consensus forecasts for 2002 and 2003 for the major economies - the United States, the Euro area and Japan - have been adjusted since mid year. The first thing to notice is that they have all been adjusted downwards, which is consistent with the change in confidence I described above Also, forecast output growth in each year is below potential, implying a widening of the gap between actual and potential output, and hence disinflationary pressure. But on the other hand, the downward revisions are not large, so they are not predicting a future recession. In fact, the sequence of three years shows a pick-up in activity from 0.6 per cent in 2001 to 1.4 per cent in 2002 to 2.3 per cent in 2003. If this outcome were to occur, the recovery would be slightly better than that from the early 1990s recession and the whole episode much better than those in the early 1980s and mid 1970s. Furthermore, when we add in the non-G7 countries, particularly the major developing ones such as China and India, projected growth rates for the world economy are appreciably higher. The IMF's forecast for world growth in 2003 is I think these numbers are a reasonable working assumption on which to begin our consideration of policy. In this case, although the next eighteen months or so will not be great, they could hardly be called disastrous. But we also have to keep in mind the risks to this scenario, and here, I think there now seems to be widespread agreement that they are mainly on the downside. That is, if an outcome very different to the consensus was to occur, it would be more likely to be a weaker one than a stronger one. That, at least, is what the financial markets are saying if I interpret them correctly. Since mid year, US share prices have fallen by about 15 per cent, bringing the cumulative fall since the 2000 peak to over 40 per cent. In Europe, the falls in both periods have been larger. Of perhaps more interest is the fact that bond yields in the United States have fallen by over 100 basis points since mid year to levels not seen since the 1950s. This suggests a very high degree of risk aversion on the part of investors, as does the fact that the spread over treasuries for many well-known corporate borrowers has widened appreciably. Not surprisingly, yield curves, which in mid year had indicated an expectation of future tightening of monetary policy in most countries, have gradually moved to showing either no tightening or an easing. In the United States, events have unfolded even further, with the Fed reducing the Fed Funds rate by 50 basis points last week. In summary, I think we could say that while economic forecasters have become mildly more pessimistic since mid year, financial markets have become much more pessimistic. Why is this so? I think the answer to this is that there are a lot of things happening in the financial and corporate sector that are very unsettling, but which are difficult to incorporate into a conventional economic forecast. The main reason is that none of us really understands the full implications of the bursting of the equity bubble that occurred in the United States and, in a slightly different Year-on-year growth rates form, in Europe. Although each of the century's major asset price booms and busts unfolded differently, the contractionary influences were usually felt over quite a long time span, with many of the effects only showing up a few years after the initial downturn. There is still a fair bit of apprehension that further bad news will appear, and a lot of questioning as to whether the full extent of the fall in corporate earnings has been revealed or is accurately reflected in current forecasts of future earnings. Failures of accountancy, auditing and corporate disclosure have left a lot of investors and businesses in a position where they are reluctant to commit themselves because they are unsure of the veracity of the information on which they must base decisions. Some major sectors of important economies are still under pressure as they adjust to a situation of over-capacity and extreme competition. This applies to the world's telecommunications, media and IT industries. Others are suffering directly from the worldwide fall in the value of equities, for example the European insurance and re-insurance sector, plus those well-established companies on both sides of the Atlantic which are facing under-funded employee pension and health schemes. We at the Reserve Bank have closely followed these market developments, and they do naturally influence our judgment about the balance of risks to the forecasts of the world economy referred to above. It is this judgment - much more so than the central forecasts - which explains our approach to monetary policy since mid year. I turn now to the Australian economy which, despite this uncertainty about the world economy, has remained in good shape. I will not go into much detail because we released our quarterly only two days ago. Suffice to say that over the course of the current year, output and employment have grown well and unemployment has fallen to a decade low. Inflation in underlying terms is within our target range, and we now think likely to stay there over the forecast horizon. Even the balance of payments has held up much better than could be expected in an environment of strong domestic demand and weak external demand. Not surprisingly, given our better underlying economic fundamentals, financial markets in Australia have performed better than elsewhere. Although share prices have fallen, they have done so by less than in major markets. The same applies to the decline in bond yields and to the widening in the spread that private sector issuers must pay over government bond yields. Similarly, over the last year, the market valuation of our banks and insurance companies has held up better than elsewhere. When we look ahead, we can still do so with a fair amount of confidence. While GDP growth over the next 12 months will, no doubt, slow from its current rate, the main drivers of growth - private consumption and private fixed investment - should make further strong contributions. Indeed, it is the strength of the latter which marks us as different to other major economies. This, in turn, is due to the good profitability and balance sheet strength of the Australian corporate sector, and to the fact that we did not go through a recent period of over-investment which resulted in over-capacity. To the extent that negative influences on the economy are larger than when I last spoke in August, they are principally in two areas over which we have no control, namely the world economy and the drought. As to the world economy, we expect to see the change in our real trade balance subtract from GDP growth in 2002/03, but by a smaller amount than in the previous financial year. Similarly, the drought is estimated to also subtract about a percentage point, which means it is approaching the severity of the drought of Drawing these pieces together, we see the Australian economic expansion, that has now completed its eleventh year, continuing in the forecast period, although at a slower pace than over the past year. It has been a remarkable achievement by the economy to keep expanding for so long while so many other economies have fallen by the wayside. Usually, when an economy has a very long expansion, over-confidence or hubris creeps in and potentially dangerous distortions or imbalances start to appear. As I have pointed out on a number of occasions, these imbalances often take the form of an asset price boom, usually in equities or commercial property, a boom in physical investment or, in earlier years, a surge in real wages. We have not had any of these in Australia in this expansion, which goes a long way to explaining why it has endured. The closest we have come to such an imbalance is the rise in residential property prices, which has produced distortions in some parts of that market. I will conclude by saying a few words about that subject. It is not surprising that house prices have risen a lot over the past half decade or so. With Australia's return to being a low-inflation economy, the general level of interest rates, including mortgage rates, fell to less than half their level of the previous decade. This enabled households to take on higher levels of debt, which they did, with most of it put towards buying better and more expensive houses. If a decade ago we had known with certainty what was going to happen to inflation and, hence, interest rates, we should have been able to predict this outcome. The difficult part, however, is to determine how much of the rise in house prices was the logical outcome of this economic adjustment, and how much, if any, indicated overshooting or bubble-like behaviour. My guess is that nearly all of the rise in house prices was in the first category, and I have been very reluctant to conclude that any was in the second category, at least until early this year. But when it became apparent that over the past year or so an exceptionally high proportion of lending for housing was being directed towards investors rather than owner-occupiers, we at the Reserve Bank started to become concerned. In fact, the figures we presented in our Statement on showed that over the year to August, lending approvals to investors rose by 42 per cent, while approvals to owner-occupiers rose by 1 per cent. Something very unusual was clearly happening, and this was confirmed by the building approval figures showing much stronger increases for apartments than for houses. All this, of course, was occurring at a time when owners of investment properties were having difficulty in finding tenants and when rents were falling. It seemed pretty clear to us that investors were moving into an already over-supplied market, and this behaviour could only be explained by their usual desire for tax minimisation plus their expectation that they would benefit from future large capital gains, an expectation which was encouraged by the marketing programs employed by developers of investment properties. Recent events, however, suggest that the market is actually beginning to work, if belatedly, as it is supposed to. There is certainly a change of sentiment as indicated by the numerous stories in the press highlighting potential over-supply and urging caution on the part of would-be investors. There is also evidence from micro-data that apartment prices have flattened out or fallen in the September quarter. By micro-data I mean the detailed suburb-by-suburb, or even building-by-building, analyses that are carried out by the research firms that sell data to the real estate industry, some of which we quote in the recent . Thus, although lending for investor housing has not slowed yet, we have the unusual situation where most of the finance available for housing is going into the sector where prices are rising least, or not at all. This is likely to be a transitory phase. Finally, we are now reading accounts of how some large multi-unit developments that were planned to start construction have been shelved because of insufficient pre-commitment by investors to get them started. This has to be a good development, as it will limit the extent of over-supply, a fact that is appreciated by many in the property industry. My final comment on house prices is that what we have seen - a very high rate of increase in residential property prices and excessive lending for investment properties over the past year or so - was a problem of coping with success. We only have to remember that if we had followed the experience of previous decades, the rise in property prices would have come to an abrupt halt three or four years ago as a result of the economy entering a recession. It is the length of this expansion, as much as the other things I have described, that provided the environment which encouraged this type of investor behaviour. When we come to monetary policy more generally, and we look around us at the challenges facing central banks in other countries, we are reminded that decisions are never easy. But if ever I am tempted to regard the Reserve Bank of Australia's task as difficult, I quickly banish such thoughts when I look at the task faced by our counterparts elsewhere. I do not think any of us at this time would wish to trade our economy for another, or our monetary policy outlook for that of any other country of which I am aware.

r021206a_BOA

australia

macfarlane

Governor, in testimony to the House of was released on I would like to endorse the remarks of the Chairman and say what a pleasure it is to be in Warrnambool, for the second hearing to be conducted outside the Sydney-MelbourneCanberra triangle. The first was in Wagga Wagga, and I remember at the time suggesting that the second should be a little further away from Canberra. Warrnambool passes that test and is an important agricultural and tourist centre, so it is a fitting venue for this meeting. I would also like to thank the Mayor of Warrnambool, Councillor James Nicol, for his hospitality in hosting a civic reception for the Committee and the members of the Bank appearing before it. I would like to start the substance of this statement by observing that in the six months between this Hearing and the previous one in May quite a lot has changed, and this has had an important influence on our judgment about what we have needed to do with monetary policy. This change has happened relatively steadily, with the result that the financial markets and the public more generally have had no trouble in adjusting to the changed outlook. We have assisted, where we thought necessary, by way of several speeches and articles on the subject over the past six months; they have probably helped at the margin, although I think the public was not having any difficulty in recognising the changing outlook as it unfolded. That being so, it could be argued that there is nothing further to add on the subject. However, I am very aware of the fact that I gave some quite frank indications about the expected future direction of monetary policy at the previous Hearing, and that those indications have not been followed through. So I would like to place on the record before this Committee another account of the changing circumstances, even at the risk of being accused of going over old ground. In May I said to this Committee that since the Australian economy was behaving normally, and the world economy was getting back to normal, unless unforeseen developments intruded, we should continue the process of getting real interest rates back to normal, while all the time carefully examining incoming data, both from here and abroad, to ensure that developments remained on track. We did continue the process of getting interest rates up towards normal in June, but have not done anything more in that direction in the following six months. Why not? I think the answer has been obvious to nearly everyone - something did intrude and the incoming data from abroad showed that developments were not remaining on track. After a promising start to the year, the world economy began to weaken about mid year. Financial markets - particularly equity and bond markets - were the first to show this from about the beginning of the second quarter of the year. By mid year there were also signs from a range of economic indicators in the United States and the euro area that the recovery was likely to be weaker than formerly thought. These signs tended to become clearer as events progressed during the second half of the year. A good way of summarising this large body of data is to look at three indicators of perceptions of economic conditions: business confidence, consumer confidence, and consensus forecasts of GDP growth. As can be seen in the graphs for the United States and the euro area, these indicators show a clear improvement in the first half of the year followed by a clear deterioration in the second half (Graphs 1 and 2). So what we have seen for the world economy is a weakening through calendar year 2001, an apparent strong recovery in the first half of 2002, followed by a relapse in the second half of 2002. The relapse does not mean that the world economy is returning to recession, but it indicates that the recovery is going to be weaker than was thought likely in mid year. This gradual change in outlook in the second half of the year obviously had implications for monetary policy around the world. In the first half of the year, those countries with strong fundamentals, such as had started the process of getting their interest rates back up to normal. This process was occurring when we met in May, and, as I said at the time, it was a process that we thought would be continuing. In the event, it did not continue for much longer, and in fact none of these countries has raised rates since July, and one (Sweden) has cut them, as has the The caution shown by central banks such as ours derived in part from the downward revisions to world growth, but also in part from our suspicion that the risks were on the downside. In other words, if an outcome very different to the consensus were to occur, it would be more likely to be weaker than stronger. Having said that, I recognise that even though the second half of the year has been disappointing compared with the first half, equity and bond markets have become a little more confident over the past month or so. It is too soon, of course, to know whether it represents a change in direction or just another blip in the data. Turning to the Australian economy, I will approach this by way of my usual practice of reviewing the forecasts I gave the Committee last time and presenting some new ones. Last time I said we expected GDP growth through and 4 per cent - we are now forecasting around 3 per cent. Obviously, the major factor behind the reduction has been the drought, but the weaker world economy has also had an effect at the margin. On the other hand, the fact that house-building is now forecast to continue to expand for a longer period has pushed the forecast up somewhat. For next year, that is calendar 2003, our forecast is for growth through the year of per cent. The fact that it is higher than the current financial year rests importantly on the assumption that there is a recovery from the drought in the second half of the year, and that the world economic recovery gradually picks up momentum through the year. As I said before, strength in house-building has continued for longer than earlier thought: nevertheless, we still expect a downturn to occur in that sector during the course of 2003, which will subtract from growth. On the inflation front, I said that we were forecasting the CPI to remain near the top of the target range in 2002/03, although we expected it to go down slightly for a time and to then come back up. Implicit in this forecast was that the rising phase would continue after mid 2003 and so, other things equal, begin to exceed the target range by the second half of 2003. What has happened so far is that headline CPI is slightly above 3 per cent, but our estimate of underlying inflation is that it is running at about 2 per cent. We see no reason now to expect underlying inflation to rise any further, and are now forecasting that it will stay around this rate through calendar 2003. The main reasons for this slight downward revision compared with our forecast six months ago are the lower forecasts for world and Australian growth. The price effects resulting from the drought will have the effect of holding up CPI inflation in the next quarter or two and then reducing it slightly later in the forecast period. I would now like to return to a subject which the Committee spent a fair bit of time discussing in May, namely residential property prices. As you know, we became particularly concerned about this issue when we noticed that virtually all of the increase in housing loan approvals in the past year was going to investors, not to aspiring owner-occupiers. At the same time, the building approvals data showed that monthly approvals to build multi-unit developments, i.e. apartments, had speeded up to an exceptionally fast pace, while approvals to build houses were going along steadily. These developments suggested to us that a disproportionate amount of the upward pressure on residential property prices was coming from investors. One response to this would have been to sit back and do and say nothing, on the grounds that the market would sort out the problem. We accept that it no doubt would, but it could take a lot of time, the excesses could get worse in the meantime, and the eventual resolution of the issue could cause a lot of financial distress. The problem is that the market works, but with long lags during which people are encouraged to take decisions based on little more than an optimistic extrapolation of the past. Developers will continue to put up new apartment blocks while ever there are investors willing to pre-commit to buy. When investors purchase apartments off the plan (and it is almost exclusively investors to which the marketing is directed), they are making a financial commitment the wisdom of which may not become apparent for 18 months or so. It is only when they take possession of the apartment that they discover whether they can find a tenant willing to pay high enough rent to justify the financial calculation that underlay the original purchase. Of course, any individual investor can hope to get around the problem by selling to another investor, but they in turn will depend on finding a renter. Investors as a group are dependent on finding enough tenants willing to pay sufficiently high rents when the time comes, which may be 18 months away or more. are difficult, and we fear that many investors are just assuming that things will work out, which is a very dangerous thing to do if you are making a highly-leveraged investment. Certainly, recent trends would warn against such an assumption. From the best figures available, it is clear that rents are falling and that vacancy rates in apartments are rising. And, as the pipeline of partly-built buildings is completed, there will be many more new apartments coming onto the market in the next two years than in other recent years. Our purpose in what we have been saying is to try to get the market to work a little better and so avoid the overshooting that often characterises parts of the property market. We all remember the excesses that occurred in commercial property in the 1980s and the large falls in prices that followed them. Investors should remember that even when they are buying a residential unit, they are making a commercial property decision, i.e. they are borrowing for an investment which will be rented to a tenant with the purpose of making a profit. There are now some preliminary indications that market forces are starting to work at last. I have already referred to falling rents and rising vacancy rates, but there is also recent evidence of a flattening out or, in some cases, falls in apartment prices and marked falls in auction clearance rates in Sydney and Melbourne. There have also been reports of some of the more ambitious projects planned for Brisbane and Melbourne being withdrawn, which makes it all the more surprising that there has been such a large increase in October in approvals to build multi-unit buildings. On balance, however, these developments, if fully understood by investors, should make them very cautious and so limit the extent of over-supply in coming years. I suppose the other big event in our area that has occurred since we met last May is that we brought down the final report on the in August. In this context, we welcome your endorsement of the reforms, Chairman, as being 'an important win for Australian consumers'. Our intention, as stated in our document, is to put these reforms into effect in stages over the next year. Although the reforms are being challenged in court by the two main international credit card systems, I do not think this court action prevents me from answering questions. I do not think I need to say any more at present. We will have plenty of time to discuss any of the subjects I have covered plus any others that Committee members may wish to raise.

r030403a_BOA

australia

macfarlane

Tonight's subject is one that has attracted increasing attention over recent years - namely, the growth of household debt. There is no doubt that this debt has grown quickly over the past decade, and this has prompted a number of people to suggest that it is too high and that it presents a threat to the future health of the economy. What I would like to do tonight is to examine household debt from several perspectives in order to form a judgment on whether its current level poses risks for the economy, and what those risks might be. My broad conclusion is that a proportion of households have clearly taken on more risk, which has increased the risk profile for the sector as a whole. This is likely to make household consumption more sensitive to changes in economic circumstances than it formerly was, but the overall risk for the economy has not gone up to the extent that would be indicated by the rise in the level of debt or in the debt to income ratio. The subject of household debt is one that we at the Reserve Bank have been thinking about, and writing about, for some time. Over the past year, we have produced a number of studies on debt and housing, which have laid out the main facts. I will summarise them briefly, before moving on to the more difficult task of making judgments about their economic significance. Those who want more detail can consult the studies listed below. 1. Most studies concentrate on movements in the ratio of household debt to household incomes. Over the past decade, this ratio in Australia has risen from a level that was low by international standards (56 per cent) to one that is in the upper end of the range of other comparable countries (125 per cent). 2. The rise in household debt was mainly due to increased borrowing for housing. Housing debt accounts for 83 per cent of total household debt, and that percentage has risen slightly over the decade. The story of household debt is largely a story about housing and, of course, is intimately tied up with the subject of rising house prices. In the remainder of my talk I will deal only with housing debt and ignore other forms of household debt. 3. While borrowing for owner-occupation is still the largest part of housing debt, the fastest growing component has been borrowing for investor housing, which now represents 30 per cent of the stock of housing loans (compared with 18 per cent a decade ago). 4. The main reason that debt has risen is that households can afford to borrow more in a low interest rate environment like the past decade than in a high interest rate environment like the previous two decades. Allied to this is the fact that in a low inflation environment, the real value of the debt is not eroded as fast as it was in a higher inflation one. So each household that takes out a loan can borrow more at the start of the loan, and will run down the real value of the loan more slowly than formerly was the case. Analysis published by the RBA last month shows that these two related explanations could account for an approximate doubling in the debt to income ratio when their effects had fully worked through the system. 5. Financial deregulation and the associated increase in competition among lenders has also played a role by making loans cheaper, easier to obtain, particularly to investors, and providing innovations such as home equity loans and redraw facilities. 6. Over 70 per cent of households either own their homes outright or are renting and therefore have no housing debt. Owner-occupied housing debt is concentrated in about 30 per cent of households, as it has been for decades, but that 30 per cent have considerably higher debt levels now. 7. For those households with mortgages, there is a pronounced pattern in the debt to income ratio and the debt-servicing ratio over the life cycle. Both these ratios peak in the 35-40 year age group and decline thereafter, usually to zero. 8. Other measures of household balance sheet health such as the debt-servicing ratio and the gearing ratio show considerably less of an upward trend than the debt to income ratio. Does the sharp rise in the household debt to income ratio over the past decade mean that it is now too high, or, as some commentators put it, that it has reached an unsustainable level? Unfortunately, it is impossible to answer this question by looking at the aggregate ratio, even if we supplement our analysis by international comparisons (Graph 1). There does not appear to be a level at which bad things start to happen - Japan's ratio levelled off at about 130 after the equity and property bubble burst, but it was corporate debt rather than household debt which fuelled the bubble. In the United Kingdom the ratio fell in the early 1990s after it reached 115, but has now resumed its upward path to be in the mid 120s, while in the Netherlands the ratio exceeds 180 and is still going up. The debt to income ratio is only one measure of the health of household balance sheets, and, as will be argued below, not the best measure. We have to ask why the debt to income ratio rose, before we can draw any conclusions. As we demonstrated earlier, the main reason it has risen is that interest rates have fallen: mortgage rates halved between the second half of the 1980s and the past five years. As a result, a household which borrowed up to the point where debt servicing equalled 30 per cent of gross income (a common yardstick used by banks and other mortgage lenders) would be able to nearly double the size of the mortgage and still make the same monthly repayments as before. In order to judge whether the resulting increase in debt represents an increase in risk, we have to go through the following mental exercise. Compare two households - one in 1993 and the other in 2003 - that have the same percentage of their income used in debt service, and have the same gearing ratio (level of debt as a percentage of value of house), but with the 2003 household having a debt level nearly twice as high as the 1993 household. Is the 2003 household taking more risk than the 1993 household? My judgment is that the 2003 household is riskier in only one respect. For a given rise in interest rates, it will be more affected because the rise will apply to a larger loan. But it is probably not right to make the assumption about 'a given rise in interest rates'. That is because in the low inflation/low interest rate environment we have today, interest rates do not move about as much as before. In the late 1980s, on one occasion the mortgage rate rose by 3 percentage points in a year, in the 1990s we have had nothing like that (the largest rise in a year was 1 percentage points). So the answer to the question I posed above is that, provided the variability of interest rates has also fallen in proportion to the fall in the average interest rate level - which it has - the hypothetical household in 2003 is in no riskier a position than the hypothetical household in 1993. Does this mean that the large rise in housing debt that we have seen in practice has not made the household sector more vulnerable? No, it merely means that we cannot draw this conclusion from looking at the rise in the debt to income ratio without enquiring into its cause. If, as in the hypothetical example above, it is entirely due to a fall in the level of interest rates and a commensurate fall in the variability of interest rates, then risk has not increased. This is important because most of the rise in the debt to income ratio in Australia is of this type. But this does not mean that we can dismiss all concerns about the rise in household debt. This is because some of the rise in the debt to income ratio was due to factors other than the fall in interest rates, and these factors may well have resulted in households taking on more risk, and in many cases a lot more than they recognise. The rest of my talk will attempt to spell out these factors. Lower inflation The other variable that has a quantifiable and mechanical effect on the debt to income ratio is the rate of inflation or, more precisely, the rate of increase of household incomes. Not surprisingly, this is highly correlated with the rate of interest, but it has an identifiably separate influence. When the rate of growth of incomes slows, the debt to income ratio of each borrowing household is eroded more slowly than in a higher inflation environment. When a household first takes out a mortgage, it places itself in a somewhat vulnerable position in that its debt is a multiple of its income, and its debt-servicing ratio is at its maximum. It accepts the risks involved because it is a necessary part of the path to home ownership. In the past, the typical household only remained in this relatively 'risky phase' for a few years, mainly because its nominal income rose quickly (partly due to inflation), and secondly because its debt was reduced by principal repayment. In a low inflation environment, nominal incomes rise more slowly and so households remain in the 'risky phase' for longer. If they have fully factored this into their financial decision-making, it should not present a major problem, but if they are still operating on the assumption that inflation will quickly reduce debt burdens, they would be taking more risk than they perceive. Financial deregulation and increased competition A range of other factors has allowed households to maintain higher levels of debt for longer periods than previously, and most of these are, at least in part, attributable to innovations brought about by financial deregulation and increased competition among providers of credit. It is now much easier to refinance and so take out a larger loan either on an existing property or to purchase a more expensive one. Banks and mortgage brokers now actively encourage these activities, and so loan turnover has risen sharply. A similar process is seen with new lending products such as home equity loans and mortgages with a redraw facility. These developments have allowed borrowers to go back and top up their debt over their lifetime rather than simply allow it to decline through principal repayment. The contrast between the two types of behaviour is shown in Graph 2: the older pattern is shown in the top panel, and the newer one in the lower panel. Like the effect of lower inflation described earlier, this allows households to remain in the 'risky phase' for longer than was the case in earlier decades. The special case of lending for investor housing So far the analysis has implicitly assumed that we are talking about households that borrow for owner-occupation or, at the margin, for consumption. But the biggest single change over the past decade is the rapid increase in borrowing in order to purchase a dwelling for investment purposes. The annual growth rate in this type of borrowing has averaged 21.6 per cent over the past decade, compared with 13.4 per cent for borrowing for owner-occupation. To put this in another perspective - if borrowing for investment purposes had only risen at the same rate as borrowing for owner-occupation, the aggregate debt to income ratio would only have reached 109 per cent, not the 125 per cent that actually occurred. At the former figure, Australia would still be in the lower half of the countries shown in Graph 1. So borrowing for investor housing is a large part of the story of rising household debt in Australia. It is also different to borrowing for owner-occupation in several respects. First, it is a pure investment decision, not a lifestyle decision. Many people would choose to become owner-occupiers even if they understood that it might not be particularly profitable; it is hard to see why anyone would be an investor in housing other than because they expected it would be a profitable commercial decision (hence, the widespread use of 'investment seminars' to encourage this type of activity). Second, for a high proportion of these investors, tax considerations drive the profitability calculations and so provide an incentive to maximise debt. Thirdly, borrowing for investment purposes is inherently riskier than for owner-occupation, in that the investor cannot be sure of who is going to occupy the dwelling and on what terms, but the owner-occupier knows the answer to that question. There are additional risks that now accompany investor housing as a result of how the industry has changed. A high proportion of investment is now in multi-unit apartment buildings, where developers pre-sell to investors, usually on 10 per cent deposit. They have, therefore, effectively transferred the first 10 per cent of price risk onto investors.* Because the building may take about 18 months to complete, that means the investor will not know whether the risk has eventuated for 18 months. In economics, a lag between when a decision to increase supply is made and when the price effect occurs can lead to what is colloquially known as a 'hog cycle', and can be associated with large overshootings in prices. It is conceivable that at some point in time there could be a large reduction in investor demand for apartments, perhaps because of fears of over-supply. But because of the production lag, there would still be an 18-month supply of partly built apartments to come onto the market and to be digested by it. With the trend towards large-scale developments which take longer to complete, it is possible that this lag has been lengthening in recent years. For these reasons, we at the Reserve Bank have been concerned about investor housing for some time. We are concerned not only because it has been a very large factor in explaining the growth of household debt, but because the risks involved are greater than in borrowing for owner-occupation, and are unlikely to be fully understood by the many newcomers to this activity. The most important financial ratio from the household perspective is the debt-servicing ratio - the ratio of interest payments to disposable income. Understanding the movements in this ratio is difficult, as shown in the Appendix to this speech. Two measures of debt servicing are shown in Graph 3 - the bottom line shows only interest on mortgage debt and the top line adds in the interest on all other household borrowing. Both lines show a gradual upward trend, although their cyclical movements differ. By 2002, the debt-servicing ratio on mortgages had reached 6 per cent of household income, while total debt servicing reached 7 per cent. If we were to add the required repayment of principal on to this line, there would be a larger tendency for the line to slope upwards. Our estimate is that households currently pay about 2 per cent of income in required principal repayment, which brings their total debt servicing to 10 per cent of disposable income. These aggregate ratios sound quite low, but we should recognise that they are held down because they include all those households which have no debt. When we adjust for this, our estimate is that for households with housing debt, the total servicing payment (interest plus required payment of principal) averages 20 per cent of disposable income, compared with about 14 per cent ten years ago. Thus, although interest rates have trended downwards through the period covered by Graph 3, debt servicing has trended upwards. Households have increased their borrowing by more than interest rates have fallen, an outcome consistent with the developments discussed in the previous section. Another financial ratio that is important in order to evaluate risk is the gearing ratio, which is the ratio of the value of housing debt to the value of the stock of housing assets past decade from 13 per cent to 20 per cent, and therefore means that households as a whole have increased their risk. But most households hold no housing debt, so the average gearing ratio for those that do is about 43 per cent. One other fact that we can deduce is that the average gearing ratio for investors has risen a lot faster than for owner-occupiers over the past decade, although the level is not as high. It appears that there are two main classes of owners of investment properties: those that wish to live off the rental income and therefore hold little or no debt; and those that are mainly concerned with capital appreciation and tax minimisation and therefore aim for a high level of debt. Over the past decade, the sharp rise in the gearing ratio suggests that the second group have expanded a lot faster than the first. I would now like to return to the question of whether the rise in household debt will result in a reaction which will be disruptive to the economy. Some commentators have suggested that the debt to income ratio is now so high that it is unsustainable. If they mean by this that it will start to fall under its own weight, I think that this outcome is very unlikely. It is far more likely that the ratio will continue to rise for some time, even if more slowly. For a start, the effects of the lower interest rates and lower inflation have not yet fully worked their way through the system and, additionally, it is likely that over time more households will take advantage of the newer and more flexible debt products now on offer. A more fruitful approach to analysing the effects on the economy of the higher household debt level is to ask how it will affect the response to economic shocks. In other words, how differently will a 'high household debt' economy behave in the face of some temporary adversity compared with a 'low household debt' economy? Is it more likely now, for example, that an adverse shock to the economy will mean more households are forced into selling their homes, or having their banks foreclose on their mortgages? This is the sort of scenario which we would all dread because it would impart a sharp contractionary force to the economy. In principle, this could happen if the shock in question was a deep enough recession accompanied by a large enough rise in unemployment. If someone loses their job altogether or is forced to accept one at a much lower income, they may not be able to meet their debt-servicing obligations. However, the crucial variable here is the debt-servicing ratio - it is this which determines whether a household can keep its property when there is an interruption to its cash flow, not the absolute level of debt (or the debt to income ratio). And we know that the debt-servicing ratio has risen moderately - from about 14 per cent to 20 per cent. So our judgement would be that although the incidence of this type of extreme reaction would increase, it would not increase by a lot. Even if we judge that the incidence of this extreme reaction will still be relatively low, are there other forms of behaviour which are likely to have changed as a result of the higher debt-servicing ratio and higher gearing among indebted households? In other words, are households that can afford to meet their debt-servicing requirement likely to change their behaviour in other ways now that they have a higher debt level than formerly? It seems to me that the answer to this is yes. Households are bound to become more cautious if the prospect of an economic downturn increases, and this would show up as weaker consumption and a rise in precautionary savings. Thus, as a general conclusion, we should assume that consumption will become more sensitive to economic conditions. A related aspect is that it is often said that consumption is now more sensitive to a change in monetary policy. This is clearly true if we define a change in monetary policy as a given absolute rise in interest rates, say 50 basis points. Obviously, if households have more debt, a rise in interest rates will affect them more than if they had less, and so income after mortgage payments would fall more, and so would consumption. This has not gone unnoticed, and at the Reserve Bank we are aware that the heightening sensitivity of consumption means that to achieve a given change in the economy, a smaller change in interest rates will be required. What about the response to falling house prices? For those households that could afford to meet their debt-servicing obligations, one would have to assume that they would continue to do so, regardless of the fact that the price of their house was falling. Even in the extreme circumstance where the price fell below the debt level - referred to as negative equity - it is likely that owner-occupiers would endure the situation stoically because there would be little alternative. Again, the higher the gearing, the more their wealth would be affected and the more cautious they would become in their consumption spending. The behaviour of investors in this situation, however, could be quite different to owner-occupiers in that there would be a strong temptation to get rid of the troublesome investment, especially if the fall in price was caused by a difficulty in finding tenants. So for investors, there could be a flow-on from falling housing prices to increased selling pressure and hence further downward pressure on housing prices. Another channel through which the increased sensitivity of consumption could work is the phenomenon of housing equity injection/withdrawal. As we have seen, in the good times households can augment their consumption by effectively tapping into the increased equity in their homes (housing equity withdrawal). But if they become apprehensive about their economic prospects, they could easily cease this activity or go back to the old pattern of equity injection, which would involve reducing consumption. There is evidence from the United Kingdom that such a switch occurs when house prices fall. Apart from the heightened sensitivity of consumption, are there other risks that we have overlooked? In particular, are there risks to the lenders as well as to borrowers, and hence a possibility of some sort of financial crisis due to failure of financial institutions? Obviously, if the shock was large enough, we could not rule this out, but my guess is that it is highly unlikely. Throughout our work on household debt, we have assumed that lending standards of financial institutions, as typified by maximum debt-service ratios, have not been relaxed. This might be an over-simplification but, if it is, it is not a large one. I know APRA have been looking at this situation closely and have been subjecting banks to stress tests based on quite onerous scenarios - for example, a 25 per cent fall in house prices. Even under these extreme assumptions, even though bad debts rise markedly and there would be a lot of personal distress, it is very hard to conclude that there would be large-scale financial failure. Although I started with the intention of keeping my talk simple, I am afraid that the subject matter ended up being far more technical than I thought. I will therefore attempt to compensate for this by keeping the conclusions as simple as possible. There is one important factor that should give us some reassurance about the large increase in household debt. That is, most of the increase was due to the halving in the mortgage rate and the inflation rate as we moved from the 1980s to the 1990s. If this was all that was at work, I would be comfortable, given the greater stability in interest rates, in concluding that there had not been a significant increase in the risk profile of the household sector. But other factors have also been at work, and I cannot help but think they are the result of the over-confidence that follows the experience of a strong and sustained economic expansion. Much as I think the expansion has a good deal further to run, I suspect that a significant number of households have chosen a debt level which makes sense in good times, but does not take into account the fact that bad times inevitably will occur at some time or other. The other factors that have been at work show up as a modest rise in the aggregate debt-servicing ratio and a similar rise in the aggregate gearing ratio. These are not because the maximum risk a typical household faces during its life cycle is larger than it formerly was, but because many more households are now staying at or near their maximum risk position for a longer period. The other development that has clearly increased risk is the exceptionally fast increase in borrowing for residential property for investment purposes, and the accompanying rapid expansion in apartment building, which show all the signs of a seriously over-extended market. As far as we can judge at this stage, the rise in household debt does not pose a significant danger of a financial crisis, i.e. the failure of significant financial institutions such as occurred in the early 1990s after the build-up in corporate debt. But it does suggest that household consumption will be a lot more sensitive to economic conditions than hitherto. Thus, we should expect a more pronounced cutback in consumption if adverse economic conditions occur. This increased sensitivity also has implications for monetary policy, a development we have been aware of for some time. At present, there are some tentative signs that both household borrowing and residential property development may be levelling out. There is no doubt that those developments, followed by a further scaling back, would be in the longer-term interest of the Australian economy. sharply as interest rates fell. The effects of interest rate changes in the 1990s are visible as cyclical rises and falls in debt servicing, around a slowly rising trend, caused by the increase in debt levels. The upward trend in debt servicing is clearer in the lower line in the graph, which shows the debt-servicing requirement specifically for housing debt. Currently, about 6 per cent of household disposable income is devoted to servicing the interest cost of mortgages. This is higher by about 1 percentage point than the peak value in 1990, despite the much lower level of mortgage interest rates, because the size of mortgage debt outstanding is now so much higher. Allowing for principal repayments as well as interest would increase this by about 2 percentage points, an amount which is likely to be larger now than in the past because of the higher levels of debt. The fact that total interest servicing costs - i.e. those for mortgages and other loans - were so high in 1990, so that the divergence between these two lines is greatest at that time, reflects two factors. First, personal loans were a much larger share of total household debt at that time than they are now. Second, the average rate of interest on personal loans is usually higher than for mortgages, and they rose much more in the late 1980s than did mortgage rates. Both these series represent averages across the household sector. But experience differs markedly between households. Slightly less than 30 per cent of households have an outstanding mortgage against their own house; about 40 per cent of households have no mortgage debt on the dwelling they own. These proportions are little changed from a One of the important aspects of any assessment of the sustainability of debt burdens is the extent of an economic entity's income which must be devoted to debt servicing. The measure used in this speech is the ratio of interest payments by households to household disposable income. This is derived from information in the national accounts, with some adjustments. Graph 3 in the text) shows the resulting series. The notable feature of this series is that the peak value for debt servicing was in the period of high interest rates in the late 1980s. Subsequently, debt-servicing costs declined decade ago. Based on data from ABS and the Australian Taxation Office, the proportion of households owning investment properties is around 8 to 10 per cent. Some, though not all, of these properties are partly debt financed. Taking these facts into account, and allowing for the fact that households with debt have, on average, incomes about 30 per cent higher than the average for all households, interest and principal repayments probably account for something like 20 per cent of disposable income among those households who have debt . This has most likely increased by about 6 percentage points over the past decade. In summary, a closer analysis of debt servicing requirements suggests that the commonly quoted fact that the total interest servicing cost is less than in the late-1980s peak obscures the fact that debt servicing costs are on an upward trend - which only stands to reason given that overall debt levels are rising. Further, servicing costs of those households with debt are considerably higher than indicated by the average experience across the household sector, and have risen a good deal over the past ten years. Turning to consideration of housing leverage - that is, the ratio of housing debt to the value of housing assets - Graph 4 showed that leverage had risen from about 13 per cent to about 20 per cent over the past decade. However, again this is the average across all households, including the majority of households who carry no debt at all. Arguably a more relevant measure is the leverage of those households which do carry debt - namely, owner-occupiers with a mortgage still outstanding, and investors. Some estimation is involved here because the relevant data are not directly observable. On the assumption that the 30 per cent of households with debt against their homes also own 30 per cent of housing assets, we estimate that the ratio of debt to assets for indebted owner-occupiers is about 46 per cent, up from Among investors, the rise in leverage appears to have been steeper, though from a lower starting point. In 2002, it is estimated that investors had debt equivalent to 36 per cent of assets, compared with 16 per cent ten years earlier.

r030606a_BOA

australia

macfarlane

The Proof and Official Hansard transcripts of Senate committee hearings, some House of Representatives committee hearings and some joint committee hearings are available on the Internet. Some House of Representatives committees and some joint committees make available only Official Hansard transcripts. To search the parliamentary database, go to: --I declare open this hearing of the House of Representatives Economics, Finance and Public Administration Committee, and welcome representatives of the Reserve Bank, students and staff from Melbourne University and secondary schools, members of the public and the media. I also welcome Professor Peter Dawkins of the Melbourne Institute of Applied Economic and Social Research; it is great to have you here, too. Today's public hearing is the twelfth since the Treasurer and the current Governor of the Reserve Bank of Australia agreed in August 1996 that the governor would appear before this committee twice each year to report on the conduct of monetary policy. These hearings have played a valuable role in enhancing community understanding of the Reserve Bank's role and policies. Today's hearing is also the second for our review of the bank's current annual report following the hearing held at Warrnambool last December. The committee will table a report when parliament resumes after the winter recess. At this morning's hearing we will discuss a range of issues with the governor. These include monetary policy--in particular, interest rates, the recent rise in the value of the Australian dollar, the level of housing related credit, the impact of the world economy on Australia, the continuing economic impact of the drought and reform of credit card fees. To the extent we can, we will discuss this issue without canvassing matters currently before the courts. This hearing comes at a time when the Reserve Bank has chosen, for 12 months now, to maintain the current official interest rate at 4.75 per cent, the longest period of stable rates since 1997-98. It also comes at a time when Australia continues to outperform the rest of the developed world, with growth of nearly three per cent expected for this financial year. This is on top of over 10 years of is steady economic growth--an impressive record by any measure. Once again, on behalf of the committee, I welcome the governor and other senior officials of the Reserve Bank of Australia to this hearing. I remind you that, although the committee does not require you to give evidence under oath, the hearings are legal proceedings of the parliament and warrant the same respect as proceedings of the House or the Senate. The giving of false or misleading evidence is a serious matter and may be regarded as a contempt of parliament. Mr Macfarlane, I know you would like to make an opening statement before we proceed to questions. I think copies of that statement will be available shortly after you have made it. --That is correct. I will follow normal practice and start with an opening statement. In the six months since we last appeared before this committee we received a lot of information on the world economy, but it has not resolved the uncertainties we have lived with for a year or so now. As you will recall, 2002 started out on a promising note but the momentum of global growth waned in the second half of the year. A return to firmer growth was expected early in 2003, but observers watching for signs of that quickly found the picture clouded by concerns about the growing likelihood of war in Iraq and then its actual occurrence. The relatively quick resolution of hostilities and the associated drop in the oil price was a major plus for the global economy compared with the possible alternative. Confidence recovered some ground, and attention returned to underlying economic trends, but the incoming data did not give any encouragement. It is now clear that a pick-up in global growth has not occurred in the first half of 2003. The international forecasting community have now pushed the forecast pick-up back to the second half of the year, though there are few signs in support of this. It is not surprising that, in this environment, financial markets are giving rather mixed signals. Around the world, bond yields have fallen recently to historical lows, indicating that participants in this market see a weaker global outlook for growth and inflation. Equity markets, on the other hand, have been steadier after 2 1/2 years of falls. In the United States, markets have even made noticeable gains in recent weeks, suggesting that some of the gloom may be lifting. Foreign exchange markets continue the trend that started about 18 months ago, with the US dollar falling, the yen remaining broadly stable and a group of currencies, including the euro, the Swiss franc, and the Canadian, Australian and New Zealand dollars all rising. Where does that leave Australia? I will start to answer that question in the traditional way, by evaluating and then updating the forecast that I gave to this committee six months ago. When we met in December last year, I said that we expected GDP growth of three per cent through the year to the June quarter of 2003--in other words, through the current financial year. This was slower than in other recent years and an important reason for this was the temporary contractionary effect of the drought. When we moved the forecast horizon along six months-- that is, to see the growth that occurred through the current calendar year--we expected growth to rise to 3 3/4 per cent. In evaluating those forecasts, we see that the first one I gave you looks as though the growth through the financial year will be close to the three per cent forecast, or perhaps a little bit below it. We only have one more quarter of data to receive and then we will know the answer to that. As we look slightly further ahead, however, prospects are not as strong as they were. Instead of 3 3/4 per cent through calendar 2003, we now think the figure will be more like three per cent. What has caused this downward revision to the outlook? The main explanation, you will not be surprised to hear, is the weaker performance of the world economy that we have seen to date, which is affecting Australia's trade performance. Our imports have continued to grow in line with our quite strong domestic demand, but our exports have fallen appreciably and there is less confidence that they will be lifted in the near future by firmer foreign demand. I will say more about that in a few minutes. The inflation forecast I gave last time was for the rise in the CPI to exceed three per cent in the near term and then to ease to about 2 3/4 per cent in the 12 months through to the end of this calendar year. The first part of this forecast has occurred as the CPI in the most recent 12-month period--that is to the March quarter--ran at 3.4 per cent, pushed up by the high oil prices in that quarter. But the oil price pressures have already reversed and, when we looked at the likely outcome in the remainder of 2003 and into 2004, in our May statement on monetary policy-- which came out a month ago and which I am sure all members of the committee have--we reduced our inflation forecast from 2 3/4 per cent to 2 1/2 per cent, largely because of the higher exchange rate for the Australian dollar. Of course, since the statement was released, the exchange rate has risen further. Let me say a little more about the domestic economy. The thing that stands out is that domestic demand has been growing at a high rate. For example, it grew by 6 1/2 per cent last year. This was unlikely to be continued over a long period, and over the most recent four quarters it has slowed to 5 1/2 per cent, still a good figure. We expect some further deceleration as we look ahead, but the most recent data do not suggest that the deceleration will be large. Consumption has grown by 3 1/2 per cent over the year to the March quarter and the more recent data, such as retail trade, show good rises in the most recent two months, March and April. Given the growth in employment and incomes and the fact that consumer confidence is above its longer-term average, prospects for consumption look quite good. Similarly, private investment, according to the latest Capex survey, is holding up well. We cannot expect a repeat of the 20 per cent growth we had last year, but a figure in the order of 10 per cent or a little lower is likely, given the strength of investment in buildings and structures. The corporate sector as a whole is in excellent financial health, with conservative gearing, good profitability, and ready access to credit, although it is not using much of this because of its ample internal funds. Most of the surveys show readings at or above average for business conditions and business confidence. I do not wish to say much about residential construction other than that it has held up for longer than we or other forecasters expected, but it now appears to have peaked, despite the boost it is continuing to receive from alterations and additions. Within that general framework, the experience amongst different industries is, as usual, quite varied. Although in the aggregate growth has been good, some sectors are suffering. Agriculture during the drought is the obvious example and, of course, large sections of agriculture are still suffering. More recently, the tourist and international transportation sectors have suffered a sharp fall in activity, associated with the public reaction to the SARS virus, just when it looked like they were about to recover from the drop in travel associated with the Iraq war. Employment has grown by 2 1/2 per cent over the past year, although, as usual, the pattern has been very irregular and the unemployment rate, at 6.1 per cent, is about as low as it has been in the present expansion. As explained earlier, consumer prices are rising at 3.4 per cent per annum and wage costs at about 3.6 per cent. Inflation has been close to, or above, three per cent for more than a year. This would be a source of concern if we expected the situation to persist long enough to become entrenched in expectations but, as I said earlier, inflation is likely to decline in coming quarters and overall growth in labour costs is consistent with our inflation target. So the inflationary situation is not a cause for concern. These figures that I have just quoted contrast with the much lower rates of increase occurring in major economies overseas, where demand is much weaker and where inflation targets-- implicit or explicit--are, or are in danger of, being undershot. Before leaving the domestic economy I will make a few remarks about the growth of credit. Aggregate credit has grown by 13 per cent over the past year, which is quite a high figure in an economy where nominal GDP has grown by six per cent. When we look more closely, we find that household credit has grown by 20 per cent and that credit to the household sector for housing purposes has grown by 21 per cent. Credit for investors in housing is estimated to be growing at about 28 per cent. Thus, we have a situation where credit is growing a good deal faster than appears necessary to satisfy the needs of the economy. This situation is wholly due to credit being channelled into the housing sector. When we see figures of this order of magnitude it is hard not to conclude that a significant part of this must be directed to speculative purposes. There is, of course, plenty of other evidence in support of this proposition. So overall, an examination of the domestic economy leads us to conclude that there is little or no evidence to suggest that monetary policy has been too tight or is currently exerting a restrictive influence on domestic demand. But that is only part of the story, and possibly the smaller part. Policy must also take into account the impact of international forces. Let me now return, therefore, to the global economy, and then I will conclude by trying to make an assessment of the balance of risks which face the Australian economy. After the short-lived optimism that followed the end of the Iraq war and the fall in oil prices, and amidst the flow of mixed economic data, observers of the international economy were confronted with two pieces of news, both emanating from the United States, which gave pause for thought. The first was the Fed's communique from the early May Federal Open Market Committee meeting. That is their board meeting--the equivalent of our board meeting. In it, the Fed stated that the balance of risks on inflation for the US was in the downward direction. While the Fed did not mention the word 'deflation' and it clearly does not regard that as the most likely outcome, markets interpreted the Fed as saying that deflation was now at least a possibility that had to be included into the range of conceivable outcomes. US bond yields soon dropped to 45year lows. The second piece of news from the United States was the comments of the Secretary of the Treasury, John Snow, on the value of the US dollar. This was virtually unanimously interpreted as signalling the end of the so-called 'strong dollar policy' and an acceptance that a declining dollar was in the interest of the US economy. The interpretation gained added plausibility, despite later denials, when it was seen in conjunction with the Fed's earlier announcement on the downward risks to the inflation outlook. The likelihood that the US dollar might decline further, with tacit acquiescence from the US authorities, has lead many observers to believe that a significant change is occurring in the international environment. A declining US dollar helps the US economy adjust to its problem but it also shifts those problems, in part, to other countries. In passing, I have to say that I am not criticising the United States for this. To date they have shouldered more than their fair share of the responsibility for getting the global expansion going. But if we are interested in increasing global growth, rather than just having a redistribution of the pattern of growth between countries, many countries which so far have enjoyed the stimulus of exporting to the United States when the US dollar was high will need to find domestic sources of expansion. There is a great deal of scepticism about how successful the two main areas outside the United States--Japan and the euro area--will be in this endeavour. It is in this general context that some central banks have reduced interest rates over the past few days. In fact, last night we saw the European Central Bank and the Riksbank, which is a Swedish central bank, reduce interest rates. As you know, earlier this week we had a board meeting and we did not. This was not because we are unaware of the downward risks that are presented by the global economy, nor because we think our economy is somehow immune to international problems. It was because we clearly have stronger domestic conditions in place already as a result of current policy settings, not to mention higher inflation than most countries. Hence we have not had the same sense of urgency in reducing interest rates that several others clearly did. We are, however, very conscious of the risks the Australian economy faces. Obviously, the first one and the major one is that the world economy fails to recover and that in time this feeds through to a protracted weakening in the Australian economy. The main direct channel through which this could occur would be through a further weakening of exports. At the same time, we have seen that because our economy is healthy relative to others and hence our interest rates are not as low as others, foreign investors have found Australian dollar denominated assets attractive to acquire. Thus, a second channel could be through an excessive appreciation of the Australian dollar. Not that I think what has happened to date could in any way be labelled excessive. The trade weighted exchange rate has returned roughly to its post-float average, while the rate against the US dollar is still well below the post-float average. On the purely domestic front, the main risk is associated with the rapid growth of household credit. Not only does it seem excessive in terms of purely domestic needs, it is far higher than in any other comparable country. Most of the credit has been directed towards bidding up the price of housing, and in some parts of the housing market the motivation has been dominated by the pursuit of speculative profit. Will this domestic activity continue? I think there is now some evidence that in the most speculative hot spots a degree of commonsense is returning. Investor interest in inner city apartments, particularly in this city, is well down and quite a number of proposed projects have been shelved. In addition, estimates of future vacancy rates are being revised upwards and rents are falling. If this interpretation is correct, it should in time be reflected in the normal statistical collections on credit and prices. But these statistics inevitably contain quite long lags, so they will be the last indicators to turn down. When we put these two sets of risks--the international and domestic--together, there are several possible outcomes. There are about four, in fact. Let me go through them. A weakening world outlook and an abating of domestic credit and asset market pressures would provide a reasonably clear prognosis for monetary policy. In other words, if it were weak internationally, and weak domestically, that would be easy. In the other direction, so too would a combination of a clear strengthening of the world economy and continued domestic buoyancy. That would be easy. A third possible combination, and the most favourable one for Australia, would be a firming world economy and an easing in domestic pressures, resulting in more balanced growth for the Australian economy. But the combination that would be most damaging to the Australian economy would be if the household sector were to continue putting itself into a more exposed position at the rate it has over the past few years while, at the same time, a further weakening of the world economy was starting to feed through to Australian activity and incomes. That would be a recipe for ensuring that when the house price correction came, as it inevitably would if the world economy was weak enough, it would be bigger and more disruptive than otherwise. I am not saying that this is the most likely outcome, only that it is a risk that we have to take into account. It is this risk that adds an extra degree of complexity to the making of monetary policy in Australia, and gives some context to my earlier remarks about there having been less urgency in Australia than elsewhere to respond to the weakening world economy by reducing interest rates. In conclusion, the international environment has not yet improved in the way we had hoped and the changing fortunes of the US dollar throw an additional complication into the mix. To date, the domestic economy has weathered the unfavourable international environment very well. Nonetheless, growth will be further adversely affected in the period ahead if the international situation does not improve. If this were to occur, it would change the balance of forces that has been keeping interest rates steady over the past year. --Thank you very much, Mr Macfarlane. As always, that was a very comprehensive assessment of the current situation. We certainly appreciate the amount of effort you put into that. The committee has received the opening statement as evidence on the record. I would like to start with a question on interest rates and the effect of what has been happening overseas. As you mentioned, the European Central Bank have dropped their interest rate by half a per cent. It is already very low. The New Zealanders, as you have also said, dropped theirs by a quarter of a per cent yesterday, which comes on top of a quarter of a per cent drop last month. The other point is that, when the New Zealand governor announced that yesterday in his statement, he said: In light of that, would it be reasonable to say that, as compared to six months ago when I think you were suggesting that the pressure could be for interest rates to possibly go up, that is now not the case and, if anything, the likelihood is that if there is a move in interest rates it is more likely to be down? --Let me say first of all that I don't think even six months ago I was saying that it was likely that interest rates would go up. I said that 12 months ago--I certainly said that 12 months ago. Six months ago my interpretation of what I intended to say was that anything could happen. There was no presumption that interest rates would go up; they could go up or they could go down. I think it is quite clear that, as events have evolved over the last six months--not just here but everywhere else--the situation has changed again. What we really are talking about is whether interest rates stay the same or whether they go down. We are talking about what is the optimal path and we are talking about how some countries are influenced more by these considerations and other countries, essentially because they are healthier, are influenced less. But the framework that we are dealing with is one where the issue is: do we stay where we are or will we need to go down and, if the latter, would it have to happen quickly or could it happen in a more measured way? All the central banks around the world are grappling with that issue, and we are no different to the others in that sense. You mentioned two particular ones there who, in grappling with it, came to a different decision this week than we came to. The first was New Zealand. You quoted from the statement that the New Zealand governor made, which I have also read. It is interesting and it is, to me, quite consistent with the difference between their position and our position in several points. First of all, their level of interest rates was higher than ours. They were a full percentage point higher. They are moving their rates down towards ours. So instead of being a full percentage point higher, now they are half a percentage point higher. In their statement they made reference to their sensitivity to what has been happening to their exchange rate. I am not surprised, because the New Zealand dollar has actually gone up by more than the Australian dollar--not over the last week or so, but over the last 18-month period I described. When all these currencies--the euro, the Australian dollar, the New Zealand dollar and the Canadian dollar--were going up, the New Zealand dollar has gone up more than ours. New Zealand is a more open economy; because it is a smaller economy, it has a bigger trade sector than we do. So I think they feel it more acutely than we do. So I interpret the New Zealand situation as being one where their rates were clearly higher than ours and therefore very high by international standards. They are moving them down towards ours. The second factor, as I said, was that their exchange rate has gone up more than ours and they are more sensitive to their exchange rate. In the case of the ECB, everyone knew that the ECB was going to ease. With the ECB, I think the urgency was much greater there, in fact, than it was for New Zealand. The main urgency for the ECB was not necessarily that the euro was rising. That was obviously a consideration. The history of the euro is that, when it was introduced, for the first two years it just went down, and then for the last 18 months or so it has gone up and it is basically back to where it started--about $1.18. So the rising euro is part of the story, but the bigger part of the story in the European area is that they have got almost no growth at all. In the first quarter of the year it was zero, and in the last quarter of the previous year it was negligible. To all intents and purposes the euro area is completely flat, showing no growth. In the euro area's biggest economy, which is Germany, there is serious concern about the fact that it is declining, virtually in recession again. If the word 'deflation' gets mentioned in the US, it gets mentioned a lot more in Germany, because the rate of inflation in Germany is about 0.8 of a per cent or something. I think this theme will come up throughout our discussions today: there are healthy parts of the world economy and there are unhealthy parts. The timing of how these interest rate changes play out depends very much on whether you are in the healthy or the unhealthy part. But even if you are in the healthy part you are still part of the same world evolution. --You would still call us healthy? --Yes--in absolute terms and definitely so in relative terms. --I guess that raises the next question. You went through the scenarios in concluding your introductory words. You talked about the housing statistics inevitably containing quite long lags, so they will be the last indicators to turn down, but you do feel nonetheless that there are some signs of turning, and there certainly has been, as you pointed out, I think, in the unit prices in Melbourne and expectations there. I guess that raises the question: are interest rates really going to be dominant in that level of borrowing for housing, or is the level of interest rates more affecting the export performance vis-a-vis the dollar? Therefore, is that not a more significant weighting in your thinking now? --I think what I would like to say on this is that it is obvious, from everything we have said over the last year, that we have been disturbed by the speculative excesses that have been occurring in the housing sector. There is no doubt about that; we have said that again and again. And we think that it is in Australia's interest for that to stop, to work its way out, as it inevitably will. I made reference to the fact that credit, and possibly even the house price indices, will be the last things to turn down. I put that in there specifically because we cannot wait. Because of the external circumstances, because of the way the world economy is impinging on the Australian economy, we cannot wait until we have absolute irrefutable proof that the speculative element has gone out of the housing market. That would involve waiting far too long. So we cannot wait until we see the series for housing credit return to a normal level. We will probably have to make our decision on the basis of all the other partial pieces of information which we follow: the vacancy rates, the rentals, the stories that come out of the real estate researchers who tell you which buildings are being shelved and whether investors are still interested and whether they are not, particular anecdotal pieces of evidence about particular properties. We will have to make our decision once we think that there is some evidence there, because that will be the leading information. The lagging information--the last thing to show it--will be credit. That is why I made a reference to that. It would be a big mistake--it would be a policy mistake--to say, 'We cannot do anything until we have irrefutable proof that all the excess steam has gone out of the housing market.' We cannot wait that long. --Are you taking credit for what has already happened? --Some people have given me credit--the Housing Industry Association has. So that was the main part of that reference to the lagging indicator. The other thing I should say whilst we are on this subject is that there is a view that has gained currency that the only way the housing market will slow down would be if interest rates went up. I do not believe that. I think it is said by people who know that interest rates are not going to go up and, therefore, want to encourage further investment in the housing market. If you look at the history closely, you will discover that housing booms in the past have come to an end at a time when interest rates have gone up, but usually a recession has occurred at the same time. Which of those two things caused the housing boom to end? Was it the recession or was it the high interest rates that preceded it? You cannot really judge by looking at what happened in 1990, or looking at what happened in 1982 or looking at what happened in 1974, because both events occurred. But there is an example where we had only one of the two events occur, and that was in the mid-1980s, when interest rates went to extremely high levels. In 1985 interest rates went up to 18 per cent--the 90-day bill rate went to 18 per cent--but there was no recession and there was very little effect on the housing industry. I read from that that interest rates are not the crucial factor. The crucial factor in determining the ending of a housing boom is when economic activity weakens, particularly in those earlier cases I referred to where there was actually a recession. People lose their jobs and they cannot pay their mortgages. That kills the housing boom stone dead. History shows that that has tended to be the main thing that kills the housing boom, not high interest rates--although normally the two things went together, so it was hard to determine it. --On what you have just said, the next question clearly relates back to the other side of your balancing. You point out the rising value of the Australian dollar, our relative interest rates and the attractiveness of, I think you called it, investment money. How much higher could the Australian dollar go before you would feel concerned that it is going to cause serious effects for our economy? --We have a floating exchange rate. That means we do not really have a clearly defined upper and lower band in advance--we don't know. I want to reassure you that it is not as though we do nothing, not worry about it until an alarm bell rings when it hits a critical level and then start thinking about it. The exchange rate is continuously feeding into the monetary policy decision. Every time you make a forecast of what you think economic activity or inflation is going to do, one of the important variables is the exchange rate. If the exchange rate has gone up between point of time A and point of time B then, other things being equal, your forecast for inflation will go down and your forecast for economic activity will go down, and that will influence your decision on monetary policy. It is continuously having an influence on our decision on monetary policy; it is not as though we have to wait for a particular level to be breached for us to start taking an interest in it. --There is a rapid rise in the Australian dollar and some are suggesting that monetary policy is too tight at the moment. We have noticed the financial markets coming out with profit downgrades for many of our blue-chip companies. This gives an impression that the markets are being surprised at the moment. You have given us ample indication over the numerous hearings I have been to that you do not like to surprise the market. Would you agree with some of your critics at the moment that the RBA has been asleep at the wheel? --You will be surprised to hear: no. The RBA has been constantly at the wheel, nudging it this way and that, and has been constantly reassessing how events are unfolding. However, we are not a body that acts at the first whiff of a problem. We weigh all the factors up together and evaluate what we think is the most sensible path for monetary policy in the medium term. We are fully aware of all those factors--as I said, they are constantly being fed into our assessment. --Given what is on the front page of the today and other comments, is there conflict between you and the Treasurer and the Treasury about the direction of interest rates at the moment? --There is absolutely no conflict whatsoever between the Reserve Bank and the government. The views that I have just expressed here I expressed to the Treasurer as recently as last week, in the context of talking to him about a whole lot of other things. He is perfectly comfortable with those. I think what you have seen this morning is an overenergetic official somewhere in the bureaucracy who has tried to blunder into the debate; I am not suggesting for a minute that Dr Henry would be that official. This is not an example of conflict between the Reserve Bank and the government, and I think the government would be very irritated, just as I am rather irritated, when I see people blunder in in that way. --Given that you have said on numerous occasions that you will not release the minutes of the RBA board meetings to contradict these stories on the front page of the , would you again consider looking at some report coming out after meetings--again, because rates did not move there is one line--so that we are not left to speculate about the actual discussions that went on behind closed doors about the RBA and whether there were contradictions between board members at the meeting? --I am not denying there was a difference of opinion between the Reserve Bank and the Treasury--that is actually quite a common event. The only thing that is different this time is that someone thought it was important enough to call a journalist and talk about it. But this is quite a common event; it happened quite a lot during 2000 and 2001. It has happened under all secretaries of the Treasury and governors of the Reserve Bank. It is not at all unusual. --I want to go back to deflation. You mentioned the risk, particularly with Germany. The IMF hosted a conference on 29 May. They said that we should be worried about deflation and they listed some countries, such as Japan, Hong Kong and Taiwan. What is your assessment of that, and are there any other high risk countries where you see that? --That little IMF task force shows how the word 'deflation' is now becoming a popular topic for discussion and is appearing in a lot of the economic debate. The first thing I noticed about that study was that they classified the world into four groups and, you will be pleased to see that Australia was in the group that was least likely to suffer from that problem. As for the allocation of the other countries into the four groups, I am not absolutely full bottle on that. Mr Stevens may want to say a few words on that, having given a speech on the subject of deflation in December last year. --It is true that there are several countries in Asia which are now experiencing, or have recently experienced, falling prices. Taiwan, if they are not there, are close. Hong Kong, of course, has had quite a pronounced deflation. China has had some, though in China at present they are back to a very slight positive inflation rate. Japan, of course, has had declining prices for several years and they, I think, are the clearest case of the bad form of deflation, which is due to chronically weak demand and which arguably feeds back into making demand weak again, so that you get a kind of vicious cycle. Apart from them, one has to say that inflation rates generally in most industrial countries are quite low and they are tending to fall, so it is not at all inconceivable that one or two more countries might find prices declining at some point briefly during the current downswing, and that is what I said in December. If the question is: is this likely to be a problem which we confront? I think that is quite unlikely. For a start, we are starting with a higher inflation rate than most countries. A lot of things would have to go wrong around the world for us to find ourselves in deflation, so I regard that as a very low likelihood outcome. I am not sure whether that is enough of an answer to your question. --Machinery and plant were one of those sectors where, over the last eight years, prices have fallen an average of 2.2 per cent. Does that concern you at this stage? --There are always parts of the economy where prices are falling in any economy. If we look at the average quarterly CPI figure, you will find that 30 per cent of the prices in the basket go down in an average quarter. So relative prices are always shifting and that means that there are always some prices that are falling. They are more likely to be prices in internationally traded manufactures where competition is extremely intense and in IT where technology gain and competition again forces prices down continually. Obviously, if you are a producer of those things, that makes life harder but I think that for the economy as a whole it is most sensible to regard it as a shift in relative prices rather than a portent of serious deflation, which is where all prices fall. --Mr McFarlane, you have confirmed that there was a difference of view between the Reserve Bank and the Treasury at the last board meeting. Can you elaborate as to whether the differences related to the forecast, to the assessment of risks or actually to what should be the principal focus of policy? --I would have a lot trouble doing that I am afraid, because the interchange was really only a matter of half-a-dozen sentences. I did not hear a fully articulated view of the world, so I think I would have a lot of trouble doing that. But it is not really in the way of forecasts I think, because our forecasts are very much the same. If anything, it is this evaluation of risks about the world economy. Any two reasonable people have a right to have a different view of the risks about the world economy. We concede without any trouble that there are very big risks there. In fact, last time at this meeting--I have got the quote here somewhere; it might take me a while to dig it up--I was asked the same question and I said, 'Yes, we concede the risks are on the downside. If something very different to what we are assuming occurs it is almost certainly going to be on the downside.' It is really not about who thought the risks were on the upside or who thought the risks were on the downside; it was a matter of who thought there were risks on the downside and who thought there were even bigger risks on the downside. So that was really, in essence, the difference. I am sure this is occurring in every country in the world: people are trying to make an evaluation of how big these risks are. --Are there also differences in the views of where the big risks are? --I do not know. I cannot speak for the Treasury on that, other than to say that they put a higher risk of a big surprise on the down side. We also have a risk for that but it is not as big. --Which is the greater risk in your view: the risk of a large adjustment in house prices in the housing market or the risk for the domestic economy of a further appreciation in the exchange rate with a negative impact on our export performance? --Again, it depends on the orders of magnitude. These whole things depends on the orders of magnitude. Clearly, if the appreciation were big enough and it were hurting enough, that would be a much bigger factor than if the housing thing went up just a little bit more. It is all a function of the orders of magnitude. That is why the assessment changes every month as you get more information coming in. --If there were a difference of view and a suggestion from Treasury that perhaps rates should be cut by a quarter of a per cent, then--looking at that as a policy move--do you think that would be sending an entirely wrong signal to the property market at the moment? --It could, yes. On the other hand, I do not think--as I said--at the end of the day that interest rates are necessarily crucial there. But there is a risk that that could give another final boost to a credit cycle that was very late in its maturity and was probably almost about to turn down. That would not be very helpful. --My questions are along the same sorts of lines. At the conclusion of your statement, you looked at the four possible outcomes, which are variations of international outlook and also the domestic credit and asset market pressures. In the statement on monetary policy I think you have said that you expect some firming of the international economy. You also mentioned at the end of your statement some very early evidence that there may be an easing of pressures in the asset market or residential market. You have also said that the most damaging combination would not be the most likely outcome. Which outcome does the bank see as the most likely outcome of those four possible outcomes with the combinations of both? --At the moment, domestically we do have excessive credit. There is no doubt that credit is growing at an excessive rate. We definitely have that part. The question is whether it is coming down or whether the speculative part of it is abating. Our guess is that it is abating. But it is very difficult to find strong evidence that it is abating. On the world economy, the jury is still out. When we look at the US, the US has a lot of problems but it is not as though it is actually in recession. It is chugging along at about two per cent per annum. It is actually in that indeterminate zone where it could pick up, which is what the majority of the world's forecasters think it will do, or it could continue to disappoint. I do not think it is going to plunge back into a recession but it could continue to disappoint. If it continued to disappoint for a short period, that might not be a problem for us. But if it disappoints for a long period, even without going into recession, then that could be a problem for us. The whole thing is actually played out in slow motion. Each month, you get an update on where the probabilities are. At some point, which has not occurred yet, the probabilities will be such that you can say, 'This risk has gone up,' and either, 'That risk has gone down,' or 'That risk hasn't changed but this risk has gone up,' and that is enough for you to make a decision. This is evolving all the time. Our position has evolved all the time. As I said, a year ago we were talking about the need to get interest rates back up to normal. Six months ago we were saying there is no presumption that we should do that any more. Now we are saying it is quite clear that interest rates around the world are going down. If these international developments continue, then we will no doubt at some point along the way participate in it unless there is a change for the better, and we see that this recovery is indeed occurring. So the whole thing is evolving. There is no sense of urgency. If you disagree with me about a decision on a particular month, that is not the end of the world. You get to make the decision again the month after that and the month after that and the month after that. --I think you would say that the international outlook is weak right now. Also, we have strong credit and asset market pressures. You said that the most damaging scenario for the economy would be the combination of those two. Is it giving conflicting signals for monetary policy or is it that you might also see a bust or a drop in the asset prices as well? --At the moment it is giving conflicting signals for monetary policy; that is quite clear. What I was referring to is not what is happening now. I was referring to what might happen over the next 18 months. I was saying that if over the next 18 months the world economy does turn out to be much weaker than we expect, there is no recovery and it just sinks down further, and if the speculative activity in house buying and borrowing--the credit driven house price spiral--also continues over that 18-month period, then you would be setting yourself up for a very nasty explosion, which would cause a huge amount of financial distress and, almost certainly, a large recession. That is what I was setting up there. I was saying that would be disastrous. I do not think that is going to happen because I can see the speculative excesses starting to abate. At the moment, the jury is still out on the world economy. It is going ahead at an unsatisfactorily low rate, but it is still growth. It is not as though it is in recession. But if that were to happen--if it were to go into recession and the speculative excesses of the housing market were to continue--then there would be a huge amount of distress at the end. --Mr Macfarlane, given your comments on house prices and speculation and the associated risks, is there an even greater relative risk for regional areas? In quite a number of regional areas there has been a very rapid growth in land values and property prices. A lot of it has to do with the shift in baby boomers--people cashing in on the rapid increases that have occurred in property prices in many of the cities and moving elsewhere. This is having a fair impact on house prices in regional areas. I am talking about the relative risk in those regional areas as a result of that. --I doubt it. I think there is not a lot of risk. There is no-where near as much risk in an owner-occupier buying a house to live in, because there is very little speculative element in that. The part that becomes risky is when someone signs up to pay for something that is going to be completed in 18 months time, and then at that point they hope to rent it out to someone else whom they do not know for a rent they do not know. That is where the really speculative element comes in. But if someone in the city whose house has gone up in value decides that they would prefer a different lifestyle and they sell their house in the city and move to the country, I do not find that in any way worrying. In fact, it is probably a very satisfactory development for Australia. I would have thought that, by and large, the people living in the rural regions that these people move to would be quite comfortable with that. --I guess it is the flow-on effect which I am talking about. Because of the push-up in values in those areas, there is a delay in the associated economic activity combined with the effect of the drought and different incomes. It is more the effect on other people rather than those doing the shift that I was talking about. --I suspect there is divided opinion in most regions when the money from the city moves in and bids up the property prices. I am sure there are a lot of people who are overjoyed and there are other people who are not too happy about it. But I do not think there is a serious financial risk involved. That is my only comment. --I want to raise a couple of questions with regard to employment. Firstly, the budget forecast has indicated a slowing in employment growth in the out years. To what extent do international circumstances beyond our control make even those lower employment growth figures optimistic? To what extent are they vulnerable and are we at risk of a considerable slowing there? Secondly, regarding a microemployment issue, to what extent is the household debt issue that you have raised concerns about linked to changes in the pattern of employment--in particular, the growing casualisation of the work force feeding into the growth of household debt? --On the first question, from my cursory memory of it I thought that the figures for employment growth in the budget were consistent with the figures for economic growth, so that did not cause me any concern. Your general point, however, has to be true. If it turns out that the world economy is much weaker than we are currently assuming, then those forecast figures for GDP will be lower than are currently forecast and therefore employment growth will be lower and unemployment will be higher. We all accept that that is a possibility and a risk. I have no dispute with what you say or what was said in the budget. On the issue of household debt and the pattern of employment, I have not looked at it closely but some people have made the point--and there is a chicken and an egg problem here--that one of the things that has contributed to driving up house prices is that in many cases a mortgage is based on two incomes rather than one income. People are perfectly free to do that, and some of them would probably feel they needed to do that. But that may mean that if one income disappears there might be difficulty in servicing the mortgage, even if the other income is still there. Some people would see that situation as slightly riskier than the situation if we turned the clock back 30 or 40 years, where borrowing was based on one income. It is one of several reasons why the size of mortgages has increased so much. --You are concerned about this issue, though, aren't you? You have put out a paper entitled 'Do Australians borrow too much?' and another paper called 'Household debt: what the data show'. Half of your report for May 2003 is based on the notion that households have too much debt, that households are geared too much. You have talked extensively in these documents about record levels of debt and record levels of gearing, so it has to be a concern, hasn't it? --Yes, but I was not asked whether it is a concern; I was asked about a particular aspect of that concerning the changing structure of employment. It is a concern; you are right. We have made a major effort to try and draw people's attention to that, although I always have to remind people that 40 per cent of people in Australia own their homes outright, so debt is not an issue for them, and 30 per cent are renters. Only 30 per cent actually have a mortgage, and probably more than half of those have had a mortgage for quite a while, so it is a modest sized mortgage because it is run down. There is only really a fringe of people at the vulnerable end, but there are more of them now than there used to be. --Mr Macfarlane, you have tried to put it into perspective but, as Ms Burke has pointed out, it does dominate a lot of the thinking of the bank. It raises the obvious question-- given the constraints you have in trying to work out where your optimum monetary policy is, and interest rates--would you like to see another financial tool available within the Australian economy to try to separate out the management of the two conflicting pressures? --We have another financial tool. It is called open-mouth policy, and I have been using it, but it may not be as effective as other tools you could conceive of. I am not putting in a plug for another instrument, although if in the longer run things turned out badly it would not surprise me if people started looking at other arms of policy--for example, tax policy. We have a tax regime in Australia which, compared to a number of other countries, is very favourable to property speculation. I am not saying 'Change it', but I would not rule out the possibility that if things do turn out badly there may be a public desire to make some changes. --There also used to be an open-mouth policy where the governor of the RBA used to talk to the major banks about their lending practices. You have also stated that half this problem goes to an opening up of the lending market--that there are all these new products that you can buy into which make it easier for people to borrow almost 100 per cent of their mortgage nowadays. Have you exercised your open-mouth policy with the banks over their lending practices and the directions they are taking? --I have spoken to some chief executives. The old open-mouth policy you referred to was more than that; it was a direct limit on how much banks could lend. You used to be able to say to them, 'You cannot lend more than 8 per cent this year,' or, 'You are not allowed to lend more than 10 per cent this year.' That was a characteristic of the old regulated system. We used to set the interest rates and not let them charge more than X for a mortgage. It was a characteristic of that whole system. So it was not just open-mouth policy; it was a very clear and very binding set of regulations which we have moved away from over the last 20 years. --Mr Macfarlane, surely if you are looking to ensure banks are exercising due diligence and taking proper prudential responsibility in lending and you are raising these concerns, isn't there a point where you could follow up on Ms Burke's point and say, 'Hang on, the lending is now becoming too free'? --The body that has responsibility for this is APRA--and APRA has been talking to them. APRA is responsible for the prudential soundness of the banks, so APRA has put them through the hoops and said, 'Are you sure that you are not putting the soundness of the bank at risk?' The banks have said--and APRA has accepted and I accept--that this is not putting banks at risk. If this turns out badly, I do not foresee one of the results being banks failing. I do not foresee that all. --No, households could collapse. --I see household distress--that is what I see. I am not sure which part of the Australian government is responsible for investor or consumer protection--these are the issues we are talking about here. Neither the Reserve Bank nor APRA is the body that is responsible for either investor or consumer protection. I know ASIC, which is responsible for investor protection, has attempted to limit one aspect of this, which is the widespread growth of investment seminars where people come along and get told how to get rich quickly by using the equity in their existing home to gear up and buy a couple more apartments. ASIC would love to stop that. The problem is they cannot demonstrate that these people are in fact financial advisers. If they were, they would have control over them. But the people who run the investment seminars say, 'No, we're not. We are humble real estate agents and we're not subject to your laws--we're subject to state laws.' --Let us raise that. The latest has a series of articles on this. The last sentence in one of those articles is: Are you trying to say that there is something missing in public regulation? --The thing that has kept this going for as long as it has, has been the investor. The property developers will build things as long as there is an investor to buy it off the plan. This is the way that most systems operate: the investor is the customer. As long as the customers are there, this will continue. I have tried, and others have tried, to influence the investor, and I think with some success. If you read the newspapers, they often say that such and such has slowed down because of Reserve Bank warnings. Certainly the Housing Industry Association--which, by the way, does not disapprove of what we are doing--has said that the recent reduction in investor demand has been due to the Reserve Bank warnings. --You said that 40 per cent of people own their own home, 30 per cent rent, and 30 per cent have mortgages, and a fair proportion of those mortgages have been going for some time. First of all, can you put a figure on the vulnerable section that you are talking about? Secondly, what exactly is the risk? Presumably, the risk is that they may have a drop in income or lose employment totally. If that does not occur, what is the ability now of the vulnerable section to pay the higher debt compared to, say, 10 years ago? --I gave a speech on this subject. It gets quite complicated. Basically, our view is that it has always been such that, when someone first takes out a mortgage and they borrow the maximum mortgage they can afford--I cannot remember the exact figure we use as an example, but they pay, say, 25 per cent of their income to service the mortgage--they are always very vulnerable. Even 20, 30 or 40 years ago a lot of people in this room, who are old enough to be in that age cohort, would have done that. They were vulnerable. If you lost your job then, you could not keep servicing your mortgage and you would lose your home. There is always a proportion in that situation: the newcomers to the market. What is happening now is not that they are any more vulnerable than they used to be, but more and more people are permanently staying in that vulnerable state. They go out and use the equity of their home to buy another property or something else, so they keep themselves at the vulnerable end. So, instead of only a small proportion of the population being at that vulnerable stage of life, there is now a much larger proportion of the population. I do not know what the numbers are--they are probably very small. Maybe it used to be one per cent; maybe now it is five or six per cent. There is no science in those numbers, but that is what we are talking about. --This is the second Treasury secretary whom you have been at odds with to some degree on the stance of monetary policy. It seems from my observation that Treasury, perhaps under Ted Evans, had decided that they wanted to run the economy a little bit harder, and with productivity improvements that was possible. What implications on the exchange rate do you see with monetary policy now and what may it do to our export competitiveness? --Those two questions seem to be unrelated. On the first one, just look at the record of the Australian economy over the last 12 years. We do not have to defer to any country in the world in terms of our economic growth--its sustainability and our growth rate and our productivity. So if you have got a better basic formula somewhere, tell me about it. But the one we have used has produced the goods. So I do not feel I have any need to apologise or explain at all. I think the numbers speak for themselves on that first one. On the second one, I think you are asking the question that has really been asked before under various guises that amounts to saying: the appreciating exchange rate is a big issue; what are you going to do about it? I think I have answered that one before, that is, to date I do not think you can classify an exchange rate which has returned to its post float average as a problem. If it were to continue to appreciate at the sort of rate that it did in the month of May, I agree it could quite quickly become a problem. My response--this is related to my response to the Chairman--is that there is no magic level where it becomes a problem. It was not a problem; now it hits the magic barrier it is a problem. It is continuously affecting our assessment of the growth prospects of the economy and the rate of inflation going ahead as it moves from the exceptionally low level that it was two years ago back to its normal level. That has already had an impact. That has already, at the margin, meant that you would want to run lower interest rates than you would want to run had it not done that. So it has already had an impact. It is one of the factors which has changed our perception--as I said, from a year ago when we were thinking we needed to get interest rates up--and put us in the position where we are now, where the discussion is really about whether they stay where they are or whether they go down. It is continuously being fed into our assessment. --Thank you very much, Mr Macfarlane. I would like to ask you about Australian investment abroad compared with foreign investment in Australia. It seems that over the last four years we have seen an increase in Australian portfolio assets and equity overseas and over the last two years we are seeing Australian FDI offshore as well. What is the bank's analysis of it? What reasons do you see behind it? --On this question, it is true that in Australia, as in just about every other developed country, we are seeing simultaneously big capital inflows and big capital outflows. It is just part of the way modern developed economies behave in an integrated world. I got some figures out on this. Over the last decade in Australia our liabilities to the rest of the world-- because of money that has come in--have gone up by 47 per cent of GDP. At the same time, our assets--what the rest of the world owes us because of what we have invested abroad--have gone up by 40 per cent. So there are very big movements on both sides. Some people might be worried about that but, to reassure you, let us look at a few other countries. If we look at Germany, for example, the figures were 88 per cent and 71 per cent. If we look at the United Kingdom, the figures were 168 per cent and 164 per cent. This is just the nature of the way modern developed economies behave in an integrated financial world. We own a lot more of them than we formerly did. They own a lot more of us than they formerly did. I do not see that as in any way being an increase in risk. --To what extent is overseas borrowing by Australian banks funding this --This is part of the same story. A lot of what we are calling inflow into Australia is Australian banks borrowing offshore. Why do they borrow offshore? Why do not they just borrow from Australian depositors? They borrow offshore at the moment--they are doing so much--because it is in their interests. It is cheaper for them to borrow offshore in foreign currency, then to swap that foreign currency back into Australian dollars so they have themselves in a hedged position. They are not taking a foreign currency risk. When the sharp pencil men go through and work out the cost of funds, it is a few tenths of a percent cheaper than if they had borrowed in Australia. That is why they are doing it. The reason it is a few tenths of a percent cheaper at the moment is because there are a lot of people out there who are very comfortable taking an exposure to the Australian dollar. This is the way they do their business. If that were to change, then those few tenths of a percent would move the other way and they would start wanting to borrow domestically. --I do not think that in your opening statement you said anything about the current account deficit. Do you have any comments on the current account deficit? --I do indeed. I am sorry. You are right, I did not say anything. I implicitly said something about it, because on a number of occasions I referred to the fact that our exports were falling and our imports were rising. As a result of that, our current account deficit has been widening. A figure for the first quarter came out a couple of days ago. It is 5.3 per cent of GDP, which is a fair bit higher than it had been two years ago--not surprisingly. Is this a cause for concern? At the first level, I would say it is not, because it has been over six per cent on four or five occasions. In fact, it was temporarily over six in the December quarter because of all those Qantas planes that were imported, and it will probably go over six again. I will be very surprised if it does not go over six at some stage later this year. That is a pattern that we have had in Australia for 20 years or more: when we are doing well and the rest of the world is doing badly, our current account deficit goes over six per cent. People could say, 'That's okay, but what if it goes a lot higher than that?' We cannot rule that out. If that were to happen, I think it would still be mainly a reflection of what we have been seeing, which is domestic demand in Australia being strong relative to the rest of the world. If that were to happen, would that lead to some disastrous result? I think it may well lead to a reaction, but I suspect the main reaction would be for people to become more wary about holding the Australian dollar and the Australian dollar would then start to go down. --In the past, when the Australian dollar has been falling, we have not seen the rise in exports that you might expect due to competition in the Australian economy. Can we now expect the opposite with a strengthening of the Australian dollar--falls in the price of --That is a technical point, and I think the answer is: we would not see as much downward pressure on prices as you would have been led to expect under the earlier relationship. Basically, you would see a rebuilding of profit margins. --In this half we will try to expand into other areas, away from monetary policy. But I have a small technical question. Mr Macfarlane, I think it is now customary for any changes you make to interest rates to be announced the day after a board meeting. However, that has not always been the case. Is there still discretion there to delay announcing a decision? --The discretion is there, but we have not used that for quite a while. We did earlier. When I first took this job we used it on a number of occasions, so change has occurred while I have been in this position. The emphasis on transparency means that it would be difficult, unless the circumstances were exceptional, to have a meeting, agree to do something and then not do it for two weeks. I think the way the world works now is that, once you have made up your mind that you want to do something, you do it and you announce why you do it. That does not rule out what would happen if an exceptional circumstance occurred. For example, after September 11 a number of central banks--which, like us, would normally only act immediately after the board meeting--took action in the interval between board meetings because they felt that an exceptional event had occurred. You might remember that we did not. We did not think it was exceptional enough for us to want to act. We did subsequently take some action, but we did not do it in between meetings. So it is unlikely unless a big event occurs. I think the market reaction would be very large if you did something between meetings other than in response to an exceptional event. --I want to give you one more opportunity to make a comment on housing. The article in last week's made the comment that the PE--price to earnings--ratios for Britain, Australia and the Netherlands pointed to a pronounced bubble, suggesting house prices in all three countries were at least 30 per cent too high. Would you comment on that. --I do not think that was a particularly sophisticated piece of research. They basically just looked at house prices to incomes and said they are 30 per cent above their average levels or above the trend. I do not think they have adequately taken into account in their calculations the fact that you can borrow more in a low interest rate environment than in a high interest rate environment. So their figure is biased upwards. In our view, it is an overestimate. --Going back to the discussion we were having before, you were talking about putting some brakes on people overextending in the housing market and you referred to the lack of regulation in the area. Do you believe that ASIC or some other body needs the power to say to lenders that it is inappropriate to conduct these seminars and then to offer people properties--to give them advice about how to get the money and then say, 'By the way, I've got this fantastic waterfront view for you'? Is there something missing in law and regulation that needs to be given to ASIC or someone of that ilk? --Yes, I think there is a regulatory gap there. It is clearly a problem if there is one group of people who are holding seminars on how to invest your money who are regulated--the financial planners--and there is another group who are doing almost exactly the same thing, although doing it within the one asset class, which is property, who are unregulated. So I think there is a need to extend the capacity for ASIC to do that. --You painted a reasonably bearish picture at the extreme end of the risk scale before the break. If that eventuality were to turn out to be correct, would the government be meeting its fiscal target of achieving balance over the course of the cycle? --Obviously, as a purely neutral statement of economics, if output growth and income growth were to decline, then one would expect the budgetary position to change. I would expect it to change and I would be very disappointed if it did not change. --But that is not answering the question about the government's fiscal policy at the moment, which is to achieve balance over the course of the economic cycle. Certainly the budget balance would turn around, and probably dramatically if the circumstances you are talking about happened. If there was going to be that kind of event, has fiscal policy being tight enough in the latter part of the cycle in recent years? --The answer to that is probably yes. We are in a remarkably strong position for our fiscal policy to withstand a contraction. The biggest indicator of that is that the stock of government debt on issue to GDP is probably the lowest in the world. Unlike a lot of countries who have already used up their fiscal ammunition, we have not used any of it yet. So I think we are in a strong position in that sense. --Were you relieved about the Treasurer's decision to abandon his project to get rid of the bond market? --I do not think he had a project to get rid of the bond market. --I think he did. --We were all in this awkward position where, if a number of independently worthwhile events occurred, a corollary would be that there would not be any government debt on issue, and that would have some implications for financial markets. In the event, it has not occurred. I managed to stay on the sidelines throughout; I think I will stay on the sidelines. --My question flows on from that and goes back to Andrew's question before about the current account deficit, which is tracking fairly similarly to how it did in 1997, around the time of the Asian crisis. We managed to congratulate ourselves that we came out of that unscathed. Monetary policy was a lot tighter then, though, and the Australian dollar was not appreciating as it is now. Do we need to cushion the Australian dollar to ensure that we can survive the same impacts we are having in terms of the current account deficit now? --I think you said that monetary policy was a lot tighter then. --Sorry, it is the other way around. What I am trying to say is that the Australian dollar was lower--my apologies. So do we need to tighten the dollar now to cushion ourselves against the growth in the current account deficit? --During the Asian crisis we did nothing. That was our great success: to do nothing. Everyone else tightened and we did not. We did not actually loosen, we just did not tighten, and we got through the Asian crisis very well. It is true the currency did weaken, but it did not weaken anywhere near as much as it subsequently weakened in 2000-01. So it turns out that our currency was more affected by the fashions of financial markets during the new economy age than it was by this very profound event: the Asian crisis. We actually entered this current phase of world weakness with an exceptionally low currency, as you know. The recession year was 2001, and in May 2001 we had an Australian dollar at 47c. So we entered this thing with an exceptionally low exchange rate, which is one of the reasons why it has gone up-- the starting point was just so low. --So you are not concerned now that the differentials between us and the rest of the world are growing so greatly, particularly if you look at us versus the US? --We definitely take it into account. --In Warrnambool six months ago we talked about the potential impact of the drought. At that point in time, the drought had been going on a little while but probably not long enough for us to understand what the impact might be. Six months on, we have seen that impact a lot more closely in some of the figures that have come through, particularly in the last few days. Has the impact been about what you might have expected, or a lot greater? How much do you think that will improve in the next, say, six to twelve months? --I am happy to answer the question, but I do not profess to be the greatest authority on this subject. The greater authorities are the Bureau of Meteorology and ABARE-- the Bureau of Agricultural and Resource Economics. Our rough assessment--which is based on information we get from them--is that farm production will have fallen by about 30 per cent in this current financial year. This would take 0.9 of a percent off GDP. The rough rule of thumb we had is one percent. We were talking about how the drought would take one percent off GDP. It looks like it has taken virtually that--0.9 is very close to one. When we look ahead, it gets a bit trickier--and this is where the Bureau of Meteorology is of more use than any economist. They have declared that the El Nino event is over. That has to be good news. Some parts of the country, as you know, have received the benefit of that, but other parts have not received much benefit at all. Southern and central New South Wales and parts of Victoria have got virtually no benefit, but other parts have--Queensland, northern New South Wales and Western Australia. ABARE, on the basis of that information, are forecasting that there will be a rebound in agricultural production because at least a significant part of Australia has recovered. They are expecting that it would add about three-quarters of a percent to GDP in the coming financial year. So we are not quite recovering the loss of the last financial year, but we are recovering most of it. --I want to ask about things like farm management deposits and the drawdown. You commented that at the time farm debt was in a very good position, that there had been a good repay of debt over a period of time and that that had not had much impact. What has happened since then with respect to that and with respect to general farm debt? A lot of people were surprised at the end of last year that with the drought there was not a greater pull-down of FMDs and a build-up of overdraft. What is the Reserve Bank hearing about that? --I fear that you probably know more about this subject than I do. There is probably more information in your question than you will get from my answer. Can you add anything to that, Malcolm? --Farm debt is going up but not at a particularly rapid pace. You are now starting to see some drawdown of the farm management deposits, but I think we are only seeing the early stages of that now. Where you would be likely to see it starting to come through more quickly is as people draw funds to invest and plant in the current season. I think we will be seeing more of that coming through around the middle and later part of the year. --I want to get onto the subject of bank fees and other associated fees. I note that you have an article on that in the April . We have discussed competition with the banks in the past. Although it took some time, the business loan margins came down more quickly than they did for the personal and small business loans; the pressure has brought them down. At the same time, we have seen quite an increase in fees. I know you have said on many occasions and again here that the increase in fees has not offset the drop in margins, but it is still true that fees charged to households in 1997 were $1.2 billion. There has been an increase of 123 per cent, $2.7 billion in 2002, while for business there has been an increase of 78 per cent. In other words, fees for households have gone up quite dramatically. There are winners and losers. At the end of the day, is this an example of the banks recouping what they lose one way and not really being under proper competitive pressures to keep those fees down? --I will not attempt to answer that, because I have not read that thing recently, but Rick, who probably wrote it, would be in a better position to answer your question. --It is certainly the case that fees on households have, over the period we have been collecting the data, risen faster than fees on businesses. As far as we can tell, one of the important reasons for that is that the volume of transactions that households do with the banks has increased enormously over that period. The main sources of the fee rise are fees on credit card transactions and fees on housing loans. Both of those have been rising very quickly over this period. In that respect, it is not surprising that the overall fee income earnt by banks from households has risen. The actual fees charged per transaction, particularly in the case of housing loans, have fallen substantially over that period, partly because the banks are under competition from non-bank lenders, who have cut their fees. To the extent that there is a story there, it is the fact that the volume of transactions that households are undertaking with the banks is increasing so quickly. --But are there competitive pressures there? For example, you talked not only about housing borrowing but also about credit cards and so on. The banks have a very hefty interest charge on credit cards, and they also introduce all sorts of ways of trying to supplement their income. A recent example drawn to my attention is of a household running up, say, $1,000 on a bankcard and then choosing to pay back $800. The banks would still charge the interest on the full $1,000, even though the outstanding amount was only $200. That is a relatively recent innovation in raising income. My question is: is there sufficient competitive pressure and, if not, as you have done with interchange fees, what pressure can you put on them? --The competition really comes from competitors outside the banks. If you get a free market with new competitors coming in, that is where the competition comes from. We have seen that most particularly in the case of housing. We first saw it with interest rates back in the mid-90s, as all the non-bank mortgage providers came in. Then we saw it with the fees that banks charge. When you applied for a loan they used to charge $800 or $1,000; that has come down substantially. Again that has been because of competition from outsiders. On the credit card business, I think the outsiders have more trouble in competing there. This is the issue that Ian has been on about with the credit card reform. That is what it is all about. --Doesn't it also get back to the products that the bank are pushing--revolving lines of credit, frequent flyer points? The reason there has been such a huge increase in people using credit cards is that they have been told by the banks to pay for everything on credit cards. If you go to the Centrelink website, the No. 1 preferred method of paying off your family debt is by credit card. Fantastic--pay your debt by incurring another debt. Haven't we gone insane? I know it is not your area. Sadly, it is nobody's area because the ACCC cannot get a reference from the Treasurer to look into this area of fees and charges. So I suppose my broad question is: should the Treasury give the ACCC a reference so it can look into fees and charges and should someone be monitoring the excessive pushing of credit cards as a means of payment? It is becoming the most preferred method of paying everything. --I can go some way towards answering the question the chairman asked as to why we cannot do something about these various fees you are referring to, the way we did something about credit cards. The thing about the regulation of credit cards was that we did not seek to regulate any fee a bank charges its customer. We rely on the market to put some discipline there. You can argue one way or another whether there is enough discipline. The only fee we were involved in was a fee which was not set in the marketplace but which was set collectively by providers of the product. That is why we made the changes that we did to the interchange fee. That was not a market set fee. It was not a market price. It was determined collectively. On your second issue of why so many payments are being made with credit cards, some of that is starting to change, partly because merchants now have more freedom to accept or reject a credit card. More particularly, they have the freedom to pass on the costs that they got hit with from the bank to the customer and therefore give the customer the option of using a more efficient and cheaper form of payment than the credit card. We are starting to see some signs of that coming through--not on a big scale, but we have seen signs of that happening. That was one of the purposes of the reform of credit cards--to give the merchants back some of the power that had been taken away from them. --On this issue it seems there has not been as much movement as we would like. The last time we were in Melbourne we were discussing these issues, including interchange fees. Why is it that banks charge an interchange fee of 64c on BPay--bill payments--if you pay from a savings account; whereas if it is done through EFTPOS there is no interchange fee, something that you have supported? Why the distinction there and what is the bank's view of that? Secondly, in terms of BPay interchange and the ACCC review of it, why didn't you undertake a review and what is your view of the ACCC decision to essentially take no action-- hands off? --I am sorry that I am going to have to disappoint you on this in that I actually do not know enough about BPay to answer you. It is true I am the Chairman of the Payment System Board but I am very much the chairman; I am not the expert on the Payment System Board. Unfortunately, there is no-one in the group of people I brought with me today who can answer. We had to leave behind our payment system expert. I am only too happy to get back to you and take that question on notice. I am sorry; I cannot answer it. --I think it would be good if you could get back to us on that and maybe on the wider issue of what progress reform is making and what the expected further reforms are. --I can talk on credit cards, debit cards and ATMs--when I say debit cards, that is EFTPOS; it is the same thing. But I am not full bottle on BPay, sorry. --Taking up that issue as well, why hasn't there been one review, a general review, into all of these payments--debit cards, ATMs, credit cards and BPay? It seems that there are ad hoc little inquiries about essentially what is fundamentally, in my view, the same issue. --The reason is that we thought--and we still do--we could get the sorts of reforms that the community needs voluntarily on EFTPOS and on ATMs. But we clearly were not going to get that on credit cards. Credit cards are a much more difficult issue. You can see that by the fact that we are now involved in a very long court case with Visa and MasterCard, who play either no role or only the tiniest role in the EFTPOS or the ATM issue. The credit card issue is going to be a much bigger issue to crack than the other two. --We have been talking about this for some time now. You say that you hope that it will be a voluntary improvement in the lowering of costs and so on. Are you satisfied with the rate of improvement? --I was not satisfied for a while, but I think I am satisfied that on EFTPOS, the main players--although not 100 per cent of them--who are the banks, have put a proposal to the ACCC to just abolish the interchange fee; to just get rid of it completely. We think that is a very constructive step. That is probably what we would have sought to do had we gone through the formal channel of designating that payment stream and doing the sort of thing we have done with credit cards. That is an example of where, with a bit of luck, we will get the same result without having to go through the elaborate procedures we have been through with credit cards. --Do you feel that there is a difficulty in defining who has real responsibility here or do you feel that you have resolved that now? --I do not think there is. The quickest solution--the lighter touch solution--is actually to go through the ACCC. That is how, if you remember, the credit card reform started. But then it got bogged down when it became clear to us that the authorisation procedures of the ACCC were going to be very time consuming. The ACCC cannot say, 'You are doing it this way; you have to stop doing it that way; you now have to do it this way under authorisation.' All they can do is say, 'What you are doing at the moment is not in the public interest. Go away and come back with another proposal which we may then decide is in the public interest.' That procedure depended very much on the cooperation of the institutions involved and they were not giving it on credit cards, so both we and the ACCC decided it was much more effective to go down this so-called designation path. On EFTPOS, they are getting the cooperation. They have come back to the ACCC with what is a very constructive proposal. I think that one will go ahead on a much better path. --Has anyone else got any questions on that? If not, we will move on to a couple of other areas. With the US and its twin deficits nowadays--both the budget and the balance of payments--and a number of countries such as Japan, Taiwan, Hong Kong and so on having quite large reserves held in US dollars, is there any concern that those countries may choose to change where they are holding their reserves? If so, what are the impacts likely to be of that? --My understanding is that some of the Asian countries, with very high levels of international reserves, have in fact switched some of their reserves out of US dollars and into euro. The implication is that it is one of the factors that drives up the euro and drives down the --Yes, I think so. --So why are we continuing to have all our reserves in US dollars? --We do not. In fact, we are one of the few countries that has as many reserves in euro as we have in US dollars. In fact, we made a decision about 18 months ago to increase the proportion of our reserves in euro. --No, not for that reason, because you do not try and play the market, as it were. It was a longer term-- --Other people have, and they have not done it very well. --It turns out that it worked out okay, but that was not the motive; the motive was a much longer run view of how the world might evolve over 20 years. In fact, that was part of the decision to reduce our holdings of yen--that was the main motivation for our change. We took what used to be in yen and put it into euro, which built the euro share up to the US dollar share. --Have you got a benchmark for the proportion of your holdings? --Yes, we have 45 per cent euro, 45 per cent US dollar and 10 per cent yen. We publish that every year. --Do you review that? --That was the review that-- --Yes, but I mean considering the movement in the US dollar at the moment? --Yes, we keep it under review, but it is not the sort of thing you would expect to change very often. If you were changing it regularly you would be playing the market, and we try not to do that. The old benchmark must have been in place for a good 10 years or so. It has been changed once in that time, and that was 18 months ago. --Another quick question: has any work been done on developing a common currency with New Zealand? Do you see any benefits in doing that? --We have not done any work on that. I think the Treasurer has pronounced on that on several occasions. His view, if I am correct, is that if New Zealand wants to do that then he would respond favourably to anything they had to say, but I think he made it clear that the currency concerned would be called the Australian dollar and nothing else. --I will move on to something near and dear to my heart that I talk about all the time: APRA. Regarding the RBA and its role on the APRA board, do you think you came out of the HIH royal commission review lightly? --The first thing is that there are, I think, 2,400 pages of the report, of which They are the words of his finding. That does not mean he did not make some criticisms of APRA--he did make some criticisms of APRA--but, if you read the report, I think you will find that he made a very balanced judgment. He did concede, for example, that APRA was in its infancy and that it was still trying to draw together resources from Canberra, Sydney and Brisbane--it was trying to draw together three separate organisations into one. APRA was under the disadvantage of having a staffing level which was going to be lower than the sum of the three previous institutions that it replaced. I thought he was quite understanding in the way he did that. He also drew out the fact that what got APRA into trouble was something that it had inherited from the ISC. It was smouldering away there, it was going to happen at some stage, and it happened on APRA's watch, which was very embarrassing for APRA, but it was something they inherited from the ISC. The principal staff who were monitoring it from APRA's point of view were also staff it inherited from the ISC. So I thought his finding was quite fair and balanced. I might also point out that he did not make any criticisms of the APRA board--not one. What he said in relation to the APRA board was that he could not see the logic for it in the first place, and that is why he recommended the ending of the APRA board. I have to say that I also agree with him on that. I always found that it was an overly elaborate form of governance and that is the view that he took, partly of his own accord and partly because he had discussions with Mr Uhrig, who as you may know is going to report on governance of statutory authorities. I am quite comfortable with what Mr Justice Owen said about APRA and about the APRA board, and I am comfortable with what he recommended, which is that it no longer have a private sector type board, which is what it had, with a separate chairman and a separate CEO. I had let people know for some time that I thought it was a particularly cumbersome governance arrangement and I am not surprised that he had the same view. --Recommendations 18, 19 and 20 go to, as you say, getting rid of the board and setting up an advisory board. Recommendation 20 clearly states: What is your view on that recommendation? --If you read his arguing for that, I think it was quite right. Really it was saying that if you were the CEO of APRA, to do all the things to run APRA--the personnel decisions, the budgetary decisions and all the sorts of things involved in running an organisation--you had to report to a board, which included people who are running similar organisations, giving their opinion on how you should be organising your budget, how you should be paying your personnel and who you should be promoting. It was really very intrusive to have the head of ASIC and me virtually being expected to help the head of APRA make those sorts of decisions. That is one of the points that Mr Justice Owen made. I reiterate, I agree with his conclusions. --He also said that there was an assumption that at board level, discussions were actually happening between APRA, RBA and ASIC. He said that people further down the line were assuming that those discussions were happening at board level and he said that they obviously were not happening because the information was not being exchanged. Do you think that was a fair criticism? --I am not sure that he said it quite that way. I think what he said was that you have established clear channels of communication at staff level and you have memos of understanding between the three organisations so that information will be exchanged at that level. But at the same time, you are duplicating it by having another channel of communication at board level. If you have duplicate lines of communication, you run the risk that people assume that the information has been passed along one line of communication when it has not and, in the end, it does not get passed along either line. I do not think he felt that lack of communication between the three institutions was relevant to what happened in HIH. He just made the logical point that it is a mistake to have two separate and independent lines of communication. --He made some reference though that he believed--I am paraphrasing--that Wallis probably got it wrong and that bank regulation should never have actually gone over to APRA but should have stayed with the RBA. Given what has now transpired and the changing of the board arrangement, do you think bank regulation should be returned to the RBA? --No, I do not. As you know, we argued against a number of aspects of the Wallis report, but on that particular issue, which is a very large issue, we said that we accepted the umpire's decision. It is clear that in a number of other countries, a similar change occurred and an independent prudential regulatory body was set up that looked after banks, insurance companies, building societies, credit unions, the pension industry et cetera. Either system can be made to work. We have no desire to turn the clock back to the old system, which did work. If you remember, Wallis did not say that it did not work; he just said that this would be better way of doing it. But we have no desire to turn the clock back. We want to do what we can to make sure this system does work. I think it is extremely unfortunate that in its most vulnerable period, in its infancy, APRA was hit with this once in a 20-year shock, which was going to hit at some stage. It is quite clear from the royal commission that it was an accident waiting to happen; the size of it had been building and building and eventually it blew up. --Have there been any other adverse consequences in terms of the rest of the Reserve Bank's responsibilities in having lost prudential regulation of the banks? --I do not think so, no. We gained a new responsibility, which was the regulation of the payments system--which has turned out to be at least as intellectually demanding as regulating banks was. Maybe I am exaggerating. It has been, over the last 10 years, at least as intellectually demanding as bank regulation has been over the last 10 years. I am referring to the fact that bank regulation has gone extremely smoothly. The other thing is that we do retain the chairmanship of the Council of Financial Regulators. I think the point that Mr Justice Owen was making was that this was a very good body but it had been slightly sidelined by the fact that the members of it were also, by and large, members of the APRA board. So the work that they would normally have been doing at the quarterly meeting of the Council of Financial Regulators they were doing in their monthly APRA board meetings. So the APRA board had become, de facto, also the Council of Financial Regulators. So, on the one hand, the board was asked to do a huge amount of work for APRA--the sort of work which normally an executive committee would do rather than a board--and, on the other hand, it was also de facto doing the coordination role between the various regulators. Under the new arrangements, that will not be the case. The Council of Financial Regulators will be the peak body to make sure that coordination occurs at the highest level between ASIC, APRA and the Reserve Bank. I think that is a good solution. --There are no insights into the operation of the financial system that you are missing by not regulating the banks? --At the margin, you may be right--but I would say it is only marginal. As soon as we lost bank regulation, we set up a financial stability system group, which was headed by John Laker, who is an assistant governor at the same level as the two gentlemen on my left. That group has joint responsibility for the payment system, which brings us into constant contact with banks--because, basically, they are the payment system. We are the centre of it, but they are the main body of it. We also have a department which just deals with financial stability issues, just looking at all the financial risks that occur in the community as a result of the changes in products, the growth of derivative markets and the growth of these credit derivatives--all those sorts of things. This small team keep in touch with that constantly. They are also responsible for our relations with APRA and they are also responsible for supporting me in my membership of the Financial Stability Forum, which is an international body. I would have to say that whatever loss of expertise or feel for what is happening that has occurred because we no longer do face-to-face supervision has been very marginal, because I think we have made up for it with our other activities. --One of the things that I have noticed over the years is that any organisation that is basically appended off the Treasury portfolio, with the exception of the Reserve Bank, tends to be restricted somewhat in the amount of resources that it is given to perform new functions. Do you think that is a problem with APRA? --I think that was a problem in the formation of APRA, yes--I think that is quite clear. Mr Justice Owen makes it clear that it was a mistake for the Wallis committee to come out and say, 'Not only have we got a better system of regulation; it is going to be cheaper and it's going to involve fewer people.' That was a mistake. The government accepted the Wallis committee advice on that, and they now recognise that it was a mistake, because they now have, as a result of this very unfortunate experience, increased the allocation to APRA. --I had serious concerns in the course of the previous government about the ISC and the resources that were available to it. When I tried to pursue those concerns, I found that Treasury could not nominate anyone who was competent to look at the ISC to see whether it was doing its job. Who would you see as being the most competent group in the official family to give the government advice as to whether APRA is functioning well? --I am not sure what you are asking for. If you are asking which body is most capable of doing prudential regulation of the various groups of financial institutions, APRA will be able to do that. As to who would advise the government about how to handle APRA or how to construct APRA, a whole lot of bodies have given their advice and obviously Treasury has a very big role in that. Commissioner Owen has given some advice, Mr Uhrig has given some advice and I have given some advice. Between the four of us, with a bit of luck, we will get it right. --The Auditor-General has been doing a series of performance audits on APRA'S various functions. Since I have been off the public accounts committee I have lost track of how those are going. In a policy advising role, who do you think provides the Treasurer with advice --I presume that is Treasury. It is their job to provide advice to the Treasurer. Clearly, the overwhelming event that has drawn attention to APRA is the failure of HIH. I do not think anyone had to interpret that, because we had a royal commission and the royal commission is the biggest single source of advice. I do not know that there is much more I can say about that other than APRA was most unfortunate that, in its infancy, when it was still putting itself together, it got hit with a once-in-20-year tidal wave. --Mr Macfarlane, moving onto some international issues, 5 1/2 years ago at a hearing--I know it is going back a while now--you made a comment about Japanese banks. You As you are obviously well aware, the Resona bank, the fifth-biggest bank in Japan, had to admit that its capital adequacy ratio had fallen to around two per cent, which required the Japanese government to tip in money to keep it going. Is this banking problem in Japan part of the reason why the Japanese economy has been so flat? If so, what are the implications for our trade with Japan, given what is happening to its banks? --Yes, the weakness of their banking system is one of the reasons why the Japanese economy has been so flat. Remember that, even if it did not have problems, the Japanese economy will not grow very fast. Japan is facing a decline in its working-age population. With a declining working-age population, the only source of growth is productivity growth. As a very mature economy it will not have a lot of that. It may well be that, even if Japan were firing on all cylinders, it would only be growing 1 1/2 per cent per annum. Maybe that is an optimistic assessment of how fast it would grow. That is the first part of my answer. The second part of my answer is that we have been very fortunate in this country in that, even though our biggest trading partner has had an appallingly bad decade, our exports to our biggest trading partner have done reasonably well. They have grown much faster than the Japanese economy. I do not know what the exact numbers are or whether anyone can remember them, but we have done remarkably well in our exports to Japan. In addition, one of the other weaknesses in Japan is the shifting of its manufacturing base to China and elsewhere. Some of the exports that would formally have gone to Japan, we are still making, but they are being made for Japanese subsidiaries in other countries. So I think we have probably been just plain lucky that our exports have managed to hold up so well. It makes the achievement of the last 10 years all the more remarkable--that we have managed to grow as well as we have, despite the fact that our biggest trading partner has made very little contribution through its own economic growth. --On another area, the Basel II recommendations for capital for banks, which is, I believe, to come in in January 2007, means that, for a lot of banks, the capital will have to be increased. What impact is that likely to have in Australia? --I think what it means is a literal interpretation of Basel II. Because our banks are quite sophisticated and would be able to use the most sophisticated alternative available to them, it would result in a decrease in bank capital, not an increase. --For the big banks. --For the big banks--for the sophisticated ones that can take advantage of the particular channel. But there are a number of problems with Basel II which I will not bore you with. We are not sitting on the edge of our seats hoping for it to come in quickly; we are quite pleased that it will not be in until 2007. By that time, it probably would have changed another five times, because it changes every time I look at it. --We talked earlier in this area about the international Financial Stability Forum that you are a part of. One of their recommendations has been that the central banks publish statistics or reports on the vulnerability of their countries to external shocks. New Zealand has produced one of these reports and has made some statements that, yes, they are vulnerable. Given that New Zealand banks are our banks and that Australia has not produced one of these reports, do you intend to produce a vulnerability report? If not, why not? If you are going to produce one, what do you think it might tell us? --I think that what you are referring to is a thing called an FSAP--a Financial Sector Assessment Program. These are produced by the IMF at the suggestion of the Financial Stability Forum. This is one of the outgrowths of the Asian crisis. The Financial Stability Forum and the IMF said that one solution would be to establish a whole lot of codes that countries could be assessed against, and one of these is this FSAP. We are perfectly happy to have one whenever the IMF want to come and do it, and we have made it clear to them from the beginning. But the IMF can only do a certain number per year. We are on their list but we are a fair way down their list, because they tend to go to the more vulnerable countries first. So a lot of the big countries like the US, for example, and us--and probably a whole lot more I cannot think of--have not had one. But we are only too happy to have them here and do it whenever they want to. --Would you say the New Zealand one we made reference to was one of those? --Yes, it was. It was one of those. --It was not something they just initiated out of their own view of looking at what their vulnerability was? --When people started talking about this a number of years ago, a number of countries did a voluntary self-assessment, and we did one of those for ourselves. But it must have been three or four years ago that we did that. --We were one of the first to do that. --We were one of the first to do that, and I think that is another reason why the IMF has put us a fair way down the list. But we were only too happy to do it. I have to say, these things are mainly directed at emerging markets and developing countries. If you want to be cynical, it is a way that the developed countries and the international capital markets keep an eye on what is happening in the developing markets. --I want to come back to a question I have asked in the past about credit derivatives. There has been a massive growth in credit derivatives. According to the British Bankers Association, the level will double by next year, which, depending on how you look at it, is quite large. And, for example, Warren Buffett has described derivatives as 'financial weapons of mass destruction'--a bit of colour. Is there adequate disclosure of the level of credit derivatives being used by Australian financial institutions and is this massive growth a threat to stability? --This is exactly one of the subjects that I was alluding to when I answered the question from David Cox about how we try to keep on top of all these changes that are occurring. We actually put out a paper in our bulletin a few months ago on the growth of credit derivatives and the implication of the growth of credit derivatives. It is happening here, but on a relatively smaller scale--nowhere near the scale to which it has happened in the US and Europe, but particularly the US. It has happened on an enormous scale there. There is a fear--I am sure Warren Buffet is one of the people who has this fear--that whilst the growth of credit derivatives enables risks to be shifted and dispersed around the world, maybe it is being dispersed to institutions that are not in a good position to hold it. There certainly has been a fear for some time that the banks, being a little more sophisticated in this than the insurance companies, have bundled up a lot of their credit exposure and sold it to the insurance companies--not to our insurance companies but to some of the big European insurance companies. So this is something that the Financial Stability Forum is looking at very closely. It is something which we monitor. No-one is keeping it secret, but encapsulating what is happening and what the risk exposure is in terms of numbers is very difficult. You said that some people think there is not enough disclosure. It is very difficult, if you pick up the annual report of a bank, to know just how much risk is involved behind all the numbers they will disclose to you about the credit derivatives they have been selling, essentially. Basically banks sell their credit risk to someone else, who earns an income for taking that credit risk. It is something which we are monitoring closely. We have written an article on it. Again, I do not claim to be the expert on it, but we have a couple of people who are very knowledgeable about it, who have read all the literature on it, who are up to date with it and who know the size of the risk the Australian banking system is running compared to other banking systems offshore. --So you are feeling comfortable at the moment? --Earlier we were talking about housing. One of the other areas which has changed dramatically in the lasts few years is investment in shares, et cetera. I am no great expert in this area. In the margin lending area, there seems to be a fairly substantial increase in activity on the figures that I looked at; you might explain it. Even in the space of two years, if you look at the dollar value increase--the RBA produces the results--the average number of margin calls per day per thousand clients has gone up about four or five times. Is there something happening that a closer eye ought to be kept on? Should the Reserve Bank be saying something about it in to he same way it has provided cautionary advice with respect to investment in property? --I will hand the technical part of the question to someone else. I am glad you asked that question; it is very interesting. Margin lending for shares is the first cousin of negative gearing for buying property. The difference is, No. 1, when you buy a share, you know the price of it every day. No. 2, if your gearing goes up because your equity is declining, your banker phones you up and makes you put in some more equity the same day. So it is exactly analogous to the negative gearing of property, but it is closely monitored on a day-to-day basis. The problem with the negative gearing of property is that you do not know what the thing is worth and maybe you are going to get a rude shock in two years time--but you will not know it until two years time. If it were a margin loan on shares, you would be reminded of it every day and you can cut your position whenever you want to. That is all I want to say at this stage but, Rick, do you want to add anything on the orders of magnitude? I think the orders of magnitude are quite small. They are nothing like what we are talking about on investment property. --Yes, that is right. The overall orders of magnitude are quite low. We started collecting data on this a few years back, because the industry started to grow. The thing that has come out of it is that the banks are really quite conservative in lending in this area. The maximum they will lend is 70 per cent and, on average, the customers are even more conservative. The average they borrow against their shares is about 50 per cent. We were worried about what would happen--this all started when the share market was going up--when the share market goes down. We have had some reasonable tests of that because a lot of these margin loans were against Telstra shares et cetera, which have gone down a fair way. It turns out that the customers have no trouble making margin calls at all. Even though the number of margin calls has gone up a lot, the system has worked very well. Nobody at this stage seems to be getting into big trouble on this thing, but it is something we are watching very closely. --You took Mr Albanese's question about BPay on notice. Could you take on notice my question about whether the government is, on a reasonable range of assumptions, likely to achieve its fiscal target of balance over the course of the cycle? --I will take it on notice, but I warn you that I will probably refer it to the fiscal experts in the Treasury. They will tell me exactly how sensitive the budgetary position is to various assumptions about economic growth. --Mr Albanese also referred earlier to unemployment. In the of May 2003 there is a table listing the figures. The unemployment rates for most countries were as good as or better than Australia's, but our economy is tracking better. We have asked this on a number of occasions. Why, even though we have had strong economic growth, have we paradoxically not matched their employment growth or achieved a lower level of unemployment within our --I do not feel particularly comfortable in answering that one, because I think you could answer it in separate ways. You could have two groups of economists here. We have one of the best experts on the subject in the back there. One would tell you that the reason employment has not grown as fast as you would think, given our terrific economic growth record, is that markets are insufficiently deregulated and there are too many impediments to hiring and firing and what have you, like in Germany. Another group of economists would tell you, no, it is due to the fact that we have not got an active labour market program. I think that is something that you just have to try to sort out amongst group of labour economists and experts in that subject. But you could easily find yourself with two totally opposing views about what is the best way of translating economic growth into jobs growth. --Given that one of the terms of reference under the act and the memorandum of understanding with the government about what you look at in setting monetary policy is unemployment, is it something you therefore monitor and have an opinion on? Do you view it as one of the things you do when setting monetary policy? --Basically, the way we interpret it is that we want to provide sustained economic growth, which is an absolute necessity for getting any employment growth. If the employment outcome is a function of all sorts of things like the minimum wage or the hiring and firing conditions or the award structure, we have no control over that. --Given that one of the main drivers of how you set things is inflation and that inflation has stayed fairly stagnant for a long time, is it appropriate that the bank should be looking solely at it, or should we now be opening up the gamut and asking whether other factors drive monetary policy? --The reason for that goes back to the whole logic of the inflation targeting regime. The reason you have an inflation targeting regime when you do not have an unemployment targeting regime is not because you are not interested in unemployment, not because you think it is unimportant; it is because history has told you that you can achieve a particular inflation rate with monetary policy but you cannot achieve a particular unemployment rate just with monetary policy; it depends on all these other factors. That is why not just Australia but so many other countries have an inflation targeting regime, not an unemployment targeting regime, even though they may be equally or more interested in employment in the long run than in inflation. --But is there something outside those two? Have we got to the stage nowadays where we have to ask if there is some other target we need to be looking at? --For a start, I do not think, for example, that the unemployment rate we have at the moment is the minimum. If we had a more favourable international environment and we could grow faster than we currently are, I think our unemployment rate would go down, that it does have further to go down. But with the environment we are in at the moment, I think it is remarkable that it is where it is. --Going back to my very first question, are you still ruling out never giving us the minutes of the RBA hearings and never coming back with broader statements? --I do not think there is much value in doing that--other than enabling people to get a lot of stories about conflict. I do not think they are going to learn anything more about monetary policy by doing that. --I want to follow on from Anna's question about the unemployment rate in Australia. My family can vote in Italian elections. One of the questions in a recent referendum related to unfair dismissal--they put it to a referendum. I noticed in the same table that Anna was referring to in the of 24 May that the latest unemployment rate in Italy is nine per cent. I guess I am asking you to be subjective, but what part do you think inflexible labour reforms play, particularly if this sort of thing is going to a referendum? --This is interesting: when both of you looked at the same table, one noticed the countries that had unemployment rates below ours and the other noticed the ones that had unemployment rates above ours. --That is why we are here--for a balanced view. --Most of Europe has unemployment rates well above ours. There are a few exceptions, but even then you have to look very closely. Some of the countries that have low unemployment rates have an incredible number of people on disability pensions, and if you were to put the two together you might get a fairer assessment. You are bringing me back to the same thing Anna Burke mentioned. There is some evidence around the world that stringent unfair dismissal rules lead to higher levels of unemployment. This used to be summarised by people who contrasted the huge growth of employment occurring in America with the almost zero growth of employment occurring in Europe and said that the country that fires the most hires the most. That is why it is a big issue in some of these European countries. I think there is recognition that it enormously reduces the flexibility of their economies, and it makes firms very reluctant to hire if that flexibility is taken away from them. Once again, I am not an expert on the subject, but certainly a lot has been written about the capacity for creating jobs in countries with flexible labour forces and the difficulty of creating new jobs in the heavily regulated European economies. --Thank you. --I think we have had a very good innings. Before we close, there is one question I feel I should ask. Looking at the longevity of Alan Greenspan, does that mean being a central banker gives you a healthy future? --I think chairman Alan Greenspan will be in his 80s when he finishes his final term. That is pretty old, isn't it? --You are not looking for the same reign? --I think that would be an awful result. appearing before the committee. Thank you to everyone who has come along today. I hope it has been of some value and of considerable interest to you. Thank you also to Hansard and to my committee colleagues. Resolved (on motion by

r030708a_BOA

australia

macfarlane

I would like to start by thanking the Business Council of Australia for inviting me to its Annual Dinner. This is the first such occasion I have attended, and I note that the price of my invitation is that I have to give the after-dinner speech. Given the time of day, you will be pleased to hear that I will confine myself to a few simple observations, rather than delivering an economic treatise. Some people may be expecting a commentary on the current outlook for monetary policy, but I am afraid they will be disappointed. Last week we made a decision on monetary policy at our July Board Meeting, and it received a lot of press coverage. Not everyone agreed with the decision, but I have to say that I was quite impressed with the quality of the discussion it generated. I think there is a very well informed and reasoned appreciation of the conflicting pressures and trade-offs we at the Reserve Bank face. Given that, I am reluctant to add any more at this stage, because, no matter how carefully modulated my comments, I would run a great risk of destabilising a basically stable situation. Instead, I would like to move into my talk by starting with the observation that the Australian economy has now gained international recognition for its stability, whereas in previous decades it was noted more for its booms and busts. In the jargon of financial markets, investing in Australia is now a "stability" or "safe haven" play whereas formerly it was known as a "cyclical" play. The latter term meant that the Australian economy did better than the world economy when the world economy was doing well, and worse when it was doing badly. The change in the world's perception of the Australian economy from one of instability to one of stability has obvious advantages to us, but it does not eliminate the need for hard policy decisions - it simply changes the nature of those decisions. But before discussing that, I would like to illustrate some of the changes in the behaviour of economic variables that have given rise to the changed perception of the Australian economy. The first clear sign that the Australian economy was showing a new-found stability was the way in which it handled the Asian crisis. Although we had a higher share of our exports going to the crisis-affected Asian economies than any other developed country, we were able to negotiate this difficult period without any noticeable economic slowdown. It was not that our exports were unaffected - total exports fell by 6 per cent in 1997/98 and exports to Asia by 19 per cent - but that strong domestic demand offset that effect. The second episode where Australia's relative stability showed up was during the recent recession that occurred among the major economies in 2001. Over the course of that year, the G7 economies showed zero growth whereas we grew by about 4 per cent. Another interesting feature of that period was the divergent pattern between the Australian and US economies. It used to be common to remark on the close link between growth in the Australian and US economies, but that pattern broke down during the recent US recession. Note that we did have a slowdown in the second half of 2000, but that was a once-off effect caused by a fall in house-building following the introduction of the GST. Turning to financial variables, the one we are most frequently made aware of is equity prices. Again, Australia stands out for relative stability. If we compare the behaviour of the ASX 200 with its equivalents in the US, UK and Europe, the contrast is very striking. The boom and bust behaviour of the other three indices is hardly apparent at all in our stock prices, and over the whole six-and-ahalf year period since the start of 1997, our stock market has risen as much from end-point to end-point as any of them. Two real economic variables that are closely related to my previous graph are business fixed investment and the profit share of GDP. For simplicity, I have only compared the Australian experience to that of the US. On business fixed investment, again we have experienced none of the boom and bust that was apparent in the US. In fact, our business fixed investment remained remarkably subdued during the period of booming stock markets, but has picked up over the last 18 months or so, when it has been most useful for us in a counter-cyclical sense. The comparison for profits is very similar. Corporate profits in Australia have risen relatively smoothly over the past decade, while in the US they rose until about the end of 1997, but have fallen thereafter. The interesting thing to notice about the US was that profits were falling through the boom years on the stock market of I think I have shown enough to get my story across, so I will not labour the point by showing any more comparisons. Instead, I will try to answer the questions of why our recent outcomes have been more stable than in the past, and why they have been more stable than most comparable countries. The first of these questions is why has the Australian economy recently been more stable than it formerly was? My answer to this is that it is largely the result of policy reforms, but luck also played a part, which I will refer to later. On economic policy, I would point to a number of major reforms over the past 20 years that have been crucial: The floating of the exchange rate. The non-inflationary financing of budget deficits through the tender of government debt. The move of monetary policy to one based on an independent central bank and inflationtargeting regime. The move towards a more disciplined fiscal policy. Labour market deregulation. The main change here was to decentralise, i.e. to move away from a system based on a National Wage Case which awarded every worker a given percentage rise once a year (or, in earlier times, once a quarter). The labour force looks a lot different today, with a considerably smaller proportion working for the government, and a smaller proportion unionised. The opening up of the economy to international influences, both through the reduction in tariffs and the abolition of controls on capital movements. Competition policy applied both to the private sector and the government sector, and significant privatisation of the latter. These changes have generally moved the economy away from centralisation to decentralisation and away from regulation towards deregulation. They have resulted in a myriad of small changes occurring almost continually, rather than a few large ones. So the economy shows more day-to-day volatility but is less likely to build up the pressure that results in crises and large disruptive adjustments. There is another reason why the performance of the Australian economy has become more stable than formerly which is not the result of deliberate policy decisions. I refer to the changed behaviour of our terms of trade, a subject I have spoken of on many previous occasions. The terms of trade is the ratio of the price of our exports to the price of our imports, that is the "buying power" of our exports. For much of the 20th century our terms of trade trended downwards because the prices of commodities, which make up much of our exports, failed to keep up with the prices of manufactures, which make up most of our imports. In my view, this trend started to change about 15 years ago, as new sources of low-cost manufactures started to come on stream from Asia, particularly from it is manufactures prices that act like "commodity" prices, and not just in a trend sense, but cyclically too. You will note from my next graph that in the recent major-country recession of 2001, our terms of trade actually improved. Normally, we would have expected them to fall, which would have magnified the contractionary effect of the global slowdown. The second question is why has the Australian economy recently shown much more stable behaviour than the much larger and more diversified US economy? This is not what you would normally expect of the two economies on the basis of their size or their history. I think the major reason for this is that the US had an asset price boom and bust - commonly known as a bubble - and we did not. I have already shown the rise then fall in equity prices, profits and business investment in the US and the effect this has had on economic activity. The US economy is suffering from a hangover after the binge; we did not have the binge and so have avoided the hangover. I would like to say that it was excellent economic policy that prevented us from participating in the binge, but that would be claiming too much. No-one really understands the relationship between macro-economic policy and asset price booms and busts well enough to make that claim. The unfortunate fact is that it seems to be possible to experience an asset price boom in an economy where macro-economic policy settings seem to be relatively well disciplined and inflation quite restrained. One thing we do know, however, both from the US experience and the earlier Japanese experience, is that once the asset price boom has turned into a bust, the effect on the macroeconomic policy settings is profound. Partly this is because the contracting economy affects the policy settings, and partly it is because policy-makers are quick to adjust their levers in an attempt to head off the contraction. Again, a comparison with the US makes the point. On fiscal policy, the Australian budgetary position has varied little over recent years, with predominantly small surpluses being the order of the day. In contrast, the US budgetary position has moved from a surplus of 2 per cent of GDP in 2000 to an expected deficit of 4 per cent of GDP in 2003. The US has used a huge amount of its fiscal ammunition, while we have not even started to do so. monetary policy, the contrast between the two countries is equally pronounced. The US put interest rates up slightly more than we did in 1999/2000, but the difference was minor. However, since the US recession hit in 2001, they have reduced their interest rates much more than us. From a peak in the second half of 2000, they have come down by 5 1/2 percentage points, while we have come down in net terms by 1 1/2 percentage points. I do not want to give the impression that I think stability of interest rates is a goal in its own right - only that it reflects the greater stability of the Australian economy. Again, the contrast in both of the above policy variables between the two countries is as great as the contrast in the other variables I showed earlier, with Australia again representing stability and the US instability. Equally importantly, stability was not pushed at the price of lower growth: to the contrary, the Australian economy has grown faster than the US, not just over the past few years, but over the past decade. This, of course, has been the main point of my presentation this evening. The other point, I hope that has come out, is that the really large examples of instability in recent decades have emanated from a species of financial event - namely, an asset price boom and bust - rather than from the normal cyclical fluctuations we are all familiar with under the heading of the business cycle.

r030809a_BOA

australia

macfarlane

From the perspective of a developed OECD (Organisation for Economic Co-operation and Development) economy, what is the biggest risk to financial and economic stability? I suspect that at various stages over the past few decades, we would have come up with different answers. For much of the period, we would point to our apparent inability to control inflation, or to oil price shocks, or to governments' inability to control their finances. At other times, people would point to more purely financial vulnerabilities, such as fragile under-capitalised banking systems, excessive short-term international capital movements, poor prudential regulation or inadequate systems of governance. Others would point to the tendency of governments, central banks or the IMF (International Monetary Fund) to bail out failed systems and so create a moral hazard, as the main risk to future stability. You can make a good case for most of the candidates I have put forward. However, I think there is one other risk that we have become aware of that now seems to be larger than those I have listed above. I refer to asset price booms and busts. While the existence of these was recognised, they were usually regarded as historical curiosities, or at least very low frequency events (e.g. once or twice a century). The US experience in 1929 and its aftermath was the classic case until recently. But now that we have seen the world's second largest economy - Japan - experience one in the 1980s, and the world's largest one - the United States - experience one in the 1990s, they seem to be not quite so 'low frequency'. We should also not forget that many other economies, including our own, experienced an asset price boom and bust in the late 1980s and early 1990s. Although they were not of the size of the Japanese one, or of the international significance of the US one, they were very costly to their respective economies. What can be done about this tendency of otherwise well-managed economies to exhibit periodical asset price booms and busts? One response would be to give the task to monetary policy, so you will probably expect me to expound on this subject. Unfortunately, I must disappoint you because the subject is too complex to cover in the short time I have available, and besides, we at the Reserve Bank are hosting a conference on the subject in about a week's time. Instead, I want to follow a different path and ask are there factors that contribute to asset price booms, that can be identified and eliminated or, at least, reduced? I have in mind various incentives, informational deficiencies and dubious practices which occur during the boom, but which we always seem to discover well after the bust has occurred. We realise then that these practices allowed distorted views of the profitability of businesses and investment strategies to remain in place long after they should have been corrected. Each boom is different and the lessons we learn after the bust has occurred are also different. For example, after the asset price booms of the late 1980s collapsed, we learned that a lot of the problem was due to very poor banking practices - connected lending, concentrated risks, weak credit committees, forbearance whereby new loans were made to service existing debt, etc. In response to this, there have been enormous improvements in banks' risk management, accounting practices and bank supervision. Partly as a result, or partly due to good luck, banks do not figure prominently in the wash-up of the latest boom the US equity boom. Instead, we discovered a new set of dubious or unsavoury practices. One could construct a long list of abuses, and a correspondingly long list of needed reforms. In various countries this is being done by governments and their agencies - particularly the conduct-of-business regulators such as ASIC (Australian Securities and Investments Commission) in Australia or the SEC (Securities and Exchange Commission) in the United States. Internationally, a lot of this is being co-ordinated by the Financial Stability Forum. Usually it is being pursued in the interests of investor protection and of ensuring the integrity of markets. But from my perspective, I see these reforms as serving the equally important macro-economic purpose of reducing the tendency for asset price booms to occur, or shortening somewhat their duration. I would not be so confident as to suggest that the reforms, no matter how well designed, would be able to prevent such booms, but any reduction in their extent will reduce the severity of the subsequent bust. I will conclude by making a comment about what we mean by a systemic financial crisis. Usually, it means a series of bank failures, bank runs, and the government or central bank having to recapitalise the banking system. Because of the improvement in banks' risk management and bank supervision, we have not even been close to systemic financial failure in any major country on this occasion. For this we should be thankful. But what we are getting instead are failures in the non-finance sector, Enron, WorldCom, etc., and more particularly a severe tightening of belts in the corporate sector with consequent contractionary effects on investment and employment. So the thing that is different this time is that the boom has not been followed by a financial crisis, but by an economic contraction as the most severely stretched parts of the economy seek to restore their balance sheets.

r031016a_BOA

australia

macfarlane

The following is the text of the Tenth Annual I would like to start by thanking the inviting me to deliver this lecture commemorating such a distinguished is a great honour, and I will devote the major part of my lecture tonight to Australia's economic relations with Asia - a theme of which I am sure he would have approved. But before moving on to the main topic, I would like to follow normal practice by saying a few words about the person whose memory we are honouring. In doing so, however, I intend to follow up on a couple of unusual connections that occurred to me as I was preparing the lecture. I do not intend to dwell on Weary Dunlop's achievements or his place in Australia's history or folklore. I assume that everyone here tonight is familiar with these. Instead, I ask your indulgence to start by drawing what you may find is a tenuous connection between Weary Dunlop and two important economists, one he may or may not have met, the other he certainly did meet. The first economist was Professor LF Giblin, who was Australia's foremost economist in the inter-war period. Since he held a chair in economics at Melbourne University in the 1930s, the two men may have met, but there is no record of them having done so. But if they had, it would have been an interesting meeting because from what we know from their biographies, they had some remarkable similarities. Both were big strong men and natural leaders. Both had excellent minds and rose to the top of their professions. Both were decorated for their courage in war - Giblin in the first world war, Dunlop in the second. Both were outstanding sportsmen in the same sport - rugby. If Dunlop, the Victorian, playing rugby for Australia is a sporting oddity, what of Giblin, the Tasmanian, playing rugby for England during The connection with the other economist of note was only recently revealed, and I am indebted to Professor Leeson of Murdoch University for his excellent detective van der Post, amongst others, were in the Japanese prisoner-of-war camps in Indonesia and Thailand, they tell of the miniaturised home-made wireless that they used clandestinely to keep up with the course of the war. This device had been cobbled together by a fellow prisoner of war - a New Zealand officer in the RAF. That officer we now know was Flight Lieutenant AWH , known to economists the world over as the inventor of the 'Phillips Curve'. Phillips had been trained in New Zealand and Australia as an electrical engineer, had spent time in Asia before the war, spoke fluent Cantonese, and only embarked on a career in economics after his discharge from the RAF when the war ended. Enough of these biographical curiosities. I will now turn to the main subject of my lecture tonight which is the role of Asia in Australia's economic future. I think for most of the past two decades, there was general agreement on the importance - if not the primacy - of Asia in Australia's economic future. But this agreement suffered a couple of setbacks in the and the one which had been the main driving force, fell back into a period of very slow growth at the beginning of the 1990s. Second, the Asian crisis which started in mid 1997 and lasted for about 18 months, severely dented many people's confidence in Asia's future. This event - the Asian crisis - had a profound influence on opinion for three or four years. Many people saw it as evidence that the 'Asian miracle' had feet of clay after all. There was a widespread view among western observers that the crisis was the inevitable result of severe governance deficiencies in Asian countries, and that these deficiencies would hold back further economic development. During the 'tech boom' and the period of infatuation with the 'new economy' in the late 1990s, perceptions of Asia suffered again as its economy was compared unfavourably with more technologically advanced western economies, especially the United States. We now know that governance deficiencies were not confined to Asia, and that some countries that were pointing the finger had governance deficiencies closer to home to worry about. The infatuation with the 'new economy' also resulted in a bubble, the bursting of which has been exerting a dampening influence on world economic growth for the past three years. We also know that during the period when many Asian countries were suffering from the crisis, one important Asian country - China - was powering ahead. Now the dust of the Asian crisis has largely settled, it is worth sitting back and taking a fresh look at Asia's place in the world economy, and particularly its place in Australia's economic future. I propose to start this task by looking at the world economy and asking the question - which regions are increasing their share of output, and which regions are finding that their share is falling? I will use a long-running IMF database for the comparisons, the results of which are shown in Tables 1 and 2. No-one should be surprised to find that over the past 20 years Asia's share of world output has risen noticeably, or that the share of the developed OECD countries has fallen. Note that I include Japan in the latter group because it is a developed high-income country and as such has been a member of the OECD since the 1960s. While much of the rise in the share of Asia is due to China, even when it is excluded, the rest of Asia's share still rises from 7.8 per cent to 12.2 per cent over the two decades. In the above comparison, I chose a 20-year period because it gives a good idea of how longer-term trends have developed. If we instead chose the past five years for the comparison, we would be choosing Asia's worst period, that is the one that contains the Asian crisis. As a result, we might expect to find a different conclusion. But even here, the same picture emerges - Asia's share of world output has risen from 22.3 per cent to Per cent Per cent 24.9 per cent. It is true that most of this growth is due to China, but even without China, Asia's share rises slightly. Thus, the conclusion is that, whatever time period we choose, Asia's share of world output is rising. Before we leave the tables, it is worth having a look at the performance of OECD countries in more detail. Over the 20-year period from 1982 to 2002, there are only two significant OECD countries that have increased their share of world output - Australia and the I have used this fact before to try and cheer up my fellow citizens who for a long time were inclined to assume that we were slipping behind. When we shift the comparison to the past five years, Australia still comes out looking good. We have increased our position more than any other significant OECD country, and the only other ones to show an increase over this shorter period were Canada, Greece, Finland and Spain. The general conclusion from these comparisons is that Asia has been, and still remains, the world's fastest growing region and that Australia has done well compared to other high-income developed OECD countries. The two facts are, of course, not independent. But that still leaves open a number of questions. Have our exports become overreliant on Asia? Alternatively, have we kept up our share of Asian imports? Has the closeness of our trade linkage been mirrored in the capital markets? And are we well placed to adapt to future changes in patterns of growth, as we appear to have done in the past two decades? These are the questions I will address in the remainder of my talk tonight. More than half of Australia's exports go to Asia, and the proportion has not greatly altered over the past two decades (Table 3). It rose in the 1980s to peak at 59 per cent in 1996/97, then fell back slightly as the Asian crisis had its effects to a figure of 55 per cent in 2001/02. Within this relatively stable total, there has been a clear fall in the share going to Japan, and a commensurate rise in the share Share of total thing that stands out is that the share going to China, while clearly increasing, is still quite low. Moreover, when we look at these exports to Asia and compare them to the total imports that these economies are taking in, we see that Australia's share is quite small - less than 5 per cent in most cases, and only 2 per cent amount of room for expansion here. The question for Australia then is whether our exports to Asia are growing as fast as those of other countries into Asia. It is difficult to answer this with precision, in large part because of gaps and inconsistencies in data, but the approximate calculations we have made suggest that our exports are keeping up imports into non-Japan Asia and its two biggest economies - China and Korea. As already established, the relevant question for us is whether imports from Australia are growing as fast as imports from other countries outside the region. The data we have suggest that this is the case; imports from Per cent of total; year to May 2003 One of the major characteristics of the development of Asia over the past decade has been the increase in cross-border interdependence of production, as China became the centre for labour-intensive phases of manufacturing using intermediate inputs manufactured elsewhere, which were then re-exported as finished manufactures. As a result, there has been a large increase in intraAsian trade, particularly between China and its neighbours. This intra-Asian trade, which is predominantly in manufactures, has grown more quickly than trade between Asia and the rest of the world. It mirrors a general shift in the trade patterns of developing economies which are now predominantly exporters of manufactured goods. As recently as 1980, only 25 per cent of the exports of developing countries were manufactures; now the figure is well over 80 per cent - for Asian countries, the figure is likely to be over 90 per cent. Australia have grown faster than imports from the G10 countries. This is less true for China, where our performance is more or less in line with the G10 countries, but for Korea, imports from Australia have grown a lot faster than their imports from G10 countries. As we would probably expect, when we look at the breakdown of Asian imports by category, it is in categories such as food, fuels and crude materials that Australia's performance has been particularly strong. Imports of these goods to China and Korea from Australia have grown much more quickly than their total imports. Australia has been increasing its exports of manufactures into Asia as well, particularly to China, but this is from a very small base. Exports of manufactures to China grew at an annual rate of 22 per cent over the past five years, but even then they represent only 4 per cent of our total manufactured exports. In summary, I think these comparisons show that we have been doing reasonably well. Our pattern of international trade is strongly integrated into Asia, and apart from a small downward adjustment due to the probably temporary effects of the Asian crisis, the trend is stable. There appears to be a lot of upside potential in the trading relationship with China, given our low market share in that country. When we come to financial integration, however, the story is very different because we do not have a high propensity to buy Asian struck by the contrast between the closeness of our trading relationship with Asia and the lack of closeness in our financial integration into Asia. Australian direct investment in Asia, that is owning or having a controlling share in Asian companies, has always been relatively small. We have always been more comfortable running businesses in the United States, New Zealand. What is perhaps more surprising is that the share of direct investment going to Asia has fallen over the past decade, Per cent of total stock as at 30 June particularly over the most recent five years. During this most recent period, the share of our direct investment going to the United States has risen sharply, which is not unique to Australia - the strong performance of the US economy during the stock market boom years around the turn of the century attracted significant direct investment from all developed economies, and portfolio investment from everyone. While Asia is a very big player in the world of international trade and is also a major recipient of direct foreign investment, it receives very little portfolio investment. Financial markets generally in the region are not well developed, and portfolio investment is costly and involves investors taking risks that are hard to evaluate. The lack of development is reflected in the low weights for the region in the global market indices which drive so much of the allocation of portfolio investment in the present world: Asia accounts for less than 4 per cent of the Morgan Stanley MSCI global equity index - the most widely used - and an even smaller share of global bond market indices. In both cases, the shares are very much lower than the region's 25 per cent share in world GDP. Needless to say, the share of Australia's outward portfolio investment going to Asia is also quite small, accounting for only 10.9 per cent of our portfolio investment in 2002. In its foreign economic relations, Australia has given a very prominent place to Asia over recent decades. As a result, Australia is a member of a range of Asian regional institutions aimed at encouraging growth and trade. We at the Reserve Bank are also involved closely in a number of similar groups that bring the central banks of the region together. The main aim of these meetings is to find ways of encouraging the growth of Asian financial markets in order to emulate the success of Asia in the international goods markets. One concrete outcome of such co-operation has been the establishment of the Asian Bond Fund, through which central banks in the region (including the RBA) have invested some of our foreign reserves in bonds issued by Asian governments. So far, the only bonds included have been those denominated in US dollars. In time, however, the central banks of the region hope to add bonds issued in local believe that this will help regional bond markets develop greater liquidity and become attractive to a broader range of investors. In time, there should be an increase in investment flows both within Asia and between Asia and other economies. This is likely to see an increase in financial integration, but the process will be a slow one. Of course, the global economy does not stand still and we do not know how the recent trends within Asia will develop. The story of the rise of China seems likely to have some way yet to run. But I doubt that the rise in importance of China, and its impact on Australia, will turn out to be the end of the story for Asia because the next chapter will probably contain a greater role for India. In terms of population, India is growing at twice the rate of China and fast approaching it in size. It is noteworthy too that India is now looking to the Asian region in its trade policy, recently concluding an agreement with ASEAN to eliminate most tariffs within eight years, at the same time as ASEAN is eliminating internal tariff barriers and concluding free trade agreements with China and Japan. If India emerges as a second Asian engine of growth, Australia will face new opportunities and challenges. But we are well placed to respond to its increasing demands for imports of food, materials and intermediate goods. As with Korea, Australia has had a rising share over the past five years of India's imports of materials. We must make sure that we have the flexibility to respond to this additional source of growth if it happens, just as we have responded to the shift from Japan to the rest of east Asia and then to China over the past two decades. My main message - the importance of Asia to Australia's economic future - is not a new one, but it is one that people lost sight of for a while. But it will be different in the future in that China will assume an increasingly important role, just as Japan did in the 1960s and 1970s. In this sense, China is currently the big story, just as India will probably be the next. At the moment, there is great apprehension in the rest of Asia about China's rising dominance. Countries that compete with China as exporters of manufactures, and recipients of direct foreign investment, feel that they will be overwhelmed. I think most people in Australia have welcomed the growing importance of China. This is in part because we do not see China as a competitor because we do not compete with them in low-tech high-volume manufacturing. We tend to see them as a complementary economy. I do not think we would be able to take the same comfort if we had maintained the old heavily-protected manufacturing sector we had in the first half of the post-war period. This complementarity does not mean that Australia has to see itself as only a provider of resource-based products from our mines and farms. Manufactured exports to China, while they are small, are growing strongly. There is still plenty of scope for the further expansion of our high-value-added manufacturing and service exports. It is remarkable how much of the growth in international trade is intra-industry trade - that is two countries both exporting to each other within the same type of product. This is particularly true of manufacturing. I will conclude my talk tonight with two small but concrete examples of how intra-industry trade between Australia and China is developing. These examples are drawn from the Reserve Bank's Small Business Panel, a meeting we have with small businesses originally designed to hear their views about finance, but now covering a wider range of topics. The two examples I will conclude with tonight are as follows: One member of the Panel, who runs a company producing petrol- and dieseldriven electricity generators, said he was experiencing a lot of competition for small generators from Chinese imports. However, he was doing better in the export market and had just won a tender for an important export order. When questioned, he revealed that it was for the Chinese army! As an aside, the engines on his generators are imported from Japan and Italy. This is symptomatic of the extent of intra-industry international trade that occurs these days. Another Panel member runs a company that installs wooden floors in Victoria using a special locking device between the floorboards. His Australian supplier stopped supplying the specially finished floorboards, and so he was forced to look elsewhere. Eventually, he came up with a system whereby he ships the bulk wood to Malaysia, they glue and machine it to his requirements, and he receives it ready for installation in Australia at 20 per cent below the price of his former supplier. He is now exploring the alternative of moving his source of supply to China at a probable saving of 50 per cent.

r031113a_BOA

australia

macfarlane

Conference Dinner sponsored by the Melbourne Institute and newspaper, In keeping with the theme of this year's conference, I have chosen a subject which has a long-run focus. No doubt this will disappoint some who were hoping that I would deal with the 'here and now' of Australian monetary policy. But I should point out that within the last week or so we have put out both a press release and a detailed quarterly report on monetary policy and in a few weeks time I will appear before a Parliamentary Committee for three hours of grilling on the same subject. I think we keep the public well informed on the evolution of our thinking on monetary policy, and therefore do not feel the need to deal with it every time I speak in public. My talk tonight will bear a family resemblance to the talk I gave 18 months ago at the first of these conferences jointly organised by the Melbourne Institute and newspaper. As in that talk, my approach will be to start with the world and work back to Australia's place in it. I should say at the outset that I have always been an optimist when I consider Australia's place in the world. That is, I think that the opportunities before us outnumber the risks and I think that Australia is in a much better position than nearly all of the other countries I could name. It does not mean that success will fall in our lap - we will still have to make a lot of hard decisions, many of which will not be particularly popular, but this will be nothing new. Optimism is not the normal Australian position when viewing our place in the world. There has been an abiding gloominess amongst most observers who were preoccupied with the view that we as a country were slipping down the international rankings, and that this would continue. This pessimism was particularly rife in the 1980s, re-emerged briefly during the 'tech boom', but fortunately there is less of it now. The fact that we have had more than a decade of good economic performance, notwithstanding a difficult international environment at times, has helped build confidence in our ability to make our way in the world. Let me say a few words about international rankings. There are several organisations that publish rankings of countries according to income or GDP per capita. That is, they rank countries from the richest down to the poorest. In the past, I have been critical of these rankings because there are so many statistical assumptions that are involved in their construction that the results are very approximate, and therefore cannot form the basis of policy interpretation or aspiration. To illustrate this, Table 1 shows the rankings for the year 2000 as calculated by three separate organisations - the World Bank, the OECD Pennsylvania). As you can see, there is a good deal of similarity between the three rankings, but Australia's position is variously recorded as seventh, tenth and twelfth out of 22 countries. Notwithstanding these reservations, it should be pointed out that the period when Australia was slipping down the rankings from tenth in 1990 to seventh in 2000, while the World Bank numbers show it moving up from sixteenth in 1990 to ninth in 2002. I do not wish to make much of this, given my reservations about these rankings, but at least it should put a stop to stories about how we are falling behind. As I said earlier, I think we are well placed for another good performance over the coming decade for two broad reasons. First, our geographic position. When we look at the major regions of the world over the past four decades, we note from the righthand panels of Graph 1 that both Continental Europe and Japan show a distinct downward trend in their growth rates as we move forward from decade to decade. For the Englishspeaking countries, this has not been the case; even though they have not regained the growth rates of the 1960s, the three decades after that show, if anything, a slight upward trend. The thing that stands out about east Asia is just how fast growth has been in each decade (greater than 6 per cent per annum), and again there is no sign of a downward trend. Over any measure, say, 20 years, 10 years or even five years, Asia is the fastest growing region in the world, despite what we can now see was a relatively brief setback during the to believe that it will not continue. In fact, there is reason to believe that it will become more pronounced. Over the past few decades, a number of smallish Asian countries learned how to grow quickly, and now we are seeing the two truly huge countries - China followed by India - achieve the same sort of consistent A lot of countries are terrified by this, as they see China and India threatening their own industries. Other countries see themselves in a position to benefit from this growth, and Australia surely has to be one of them. The potential benefit comes from the fact that China and India will not only be large exporters, but will be large importers as well. For example, over the past year, Chinese imports rose by 40 per cent. The countries that are threatened have one or both of the following characteristics: they have large manufacturing sectors, often propped up with various protective devices; and they have relatively rigid regulations which make it difficult to shift resources (mainly labour) from the declining sectors into the potential growth sectors. Large parts of the world's manufacturing industry are being effectively transferred to China, so in other countries new jobs will have to be found for the people so displaced. The test these countries face is whether they can rise to the occasion or whether they will simply try and prop up yesterday's industries. (As an aside, I am relieved that we are not having to face the coming challenge with the sort of heavily protected manufacturing sector and centralised wage system that we had a couple of decades ago. I am sure we would have failed the test.) My second cause for optimism is related to the first. For most of the 20 century, as the new post-colonial countries were opened up, there was a massive expansion in the supply of resource-based products like the ones we have traditionally produced and exported. In resource-based, I include both agricultural products and minerals and metals. The prices of these products trended downwards relative to the prices of the things that we tended to import like manufactures and services. In economic parlance, the terms of trade moved against us decade by decade, and this held back the growth in our real incomes reason why we slipped down the international league table of income per head. I think this long trend has at last turned - by my estimate, since about the middle of the 1980s. Now the massive expansion in capacity around the world is in manufacturing (mainly Asian manufacturing) and the greatest downward pressure on pricing is occurring there. Thus, our export prices are now doing better than our import prices, and our terms of trade has risen on average over the past is to be found in China's terms of trade which has fallen by 30 per cent between 1978 and 2001. A lot of people would object to this line of reasoning as they would say that I seem to be accepting that we will remain a quarry and a farm. That is not true. I thoroughly applaud our success in broadening our export base into elaborately transformed manufactures and services, and will have more to say about this later. But with the best will in the world, most of our exports will still be resource-based in a decade's time and probably two decades' time. It has taken 20 years for the resource-based share of exports to fall from 70 per cent to 60 per cent, so you can see that change is relatively gradual in this area. We should assume that over the next decade or so we will still be a major exporter of resource-based products, but we should take comfort from the fact that this will not be the disadvantage that it once was. What are our advantages and disadvantages? Apart from being in the right place and producing the right output, what are our advantages compared with other countries? First, we should compare ourselves with other developed countries with a similar level of income per head; these are mainly European. Compared with this group, I think we have two big advantages - flexibility and demographics. Certainly, our institutional framework in goods, labour and financial markets means we can adjust to change better than virtually all of the European competitors, even if we are only on a par with the British and Canadians, and less flexible than the population is aging less quickly than virtually any other developed country, thanks to our high level of immigration. But even though we are better off than others, we should not delude ourselves into thinking that we do not have some big challenges facing us brought about by an aging population, a subject to which I will return. Second, if we compare ourselves with the countries of Asia, we have three clear we have a better legal and regulatory infrastructure; we have a less-polluted physical environment; and a higher proportion of our labour force is skilled. Against this, we have less flexibility in the labour market and a more expensive social welfare system. While the latter makes for a better and fairer society, it has to be financed by relatively high taxes, a combination of factors which means that our savings rate is low by Asian standards. This means that we will continue to rely on foreign savings to augment our own, and hence we need to remain an attractive place for foreigners to invest. Against this background, what should we do to maximise our advantages? First, I think there will be a huge premium on flexibility. The countries that can adapt to the emergence of China and India and other parts of Asia will thrive, while those that go into defensive mode will stagnate. I think that the market by itself will probably do quite a good job of handling the challenge, although at times it may need assistance. The main risk is that there will be public pressure put on the Government to prevent the changes which may be painful in the short run, but which will be in our long-term interest. Secondly, there will be a premium on moving up the skill spectrum. This can be seen most clearly in manufacturing where the mass-production of standard items will become dominated by the big Asian countries, and we must find other avenues which are opened up by the possession of more specialised skills. This is more complicated than it sounds. Some people think that China is only going to dominate low-tech things such as textiles, clothing and footwear, basic utensils, consumer electronics, etc. But they could dominate a lot more than that; they could dominate anything that can be produced on a large scale, even if it is technologically sophisticated, such as cars and semi-conductors. What we will need to be good at will be in producing things that are specialised rather than mass-produced, skillintensive and which, in many cases, may be difficult to identify other than by trial and error. They will include both manufactured goods and specialised services for export, but will also involve using the best applied science available to increase productivity in our traditional resource-based industries and in those parts of the economy not involved in international trade such as construction or domestic transport. There are no shortcuts here. The thing we know is that profitable opportunities will only be found if we have a culture of inquiry and innovation. This in turn can only happen if we have a vigorous educational and scientific environment where excellence is valued and rewarded. An illustration of this is if we think back to the discussions in 2000 at the height of the technology boom. There was a widely-held view at that time that the countries that would get ahead were those that manufactured IT and telecommunications equipment, and that if you did not do so you would fall behind. There was even the suggestion floated in this country that we should entice Intel to open a chip factory here. In fact, all the research that has now come to light shows that it is the application of the new technologies which leads to the big increases in productivity, not the manufacture. In fact, manufacturing often takes place in a huge foreign-owned factory, using orthodox mass production techniques, with very little spin-off to the rest of the economy. My third theme is demographic. All around the developed world, populations are aging and the growth of working-age populations is slowing or, in some cases, falling. More retired people are being supported by fewer working people. We should be looking ahead and encouraging higher labour force participation by older workers. The produced by the Government will be a very useful document on which to base thinking on policy options. If we are not careful, there is a potential for conflict between generations. The young may resent the tax burden imposed on them to pay for pension and health expenditure on the old. This will particularly be the case if they see the old as owning most of the community's assets. Housing is the most obvious example, where people of my generation have benefited from 30 years of asset price inflation, while new entrants to the workforce struggle to buy their first home. At the same time, people - retirees in particular - are likely to be feeling less secure as they may be disappointed with the rates of return they are receiving on their savings. It seems to me that the community has not yet come to terms with the fact that nominal rates of return on financial and real assets are likely to be much lower over the coming decade or so than over the previous two decades. Returns were held up first by inflation (although, to some extent, this was illusory) and then by an asset price boom that lasted from 1983 to 2000 - the final instalment of which reached bubble proportions in many countries. We are presently witnessing the unwinding of this unsustainable situation. A good illustration of the long swings in rates of return is illustrated below by the change over the past 130 years in real equity prices in the The potential for intergenerational conflict exists in all countries, and their future economic success depends in some sense on how they handle it. The countries that will do worst are those where the population is aging the fastest, and those where their governments have given the most generous promises. Again, we are looking mainly at Europe to find this combination of problems. But even in Australia, the conflict could become a problem and lead to all sorts of behavioural changes. At the very least, we should question the assumption that age and poverty are positively related and that concessions to alleviate the latter should be directed at the former. In fact, I think we will have to go further and be pre-emptive in conditioning the public, particularly the grey-headed part, to accept that policy must be forward-looking and directed to ensuring a vigorous Australian economy and society 20 years hence. This will mean giving priority to tomorrow's workingage population, rather than satisfying the demands of yesterday's. Last time I spoke at this forum, I ended by making a plea for raising the priority attached to improving the level of excellence in tertiary education. Although I am not an expert in this subject and was merely quoting others more expert than myself, I was surprised at the favourable public reaction my observations received. I can think of no better way of ending this speech than again stating my view that an improvement in the quality of tertiary education is probably the best investment we can make in our future.

r031208a_BOA

australia

macfarlane

Governor, in testimony to the House of was released on Mr Chairman, it is a pleasure to be here today in front of your Committee again, and I am very pleased that we have been able to meet in Brisbane for the first time. As you know, we take these hearings very seriously because they enable Parliament, through its representatives on the Committee, to question the Reserve Bank in depth and in public. As usual I will make some introductory remarks in which I will focus on three subjects: how the situation has changed since the statement I gave to this Committee in June; how our forecasts have evolved; the background to our monetary policy actions. Calendar year 2003 was an unusual one for the world economy. In the first half, prospects for world growth looked doubtful, with the most extreme uncertainty being concentrated in mid-year. If you remember, this is when talk of possible deflation in the United States reached its peak, and the US authorities gave the impression that they needed lower interest rates and a lower US dollar to help them through. In Europe, economic activity was weakening, and Asia received a temporary knock-back from the SARS outbreak. At that time, virtually all the central banks of note - the Fed, the Bank of England, the ECB, the Bank of Canada, etc - reduced interest rates, and I indicated to this Committee that if things did not improve, we might also have to do so. In the event, we did not because we witnessed one of the sharpest turnarounds in economic prospects any of us has seen. While in the June quarter most major countries, including many in Asia, saw declines in GDP, by the September quarter they were all growing strongly. The weakness we had seen in the June quarter turned out to be a 'false signal'. In financial markets, bond yields rose sharply, share prices continued to rise, and various prices connected with international trade, such as commodity prices and transport prices, also rose. Talk of deflation ceased and the short-lived bout of monetary easing stopped. Business and consumer confidence indicators around the world rose back to levels consistent with reasonable economic growth. At the same time as perceptions of the world economy were being raised, the general run of economic indicators in Australia continued to improve, particularly employment, retail sales, construction activity and business and consumer confidence. Prospects for farm production also picked up sharply following widespread rain, even though it was not uniform across the country. Economic conditions here and abroad had returned to something relatively normal and, as a consequence, we judged that we no longer needed such an expansionary setting of monetary policy: interest rates were raised accordingly in November and December. At this point, I will follow my usual practice by discussing the forecasts I gave you at the previous meeting, then adding some new ones for the coming calendar year. When we last met in June, I said that we expected GDP to grow by 3 per cent in real terms over the course of 2003. With three quarters of the year behind us, we now expect that the figure will come in a little higher, at about 3 per cent. The thing to notice, however, is the big difference between the two halves of the year, with growth in the first half being at an annual rate of 2 per cent, and growth in the second half expected to be at an annual rate of around 5 per cent. The other thing to notice is that growth of domestic demand (GNE) through 2003, at 5 per cent, is again expected to be well above the figure of 3 per cent for GDP. Over the course of 2004, we expect GDP to grow by 4 per cent. The profile of growth, however, is unlikely to be smooth. It would not surprise us if the four-quarter-ended growth rate of GDP reached 4 per cent in mid 2004 due to the effects of the sharp rise in farm GDP, before returning to 4 per cent by end year. If the world economy continues to surprise on the strong side, as it has in recent months, our GDP growth could be even higher. On inflation, we said last time that we expected the CPI to increase by 2 per cent over calendar 2003. We now think it will be a little lower at 2 per cent, largely due to the exchange rate being higher than assumed in our earlier forecast. Over the course of 2004, we expect the CPI to increase by 2 per cent, but in mid 2004 it could well be below that because the maximum effects of the higher Australian dollar could be being felt then. As we stated in our quarterly statement, this expectation implies that the profile of inflation will exhibit a shallow U-shape - falling from its present 2 per cent to below 2 per cent in mid 2004, but then rising back to 2 per cent by end 2004, 2 per cent by mid 2005, and continuing under upward pressure thereafter. Of course, it is difficult to be precise about these things, especially since future levels of the exchange rate will play a major role. I will say more about this later. As I outlined at the start of these remarks, with growth in the world economy getting back to normal, and growth in the Australian economy also getting back to normal, or slightly above it, we could no longer see a justification for Australian interest rates being clearly below normal. That is, the major reason for the two increases in interest rates this quarter is the same as I gave to this Committee 18 months ago in late May 2002 when talking about the tightening then. Another way of putting this is to say that if we had maintained the low level of interest rates we had at the beginning of 2002, there would have been a gradual build-up in inflationary pressures as the growth rates of the world and Australian economies rose through 2003, 2004 and beyond. Interest rates were just too low for an economy that was growing that well. As it turned out, this process of returning interest rates to more normal levels has been a gradual one. Two increases in interest rates were made in mid 2002, then there was a 16-month gap to the next two increases. I have explained in the previous two meetings of this Committee why that long gap occurred. It is clear that, despite our best endeavours to explain ourselves, a number of people think that the Bank tightened to cool down the property market. In fact, I have more than once received unsolicited advice that it would be better for us to explain our action in this way because people could more easily identify with it. The overheated property market is something that people can see around them; it is much more concrete than such concepts as inflation targeting or returning interest rates to normal. However, such an approach would not be consistent with the truth. For a start, signs of overheating in the housing market were clearly evident through the second half of 2002 and all through 2003, yet the Bank did not change monetary policy. It was only when it became clear that good economic growth had returned both globally and domestically that rates were raised. I have often stressed that monetary policy has to be set taking into account the average of all the parts of the economy, not to what is happening in one sector. Of course, if a sector is overheated, it may push up the average for the economy, and in that way exert a disproportionate influence. It is also true that, historically, borrowing for housing purposes has been one of the more interestsensitive sectors, and so it may have been more affected than other sectors by the previous low level of interest rates and it may respond more than other sectors to the recent increases. But that does not mean we singled it out. We have also been accused of setting monetary policy in relation to the Sydney and Melbourne housing markets, and ignoring the rest of the country. This clearly cannot be true in the case of the recent tightenings, as house prices in Sydney and Melbourne are growing less quickly than in other states; in fact, housing prices in some parts of these cities are already falling. In Australia we have conducted monetary policy by using an inflation-targeting regime for about a decade now. It has been a very successful regime in that it has delivered (along with various other reforms) the longest period of uninterrupted good economic growth in the post-war period, at a rate exceeding that of all other significant developed economies. It has concentrated our minds at the Reserve Bank in that we have been very conscious of our need to deliver the results to which we have committed. Over the 10-year period, inflation has averaged 2.4 per cent. By acting early on monetary policy to keep inflation in check, we have avoided large swings in interest rates and thereby allowed the economy to prosper. As you are aware, our target is a relatively flexible one in that we aim to achieve an average rate of somewhere between 2 and 3 per cent. It is that average by which we should be judged, or made accountable. But there are some observers who think that the system should be more prescriptive than this and there should be some strict rule which should determine our actions. For example, a few people still think we should aim to keep inflation between 2 and 3 per cent at all times. This is a clear misinterpretation of our system because it fails to realise that it is the average we are interested in. On a number of occasions, inflation has been above 3 per cent and below 2 per cent. In fact, about 45 per cent of the time it has been outside the 2 to 3 per cent range, and we have not regarded this as a failure of policy. Since our objective is to achieve an average inflation rate, there are multiple paths for inflation which are consistent with meeting our medium-term objective. We wish to choose the one which best satisfies the other obligations contained in our Act, which I summarise as achieving sustainable growth in income and employment. We are not simplistically committed to achieving the minimum possible variability in the inflation rate, or even hitting the target at some fixed period ahead, such as two years. Another approach sometimes put to us is to say that we should raise interest rates if, and only if, our forecast for inflation is above 3 per cent, and lower them if, and only if, it is below 2 per cent. Again, this is a misinterpretation of how the system works. It also ignores the complications and uncertainties involved in economic forecasting. The forecast horizon relevant for policy today is at least two, or even three, years. We can be relatively confident about forecasts for the first half of that horizon, as much of what is going to happen over that period is already set in place. But we can be less confident about the forecasts for the second half. The situation is particularly uncertain when, as is the case at present, the direction of inflation is expected to change during the forecast period. Since this type of forecast is so hard to make, we, like a number of other central banks, do not wish to lead the public to believe we can do this with much precision. In fact, we tend to appeal to the balance of risks around the central forecast in order to convey our message. In last month's quarterly statement we said that the balance of risks was shifting to the upside, which was meant to indicate that inflation was on an upward trajectory through the course of the second year. We also drew attention to the fact that domestic price pressures were increasing, as shown by the fact that the rate of increase in the prices of 'noninternationally traded goods and services' had increased from 2 per cent to 4 per cent over the past few years. That does not mean that inflation will rise to 4 per cent once the exchange rate effects have worn off, but at least a significant part of the economy will be influenced by this figure. In summary, I want to assure the Committee that the Bank remains committed to the inflation-targeting framework and that the decisions taken over the past 18 months have been fully consistent with that framework. It does not seem plausible to us to argue that the Bank could have been confident of meeting its inflation commitments if interest rates had been held at 30-year lows in the face of the pick-up in the international and domestic economies that is currently under way. Finally, let me end by updating you on a few developments in the payments policy reforms. Since we last met, the challenges brought against the Reserve Bank's reforms to credit card schemes by MasterCard and Visa were dismissed by the Federal Court. Both schemes subsequently appealed, but Visa has withdrawn its appeal. The new interchange into effect at the end of October, almost halving the fees. The Reserve Bank is monitoring the flow-through of this to merchant service fees. The data are still being gathered, but anecdotal evidence suggests that merchants are starting to see a reduction in the merchant service fees they pay to banks. There have been several developments in other payments streams, and I will be happy to answer questions on those when they arise, but I am aware that I have already taken a fair amount of your time, so I will finish at this point.

r040414a_BOA

australia

macfarlane

The following is the text of the Inaugural Studies Lecture delivered by the Governor, It is a great honour to be invited by Macquarie University to deliver the Inaugural Lecture tonight. I also note that this is the anniversary of the establishment of those years Professor Yerbury has been Vice-Chancellor - a remarkable achievement by any standard. Our paths first crossed in the late 1960s - although neither of us has much recollection of it - when Di was a lecturer and I was a tutor in the Economics course, Professor Yerbury has gone on to an illustrious career in academia, government and university administration. I will speak tonight about recent developments in the world economy and their implications for Australia. It is about 18 months since I spoke about the world economy, and a number of things have changed in that time, mainly for the better. Despite various hesitations and temporary setbacks, the recovery from the world recession that beset G7 countries in 2001 has consolidated. For the world economy as a whole, GDP growth picked up in 2002, again in 2003, and is forecast to be higher again at a relatively robust 4.4 per cent in 2004 the United States and Japan have reported growth in excess of 4 per cent, and in non-Japan Asia it has been a lot higher. At the same time, inflation in almost all countries has remained low. At the level of final goods prices, as shown by consumer price indices, inflation is low almost everywhere, and few countries report upward pressure. surprisingly, this reassuring macroeconomic picture has led to a return of confidence to financial markets. Share markets around the world have risen appreciably from their troughs in early 2003, and in many markets price/earnings ratios are well above medium-term averages. A similar return of confidence has occurred in debt markets, where spreads have narrowed to historic lows. Borrowers in emerging market economies can obtain finance on very advantageous terms as investors chase yields. A similar process is at work for sub-prime and even sub-investment grade borrowers in developed economies. Such a compression of spreads means that providers of capital perceive risks to have been greatly reduced and therefore do not need to be enticed with high premia to compensate for those risks. While the performance of the world economy has improved and the downward risks abated, this has not been reflected to any great extent in economic policies. With few exceptions, the stances of monetary and fiscal policies are still at the expansionary settings to which they were moved in order to offset the fall in asset prices and associated recessions in 2001. In fact, for the three major economies - the United States, the Euro area and Japan - monetary policy, as indicated by interest rates, is, if anything, more expansionary now than it was in 2001. If we construct a measure of the average short-term interest rates for the world, the present level is the lowest since the Second World War are not necessarily the best indicator of the stance of monetary policy, but when they are as low as they are at present, they must be telling us something. A similar picture applies to fiscal policy. The fiscal deficit among G7 countries has increased noticeably in the past three years and is now at least as large as any experienced I have not spent a great deal of time on outlining these developments, but I think we can agree that there does appear to be a contrast between, on the one hand, a reasonably buoyant world economy and confident financial markets, and on the other hand, an exceptionally expansionary setting of macroeconomic policies. I would now like to spend some time on the questions of why is it so, and how will it be resolved? The main reason that the average level of world interest rates is so low at present is that interest rates in key countries - particularly the United States - are at historical lows. And in the case of the United States, it is the absence of domestic inflationary pressure that explains why there has been no inclination on the part of the Fed to move to a less expansionary stance of monetary policy. The United States makes its monetary policy for its own domestic needs: no-one could expect it (or any other country) to do otherwise. The problem is that a number of other countries, which fix their exchange rates to the US dollar, effectively also match US monetary policy. Another group of countries, even though they have no desire to match US monetary policy, are nevertheless limited in the extent to which they can depart from it by exchange rate considerations. The net effect of all this is that, to some extent, the United States sets the world's monetary policy - a partial return to the situation that prevailed under the Bretton Woods system. This may or may not be a bad thing, depending on where you view it from. For some parts of the world, where economic activity is subdued and domestic inflationary pressures non-existent, an extremely low interest rate structure like that in the United States may be suitable. But for other parts of the world, it could lead to the build-up of imbalances. For the world as a whole, we do not yet know whether the maintenance of an extremely low average interest rate is helpful or harmful to its longer-term interests. On the one hand, the after-effects of the bursting of asset-price bubbles are still exerting downward pressure on goods and services prices in the United States and Europe, and in Japan (where it has been going on for a decade or more). More importantly, the downward pressure on goods prices - particularly internationally-traded manufactured goods prices - caused by the massive expansion in Chinese capacity continues apace. This is a structural phenomenon which has been with us for some time now and can be expected to remain important for the foreseeable future, particularly with India joining in. It is what economists call a positive supply shock, and among many of its effects, the one most relevant to the current discussion is that it has made the maintenance of low CPI inflation easier than it formerly was. While these influences are important, we should not forget that the international business cycle is also alive and well, and can be expected to have an influence as we go forward. Good economic growth and expansionary policies are now starting to make their presence felt in a range of international markets. Commodity prices (as shown in the two years and are now at their highest level since 1989. The biggest rises so far have been among base metals, where the prices of nickel, lead and copper have more than doubled over the past year. Others such as zinc and aluminium have also risen sharply. The prices of bulk commodities such as iron ore and steaming and coking coal have also shown large increases in the recent contract renegotiations. This demand has spilled down into the supply chain so we see increasing prices for such things as transporting goods and for wrapping them, as shown by the cost of new and recycled cardboard. As yet, this price pressure at the raw material and wholesale level has not fed into consumer prices, except in Asia where there is some evidence of this occurring, particularly in China. On asset prices, however, there has been a lot of action as investors have pushed up prices of equities, again particularly in Asia to lend at relatively small spreads to borrowers who until recently were regarded as not credit-worthy. This offers some support for the view that assets are being over-priced and risk under-priced. The so-called 'carry trade', where intermediaries borrow very cheaply in the United States, Japan or the Euro area and on-lend to other countries, particularly emerging markets, has regained much of the attractiveness it had immediately prior to the Asian crisis. This is, by definition, a highlyleveraged and hence risky activity. I do not want to give you the impression that the present easy stance of global monetary policy is already causing the world economy to overheat and financial markets to disregard risk. We have not reached that stage yet, but the longer monetary policy remains at this setting, the greater is the likelihood of these results. I have no doubt that this is understood by central banks around the world and in time the degree of monetary expansion will be reduced. In the meantime, it has made things more difficult in some ways for those countries where domestic demand has remained buoyant and domestic costs and prices have not been under downward pressure. previous sentence may have given you the impression that it made life difficult for us. In one respect (which I will come to in a moment), this has been the case, but overall, developments in the world economy have worked to our advantage. Certainly, a recovery in world economic activity is good for all countries, including Australia. The fact that the area of strongest growth is again in Asia means we benefit more than most other countries because we do so much of our trade with this region. The fact that commodity prices are rising is also of great benefit to us in that it contributes to a rise in our terms of trade (Graph 7). We are simultaneously gaining from stronger export prices for a wide range of our exports, and also receiving the benefit of falling import prices for the many manufactured goods that we import. This amounts to a rise in Australia's real income. I have made the point on several occasions in the past that the long period when Australia suffered a trend decline in its terms of trade (approximately from the beginning of the century) probably came to an end in the mid 1980s. Since then the terms of trade have fluctuated, but around a generally rising trend. We should expect this upward trend will continue in the foreseeable future. The shows that commodity prices have already risen appreciably over the past couple of years (when measured in a neutral numeraire). When the increases in the prices of steaming and coking coal and iron ore flow through into the index, we will soon see a further substantial impact on Australia's exports. It will take some time to recover the lost ground on that front, but the present combination of buoyant world growth, rising commodity prices and falling manufacturing prices is a favourable one for Australia. It increases the chance of more balanced growth outcomes for the Australian economy in the period ahead, and therefore of further prolonging the economic expansion. What could go wrong? There were two big risks to this generally favourable outlook. The first was the excessive growth of overall credit, especially to the household sector for housing purchases, and the consequent rapid increase in housing prices. The second was that the exchange rate could be pushed quickly to an unrealistically high level. Both of these risks now look to be less menacing than they did a few months ago, but we cannot be confident that they have gone away completely. I will start with the second of these risks because it is the one that directly results from our interaction with the rest of the world. We should not have been surprised that the Australian dollar rose over the past three years given its extraordinarily low starting point, the rising terms of trade, the fact that the US dollar was finally weakening and the associated fact that US interest rates were so low. I think this was well understood by the public, including by exporters and manufacturers, even though they saw their margins shrinking and competition increasing. Apprehension started to increase, however, when in the relatively short period between early November and mid February, the rate against the US dollar rose from US70 cents to US80 cents (14 per cent) and against the uncomfortably fast rate of increase and the prospect of it continuing was clearly a consideration to be taken into account in formulating monetary policy. If there had been a domestic need to tighten earlier this year, as there well could have been, there would have been an extremely difficult decision to make. This is the type of conflict that can arise when the world has such an exceptionally low level of interest rates, but some countries do not To put these things in perspective, the current upswing in the global economy comes after a couple of years of significant under-performance, which had a serious need, or would be positively harmed by sharing, the same low interest rate structure. The other risk we faced was that the excessive growth of credit to the household sector would continue, so fuelling further asset price rises, particularly in housing. This risk is diminishing. It now seems likely that the peak in credit demand was reached around October 2003 when monthly loan approvals for housing (owner-occupation plus investment) reached over $15 billion per month, an increase of 40 per cent over the year earlier. Since then, we have had four monthly declines in loan approvals and they are now running at about $12 billion per month. Some may be inclined to think that a decline of this magnitude - 20 per cent - represents a sharp fall in the provision of housing finance. But $12 billion per month is still a rapid rate of lending and, if continued, would be consistent with the stock of housing credit growing at a twelve-month-ended rate of about 18 per cent by end 2004. Admittedly, this would be well down on its peak of 23.6 per cent, but would still be unsustainably high. What we are talking about here is the difference between a flow (loan approvals) and a stock (household credit). The flow would have to fall quite a lot in order to bring the growth of the stock back to a sustainable rate. The jury is still out on what is going to happen here. There is no doubt that there are some areas of housing - Melbourne and Sydney apartments - where over-supply is pushing down prices, and off-the-plan purchasers and some developers are feeling the pinch. But elsewhere the slowdown, if any, has been more muted. We will naturally be keeping a close eye on these developments to see that the return to a more sustainable rate of credit growth continues. Last year was a difficult period for monetary policy where, for much of the time, excessive domestic credit growth co-existed with a rapidly rising exchange rate. As we have proceeded through 2004, the situation has been made easier in that both have eased back a little. These are both welcome developments, but we cannot be sure whether they signal a new trend or are only pauses. Similarly, we are still waiting for the durability of the world economic recovery to be sufficiently recognised so that the major central banks around the world can start the process of returning interest rates to more normal levels. When that happens, the combination of a more stable exchange rate and a more restrained pace of credit expansion will become a lot easier to achieve.

r040604a_BOA

australia

macfarlane

Governor, in testimony to the House of Statement on was released on 7 May 2004. It is a pleasure for me to be here in front of the Committee once again. As usual, I will start by reviewing the forecasts I gave to the Committee six months ago in Brisbane, then provide you with an update of our current forecasts. I will then move on to discussing the risks to these forecasts, both in the upward and the downward direction. Last December we thought that GDP growth in calendar 2003 would be about per cent. We now know that it came in at 3.9 per cent, with the second half of the year being a lot stronger than the first half, but with growth slipping to 3.2 per cent in the four quarters to March 2004. Our forecast for growth through calendar 2004 is now per cent. We began to lower our forecast because of weaker-than-expected exports and retail trade and stronger imports. We then raised the forecast following the Budget, but have lowered it again to take on board the March quarter national accounts released two days ago. I must say, however, that I think the market has over-reacted to the March quarter GDP figure. It only lowered our forecast in the mechanical sense that one of the four quarters is now lower than in our previous forecast. It did not materially change our view about the trajectory over the rest of the year, if anything it raised it. On inflation, we had forecast 2 per cent for the CPI increase over calendar 2003 and it came in a bit higher at 2.4 per cent, but has since receded to 2 per cent in the four quarters inflation will be heavily influenced by movements in oil prices, so it is best to look at underlying inflation. We are still forecasting that underlying measures will be running at about 2 per cent, as we did last time we met. By end 2005, both headline and underlying measures are likely to have moved up to about per cent. So we still have a shallow saucershaped profile for underlying inflation over the next year. Given the recent rise in petrol prices, the headline increase is likely to be higher than the underlying in the short run. This is a pretty good outlook for growth and inflation, both in absolute terms and, more particularly, relative to how things might have turned out. I would like to illustrate this latter point by referring back to a framework I put before the Committee a year ago when we met in Melbourne. This contained four possible scenarios, which I will recap. The first was: ...a weakening world outlook and an abating of domestic credit and asset market pressures. This would provide a reasonably clear prognosis for monetary policy. In other words, if it were weak internationally, and weak domestically, that would be easy. In the other direction, so too would a combination of a clear strengthening of the world economy and continued domestic buoyancy. That would be easy. A third possible combination, and the most favourable one for Australia, would be a firming world economy and an easing in domestic pressures, resulting in more balanced growth for the Australian economy. But the combination that would be most damaging to the Australian economy would be if the household sector were to continue putting itself into a more exposed position at the rate it has over the past few years while, at the same time, a further weakening of the world economy was starting to feed through to Australian activity and incomes. The last-mentioned of these possible outcomes, and the most unfavourable, was a distinct possibility in the middle of last year, but fortunately it did not come to pass. What occurred instead in the second half of last year was the second-mentioned possibility - a strengthening world economy and a continuation of domestic credit and asset market pressures centred on housing. This was the environment in which we decided twice to raise the cash rate. What has happened so far this year - although it took some time to clearly identify it - was the third-mentioned possibility - a transition to a set of conditions in line with a firming in the world economy and an easing in domestic pressures. This was the most favourable outcome and the one most likely to result in a more balanced growth for the Australian economy. I outlined this in a speech I gave to Macquarie University in April and we spelled it out more fully in our quarterly published last month. The fact that conditions began to develop along these lines is also the reason why, after two rate rises in late 2003, we have not seen the need for action on monetary policy in any of our Board Meetings this year. In short, we have been comfortable with developments - a lot more so than we were for most of last year. But, as always, there are risks to the outlook, so I will spend the rest of my presentation discussing them. On the external side, consensus forecasts for the growth of the world economy in 2004 put it well above 4 per cent, with a similar figure for 2005. Certainly, the bulk of the economic data supports this relatively optimistic outlook. We are in the third year of an international expansion, and unless something unforeseen comes along, we should expect the expansion to last for a good few years longer. This is not the impression you would get by following press reports of financial market developments, where downside risks to the outlook always seem to be easier to identify than upside ones. The risk of a further rise in the oil price is a constant concern, and there is some substance to these apprehensions, but I will say no more on the subject at present as Mr Stevens has already delivered a piece covering it a couple of days ago. A number of others in the market worry that policy tightening in China will be overdone, leading to a collapse of the Chinese economy. I have more confidence in China than that, and welcome the news that the Chinese authorities have been taking steps to rein in excessive investment. More generally, financial markets have had difficulty coming to grips with the fact that the long period of very low world interest rates must come to an end, and that they will have to adjust to an international environment of rising world interest rates over the next few years. Overall, we think these concerns are overdone and we are comfortable working on the assumption that the consensus forecast for a good world recovery is a reasonable one. We should also note that higher oil prices and higher interest rates are a symptom of global strength, not global weakness. We should also not rule out the risks on the upside. It may turn out to be the case that very low world interest rates were kept in place for too long a period. In this case, we could see greater inflationary pressure than we currently expect. In this scenario, I believe the main result would be a faster rise in world interest rates, as markets reacted to the prospect, and the reality of central banks acting to keep inflation under control. Turning now to the Australian economy, I want to start by re-emphasising that monetary policy is determined by developments in the economy as a whole, not by developments in any one component. For example, for much of 2002/03, domestic demand was increasing at an exceptionally strong pace, but the external sector was subtracting from growth. Inflation at this time was also above 3 per cent. Even so, we did not use monetary policy to rein in the rapid growth of domestic demand because, for the economy as a whole, growth was not excessive and was not threatening our inflation objective over the medium term, despite being above it in the short run. While monetary policy is directed at the economy as a whole, it does not mean that we have to direct an equal amount of attention to each of its components. Those parts that are obviously exhibiting a serious imbalance will attract more of our attention than those that are relatively well behaved. This explains why we have spent so much time talking about, and researching, the excessively rapid growth in housing credit and, until recently, house prices. While other economic variables were more important for the overall macroeconomic outlook, for example consumption and wage growth, their behaviour was not as clearly aberrant and therefore not in need of such intensive study. The forecast for GDP growth in 2004 that I presented before is based on the view that domestic demand will slow from its former rapid pace, but at the same time the subtraction from growth due to the external sector will gradually diminish. Consumption has recently slowed a bit, although it continues to be supported by strong employment growth and will benefit from the tax cuts later in the year. Business fixed investment, particularly in building and structures, will add to growth but not to the same extent as in recent years. Residential investment is expected to subtract from growth and government spending will add to it. Overall, expected GDP growth of per cent would be a good outcome. At this stage, we are not assuming a significant drought effect over the coming twelve months, but this remains a downward risk, given the dry conditions prevailing in some parts of the country so far this year. On the inflation front, we do not see a problem over the next twelve months. Beyond that, the picture is of necessity more difficult to quantify. Last time we met we were slightly troubled by the fact that inflation in the nontraded sector was over 4 per cent, and that if this continued it might imply a medium-term outlook for inflation somewhat above 3 per cent. This is still a risk, but we have taken some comfort from the fact that some of the sectors that were pushing it up - such as house-building and property services - should slow as the pressure comes off the housebuilding sector. The continued modest growth in average wages to date also gives us some confidence. To the extent that there is an upward risk on inflation in the medium term, it is more likely to come from international developments as the world recovery gathers momentum. I will conclude by saying a few words about housing credit and house prices. As we said in our quarterly , The run-up in credit growth and the associated boom in house prices in recent years presented two implications for the economy: they tended to boost growth in the short term, but carried the risk of a damaging correction if they continued too long. In fact, they represented the one internal imbalance that could have put at risk the continuation of the long economic expansion that has been so beneficial to the Australian community. It is not surprising, therefore, that we experienced a feeling of relief when data started to emerge this year which suggested the worst of the excesses may be past. First, we saw three monthly reductions in loan approvals starting in November 2003 which amounted to a cumulative fall of 20 per cent. Approvals are now running at about $12 billion per month instead of $15 billion at their peak last year. It is still far too early to know whether lending is returning to a sustainable pace - certainly $12 billion per month is still far too high - but at least some progress has been made. Certainly, the prospect of a return to sustainable rates of growth of credit seems brighter than for several years, and with it the increased likelihood that the run of good economic outcomes of the last decade will continue. More recently, we received very strong evidence that housing prices have not only slowed their rate of increase, but have fallen in level terms so far this year. This has occurred in most state capital cities, including the two largest, for Australia on average, and for both houses and apartments. As the fall in prices becomes widely known, it should allow potential house purchasers to take their time and not be afraid, as so many were, that they had to rush in and buy for fear of missing their last opportunity. It should enable them to resist the blandishments of the banks, brokers and other commission agents plying them with offers of seemingly generous quantities of credit. It should also reinforce the recent tendency of investors to question their assumptions about easy capital gains. As such, we expect that the housing market will continue to go through a much-needed cooling phase for some time yet. That is all I wish to say about the economy at this stage, but I will be happy to answer any questions you wish to put to me. I am also conscious that I have been talking on the economy for quite a while and have not left any time to cover the various other areas of the Bank's responsibilities, such as contributing to the soundness of the financial system, ensuring the efficiency of the payments system and issuing Australia's currency. But I am sure these can all be covered during the question and answer session.

r040825a_BOA

australia

macfarlane

It is always a pleasure to be in Melbourne, particularly when I am in these gracious and peaceful surroundings and contributing to such a good cause as the Bottom Line Luncheon. By a strange coincidence the my fellow Board Member of the Reserve Polglase, an old school friend. How could I refuse the invitation to speak today? I notice on the invitation that I am listed as speaking about the economic outlook. I am afraid the author of the invitation took a few liberties here, and so I will disappoint those who are expecting an analysis of current economic conditions and prospects. We at the Reserve Bank put out an exhaustive account of these earlier in the month and my deputy elaborated on them a week ago. A third rendition within a month would be counter-productive, so I will speak on a different topic, although it could be considered my views on the economic outlook in a very long-term sense. I would like to look at the factors that shape the economic success of a country in the very long run - that is, over the centuries - and, of course, I will pay particular attention to Australia. I propose to do this by briefly examining four factors which influence growth, and which can be summarised by four distinctive catchphrases: the tyranny of distance, geography is destiny, the resource curse, and institutions matter. The first factor is a country's position on the map - its distance from other countries or its degree of isolation. My remarks on this will necessarily be heavily influenced by Geoffrey Blainey's classic study which originated the term. We have always assumed that Australia was at a disadvantage because of its relative isolation from the world's great centres of commerce. This has certainly been true from the beginning. The late start of European settlement was not just because they took so long to find us, or that for the first two hundred years Europeans only sighted the barren north west coast. Even if they had found the temperate east coast two hundred years before Cook, there would not have been an economic reason to occupy the land. There were no valuables to be exchanged with the native population, such as precious metals and spices, and no case for permanent settlement because the American continent offered everything we could offer and was much closer. It was only a couple of coincidences that caused the British Government to take the extraordinary decision to establish a settlement at a place only once visited, and at the other end of the earth. This isolation continued to disadvantage us economically despite our abundant resources and relatively small population. Transport costs were enormous and delays immense. It took five months to reach England by sail, and even when steam replaced sail and modern ocean liners replaced steam, it still took about four weeks for the journey. Air travel has shortened it to about 24 hours, but it took ages for us to forget our old attitudes. We were accustomed to an overseas trip, even a business trip, being a long drawn-out affair. We had occasions before air travel when Australian Prime Ministers would spend more than a year at a time in London. Going over old Reserve Bank records of the 1960s and 1970s, I noticed earlier Governors going on business trips that lasted seven weeks. Today a one-week business trip is a long one. Modern transport and communications have enormously reduced the tyranny of distance, even if it has made our lives more hurried. The other factor that has reduced the tyranny of distance for us is the growth of Asia. on each side, is no longer the undisputed centre of world economic activity. Asia and the Pacific Rim, while not as rich as the Atlantic, are clearly the area of fastest growth and largest population. This has presented enormous opportunities for Australia and, by and large, we have been adaptable enough to seize the chances offered. But it still has not completely dispelled the tyranny of distance. For example, many international companies headquartered in the United States or Europe still find it more convenient to put their Asian headquarters in Singapore, Hong Kong or Tokyo because they are only one flight away from headquarters, whereas major Australian cities are two flights away. We should also remember that Australia's capital cities are in its southern half, while the capitals of our big trading partners - Tokyo, Seoul and Beijing - are in northern Asia. It would be easier if we were talking about Darwin and Jakarta, but that is not where the real action is. It is widely believed that geography determines whether a country will be rich or poor. This is because most of the world's poorest countries are nearer to the equator than the richer ones. Being in the tropics is thus regarded as condemning a country to relative poverty. Of course, this does not have much relevance for Australia because the populous two-thirds of our country is in the temperate zone. But it is also interesting to reflect on the question of why we should expect a hot climate to be associated with poverty. It certainly was not always so; in fact it was the opposite. For example, in pre-Columbian America, it was the hot areas populated by Aztecs, Incas and Mayans that were richer than the temperate areas. In 1667, under the Treaty of Breda, the Dutch gave up their claims on Manhattan to the English in order to retain the island of Run (in what is now Indonesia). The superior value they placed on Run was due to its being the world's principal source of nutmeg. In the 18 century, France had only enough armed forces to protect one of its two main American possessions - Canada and Haiti. It chose the latter because it was more valuable, being a major producer of sugar. Even in recent years, some of the success stories among developing economies have been in tropical climates - Singapore, Hong Kong, Thailand, Malaysia and, until recently, Indonesia. Certainly, a tropical climate does not condemn a country to poverty, even if most of the world's poverty is in the tropics. As I will explain later, the correlation between geography and poverty can be explained at a deeper level by institutional factors and the incentives that businesses and workers face. There is, however, a lot of evidence suggesting that to be landlocked and in the tropics is so big a disadvantage that no country has yet overcome it. Sub-Saharan Africa is the best example of this. There is a widespread view that countries with abundant resources (particularly of minerals and oil) under-perform resourcepoor countries. There is even some statistical evidence to suggest that this has happened on average over the post-war period. The arguments behind this relationship are based on the belief that: possession of resources is a windfall which makes the community less energetic in pursuing other economic activities; resource extraction is a low-tech/low value-added activity; and the price of resources inevitably falls relative to the price of manufactured goods. The first response to this thesis is to recognise that, even if true, it only applies on average and that there are many cases where the opposite applies. We are all aware of the failure of countries such as Nigeria and Venezuela to capitalise on their oil reserves, copper, or Argentina on its pastoral resources. But could anyone suggest that rich countries such as Australia or Canada have been disadvantaged by their possession of mineral wealth. A better example still is the United States, 'which was the world's leading mineral economy in the very historical period during which it became the world's leader in manufacturing (roughly between 1890 and The answer again is that economic success or failure depends on the institutions and incentives. Those countries that get these right will not suffer a resource curse, but those that get them wrong and allow policy to be dominated by a self-defeating battle over economic rents will under-perform. The assumption that the extractive industries are low-tech is also quite wrong. If they are conducted efficiently, they are very knowledge intensive and research is continuing to lead to many technological breakthroughs. Of course, it was not always so. 'Australia was a leading gold-mining country in the nineteenth century, but was an under-achiever with respect to virtually every other mineral, particularly coal, iron ore and bauxite...Australia's share of world production lagged well behind its actual share of mineral wealth (based on modern estimates). In a nation with a strong mining sector and a cultural heritage similar to that of the United States, why should this have been so?' The answer is that we did not have the right set of institutions or sufficient technical know-how to compete with the world's best. That is no longer the case since a complete change of mindset in the 1960s. For example, R & D expenditure by the mining sector now accounts for almost 20 per cent of R & D by all industries in Australia, and we lead the world in mining software, with one estimate suggesting we now supply 60 to 70 per cent of mining software worldwide. On the third point about the prices of resources falling relative to the prices of manufactured goods, I will say little because I have covered this point so many times before. Suffice to say that after an 80-year trend-fall, Australia's terms of trade - which is the ratio of our resource-intensive export prices to our manufacturing-intensive import prices - bottomed in 1985 but have on average risen since. More importantly, few now doubt that it is manufacturing prices which are under continued downward pressure as a result of the rapid expansion of capacity in Asia, particularly in China. More and more, development economists and economic historians are coming to the conclusion that, at the deepest level, a sound institutional framework is the crucial ingredient for sustained economic performance, and that it is far more important than distance, geography or the presence of resources. One only has to look at the extreme differences in economic performance between institutions can outweigh the same geography, culture and resources. The different economic performance of Australia and Argentina is another clear case, as is the more general economic superiority of the former British colonies over the former Spanish colonies, which has been a subject of recent studies emphasising the importance of institutions over geography. What are the 'deep' institutions that are conducive to sustained economic The first one is the enforcement of property rights. No-one will venture capital for an economic project if success leads to confiscation by the government or other powerful forces. Thus, the enforcement of property rights means a strong body of commercial law (particularly the law of contract), impartial courts, honest police force, etc. It also means eliminating, or at least minimising, corruption. It often used to be thought that corruption 'greased the wheels of commerce' and helped things get done. But modern research has unequivocally shown the higher the level of corruption, the worse the economic performance. The second institutional requirement is constraints on the ability of government or other elites to exercise arbitrary power. This usually means an open society, democratic political system and a free press, but I would also add institutions that encourage competition by challenging monopoly powers. An important ally in this is the openness of the economy to international trade in goods and ideas, which has been shown to have a significant correlation with economic performance. Some degree of equal opportunity so that people can invest in human capital formation. In this area, by far the most important component is access to education and an economic structure where positions of importance and authority are open to all comers on the basis of merit. The term 'deep' is used to describe the above institutions because they are embedded in laws, constitutions and culture and are not amenable to quick change. In addition to the deep institutional framework, there are a number of other practices and policies that a country has to get right in order to achieve sustained growth in living standards. The most obvious ones, from my perspective, are sound monetary and fiscal policy and a resilient exchange rate regime, but there are many more that space does not permit me to list. It takes decades, or perhaps centuries, for deep institutions to evolve, and many attempts to simply impose these institutions in developing countries have failed. But that does not mean the process should not be continued, only that it needs to be done more sympathetically whereby the local population become more involved and can feel they own the reforms. For countries like Australia, that start with basically good deep institutions, the job of maintaining the standard is easier, but it still requires constant attention and change. For every reform that protects the weak against the strong, there are other reforms that break down some cosy arrangement and thus reduce the level of security for the weak or for the weak and strong alike. Useful reforms will often be opposed by either organised labour or organised business, and sometimes the one reform will be simultaneously opposed by both. It is always difficult when a reform has major distributional consequences. Fortunately, in my own area the distributional consequences are of secondary importance, and with the benefit of hindsight, reform has been easier than in many other areas. The transition from a monetary policy regime that had quite short horizons, a multitude of aims and where daily decisions were taken politically as in the 1970s and 1980s, to the one we have today was achieved within a decade. It is often the case that reforms that seemed difficult at the time are well accepted in retrospect, and may even come to be seen as inevitable. The present monetary policy regime based on central bank independence and an inflation target was controversial a decade ago, but with good results now on the board it has undoubted bilateral political and community support. Similarly, the floating of the exchange rate was a decision that was hotly debated over a long period, but does anyone want to go back to any of the variants on a fixed exchange rate regime that preceded it? More controversial were the reductions in tariffs that have occurred over the past thirty years, but here again there are few voices that would wish to turn the clock back. Or would we wish to go back to the immigration policy we had during the first half of the 20 century? The list could go on and on. It is the nature of a first-rate democratic country that it will constantly be involved in economic reforms, or at least constant updating of its economic framework, and that the changes involved will generate political uncertainty and resistance. But that is the price of achieving and maintaining a first-rate set of institutions, and that is an essential condition for our continuing economic prosperity.

r041116a_BOA

australia

macfarlane

It is a great pleasure to be here again in Melbourne addressing CEDA's Annual Dinner. This is the fifth time I have done so, and it is like returning to be with old friends. I usually talk about some aspect of monetary policy, and will do so again tonight, starting with something very familiar and then moving to newer territory. When we look back to fifteen or twenty years ago, the thing about monetary policy that stands out is the lack of clarity about what it was expected to achieve. That is, what should be its ultimate objective, and therefore what should it be accountable for? This lack of clarity applied both inside the Reserve Bank and outside it. I am sure some of you are familiar with the wide variety of objectives for monetary policy that were put forward at the time. As well as the familiar aims of low inflation, low unemployment and good economic growth, there were those who felt it should also be aimed at improving the balance of payments, promoting investment or limiting the growth of credit or some other monetary aggregate. Others put forward the view that it should aim to rein in the growth of asset prices. We now recognise that there are a lot of good economic arguments against having such a wide set of aims, but I will not go into those tonight. Instead, I will say a few words about accountability and independence. A government cannot be expected to allow independence to its central bank unless that bank is also accountable to it and to the wider public. That is, the central bank must be able to be judged on whether or not it has achieved its agreed objective. When there are half a dozen objectives, this becomes impossible because there is very little chance that the optimal outcome for all these variables could be achieved at the one time. If the central bank was held accountable for failing to achieve one objective, it could always defend itself by saying that its efforts were directed at one or more of the other objectives which it viewed as more important at the time. Thus, the old system failed the test of being accountable, and hence there was a reluctance to fully recognise the independence that was essential for the ultimate success of monetary policy. It is true that the specified multiple objectives for monetary policy, but the Bank had failed to articulate a clear framework for setting priorities among these objectives. The resolution of this problem was found in the present monetary policy regime whereby independence was recognised, and the central bank was given the task of achieving an inflation target. This made sense in terms of economic logic because in the long run it is only a nominal variable such as the rate of inflation (or nominal GDP) that can be influenced by monetary policy. It also, in time, received community support because it became recognised that low inflation was a necessary condition for sustained economic growth, which in turn was the pre-condition for lower unemployment. In this way, it placed the general objectives in the within a logically coherent framework. But in addition to these purely economic improvements, the system now fulfilled the requirement of accountability. Everyone could see whether the central bank had achieved its agreed objective or not. I mention this because it is often forgotten that the origin of inflation targeting was the desire for accountability. When the economic reformers in New Zealand under Roger Douglas came into power they recognised that no arm of their government had a quantifiable objective by which it could be judged. They then began the process of setting out objectives for each department, agency and authority. When they came to the central bank they concluded, after much discussion and research, that the most sensible objective to judge it by was the rate of inflation. So in 1989, they - that is, the government - set an inflation target for the central bank. It was thus the desire for accountability that was the initial impetus for the inflation-targeting model, which was eventually adopted in various forms around the world. We in Australia are very comfortable with this model, although we adopted a less rigid one than the early starters like New Zealand and Canada. In our view, it is the best monetary policy regime we have experienced and the best one available, but it is not perfect. It has yielded excellent results so far for its central objective - an average rate of inflation of two point something per cent during the eleven years it has been in operation. This, in turn, has underpinned an economic expansion that is in its fourteenth year and has helped the unemployment rate fall to its lowest level for a quarter of a century. But there are, no doubt, some people who are still disappointed with the outcome for some other economic variables. Some have pointed to weaker-than-hoped-for export growth and a current account deficit of about 6 per cent of GDP. Others, including ourselves, have worried about a high rate of growth of credit and, until recently, an excessive rate of growth of house prices. I can understand people's concerns and their desire for better and better economic performance, but I hope they are not pinning too much faith in monetary policy because there is a limit to what it can be expected to perform. In essence, monetary policy has one instrument - it can set the path of short-term interest rates. Over the past dozen years or so, it has set a path which has achieved the outcomes for inflation, growth and employment which I have just outlined. What would have happened if, instead, we had aimed our monetary policy at one of the other objectives put forward, say a substantially lower growth of credit. I am not sure whether we would have been able to achieve this, but I do know that the attempt to do so would have required setting a path of interest rates which was significantly higher than the one we did. This, in turn, would have meant that the outcomes for inflation and economic growth would have been lower than we actually achieved. I do not think this would have been a good economic result, and it certainly would have violated the letter and the spirit of our agreement on accountability. As I said earlier, a central bank cannot be accountable for everything, and our monetary regime recognises this, while at the same time choosing the right objective to be accountable for. This, of course, does not mean that we ignore credit and asset prices. Movements in these variables can affect the future path of the economy and the evolution of inflation. So we need to study them closely, understand the forces driving their movements, and the risks that they pose. But they are not appropriate targets for monetary policy. I hope that what I have just said does not leave you with the impression that we have a very narrow interpretation of our responsibilities. If that has happened, it is unintentional and is because I have only spoken so far about our monetary policy responsibilities, but we also have a duty to do what we can to ensure financial stability. Financial stability means the avoidance of financial shocks that are large enough to cause economic damage to the real economy. It should not be forgotten that many central banks, including most notably the US Federal Reserve, owe their origins to the desire to avoid financial crises - the monetary policy functions only came later in their life. At the Reserve Bank, our financial stability responsibilities are handled in several ways. For a start, we run the high-value wholesale payments system, which is the epicentre of the financial system. We are also responsible for the policies and procedures that ensure that the system can continue to operate, even if one or more of its members fails. Our payments responsibilities go further than this and extend to the competition and efficiency of the system, for which the Government has provided us with separate legislative powers and a separate Board, but I do not need to delve further into these in the context of tonight's talk. While our responsibilities and powers with respect to the payments system are clearly defined, that is not the case with our more general responsibilities for financial system stability. In this broader area, we have to work closely with other bodies that have clearly defined regulatory powers. An important role for the Reserve Bank is to identify potential vulnerabilities in the financial system, conduct research and provide our twice-yearly . Externally, I chair the Council of Financial Regulators, which also includes the Chairman of APRA, the Chairman of ASIC and the Secretary to the Treasury. The Council of Financial Regulators, at its meetings and on an informal basis between meetings, keeps members aware of developments in each of the separate areas, and attempts to achieve a co-ordinated approach to problems that extend beyond one regulator. It also tries to plan ahead in order to put in place policies that reduce the risk of a financial crisis, or help to manage one should it occur. In this latter aim, the Reserve Bank's ability to act as lender of last resort is crucial. The exchanges of views that occur at these meetings are extremely valuable, as is the opportunity the Council provides for staff of the Reserve Bank, APRA, ASIC and the Treasury to work together on common projects. Many of the subjects discussed are regulatory in nature, but the Council also affords an opportunity to exchange views on economic and market developments which may affect the vulnerability of the financial system. This is of particular interest to the Reserve Bank, as these developments have more of a macroeconomic character. It is where our responsibilities for monetary policy and financial stability overlap. At the moment, as our recent pointed out, all the conventional measures of the health of the Australian financial system are giving extremely favourable readings. For financial intermediaries, capital positions are strong, profits are high and non-performing loans exceptionally low. In financial markets, volatility is low, as are spreads on corporate debt over treasuries. It is not hard to see why many market participants would feel that things have never been safer. But we should remember that it is in these circumstances where the biggest mistakes can be made. When everyone feels that risks are at their minimum, over-confidence can take over and elementary precautions start to get watered down. In addition, competitive pressures from those who under-estimate risk can push even the more prudent institutions into actions they will later regret. Let me illustrate this point in relation to household borrowing. Following the more than halving of inflation and interest rates that occurred over the past decade or so, there was a surge in household borrowing and an accompanying rise in house prices. We have examined this process at length before, so I will not go over it again tonight. During this process, banks and other lenders were able to grow their balance sheets rapidly and, despite narrowing margins, were able to record rising profits year after year. At some point, however, the surge in household borrowing had to slow, and house prices stabilise, or fall. That is what has been happening over the past three quarters, and it is an entirely helpful development. Had the credit growth and house price growth of 2003 continued through 2004, the risks of future financial instability would have been much larger than is now the case. It is important that this slowing in household credit be accepted by financial intermediaries as a fact of life, even though it probably means the heady growth of profits from mortgage lending they have become accustomed to may not continue. There is a risk, however, that in attempting to resist the slowing in credit demand, financial intermediaries may be tempted to further lower lending standards, and that would carry with it serious medium-term risks. When I said earlier that lenders may be tempted to further lower lending standards, the use of the word further was deliberate. The incentives in the mortgage distribution system have changed in such a way that there has been a step-by-step reduction in credit standards over recent years. A significant proportion of mortgages are now sold by brokers who are paid by commissions on volumes sold. The growth of low-doc home loans means that intermediaries are now lending to individuals whose income is not substantiated. There has also been an upward drift in the maximum permissible debt-servicing ratio. When once a maximum of 30 per cent of gross income was the norm, now it is possible for borrowers on above-average income to go as high as 50 per cent of gross income (and a much higher percentage of net income). The new lending models used by the banks (and provided on their websites to potential borrowers) seem to regard the bulk of income above subsistence as being available for debt-servicing. It is not hard to see how a situation like this develops. Once a few lenders adopt an aggressive approach, others must match them or lose market share. They are then re-assured by standard risk-management models, which are based on Australia's history of extraordinarily low mortgage defaults. Even those lenders who have reservations find it difficult to follow a different path, especially as the lenders taking on more risk may well be rewarded by higher profits (and higher share prices) in the short run. There have been a few occasions recently where banks have taken the decision to tighten up on lending to particular sectors, e.g. inner city apartments. Despite this causing some pain to developers, it is a good thing overall for the economy. But these have been small steps compared to the much bigger drift to lower credit standards, and it may be more difficult to expect future instances of such prudence in an environment of slowing overall credit growth. We highlighted some of these concerns in our recent , and I am taking the opportunity tonight to repeat them. They were also made last week by Dr Laker, the Chairman of APRA, in a speech which sadly went unreported. I am not suggesting we have an urgent problem on our hands, but if present trends continue we could well have one in a few years. More importantly, I think the time to air these concerns is when confidence is at its highest and people are least likely to worry about the future. One of the great benefits of the long economic expansion we have now had is that it has restored consumer and business confidence, and people's pride in Australia's ability to achieve economic success in a difficult world. But when thinking about financial stability, it is important to look beyond the present favourable circumstances and attempt to foresee potential risks ahead. In doing so, one runs the risk of sounding like a Cassandra occasionally, but, for central bankers, this has to be accepted as one of the risks of the job.

r050218a_BOA

australia

macfarlane

It is a pleasure to be back in front of the Committee after a break of about eight months. As you know, we take these appearances very seriously and appreciate the opportunity it gives us to explain our position to Parliament and to the public. I hope the new Committee will fi nd it as valuable as we do. Earlier this month we issued our quarterly which set out pretty clearly how we see the current situation. So instead of going over the same material again, I would like to review the medium-term aspects of economic policy. As you know, the current economic expansion, which is in its fourteenth year, is the longest expansion we have had since quarterly national accounts statistics were fi rst published in 1959. We had one from 1961 to 1974 that was nearly as long, but it ended up with infl ation pushing up into double digits followed by a recession. The following two expansions lasted about eight years each before they came to an end. In the current expansion, the annual growth rate has averaged 3.7 per cent, but, like all expansions, it has not been completely smooth. For example, the annual growth rate has been as high as 6 1/4 per cent and as low as 1 1/2 per cent; on two occasions, there has been a quarterly fall in GDP. But overall results have been very favourable: infl ation has averaged 2.5 per cent per annum and we have seen the unemployment rate fall from 10.9 per cent to 5.1 per cent. The longevity of the expansion has been due in part to the fact that it has been possible to avoid obvious excesses in the economy. Relatively small changes in policy have prevented the build-up of the type of excess which in the past required a large and determined policy response. The excesses on previous occasions have been of three main types. The most common was a rise in infl ation. The second was an asset-price boom and bust, and the third, particularly in the fi xed exchange rate era, was a balance of payments crisis. I would now like to review the current situation in light of the risks posed by these three types of excesses. The infl ation risk is the one that our infl ation-targeting monetary policy is specifi cally designed to control. We feel pretty confi dent that the type of strong monetary policy response to rising infl ation that had been necessary in the past is unlikely to be needed again as long as we are vigilant. While pressures will undoubtedly arise, they should not be as powerful or as widespread as previously. First, the infl ation-targeting regime means that the longer infl ation has been contained, and the lower are infl ationary expectations, the easier it is to keep things that way. Second, there have been important changes in wage-setting arrangements that have meant that pressure in labour markets does not feed as quickly as previously into wage infl ation. The main changes have been the decentralisation via enterprise bargaining and the lengthening of contracts out to two or three years. The third infl uence on infl ation has been the increase in competition both at home and from abroad. But infl ationary pressures cannot be completely eliminated and can be expected to make their presence felt as the economy pushes up against capacity constraints. That is something that is happening now, although it is a piecemeal process. There is no economy-wide defi nite dividing line between a situation of ample capacity and one where growth is limited by capacity constraints. For example, there has clearly been pressure on capacity in the building industry for some years, as anyone attempting to get a house built or renovated will confi rm. Over the past year, many parts of the resources and heavy engineering sectors have also been at virtually full capacity, and this has, among other things, limited our export performance. Some parts of the services sector, such as accountancy and other professional services, are also fully stretched. On the other hand, there are other parts of the economy where things are relatively normal. But overall we are hearing more reports of businesses fi nding diffi culty in hiring suitable labour and having to pay more for material inputs. The most obvious signs of this are the increases now being seen in producer prices at all levels and output prices for building and construction. There has not as yet been a big effect on consumer prices, but even so, the rise over the past year has been higher than our earlier forecasts had suggested. We have not seen evidence of an acceleration in across-the-board wages in the standard statistical series, although there is plenty of evidence from surveys that businesses are fi nding it more diffi cult to attract labour and that wage pressures are rising. Of course, there is no reason why the infl ationary process has to be triggered by a wage acceleration; it could just as easily start with prices themselves and then move on to wages. The second risk that I mentioned earlier was a boom and bust in asset prices. I do not think this is a serious risk at the moment, although it was not that long ago that it posed a threat. In 2003, we had both household borrowing and house prices growing at over 20 per cent, and that was on top of several earlier years of strong rises. If 2004 had produced another year of 20 per cent growth, then we would have had the makings of a serious boom and bust situation. As it was, 2004 was a very good year in this respect as borrowing slowed and house prices retreated for most of the year. Growth in borrowing seems to have now settled for the time being at a rate of about 13 per cent per annum, and house prices may have risen in the December quarter of 2004. It is too early yet to know where either borrowing or house prices are headed. The third risk I mentioned was the balance of payments, where the current account defi cit is estimated to be 6 3/4 per cent of GDP. This is not very different to the level reached on a number of occasions over the past two decades, but it is disappointing given that it has occurred against the background of a reasonably buoyant world economy and a strong rise in the terms of trade. Strong domestic demand pushing up imports is part of the story, but the bigger part is the failure of the volume of exports to rise suffi ciently to take advantage of the strong world demand. We have recently analysed this at some length, and presented our conclusions in our quarterly . I will be happy to talk about this later in more detail. But while the balance of payments result is disappointing, it is not of itself a reason for a monetary policy response. At this point, I usually look back at the forecasts I gave the Committee last time to see how the outlook has changed. I also make a couple of new forecasts. On economic growth, last year was one of the few examples where the growth rate we now expect will be well below what we had forecast. In the middle of last year we were forecasting 3 3/4 per cent growth for the year to the December quarter 2004; now we think that when we receive the December quarter national accounts next month, they will show a growth rate of not much more than 2 per cent. How do we explain the difference? One explanation would emphasise that the national accounts are showing a picture of the economy which is considerably weaker than that shown by most other indicators. For example, employment growth has been booming throughout the twelve months that GDP has apparently been restrained. The lagging nature of the employment/GDP relationship may explain part of this, but not all of it. There is a similar discrepancy in the comparison with high business confi dence, high consumer confi dence, increasing business profi ts, booming share market and government tax receipts. It would be tempting to disregard the national accounts entirely and rely instead on the other indicators of economic activity mentioned above. However, I do not intend to do so. While I think there is some tendency for the national accounts to be understating the level of economic activity at the moment, I think that they are right in the sense that they show that growth has slowed somewhat from 2003 to 2004. The next question is to ask why. is where capacity constraints enter the picture again. policy in most notably monetary policy, has allowed domestic demand over recent years to run at a reasonably fast pace. But as can be seen from the numbers below, this has not been translated into an equivalent growth of output as measured by The most obvious explanation for this discrepancy is one particular capacity constraint, namely that which has restricted the expansion of our export volumes, particularly resource exports. But it is highly likely that other capacity constraints have also begun to operate. For example, the growth of manufactured and service exports has also slowed and this is partly due to the fact that an increasing proportion of existing capacity is used to supply fast-growing domestic demand. After nearly fourteen years of economic expansion, we do not have the spare capacity we once had. Looking ahead, we have to recognise this situation. Attempting to maintain demand growth at the rates to which we were accustomed would risk a rise in infl ation and would probably not result in an appreciable increase in output growth. Fortunately, demand has already started to slow somewhat and it is getting closer to the growth of output. Despite its growth probably being understated, GDP is also starting to slow under the constraints imposed by capacity limitations. I think we will have to get used to seeing GDP growth rates starting with the numbers 2 or 3 rather than 3 or 4 for a time. On infl ation, our forecast a year ago for underlying infl ation in the four quarters to the December quarter 2004 was 1 1/2 per cent. At our June meeting we had raised it to 2 per cent. In the event, it came in at 2 1/4 per cent, while the headline fi gure was 2.6 per cent. Some of this was due to the increase in the oil price, but some of it was more general, as indicated by the fact that the December quarter CPI came in above all forecasters' estimates. Overall, the infl ation outcome to date is still a good result given the pressures we are now starting to see around us, but looking over a longer period it seems that infl ation has now reached a trough and is showing signs of turning up. At earlier stages of production, there has been a noticeable pick-up in prices between the fi rst half of 2004 and the second Looking ahead, we forecast gradual rises in underlying infl ation, with it reaching 2 1/2 per cent by end 2005 and 3 per cent by end 2006. Like all forecasts, they are smoother than reality will probably turn out to be, and they are subject to risks. Our assessment is that the risks are more likely to be on the upside, as we do not see any obvious downside source of risk unless there was a sharp weakening in the world economy, an eventuality on which we would place a low probability. I suppose you could conclude that this combination of weaker-than-expected GDP growth and higher-than-expected infl ation is a disappointing situation. But while less than ideal, the fi gures I have quoted are still pretty good for this stage of an expansion. Our feeling is that we - that is, policy-makers and the public - will have to realise that there comes a time when we have to accept some moderation in growth in order to prevent the build-up in the sort of imbalances that have got us into trouble in the past. First half Second half

r050323a_BOA

australia

macfarlane

I suppose I should start by explaining why I have chosen this title for my talk today. Gresham's Law is usually stated simply as 'the bad currency drives out the good' and it refers to a time when all transactions used coins. If you had to buy one pound's worth of merchandise and you had two coins - one which you knew contained one pound's worth of gold and another where some of the gold had been shaved off - you would pass the second coin and keep the fi rst one. In that way, most of the transactions would take place using the inferior transaction medium and the superior one would play a minor role. Note that this can occur only if both the inferior and superior transaction medium were accepted at the same price, or in modern parlance, the price signals were not getting through to the users. Having introduced this quaint historical economic law, I would now like to put it aside for a moment and move on to the main subject of my talk today, which is the regulation of the retail payments system. As you are probably aware, the Payments System Board of the Reserve Bank, of which I am the Chairman, is charged by an act of Parliament with responsibility for the effi ciency, competition and safety of the payments system. This is quite a daunting task, and has involved us in an enormous amount of research and consultation on payments system issues, some controversy with payments system providers and, to a lesser extent, with some payments system users. Most of us at the Reserve Bank come from a background in economics and hence have a predisposition in favour of free markets and a sceptical attitude towards intervention in those markets unless there is a clearly defi ned economic rationale for it. After much analysis and discussion, we came to the view some time ago that there was, in fact, an overwhelming case for regulation of some parts of this market, and that competition, such as it was, would not lead to an optimal outcome in terms of the public benefi t. In my remarks this afternoon I would like to set out why this is so and, in the process, I hope it will become clear why I introduced this talk by referring to Sir Thomas Gresham and his famous law. There are fi ve basic ways of making a payment in the Australian retail payments system: with cash, cheque, credit card, debit card (EFTPOS) and electronic transfer. When we looked at how these methods of payment were evolving, we saw that credit cards were growing faster than the other means of payment. This was initially somewhat surprising as credit card transactions are more expensive than most other means of payment - that is, they involve a larger payment from the users of the payments system to the providers of the payments system. In effect, what was happening was that the most expensive way of paying was driving out the cheaper ways and, in the process, raising the average cost of the Australian retail payments system. Why was this possible? We concluded this was because there was an asymmetry between the price signals (and the capacity to act on them) faced by the two classes of payments system users - the cardholders and the merchants. For cardholders, the price signal they received was that credit card transactions were free, or could even result in receiving a payment in the form of 'points'. Furthermore, cardholders were able to act on this signal as they were the party that chose the method of payment at the point of sale. Merchants, on the other hand, received a signal that the credit card was the most expensive way of making a payment (via the merchant service fee that was paid to their bank). But merchants had no power to infl uence the method of payment for the transaction - for that was in the hands of the cardholder. Thus, the incentives in the system were designed to encourage the decision-maker to choose the form of payment that was the most expensive from the perspective of society as a whole. Now it could be argued that merchants could have refused to accept credit cards in the fi rst place. But that would have been a big decision, and the fact is that most merchants felt that they would forgo too many sales if they had taken that path (particularly if their competitors did not). They did not feel that they had much bargaining power vis-a-vis the credit card schemes and the banks. And until our recent reforms, they did not have the power to 'pass on' the merchant service fee to the customer, that is, employ the 'user pays' principle by insisting that if customers use an expensive means of payment they should pay more than if they use a cheaper one. Merchants now have that power as a result of our reforms, but in most cases they are reluctant to use it as the public have become accustomed to the old system and thus often resist the transition to user pays. In short, the asymmetry in price signals is still there despite our efforts to redress the imbalance by 'empowering the merchants'. It is this asymmetry which is at the heart of the process whereby the more expensive means of payment expands at the expense of the less expensive. The mechanism that allows the asymmetry to be exploited is the system of fees that banks in the payments system pay one another - commonly known as interchange fees. In the case of credit cards, the fee is paid from the merchant's bank to the cardholder's bank on each transaction. These fees play an important role in determining the prices charged to both merchants and cardholders for payment services, yet they are not subject to the normal competitive forces that operate in most other markets. To the extent that competitive forces work at all, they perversely have had two effects: * they have encouraged the high-interchange-fee means of payment to grow at the expense of the low-interchange-fee one; * they have tended to push interchange fees up for the competing systems, not down. In this respect, the Australian experience is not unique. There are many examples around the world where these two effects are evident. I would like to illustrate this process by drawing on three examples, two of which are from the United States and the third from Australia. I am using US examples, not because examples do not exist elsewhere, but simply because legal cases in the United States have shone the spotlight on interchange fees more intensely than has been the case elsewhere, and because in many other countries interchange fees remain closely guarded secrets. The fi rst example relates to the interchange fees in the MasterCard and Visa credit card systems in the United States, where over the past decade there have been a series of competitive increases in these fees (lower half of Graph 1). There is an incentive for each scheme to raise its interchange fee in order to encourage banks to issue its cards because the higher fee provides the issuing bank with more revenue. The issuing banks in turn use the revenue to attract cardholders away from the scheme with the lower fee by offering cardholders more attractive pricing or more 'reward points'. Once one of the schemes raised interchange fees to give itself an advantage in attracting issuers and cardholders, the other responded in the same way. The result has been that competition amongst the schemes has seen fees increase from under 1.3 per cent in 1994 to 1.65 per cent today - a perverse outcome to anyone with an economics background who expects competition to lower prices. I might add that this is three times the average level of interchange fees in Australia following the Reserve Bank's reforms in 2003. Of course the increase in US interchange fees has to be paid for by somebody. And, in the fi rst instance, that somebody is the merchant, since interchange fees are built into the merchant service fee (what the merchant's bank charges it for processing credit card transactions). Not surprisingly, average merchant service fees have increased broadly in line with the increase in interchange fees since the mid 1990s (upper half of Graph 1). The end result is that merchants have to bear the extra costs of the competition between the credit card schemes. But, of course, the story does not stop here. Ultimately, higher merchant costs fl ow through into higher prices for the customers of those merchants. This is a cost borne by all consumers whether they use a credit card or not. There is a similar story in the competition between two types of debit card systems in the United States. In one system, operated mainly as regional networks, transactions are authorised by PIN (the PIN-based systems), while in the other, operated by Visa and MasterCard, transactions are authorised by signature (the scheme-based systems). The interchange fee paid by the merchant's bank to issuing banks is much higher in the scheme-based systems than the PIN-based systems issuing banks have been switching to the scheme-based systems and their share of the market has increased from 45 per cent to 60 per cent over the past decade (lower panel of have retaliated to some extent, and their interchange fees have more than doubled over the decade, although they are still well below the scheme-based systems' interchange fees. Once again, interchange fees have encouraged the growth of the relatively expensive payments system at the expense of the lowercost system, and forced the lowercost scheme to raise the price that is charged to merchants. There is an interesting additional twist to this story, and it concerns the question of why the merchants of America allowed this to happen? Why didn't they resist more strongly the inroads into their profi ts caused by the expansion of the expensive system? Partly, of course, it was because they could pass the costs on to consumers in the form of higher prices, but there was an additional factor at work. This was the 'tie-in' arrangement imposed by Visa and MasterCard that forced any merchant accepting their credit cards to also accept their debit cards. By the mid 1990s, the merchants had become so upset by this rule that they took the credit card schemes to court - in what became known as the Wal-Mart case - arguing that the rule breached anti-trust laws. In April 2003, the case was fi nally settled, with Visa and MasterCard agreeing to abolish the rule, reduce the interchange fee, and pay damages of $3 billion to the merchants. This brings me back to where I started. In Australia, prior to the Bank's recent reforms, the average interchange fee for a $100 transaction paid to a credit cardholder's bank was 95 cents. the interchange fee fl ows in the opposite direction and the cardholder's bank has to pay around 20 cents per transaction to the merchant's bank (upper panel of Graph 3). Given these fl ows, it is clear why card-issuing banks wanted to issue credit cards rather than EFTPOS cards - they received $1.15 more for each $100 transaction. During the mid 1990s, the Australian banks worked hard at developing reward schemes (largely fi nanced by their interchange fee receipts) to encourage cardholders to use credit cards. Reward points, together with interest-free credit, meant that many cardholders were being paid 1 per cent or more of the value of each transaction by credit card. Not surprisingly, there was a big shift towards credit cards, with transaction numbers growing at 20 to 30 per cent for around fi ve years, while EFTPOS growth fell to less than 10 per cent per year (lower panel of a higher-cost payments system was displacing a lower-cost one, and the community's resources devoted to making payments increased. One of the longer-term aims of our reforms is to reduce the distortions in the payments system caused by the pattern of interchange fees. If large differences in the fees in the credit card and EFTPOS systems continue, it is hard to see why in the long run banks would continue to put resources into promoting the EFTPOS system. This is why we think that the merchants who oppose our EFTPOS reforms are extremely short-sighted. Without the proposed reforms, we could see a gradual withering away of the EFTPOS system, so that the merchants would face a larger and larger proportion of their sales taking place using the higher-cost credit card system. It is pretty obvious by now where Gresham's Law fi ts into my account, so I hardly need to spell it out. Instead of the bad currency driving out the good, we have the high-cost means of payment driving out the low-cost one. To take the most obvious example, a credit card offers the same service to a merchant - irrevocable payment - as a debit card, yet costs the merchant a lot more. To the cardholder, the credit card offers more - about 50 days free credit - yet it costs less, with the cardholder often receiving payment for using it. Clearly, the second condition for Gresham's Law is met, namely that the price signals to the decision-maker do not refl ect the underlying costs, that is the 'user pays' principle is not being applied. This tendency for competition to favour the high-cost product seems to be a feature of card-based systems around the world and explains the increasing attention given to the system by competition regulators. Before I fi nish, I would like to reassure you that in some other parts of the retail payments system, the normal laws of economics are leading to the normal results. The cheque provides the best illustration of this. All over the world the cheque - universally acknowledged as a relatively high-cost means of payment - is in decline, replaced by more effi cient forms of electronic payment. The most important reason for this is that banks at both ends of the payments chain are charging their customers for the costs of writing and depositing cheques. So the 'user pays' principle works well in this case, but of course, there are no interchange fees. At the Reserve Bank, we are in favour of a retail payments system that provides users with a wide choice of options from a wide range of providers. Each payments method has its strengths and weaknesses, and so users should be able to choose the most suitable payments method for each particular type of transaction. In some cases the pricing of the transaction enables them to do so in a manner which contributes to an effi cient low-cost retail payments system, while in some other cases it does not. The best way of improving effi ciency is usually to increase competition rather than to regulate, but I think I have shown that some parts of the retail payments system are constructed in such a way that competition increases costs and reduces effi ciency. In those areas, regulation is required, and the Reserve Bank through the Payments System Board will continue with its task of improving effi ciency, competition and safety of the retail payments system.

r050507a_BOA

australia

lowe

Thank you for the opportunity to participate in this excellent conference. It is fabulous to see so many people from academia and the public and private sectors so interested in the economics of interchange fees. When the Reserve Bank of Australia started looking at these fees in 1998 we found it hard to fi nd people to exchange ideas with. Fortunately, this is no longer the case, and we would like to thank the Federal Reserve Bank of Kansas City for its role in helping bring this about. Given the title of this session - Central Bank Perspectives and Options - these remarks touch on three topics. The fi rst is to explain how the Reserve Bank of Australia (RBA) found itself as a regulator of the payments system. The second is to outline what we have done, and why we have done it. And the third is to make a couple of general observations about how things have gone. Most central banks have some type of broad responsibility for oversight of the payments system. Often this responsibility is coupled with regulatory powers relating to high-value payments. In Australia, however, the responsibility runs much broader than this, encompassing the effi ciency and competitiveness of the payments system as a whole, including retail payments. This responsibility was given to the RBA following a wide-ranging inquiry into the structure of fi nancial regulation in the mid 1990s - the so-called Wallis Inquiry. This Inquiry recommended that bank supervision be moved from the Reserve Bank to a stand-alone prudential regulator - that the RBA be given responsibility for the overall effi ciency of the payments system. This recommendation refl ected, in part, recognition of the fact that the RBA was already highly enmeshed in the payments system and had considerable expertise in what are often highly technical matters. It nevertheless came as a surprise to us. We had not been arguing for an extension of our powers and we had not been seeking responsibility for payments system effi ciency. In accepting the Committee's recommendations, the Government took the rather unusual step of establishing a second board within the Reserve Bank - the Payments System Board. This Board is chaired by the Governor and has up to eight members, six of whom come from outside the RBA. It is charged with controlling risk in the payments system and promoting effi ciency and competition. The Board has the power to formally designate payment systems, and having done so, can then set standards, determine an access regime and give enforceable directions to participants in the system. The Government envisaged, however, that these powers would be used only if the RBA was not able to achieve voluntary reform by industry participants. So that in a nutshell is what we can do. Now to what we have actually done and why we have done it. Soon after being given its powers, the RBA, in conjunction with the competition regulator, undertook a major study of interchange fees and competition in card-based payment systems. This followed longstanding concerns about the degree of transparency and competition in these systems. Out of that study we came to the view that the effi ciency of the overall system would be improved by cardholders facing relative prices for various payments methods that more closely refl ected relative costs than was then the case. We also formed the view that existing access arrangements and restrictions on merchants imposed by the card schemes were stifl ing competition. Our main focus has been on the relative costs and prices for transactions on credit and debit cards. This refl ects the fact that for many people there is a high degree of substitutability amongst payments through the credit card, PIN-based debit card and the signature-based debit card systems. Our original study showed that the PIN-based debit card system had signifi cantly lower operating costs than these other two systems. Despite this, cardholders faced much higher prices for using this system. At the time of the study, it was not uncommon for transactions using a PIN-based debit card to attract a fee of around 40 to 50 cents. In contrast, transactions using the signature-based system were not charged, while many holders of credit cards were effectively paid each time they used their card as a result of the combination of interest-free credit and reward points. Not surprisingly, consumers responded to these price signals with spending on credit cards growing at rates of 20 to 30 per cent over the second half of the 1990s, while spending on PIN-based debit cards grew at an average rate of around 10 per cent. When we looked at why the relative prices were so far out of line with relative resource costs it was clear that interchange fees played an important role. In the credit card and signaturebased debit card systems the average interchange fee was around 0.95 per cent of the transaction value, paid to the issuer. In contrast, in the PIN-based debit card system we had the somewhat unusual situation in which the interchange fee fl owed in the opposite direction - that is, from the issuer to the acquirer - and averaged around 20 cents per transaction. Not surprisingly, these different arrangements for interchange fees were refl ected in pricing to cardholders. In particular, the credit card interchange fees were helping subsidise the use of credit cards. As usual though, the subsidy has to be paid for by somebody. In the fi rst instance it is the merchants that pay through their merchant service fees, but ultimately merchants need to cover their costs. One obvious way that they could do this would be to charge customers using a credit card a higher price than those using lower-cost forms of payment. But, of course, the credit card schemes' so-called no-surcharge rule prohibited them from doing this. The end result was that merchants had little option other than to charge higher prices to all their customers to pay for the relatively large subsidies to credit card users. In thinking about appropriate regulatory responses to these distorted price signals the RBA considered simply requiring that the no-surcharge rule be removed, thus allowing merchants to charge customers using a credit card a higher price. To the extent that merchants did so, the subsidy that credit card users received from their bank could, in principle, have been unwound, at least in part, through a higher price at the point of sale. We saw considerable merit in this approach, and have in fact required that the no-surcharge rule be removed from merchant contracts. However, our view has been that removing this rule was not enough, by itself, to establish more appropriate price signals to cardholders. This largely refl ects the considerable customer resistance to charging for credit cards. This resistance is hardly surprising given the long history over which cardholders have not had to pay higher prices for using a credit card. Many merchants fear that the imposition of even a small charge would put them at a signifi cant competitive disadvantage. Having removed the rule in Australia, we have seen a number of businesses charge for credit cards, including some in very competitive industries, but the vast majority of merchants have so far chosen not to do so. Over time we expect to see more charging as attitudes change, but it is unlikely to happen quickly. Given this assessment, we felt it necessary to also address interchange fees. These fees are not subject to the normal forces of competition and in the RBA's view were distorting the use of payment methods in Australia. Where interchange fees are set by the card schemes - as is the case with credit cards - competition between schemes can perversely push interchange fees up, not down. The higher is the interchange fee set by the scheme, the higher is the subsidy that issuers are able to offer the cardholders to use the scheme's cards. Merchants are forced to pay for these subsidies as most are unwilling, except in extreme circumstances, to refuse acceptance of credit cards. As the US experience demonstrates, the result can be a series of competitive increases in fees, with the higher-cost system tending to drive out the lower-cost system. Where fees are set bilaterally, as in the Australian PIN-based debit card system, normal competitive forces also appear to be weak, with fees in this system typically having remained unchanged for many years despite signifi cant changes in costs and revenues on both the issuing and acquiring sides of the market. In pursuing reform of interchange fees we initially sought a voluntary reduction in these fees in both the credit and debit card systems. It quickly became apparent though that MasterCard and Visa would not agree to do so, nor would they remove the no-surcharge rule or liberalise access arrangements. This led us to fi rst designate the credit card systems and then set two standards: one that abolished the no-surcharge rule and one that set a standard for the calculation of interchange fees. The interchange standard has had the effect of reducing the average credit card interchange fee from about 0.95 per cent of the transaction value to around 0.55 per cent. Our understanding is that this is one of the lowest interchange fees for these schemes in the world, although given the secrecy still surrounding these fees in many countries, it is diffi cult to be sure! The standard requires Visa and MasterCard to calculate a benchmark fee, with the weighted average of the fees in each scheme to be below the respective benchmarks. These benchmarks are based on eligible issuers' costs as set out in the standard. We adopted this cost-based approach not because we believed it had particular theoretical merit, but rather because it was a pragmatic and transparent way of moving to a regime with less distortionary interchange fees. The alternative was simply to specify a specifi c per cent cap on interchange fees. We elected not to do this partly because, while we have strong powers, there is some doubt as to whether these powers extend to fi xing a price - in this case an interchange fee. The lower interchange fees came into effect on 1 November 2003, and almost immediately merchant service fees fell by a similar amount as acquirers passed on their lower costs; the average merchant service fee on credit cards in Australia is now almost exactly 1 per cent. We are confi dent that these lower costs will fl ow through into lower prices for goods and services, with our calculations suggesting that the Consumer Price Index will be 0.1 to 0.2 of a percentage point lower than would otherwise have been the case. For the domestic PIN-based debit card system the reform process has been more protracted. Following discussions with the RBA, the banks took a proposal to the competition authority to abolish interchange fees. At the time, we saw this industry-led approach as preferable to one in which the RBA used its regulatory powers to impose an outcome. The competition authority eventually approved the proposal, but it was then successfully challenged in a review tribunal by a group of merchants, arguing that there were no net benefi ts from what was ostensibly an illegal collective price fi x (that is, a fi x at zero). Following the review tribunal's decision we came to the view that if progress was to be made then it would need to be done by the RBA using its regulatory powers. As a result, we designated the system in September 2004 and have recently released proposals, which if implemented would likely see the average interchange fee fall from around 20 cents to around 5 cents. The fee would remain payable by issuers to acquirers. We have also recently released for consultation proposals to reduce the interchange fee in the smaller signature-based debit card system operated by Visa. If implemented these proposals would see the interchange fee in that system fall from a percentage-based fee averaging around 40 cents currently to a fl at fee of around 15 cents. We have also proposed requiring that Visa remove the rule that requires a merchant to accept Visa debit cards as a condition of accepting Visa credit cards. Similar arrangements would apply to other scheme-based debit cards introduced into Australia. In proposing these reforms to the two debit card systems we have been mindful not only of the substitution possibilities between credit and debit cards as well as other means of payment, but also between different debit card systems. One concern has been that if the current interchange fees were to remain in place then, over time, issuers of debit cards would fi nd it more attractive to issue and promote the signature-based system - in which they receive an average interchange fee of 40 cents - at the expense of the lower-cost PIN-based system - in which they have to pay an interchange fee of 20 cents. A central issue right through the reform process has been the fact that, by its very nature, a credit card offers many cardholders a subsidised method of payment. If the balance is paid off by the due date, the cardholder receives a per-transaction subsidy equal to the value of the interestfree period, to say nothing of reward schemes. The issuers' costs of offering this subsidy are paid for by a combination of annual fees on cardholders, interchange fees, and the interest margin on those who do not pay their balance off by the due date. While ever the credit card product exists as it currently does, this subsidy will remain for a large group of cardholders. At issue is how competing payment methods should be priced in an effi cient system given the existence of this subsidy. Resolving this issue is far from straightforward. Given the complexities involved, our approach has been to move interchange fees in what we see as the right direction, rather than to seek the perfect solution, whatever that might be, in one step. This gradualist approach, however, has meant that if the current proposals are implemented we will have three different interchange standards, each based on different eligible costs. We have indicated that, to the extent possible, we would like to move to a more consistent approach to the setting of these fees over time and will undertake another major review in 2007. Finally, a couple of observations about the reform process and the involvement of the central bank. The fi rst observation is that the process has been more diffi cult and more protracted than we initially thought. In a number of cases, achieving voluntary reform has proved to be all but impossible. Perhaps this is not surprising because there are strong commercial interests at stake and those who see themselves as losers from any particular reform typically strenuously oppose that reform. The reform process has also been subject to legal challenges. In the case of the credit card reforms, both MasterCard and Visa took the RBA to court, arguing that it had overreached its powers. After a six-week hearing, preceded by more than eight months of intensive preparation, the challenges were comprehensively rejected and MasterCard and Visa were ordered to pay the RBA's costs. The real winners from the case were undoubtedly the lawyers and consultants. Now again we are due in court in three weeks time to defend another challenge. This time it is by a group of merchants. While these merchants strongly supported the credit card reforms they are opposed to the proposed reforms of the PIN-based debit system, given that these reforms are likely to lead to higher merchant fees on transactions using this system. We have argued that their objections are short-sighted, for as mentioned earlier, if the current arrangements remain in place, use of the PIN-based debit system is likely to decline in relative terms, with its place being taken by signature-based debit and credit cards, both of which are more expensive for the merchants to accept. The reform process has also been made more diffi cult by the relatively underdeveloped nature of economic theory in the area of interchange fees. In particular, there is little guidance as to what constitutes an optimal set of fees in a world where there are multiple competing payments systems each with different costs at the issuing and acquiring ends and where, in at least one payment system, there is an inherent subsidy to cardholders. In addition, at the empirical level, there is a dearth of comprehensive studies on the degree of substitutability between various payment methods. This has meant that we have had to proceed carefully, collecting evidence where it exists and making informed judgements where the evidence is incomplete. The second general observation relates to the role of a central bank in all of this. It is fair to say that having specifi c payment system legislation with responsibility assigned to the central bank has led to greater scrutiny than might otherwise have been the case. Given our experience and the diffi culties of unravelling and understanding the details of the payments system there would appear to be merit in having an institution with ongoing responsibility for effi ciency, with that institution being able to act proactively, rather than just reactively in response to breaches of competition law. Another positive aspect of our arrangements has been the Board process. Not only do the external members bring considerable expertise, but the fact that decisions are taken by a Board gives those decisions some extra credibility in the eyes of the public. The formal processes associated with the Board have also provided a useful internal discipline. One concern sometimes expressed about central bank involvement in reform of retail payments systems is that controversy surrounding the process has the potential to damage the bank's reputation, harming its ability to successfully pursue its other responsibilities. This has not been an issue in Australia, although there certainly has been plenty of controversy! None of this though means that the case for giving the central bank, rather than another institution, responsibility for the effi ciency of the payments system is compelling one way or the other. What is compelling is that someone has this responsibility and that it be taken seriously. Thank you.

r050512a_BOA

australia

macfarlane

My talk today is about payments imbalances in the world economy, a subject that has received exhaustive attention over recent years. The reason for this is simple: it is not just that there are large imbalances between deficit and surplus countries, but that the pattern seems to have become entrenched over recent years. Table 1 below summarises the results for the past five years. Most of the discussion has centred around the sustainability of the deficits, especially the deficit of the United States. Not surprisingly, the United States Government is then urged to adopt policies to reduce its deficit, and other countries are also encouraged to adjust their policies with the aim of reducing the US current account deficit. The US Administration has become quite vocal on this subject, but it is not clear that its outspokenness is helping to resolve the issue. I find this approach of starting with the US current account deficit not to be very constructive for several reasons which I will outline in this talk. A balance of payments account measures two separate concepts, each of which is the mirror image of the other: The first is summarised by the current account and the second by the capital account; the two by definition have to add to zero. Attention is invariably concentrated on the current account rather than the capital account, and especially when the current account is in deficit. Why should we assume that the deficits are the problem? Why not assume that the surpluses are the problem? I think the answer is that there is a belief that current account deficits are unsustainable, whereas surpluses could go on forever. This was a reasonable assumption for most of the post-war period, particularly under the Bretton Woods system, but may no longer be so. In a world of floating exchange rates and mobile international capital, the old rules may no longer apply. The discipline applied by the international market place on developed countries with current account deficits now may be very weak. Even under earlier monetary regimes, there are examples of countries that have maintained current account deficits for long periods. The United States in the nineteenth century is a good example, as is Australia in the twentieth. In the 1970s, Singapore ran a current account deficit which averaged 15 per cent for a decade. For developed countries with deep financial markets and little or no foreign currency exposure in their borrowing, current account deficits are not the problem they once were. The United States has now run a current account deficit for fifteen years. During the first phase, it was predominantly financed by private investment and the US dollar strengthened. During the more recent phase, the gross inflows have still been private, but financing from foreign central banks has also been important and nearly matches the size of the current account deficit. Over the past four years, the US dollar has depreciated, but after fifteen years of cumulative deficits, the effective exchange rate of the US dollar is similar to what it was at the start of that period. The important point is that, despite widespread predictions to the contrary, it has not been difficult for the United States to finance its deficit. So the scenario whereby world financial markets react to the US current account deficit by withdrawing funding has disappointed those who thought it would come into play. It may happen yet, but people have been predicting it for a long time and yet it seems no closer. A large part of the reason for this is that investors who want to get out of US dollars have to run up their holdings of another currency - they cannot get out of US dollars into nothing. They have to take the risks involved in holding some other currency, possibly at an historically high exchange rate, and they may well be reluctant to do so. The other mechanism that could bring about a correction would be if the United States chose to implement policies aimed at reducing its current account deficit. This is not something that the Government would embrace quickly, as the population, by and large, is not complaining about the current situation whereby their consumption is subsidised by cheap loans from the rest of the world. Some of the appropriate policies may be worthwhile on other grounds, such as reducing the budget deficit, so I do not wish to argue against them. All I want to point out is that the usual policies which could reduce the current account deficit are not very appealing politically. In a world of floating exchange rates, all the policies available to the US Government involve reducing domestic demand, increasing national savings and putting downward pressure on domestic prices and wages. They are all restrictive and aimed at reducing consumers' purchasing power. Short of a crisis, most governments are reluctant to adopt such policies. Thus, my judgment is that the difficulties of sustaining current account deficits have been overstated for any country whose financial markets are developed enough to be able to borrow in its own currency. Of course, this is even more so if its own currency is a reserve currency which foreign central banks are willing to accumulate. I would now like to approach the subject of imbalances from the side of the surplus countries, particularly Asian countries. The thing that stands out today is that Asian countries run large surpluses, which amount to a bit more than half the deficit run by the United States. As we have seen, when a country runs a surplus on its current account, it has to be exactly matched by capital outflows in the form of loans or investment abroad. Thus, we have the counter-intuitive situation of a region consisting predominantly of developing countries lending to the richest developed country in the world. Not only does this seem to be counter to economic logic, it is also contrary to historical experience. Developing countries are characterised by relatively small amounts of capital relative to labour, and hence relatively high rates of return on additions to their capital stock. It makes sense for funds to flow from the mature economies to the developing economies in order to receive a higher rate of return on those funds. To some extent, this is happening, principally through direct investment, but this is dwarfed by other flows in the opposite direction so that overall finance is flowing from the developing to the mature. Historically, it has gone the other way. In the nineteenth century, the main movement was from old Europe to the new and expanding United States, and this flow continued in the twentieth century as newer areas such as Australia, Argentina, Canada, etc. received funds from Europe and later the United States. There are a number of explanations for this unusual pattern of capital flows. Many people attribute it to the desire by Asian countries to keep their exchange rates low in order to maintain competitiveness. I do not wish to argue that this has not been a factor, but I think there is a more important explanation. There are two relevant facts about this pattern of capital flows. The first is that it is a relatively recent phenomenon. Table 2 below compares the pattern in 1996 - the year before the Asian crisis - with the pattern now. In all cases, the Asian current account surpluses were much smaller (or were deficits) in the earlier period than now. This pattern is not consistent with the view that competitiveness considerations were the main driver, because if that were so, Asian countries would not have waited until the past five years to put them into effect. The second fact is that, as shown in Table 3, the predominant change in economic behaviour by the Asian countries between the two periods has not been to increase saving, but to reduce investment. In the case of Japan, investment has fallen by 5.2 per cent of GDP since 1996, and in the rest of Asia (excluding China), it has fallen by 8.7 per cent of GDP over the same period. China is different, in that both savings and investment have not changed by much. My conclusion is that because of the timing and the composition of the change in the Asian current account position, much of the reason behind it can be attributed to the fallout from the Asian crisis of 1997/98 and the desire of Asian governments to avoid a repeat of it. After the devastation faced by Thailand, Korea and Indonesia (and observed with interest by China), Asian countries felt they had to make their economies more resilient to international capital flows. The simplest way of doing that was to cut expenditure (particularly investment expenditure), keep savings high, run current account surpluses and build up reserves. Since the reserves are largely in US dollars, that means lending to the United States. There is a cost to this as it means forgoing spending and building up savings which will be lent at a low interest rate. It is a very expensive form of insurance designed to reassure international investors of the ability of the country to withstand a crisis. I remember that up until a couple of years ago, officials from Asian countries (especially China) usually started any presentation on their economy by referring to their high level of international reserves. They do not do that any more since the level has become so high that they exceed any likely need. Thus, I think that in a world of floating exchange rates and mobile international capital, a number of emerging market economies came to the conclusion that the international financial system was so potentially unstable that the only way they could participate was by paying this large insurance premium in the form of cheap loans to the United States. I have a feeling that this sentiment is starting to change now, but it was a large part of the reason that we have ended up where we have. This is not a new thought of mine, because I was already worrying about it in 1998 when I wrote: I think it is possible to argue that for countries with a fixed exchange rate, surpluses may be more difficult to sustain in the long run than deficits are for some other countries. I speak from experience here as Australia faced this problem in the early 1970s and did not handle it successfully. At that time, Australia briefly experienced a current account surplus and also became a favourable destination for capital flows. As the money poured in from both these sources it had to be sterilised or it would flow directly into the banking system and through that into money and credit aggregates, with obvious inflationary results. The problem we found was that in order to sell the official paper in sufficient volumes to soak up the inflow, interest rates had to be raised, and this induced further inflow. In the end, the monetary aggregates grew too quickly and inflation soon rose to an unacceptable rate. We came to the conclusion then that it was not possible to restrain an over-exuberant and inflation-prone economy only by domestic tightening. Exchange rate adjustment was required in order to take away the 'one way bet' aspect of the exchange rate. We eventually did this, but we were too slow and the inflation had already become entrenched. So far, China has made a much better job of handling this situation than we in Australia did 30 years ago. And, of course, it is made easier by the fact that it is occurring in a world environment of low and stable inflation rather than the rising inflation of 30 years ago. But, ultimately, I think the point will be reached where domestic restraint has to be augmented by action on the exchange rate. Sterilisation is not as easy as it sounds. If all the central bank does is sell official paper to the commercial banks at a below-market interest rate, it is not really sterilisation. It merely exchanges commercial banks' balances at the central bank for central bank paper, but does not offset the initial increase in bank deposits caused by the official purchase of foreign currency. For sterilisation to offset the initial rise in bank deposits, the official paper must be sold at an interest rate that attracts non-banks to withdraw deposits from the commercial banks in order to buy the official paper. This is rarely done because it would push up interest rates and attract more inflow. Instead, countries usually rely on a combination of raising reserve requirements and direct lending guidelines to limit the growth in banks' balance sheets, and hence the money supply. These have their own set of problems for both commercial banks and/or central bank profitability, and hence cannot be maintained indefinitely. Ultimately, the inflow of foreign funds through the current and capital accounts has to be reduced through a higher exchange rate. It is in the country's own domestic interest to do so, but it is difficult to make the decision at the right time, i.e. before the inflationary consequences in goods and asset markets show up. We in Australia did not pass that test, but I suspect China will handle it better than we did. I have tried to make a number of points in this talk, but I may not have been as clear as I would like to have been. I will, therefore, conclude by restating my main points in the simplest of terms.

r050614a_BOA

australia

macfarlane

Let me start by saying what a pleasure it is to be here before such a distinguished gathering at the Australian Institute of Company Directors. I have not spoken on the economy since February, so I will take this opportunity to do so today. My main topic is how global and domestic infl uences are interacting on the Australian economy. But before doing that I would like to say a few words about monetary policy, in particular how it is formulated. As readers of the fi nancial press, you will have encountered reports nearly every day of some new economic statistic being released, and some pundit giving an opinion of what this implies for future movements in interest rates. You could be forgiven for thinking that the formulation of monetary policy was simply a matter of collecting the latest month's statistics, weighing them up to see whether they were strong or weak on balance, and then adjusting interest rates accordingly. This very short-term view of monetary policy arises because journalists have to write a story every day and economists in fi nancial institutions have to advise their dealing rooms every day. But monetary policy is a much more slowly-evolving process than this, and there are elements in the process that are more important than the evaluation of the latest statistics. The fi rst of these is to have a clearly enunciated framework of what monetary policy is seeking to do, and the second is to have a view of how the world economy is developing and how it is affecting Australia. Let me now say a little more about each of these subjects. Views about what monetary policy can and cannot achieve have evolved over the past century or two. The current consensus, based on the experience of the post-war period, is that the principal contribution it can make to economic well-being is to maintain low and stable infl ation. As a result, a number of countries, including Australia, have adopted a monetary policy regime based on infl ation targeting. Ours is designed to ensure that the average rate of increase in consumer prices is between 2 and 3 per cent. Note that it is expressed as an average over time; the actual rate does not have to stay between 2 and 3, and in fact it has often been outside that range, though not by much. The centrality of infl ation in the monetary policy regime is not because infl ation is all we care about. It is there because we believe that low infl ation is a necessary condition for sustainable economic growth and good monetary policy is essential to its achievement. The results over the past fourteen years provide evidence in support of this assessment. It is important to have a framework because there has historically been a temptation to use monetary policy for too many purposes. We still hear calls from time to time to raise interest rates to improve the balance of payments or to stop rising house prices, or, on the other hand, to lower rates because the economy has slowed. In the past, these and other motives often lay behind monetary policy changes, but now it is easier to resist such temptations because they have to be viewed within a more general framework based on their likely implications for future infl ation. The second important element is to have a view about how the world economy is evolving and how this will affect Australia. It is fair to say that the major macroeconomic events that have affected Australia have to a large extent been imported rather than home-grown. In Australia, the two major economic events of the last century - the Depression of the thirties and the Infl ation of the seventies - the world's only peacetime infl ation - were both part of worldwide developments. More recently, the international business cycle has been the main determinant of our own; the three most recent Australian recessions of 1974, 1982 and 1990 were part of global recessions. Over this period, we have not had an entirely self-induced recession. Our one signifi cant deviation from the international business cycle is that we did avoid the (admittedly mild) 2001 recession that affected most G7 countries. Similarly, our infl ation experience shadowed that of the OECD area, although we were later than most in bringing it down after the initial surge in the seventies; our good infl ation record only dates from the early 1990s. I think it is true to say that if you wished to forecast the path of the Australian economy, and you were able to have foreknowledge of only one economic variable, the one you would choose would be the path of the world economy. That is not to say that we have no infl uence over our own destiny - we can make the situation better or worse than it would otherwise be - but we cannot escape the infl uence of the world business cycle and the other factors that feed off it. Once the central bank has established what it is trying to achieve with monetary policy and how world events are shaping the direction of the Australian economy, then it is in a position to evaluate the multitude of statistics about the economy that each day brings forth. They essentially indicate whether the 'big picture' view of how the economy is evolving is on track or not. Mainly they show whether events are happening quicker or slower than expected, but in extremis , they could mean that the overall assessment was incorrect. There is so much semi-random variability in economic statistics that, unless the underlying processes are known, the statistics alone are unlikely to be able to show where the economy is heading; this is particularly the case if too much emphasis is placed on one month's statistics. I have spoken on several occasions about the risks that can develop as an economic expansion lengthens and economic imbalances emerge. With the Australian economy in the fourteenth year of expansion, we have naturally paid particular attention to these imbalances. The one that was most prominent until recently was the sharp increase in house prices and household debt. More recently, it has been the emergence of capacity constraints in some parts of the economy. No-one should be surprised by this development; it would be remarkable for any economy in the fourteenth year of an expansion if this were not to happen. Finally, we have seen the Australian current account defi cit as a per cent of GDP move relatively quickly from its smallest level in twenty years to its largest. These developments are all related, as I hope to show, but I will start my story as usual from the perspective of the world economy. After the mild recession of 2001, the world economy moved into an expansionary phase, which has been robust overall, but has been marked by very disparate growth rates among major regions. Two regions in particular - Japan and Europe - have made only minimal contributions to the expansion which has been led by the United States, China and other east Asian countries. A notable feature this time is that the rest of the world, which tends to be overlooked in most assessments, has also grown strongly. By the rest of the world, I mean Latin America, India, divergences, the world economy has expanded at above-average rates over the past few years providing a very favourable backdrop to the Australian economy. Consensus forecasts for 2005 and 2006 are also for above-trend growth, although somewhat lower than last year. A particular feature of the world economy in this episode is that commodity prices, led by Chinese demand, have risen sharply at a relatively early stage of the global expansion. Apart from oil, the rises have been concentrated in base metals and the two bulk commodities important for Australia - coal and iron ore. As a result, Australia's export prices have received a huge boost. Our terms of trade, which is the ratio of our export prices to our import prices, rose more quickly and to a higher level than anything we had experienced since the early 1970s A rise in the terms of trade is an increase in the country's real income. We estimate it has increased our real income by an amount equivalent to about 1 1/2 percentage points of GDP on average in each of the last two years and more is to come. Some of this accrues to workers in the resource sector, some to domestic shareholders and a signifi cant amount through increased taxation and royalties to governments. When the additional income is spent, it provides a signifi cant boost to domestic demand through increased consumption and investment as well as via the government sector, although some fl ows overseas through imports. In the past, we have sometimes had diffi culty in coping with these expansionary effects, as they pushed up infl ation and added to the boom and bust character of the Australian economy. With domestic demand in Australia growing at over 5 per cent in 2002/03 and 2003/04, which is well above long-term potential, and with the economy approaching full capacity in a number of sectors, the extra domestic demand generated by the exceptional rises in the terms of trade could well have had serious infl ationary consequences if it had continued. This was particularly so as important prices such as those for oil, steel, plastics, shipping and other inputs to production were rising rapidly around the world. It was these types of concerns that led the Bank to raise interest rates a little further earlier this year. In the event, the economic situation has evolved quite favourably, with domestic demand continuing to slow to what appears to be a sustainable pace. Output, as measured by GDP, has also slowed and some people are disappointed that GDP growth is now running at a belowaverage rate, but I view recent events as a healthy correction, and certainly a much better outcome than several other potential outcomes. There are also indications that infl ationary pressures are not building as quickly as might have been expected earlier in the year. How has this relatively orderly slowdown come about? The fi rst reason for the slowing in domestic demand is the change that has occurred in the housing sector. Fuelled by a rapid increase in mortgage lending, house prices rose sharply and house-building activity surged in the fi rst few years of this decade. Over the past year, however, we have had a turnaround in all three; house prices have fl attened, mortgage lending has slowed and house-building has contracted of the last-mentioned is the easiest to measure; house-building grew by 11.1 per cent last fi nancial year and has contracted by 5.3 per cent so far this year. This means it added 0.7 per cent to the growth of demand last year and has taken 0.3 per cent off this year. Note, however, that as a per cent of GDP, housing is still high by historical standards. A second reason for the slowing in domestic demand may be the indirect effects of the change in the housing market. These are harder to measure, but there is some evidence that the fl attening of house prices has led households to tighten their belts. Growth in borrowing against housing has slowed to an annualised rate of 10 per cent in the fi rst four months of 2005. While this is well down from a year ago, it is still faster than the growth in household incomes. After several years when borrowing was much higher than housing investment as households withdrew equity to fund consumption, it appears that housing equity withdrawal has now ceased. In line with this, growth in consumption has slowed from 5.9 per cent in 2003/04 to an annual rate of 3.4 per cent so far this year. In other words, while households have stopped adding to their consumption by borrowing against the equity in their houses, there has not been a major scaling back in order to build up savings. It is hard to know whether this household consolidation will continue, for how long it will last, or whether it will intensify. It is early times yet and the situation bears close watching. As a result of these two infl uences - the slowing in consumption and the fall in housebuilding - domestic demand growth has fallen from just over 6 per cent to about 3 1/2 per cent so far this fi nancial year. Business investment continues to grow strongly, which is important given our need to increase capacity, particularly in the exporting sector. Strong employment growth is also underpinning the economic expansion. Growth of 3 1/2 per cent in domestic demand sounds reasonable, but growth in output, as measured by GDP of only 1.9 per cent over the past year, sounds less satisfactory. What lies behind the lower output growth? The simplest factor to identify is the fall in farm output of 16 per cent. Setting this aside, the growth in non-farm GDP is 2.6 per cent over the past year. But the more interesting story concerns the balance of payments, so I will conclude by saying a few words about our external trade position. It is well-known that, despite the rise in world prices for our resource exports, Australian exporters have struggled to increase export volumes over recent years. In large part, this is because of the size and speed of the rise in demand coupled with the very limited investment in capacity that has taken place in the late 1990s and early in this decade. This is a worldwide phenomenon; it was because world producers were not able to increase supply to match the increase in demand that world commodity prices increased in the fi rst place. A couple of port bottlenecks in Australia also limited our supply response, but they are not the main part of the story. At the same time as export volumes remained weak, import volumes over recent years rose strongly. Imports were boosted by the strong domestic demand, partly refl ecting the increase in real income due to the terms of trade rise, and by the accompanying rise in the exchange rate. This latter factor, combined with the worldwide fall in the prices of manufactured goods, meant that import prices in Australian dollars fell sharply until recently which encouraged import volumes to rise strongly. This is a normal process whereby a fl oating exchange rate relieves the pressure on domestic supply and infl ation, but at some cost to the balance of payments. The good news is that it does not go on forever. In time, export volumes begin to rise again, as I believe they are now, and the slowing in domestic demand feeds through into slower import growth. While the rising exchange rate has been an important factor over the past couple of years, if we look at it over the past fi ve years or so, it did not rise as much as would have been expected on the basis of its past relationship with the terms of trade (Graph 3). Interest differentials in Australia's favour also pointed to a larger rise in the exchange rate. This suggests that some other factors must have been at work in the opposite direction, perhaps concern about the weakness in export volumes or broader apprehension about the widening current account defi cit itself. What do we make of all this? The big picture is, I think, that the world business cycle is still at an early stage of expansion, so we can expect continued economic growth over the next few years. This, together with our higher terms of trade and strong investment growth in the presence of some capacity constraints, is exerting an expansionary infl uence on domestic activity and upward pressure on infl ation, mainly at the producer price level, although we also expect consumer price infl ation to increase somewhat from its present rate. At the same time, the economy is at present being affected by some countervailing forces. Consumption has slowed and house-building and farm output are falling; these have exerted a moderating infl uence and may continue to do so. While there is a natural tendency to be disappointed that the second set of infl uences is now occurring, the fact is that the economy could not have taken on board the external situation without this moderation in the domestic economy. A failure to slow would most probably have produced the set of economic imbalances, particularly rising infl ation, that have ended previous expansions. In this respect, the recent moderation in growth is more likely to prolong the expansion than bring it to an end.

r050812a_BOA

australia

macfarlane

I would like to start by saying how pleased I am to be back in Melbourne in these familiar surroundings. Since these half-yearly hearings started in May 1997, this is the sixth time we have appeared in Melbourne, and the seventh time in Victoria - the other time being in Warrnambool in 2002. I hope that the discussions are as fruitful and informative as they have been on the earlier occasions. On Monday we released our quarterly , and you will not be surprised to hear that what I have to say today is very similar to it. In fact, what I have to say is also very similar to a speech I gave on 14 June. The past couple of months or so has been a particularly stable period and we have not felt the need to change our views much, if at all. Rather than going over all the recent developments at this time, I will concentrate on a few that I think are important. The first, as always, is the world economy. It would be possible for someone reading the newspapers to get the impression that the world economy is in a parlous state - rising oil prices, large US current account deficit, China on a knife edge, Japan still stagnating, the US dollar about to plunge, etc. You will be pleased to hear that we are not of that view. In fact, we have for quite a long time been relatively optimistic about the outlook for the world economy. When looked at region by region, there is good growth nearly everywhere. Obviously, the United States, China, India and east Asia are doing well, but the places we tend to overlook are also doing well - for example, Latin America, the Middle East and the former Soviet Union. Even Africa has picked up, and so has Japan. The only area that continues to disappoint is continental Europe, particularly the big three - Germany, France and Italy. Oil price increases are a source of concern, but their rise is primarily due to strong world demand, not to supply restriction as was the case in OPEC I and II. They also do not appear to have added to inflation or inflationary expectations, and so have not required a policy response. Much discussion recently has focused on the US current account deficit as a source of risk to the world economy. It has been argued that the United States might encounter difficulty financing its deficit and that this would put downward pressure on the US dollar and upward pressure on world interest rates. In fact, the US current account deficit has been financed relatively easily, and the US dollar has risen over the past year. More importantly, long-term real interest rates around the world have stayed exceptionally low, which indicates a more-than-adequate supply of world savings, rather than a shortage. Although China has been cited as a third source of risk to the global expansion, it continues to power ahead, and the recent changes to its exchange rate regime, although small, will improve its prospects at the margin. The most reasonable assumption is that the current world expansion, which has been going for almost 3 1/2 years, will continue for a good while yet. Most private forecasts for global economic growth for the rest of this year and the next show above-average rates, although not as strong as in 2004. The second subject I would like to say a few words about is the interaction between developments in the housing market and household spending and saving. Recent evidence from several countries, including Australia, shows that during periods where house prices are rising rapidly, households tend to react to this by increasing their consumption expenditure faster than their income. They can do this by either reducing discretionary savings, or by borrowing against the equity in their house to finance non-housing expenditure, a process referred to as 'housing equity withdrawal'. This process occurred in Australia, particularly in 2002 and 2003. Over the past eighteen months, during which Australian house prices on average have not risen, this process seems to have stopped, and so consumption and borrowing have slowed noticeably. In the eighteen months to the December quarter of 2003, real retail trade rose by 10 per cent, whereas in the most recent eighteen months it has risen by 4 1/2 per cent. These developments have not been a concern to us because: * The pace of growth in domestic demand had been clearly unsustainable, averaging 6 per cent per annum in 2002 and 2003. This needed to be brought back to a more sustainable pace, and this necessarily involved some slowing in consumption. * Other parts of the economy are still showing good growth, particularly employment and investment. The external sector is also exerting an expansionary influence through higher demand for exports and higher export prices. * After periods of rapid borrowing and rising interest servicing costs, a period of consolidation is welcome. The corporate sector did this in the early 1990s and is now in excellent shape; the household sector will be in a better position in the long run if it also consolidates its balance sheet. Nevertheless, we are taking a great interest in the relationship between housing and household spending, as it has been and will probably continue to be an important influence on economic developments. One area where it has been influential has been in explaining the different economic performance of the different states. We have also recently undertaken a survey of a sample of households to study the extent to which they have engaged in mortgage equity withdrawal and to see how the funds were used. We will soon be reporting on the results of that survey. The third subject I would like to cover is inflation and inflation prospects. This is particularly important given that our monetary policy is based on inflation targeting. That is, we want to ensure that the rate of inflation averages somewhere between 2 and 3 per cent. We aim for this - not because inflation is all we care about - but because the maintenance of low inflation is a necessary condition for having a long economic expansion in output and employment. Over the past two years, inflation in Australia has been restrained by the appreciation of the Australian dollar which took place between mid 2001 and the beginning of 2004. However, there have been a number of influences which have pointed to a rise in inflation further ahead: * the fact that after a long expansion we were encountering some capacity constraints; * the rising prices of oil and some other important industrial inputs; and * the fact that the downward influence on prices from the exchange rate appreciation would eventually fade away. The likely extent of the upward pressure has been difficult to assess as the signals have varied quite a bit. When I was last before you in February, the signals were quite strong. We had received two quarters of large rises in producer prices at all stages of production and the increase in the CPI in the fourth quarter of 2004 had exceeded everyone's expectations. There was also some evidence that the slowdown in credit had run its course and was picking up again. Shortly after we met last time, the Bank raised the cash rate by 25 basis points. Since that time we have had more reassuring news on inflation. There is also some evidence that the monetary policy tightening itself may have had a quicker effect than normal. I do not want to make too much of this point, but the saturation coverage of the event in the print and electronic media must have had some dampening effect on expectations, as some surveys have suggested. It would not be surprising if the household sector had become more sensitive to news about interest rates, given the increased debt and debt-servicing loads that it is now carrying. To cut a long story short, the next set of producer and consumer price inflation data that we received was more reassuring. True, it was only one quarter's information and that was not enough to change our numerical forecast of inflation, but it did lead us to conclude in our that there was no longer an upward risk to our inflation forecast. The subsequent set of data confirmed a similar picture. With two quarterly sets of more reassuring price data now behind us, we were able in our recently released August to conclude that the CPI increase will peak at 3 per cent per annum in the second half of next year. As was widely noticed, we also refrained from making the point we have been making for the past year or so about it 'being unlikely that there would be no further rises in the course of the expansion'. That does not mean that further rises could not happen; it only means that in our present estimation there is no longer a more than 50 per cent possibility of it happening. This is a pretty comfortable position in which to be. We are not expecting to change monetary policy in the near term, and when we look further into the future we no longer see a clear probability of it moving in one direction rather than the other. Importantly, this is also the collective view of the market, as shown by the yield curve and by economists' forecasts. Of course, individuals do not all share this view, but on average that is the collective forecast. I do not intend to say any more about the economy or monetary policy at this stage, but, of course, am happy to answer any questions that you have on these subjects. I am also happy to answer any questions on the other important area of the Bank's responsibilities, namely financial system stability. Within that general area, the subject that has attracted the most recent attention has been the regulation of the retail payments system by the Bank's Payments System Board. I know that Committee members have met with the various industry participants, including members of the Bank's Payments Policy Department, to discuss the main issues, and, of course, I would be happy to address any questions members have on that subject.

r050928a_BOA

australia

macfarlane

I have given a number of speeches to the Economic Society over the years, and it is a pleasure to be doing so again tonight. The last time I gave the closing address to the Conference of Economists was in 1997 in Hobart. The subject I want to speak about tonight is one which has loomed particularly large in international macroeconomic discussion in the period since then. I refer to the subject of global imbalances in international payments. Most of the discussion, at least until quite recently, focused on the large US current account defi cit and questioned its sustainability and the risks it posed to the world economy. Tonight I would like to approach the subject of global payments imbalances from a broader perspective. In doing so, the focus of attention is shifted towards Asia, recognition is given to the weakness of Europe, and the United States is cast into an accommodating role, rather than an initiating one. When we look at the global economy over the past half dozen years, there are a number of developments that have been diffi cult to satisfactorily understand and explain. I suggest that the following fi ve developments are the central ones in need of an explanation. 1. Why did the US current account defi cit start to widen sharply after 1997, reach such a high percentage of GDP, and yet has been relatively easily fi nanced? 2. Why has Asia run such large current account surpluses and built up such a high level of international reserves? 3. Why did the world's central banks push short-term interest rates to their lowest level for a century, and why has this apparently easy monetary policy not led to an appreciable pick-up in infl ation? 4. Why have bond yields been so low, and why have they stayed low even when short-term interest rates have been raised? 5. Against this background of wide payments imbalances, why have the margins for risk in corporate and emerging market debt been so exceptionally low? A number of explanations have been put forward to account for each of these developments. The most common explanation has started with the widening US current account defi cit, and attributed it mainly to excessive spending and borrowing and insuffi cient saving by US households and the US Government. While this explanation is consistent with the widening US current account defi cit, it has a number of shortcomings because it is inconsistent with some other developments we observe in the global economy. For an explanation to have any plausibility, it must be consistent with all the fi ve simultaneous developments listed above. In my view, the most promising explanation at present is one which starts with the surplus countries and focuses on why national savings are so much higher than national investment in those countries. Although it is not, in itself, a complete explanation of everything that has happened, it is the most plausible in that it is consistent with all the fi ve developments listed above. The best starting point for any explanation is to recognise that there is a wide disparity between saving rates in different countries. Broadly speaking, Asian countries tend to have high saving rates, Anglo-Saxon ones low saving rates, and other countries somewhere in between (row 1 of Table 1). For balance of payments purposes, this would not matter if investment rates in each country matched the saving rate, but this is not the case (row 2 of Table 1). In countries with high saving rates, investment rates, while high, are not as high as the saving rate, and these countries run a current account surplus. The opposite applies in the low saving countries. To understand developments in current accounts, we have to understand developments in saving and investment ratios in different countries and regions. In short, Asian countries have more savings than they wish to invest in their own countries, and so they have to invest or lend abroad. This is the most basic of all balance of payments identities. Other countries that invest more than they save have to fi nance their investment by using the savings of foreigners. The actual channel can take many forms, but that is not crucial to the story. To complicate the story slightly, it is not only Asian countries that are running surpluses at the moment. As a result of the high oil price, the Middle East and Russia are also doing so, as anglosphere area east Asia are the Latin American countries for different reasons. While acknowledging these surpluses, I intend to leave them out of the rest of my account on the grounds that they are a good deal smaller than in Asia, and that, on past experience, they are likely to be temporary. For those who want to follow them up, I recommend a recent paper on our website. Returning to Asia, we can ask why these countries do not invest more in themselves, and can fi nd several explanations which I will outline later. Whatever the explanation, we should probably accept that in the medium term, a surplus of Asian saving over Asian domestic investment will be a fact of life; hence, Asia will run large current account surpluses and therefore will have an excess supply of savings to be invested abroad. Given that this is going to happen, some other countries must run defi cits - this is another important balance of payments identity which must hold. If no other country was prepared to run a defi cit, then the world economy would enter a downward spiral with ex ante saving greater than ex ante investment. Clearly, the countries that will run the defi cits will be those where consumers, businesses and governments are most willing to spend and whose fi nancial systems are most effi cient at intermediating the fl ow of world savings. For ease of exposition, we can focus on three main regions of the world - Asia, the euro area and the anglosphere (mainly the United States, but also the United Kingdom, Canada, Australia and New Zealand). Asia runs a large current account surplus, and we might expect it to be balanced by defi cits in the other two regions. In fact, the entire defi cit shows up in the anglosphere, with the euro area in approximate balance (Table 2). While balance sounds like a good thing, the euro area has achieved this largely because of weak domestic demand and high unemployment over recent years. So what appears to be a balance in European payments, is in fact an important imbalance in the global economy. As explained before, the Asian surplus has to be invested in the rest of the world, and it will tend to fl ow to those regions which offer the highest return on capital. While foreign investment fl ows both ways, in net terms it has fl owed from Asia mainly to the United States and has underpinned the level of the US dollar, despite the US current account defi cit, and provided easy access to fi nance for US borrowers in the business, household and government sectors. area east Asia Per cent of GDP There have been widespread fears expressed over the past half dozen years that the United States would have diffi culty fi nancing its defi cit, that the US dollar would fall sharply, and that real interest rates in the United States would rise as borrowers competed for funds. In fact, the US current account defi cit has been relatively easily fi nanced despite it continuing for 15 years and reaching 6 per cent of GDP. The US dollar in real effective terms today is at or slightly above its level of 15 years ago when the recent run of defi cits fallen in net terms since its early 2002 peak, this has only unwound its rise since the mid 1990s. This is not what one would expect for a country having diffi culty attracting the funds to fi nance its defi cit. Similarly, the real interest rate at which borrowing has occurred is a lot lower than a decade ago, a subject I will address later. Overall, the US experience is consistent with a plentiful supply of internationally-mobile savings rather than one where it has had to struggle to fi nd the funds to fi nance its spending. This is the starting point of my explanation, not something that has to be explained by the other developments. Even so, it is of some interest to know why Asian countries seem content with the situation. Although there are some common factors among these countries, there are also some interesting differences. with as it has had a large surplus for a long time, as you would expect from a high-income country with a rapidly-ageing population. But the situations of China and other east Asia are more interesting as they have only moved into signifi cant surplus over the past half dozen years. In the case of other east Asia, I think it is very clear that this occurred as a reaction to the pain they suffered during the Asian crisis and government sectors cut back sharply and this shows up as a fall in the investment ratio of about 7 or 8 per cent of GDP to a lower level, at governments of the region reached the conclusion that they 'had to make their economies more resilient to international capital fl ows. The simplest way of doing this was to cut expenditure (particularly investment expenditure), keep savings high, run current account surpluses and build up international reserves'. In China's case, the story is more complicated. It did not suffer in the Asian crisis, but it still absorbed the same lesson as the countries that did. That is one of the reasons that China has chosen to run current account surpluses and build international reserves (Graph 4). But a more over-riding reason is the awareness by its government that, as a result of its economic liberalisation, it has to create about 20 million jobs per year just to absorb the exodus of workers from the countryside. In other words, it has to run its economy at an exceptionally fast pace, and is reluctant to adopt policies which might run counter to this aim in the short run, even if they would contribute to maintaining longer-run sustainability. I think historians will regard the economic liberalisation of China as the major economic event of the past 30 years, with its effects showing up in countries and economic variables that at fi rst sight seem remote from it. To date, the size of the Chinese surpluses have been smaller than for Japan and other east Asia, but China's infl uence in other ways has been greater. All Asian countries are acutely aware of their level of competitiveness vis-a-vis China, both in international trade and investment, and this is an additional reason why they have resisted appreciations of their own currencies. The rapid increase in Chinese manufactured output and exports, based on its exceptionally low labour costs, has affected its competitors in Asia as much as its customers such as the United States. The high supply of Asian savings is not the explanation for the sharp fall in central-bankdetermined interest rates in 2001 and 2002. That fall was a response by central banks in the developed countries to the collapse of the global equity market boom and associated recession that occurred in most of their countries. But the interesting question is why did those interest rates go so low; for the United States, Japan and the euro area they fell below their 1930s levels. And why have they stayed so low, even accepting that the United States has gone some way to restoring them to a more neutral level? The answer has to be that infl ation has remained so low. If infl ation had picked up in the way that it did in earlier cyclical recoveries, central-bankdetermined interest rates would have risen more by now. So the real issue is why have infl ationary pressures stayed so low? An ex ante excess supply of world saving means that it would be unlikely for a situation of generalised excess demand in the world's goods markets to occur, and hence for infl ationary pressures to emerge. Another way of thinking about this is to remember that a surplus of savings in a given country means that the country is producing more goods and services than it absorbs in domestic spending. In China's case, there has been a massive increase in its capacity to produce manufactured goods, and its domestic spending has not kept pace with the expansion in supply. The result has been a rapidly growing supply of low-cost manufactured goods supplied by China to the rest of the world. The same has been true on a smaller scale for other Asian countries running surpluses. The increased productive capacity in China and other parts of Asia can be seen as part of the mechanism by which their trade and current account surpluses have been exerting downward pressure on global infl ation. The fact that bond yields have remained low despite rising oil prices and the Fed raising shortterm interest rates is really the nub of the issue. If excessive US spending and inadequate saving were the main story affecting the world economy, bond rates would be rising not falling. Clearly, developments in the bond market are far more consistent with a world of plentiful saving than one of excessive spending and borrowing. The low level of nominal interest rates may be partly explained by the forces already cited which have held down infl ation. But real interest rates have also fallen to extremely low levels and infl ationary expectations that are at work - the real demand and supply for borrowed funds must have changed. In economic terms, a fall in price suggests that the supply curve of saving has moved outwards relative to the demand curve. Again, this is entirely consistent with a world of excess supply of funds looking for attractive yields. With yields on high-quality government paper having been driven down to low levels, investors have been attracted to other securities that can offer something higher. Thus, margins on all grades of corporate debt and emerging market debt have been driven down. This has occurred despite the recent history of US corporate scandals and the default by Argentina, which would normally have heightened perceptions of risk in these securities. Of course, this search for yield has not just affected debt; it also explains rising prices on assets of all types from houses to equities as investors take advantage of low borrowing costs and seek alternative investments. Some observers may think that in my explanation of global developments, US profl igacy and excessive reliance on debt have been let off too lightly. What, they may ask, would have happened if increased US spending and reduced savings had not been accommodated by Asian saving and lending? The answer is that the increased US spending and lower US saving would not have occurred, or would only have occurred on a greatly reduced scale. If the excess world saving had not been available, the global economy would have been in the opposite position, namely excess demand in goods and capital markets. US demand for funds would have pushed up bond rates, infl ationary pressures would mean US monetary policy would be tighter, and the US Government would have diffi culty funding its budget defi cit. Businesses and households in the United States would face tougher monetary and fi scal policies and spending would be more restrained. Despite higher US interest rates, the US dollar would probably be weaker because foreign demand for US assets would be lower. The US current account defi cit would be smaller due to the weaker domestic demand and lower US dollar. It is not clear whether the world economy would be weaker or stronger. On the one hand, the extra Asian spending would have pushed up world demand. On the other hand, higher infl ation, higher world interest rates and reduced US spending would have held it down. But the imbalances in international payments would have been smaller. I do not want to give the impression that the large US current account defi cit is not an imbalance, or that it can go on rising forever. Clearly, that is not the case. My view is only that we should not start our analysis with the US current account, or look to its remediation as the key to unwinding the imbalances. For example, the most commonly heard prescription is for the United States to reduce its call on world savings by reducing its fi scal defi cit. However, if my analysis is correct, a reduction in the US fi scal defi cit by itself would be unlikely to have a major impact on international imbalances. In the absence of policy changes in Asia, the Asian countries would be likely to continue running surpluses, and so a fi scal contraction in the United States would only add a contractionary infl uence to a global economy already characterised by surplus saving and unusually low interest rates. Another view that has recently been put is that it was excessively loose monetary policy rather than saving/investment imbalances that was at the heart of the problem. This view is generally bolstered by some reference to excessive liquidity, although the concept is left undefi ned. I do not fi nd this argument at all convincing. There is no doubt that world interest rates have been exceptionally low, but does that of itself mean that monetary policy has been exceptionally loose? To maintain this view, you would have to believe, for example, that monetary policy in Japan and Europe, where there has been weak demand growth and negligible infl ation for a number of years, should have been tightened, i.e. European and Japanese interest rates should have been raised. This would make no sense. The low level of interest rates in most developed countries is not the fi rst cause of the global imbalances, it is the result of them. In making Asia the focus of my account, I hope I did not give the impression that I am blaming Asia for the imbalances. This is not the case, partly because I have never been a pessimist about the sustainability of the imbalances, and partly because I can sympathise with much of the recent Asian experience, particularly during the Asian crisis. My account takes its form purely from the fact that it is the only one that seems to me to be consistent with the fi ve questions I posed at the beginning. It is the only one that explains why there is downward pressure on CPI infl ation and interest rates, and in consequence upward pressure on asset prices. As a central banker, I cannot complain about these events because they have made my central task of maintaining low infl ation easier. Similarly, as an Australian, I can see that the impressive economic development of Asia has benefi ted our complementary economy in many ways. I have not provided any assessment of the risks involved in the current situation because that would involve another talk at least as long as tonight's. But, if it is any reassurance, I think we are seeing some early signs of a return to normality, even if they are small and the process likely to be a long one. The Fed's policy of gradually moving up US interest rates towards neutrality is the most obvious sign. The other one is China's abandonment of its fi xed parity to the US dollar. Although its upward movement so far is extremely modest, they have clearly set the direction for the future. To me, it is an extremely signifi cant move and suggests that they will countenance policy changes which in the short run might slightly restrain demand, but in the long run increase the chances of sustainable growth.