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r051213a_BOA

australia

macfarlane

I see from my records that this is the sixth time that I have addressed the Australian Business Economists, but the last time was four years ago. At that time most of the G7 countries were in recession and interest rates were still heading down. The world looks a lot better now as it adjusts to stronger growth and a new set of challenges. I confess that I had diffi culty in deciding on a topic for tonight's talk. There were, in my view, no burning issues that I wanted to address, or messages that I wanted to leave my listeners with. In the event, I have decided to talk about three topics: how the world has coped with a tripling of oil prices, how the world is emerging from a period of exceptionally low interest rates, and, quite separately, is there an Australian model of macroeconomic policy? I will start with oil prices. At the beginning of 2002, when oil prices averaged about $US20 per barrel, most observers would have been very apprehensive if they had known that over the following three years prices would more than treble to a recent peak of $US70 per barrel. I think it would have been assumed that this event would lead to a signifi cant rise in infl ation and a major slowing, if not contraction, in the world economy. Memories of OPEC I in 1973 and OPEC II in 1979 when oil prices rose by a factor of three or four were still being seen as a guide to possible outcomes. Certainly, over the past couple of years, the media has been full of stories about rises in oil prices and the dislocations and hardships they have caused. But looking back from our current vantage point, the thing that stands out is how comfortably the world economy has handled developments. Virtually all of the rise in oil prices has by now been refl ected in statistics on infl ation and GDP growth, and the results have been surprisingly small. Global GDP growth was 4 per cent per annum or higher in 2003 and 2004 and is expected to remain so in 2005 and 2006. Of course, a lot of this growth has come from outside the OECD area, with the fi gures for OECD area growth being more than 1 per cent lower than for global growth. On infl ation, the pick-up has been quite modest, with most OECD countries still recording headline infl ation below 3 per cent per annum in the 12 months to September 2005. Interestingly, the United States where headline infl ation was 4.7 per cent, stands out on the upside and lifts the OECD average infl ation rate to 3.3 per cent. In Australia, as you are aware, headline CPI rose by 3.0 per cent in the year to the September quarter, up from a recent low point of 2.0 per cent eighteen months earlier. There have been a number of reasons for these favourable outcomes around the world, including the developed world's lower oil dependency compared with earlier years, but I will concentrate on a few that I think are important. The main reason that economic growth was so little affected was that the rise in oil prices was caused by strong world growth, particularly from developing countries such as China and India. For the world as a whole, the rise in oil prices was not a negative supply shock, as it was in the seventies, but was the result of a positive demand shock. Of course, global growth could well have been stronger in the absence of the oil price rise, but even with its constraining effect, there was still plenty of growth to go around and current forecasts are still looking good. On why the rise in infl ation was so modest, the story is very interesting. We should start by reviewing a bit of history; this shows that even before OPEC I and II came along, OECD area infl ation was rising year by year. Immediately before OPEC I, it had already risen to nearly 9 per cent, with Australia being one of the highest at 10.1 per cent. Infl ationary expectations were also on the rise. In the business community the assumption was that any increase in costs could be easily passed on into prices, and the unions assumed that all wages would be indexed to rising infl ation. The situation is very different now. After more than a decade of low and stable infl ation, infl ationary expectations are better anchored. Discipline in goods markets from domestic and foreign competitors means the old 'cost plus' mentality no longer prevails. While pass-through at the fi rst round still occurs, as the rise in retail petrol prices demonstrates, subsequent price pressures are often absorbed. With only limited and manageable increases in overall infl ation throughout the world, monetary tightenings specifi cally directed at oil-price-instigated infl ation have not been needed. That is all I wish to say about oil prices, other than to add the caveat that I am only talking about the increases to date. Obviously, if we enter a new round of similar increases, the situation would have to be reassessed. It is well known that the world has recently gone through a phase of exceptionally low interest rates, but I am not sure that people appreciate how low they were by historical standards. In fact it is not much of an exaggeration to say that interest rates in mid 2003 were at their lowest level for a century. This was the time when offi cial overnight rates - the ones set by central banks - were 1 per cent in the United States, 2 per cent in the euro area, and zero in Japan. The only qualifi cations I have to make to my earlier generalisation is to concede that rates may have been slightly lower during the second world war in some countries such as the United States and United Kingdom when quantity rationing was the norm, but they have not been lower in peace time. We can construct an indicator of world interest rates for a century or more using a weighted average of the rates for the United States, United Kingdom, Germany and Japan. Graph 1 shows the results for offi cial overnight interest rates or their nearest equivalent since 1860. Although the graph is dominated by the high interest rates during the great infl ation of the 1970s, the readings for 2002 and 2003 are lower than any other time in this long span of years. Part of the explanation is that infl ation was low, but it was only low compared with the post-war standard - it was not low compared with most of the period covered by the graph. In fact if we construct simple measures of real interest rates (based on realised infl ation rates), they were also low by the standards of earlier low infl ation periods. Table 1, real interest rates in the fi rst fi ve years of this decade are lower than in any previous decade apart from those containing the two world wars and the 1970s. We could ask the question of why such low interest rates were put in place in this decade when it had not been seen to be necessary to do so on earlier occasions. This is a very big question and I do not propose to answer it tonight. Nor do I wish to maintain that a different global monetary policy should have been put in place. Defenders of the monetary policy that was pursued would argue that it resulted in continuing low infl ation and reasonable economic growth for the world economy, apart from the mildest post-war recession in 2001. They would say that in light of this outcome, it would be hard to argue for a higher level of interest rates during the period. Decade beginning Real overnight interest rates Usually when interest rates are kept very low for an extended period the main risk is that there will be a pronounced pick-up in infl ation. As we know, there has been little of that on a global scale, or indeed in individual countries, even though commodity prices have risen sharply. Where the risks have mainly arisen has been in the fi nancial sphere, where there has been a 'search for yield' and a driving-up of many asset prices. So far this decade, the most obvious sign of the latter phenomenon has been the surge in house prices, particularly in those anglo countries with very competitive fi nancial sectors such as the United States, United Kingdom and Australia. What I have been describing so far is a global development, and although we in Australia have shared it in some aspects, in others we have differed. The main aspect in which we differed was that we did not reduce interest rates to anywhere near the extent they were reduced in the three biggest monetary areas - the United States, Japan and the euro area. The low point in our short-term interest rates of 4 1/4 per cent this decade was not very different to the low point in the 1990s of 4 3/4 per cent. We were also the only country of any signifi cance to resist the general trend to lower interest rates during 2003. Nevertheless, we still have shown many of the same symptoms in our asset markets that others have shown. What we are seeing now around the world is a gradual return to normality in interest rates. We in Australia can make some claim to being the fi rst in this process because we began in mid 2002. Over the past two years the predominant tendency among countries has been to raise interest rates. Virtually every developed country except Japan has now participated, with the move by the ECB earlier this month being an important step. The point I want to make that links the fi rst two parts of this talk together is that the major reason for the rises in interest rates is, I think, the need for a return to normality, not a specifi c fear about oil prices. Of course the two are related in that the low level of interest rates has accommodated the growth in demand that lay behind the rise in oil prices. But the most important factor behind the recent moves is the realisation that the world could not have safely continued with the sort of interest rates that prevailed in 2002 and 2003. I was recently visited by the Chilean Minister of Finance who, like many in the same position in Latin America, is a very good professional economist. Our discussions were very interesting, and at one stage he answered one of my questions by saying that Chile 'was following the Australian model'. He meant this in a very specifi c way, and it is worth examining exactly what he meant by the term. First, he was talking about a macroeconomic policy model that had the following structural * a fl oating exchange rate with a currency viewed as a commodity currency; * a monetary policy regime based on central bank independence and an infl ation target; and * a disciplined fi scal policy which aims at balance or surplus in the medium term. These were important, but the most important characteristic he wished to focus on was the internationalisation of the currency, i.e. the ability for Australian entities to borrow abroad in Australian dollars, or to borrow abroad in foreign currency and hedge back into Australian dollars. This allows Australian corporations and banks to participate fully in international fi nancial markets without incurring foreign currency risk (or to only incur it where they have a 'natural hedge' such as foreign currency export earnings or to fi nance a foreign acquisition). We, of course, have been very aware of the importance of this characteristic and regard it as a virtual necessity if a country is to be able to run a fl oating exchange rate regime successfully. But many, if not most, countries do not reach this stage. It was foreign currency exposure which led to the collapse of many Asian banks and corporations when their currencies fell during the Asian crisis. In Latin America, traditionally all foreign borrowing was in US dollars, which made their countries extremely vulnerable to falls in their exchange rates. It also gave rise to what is known as 'fear of fl oating' which means the tendency for their central banks to quickly resort to raising interest rates whenever the exchange rate is in danger of falling. What the Chilean Finance Minister called the Australian model, of course, is not unique to Australia, but it is associated with Australia in Latin American and Asian economic circles because of Australia's success in withstanding the Asian crisis. While some countries such as Chile see it as a sort of role model, many Asian countries have chosen a different path by running current account surpluses, building up large holdings of international reserves and resisting changes in their exchange rates. As you know, we think this is a major reason for the growing global payments imbalances, and would be happier if they followed a model closer to our own. But that is another story. The interesting issue for other economies, particularly emerging-market economies, is how do you reach the situation where you can borrow abroad in your own currency, or, to put it differently, where investors in other countries will willingly hold assets denominated in your own currency. When we look back and see how Australia reached this position, it is a very interesting (and reasonably recent) story. The major step occurred when the Government decided that it would borrow honestly from its own citizens. That is, it would stop using captive arrangements that force fi nancial institutions to take government paper, and stop setting the interest rate on its own paper. In our case this occurred when we introduced the tender system for selling Treasury notes in 1979 and bonds in 1982, and soon after made clear that the Government would no longer borrow from the Reserve Bank, but instead borrow from the public to fi nance the budget defi cit dollar for dollar. At fi rst we had to accept very high interest rates, but in time demand for government paper expanded, and most importantly overseas investors began to fi nd Australian government bonds denominated in Australian dollars an attractive investment. It was not necessary to ask them to invest, nor to do 'road shows' on Wall Street to entice them. At the same time, old habits died hard so that as recently as March 1987 the Australian Government made its last overseas borrowing in the US market in US dollars. In time, overseas investors became comfortable with holding Australian government paper, semi and local paper, and eventually corporate bonds and asset-backed securities. Turnover in the Australian dollar is sixth amongst the world currencies and there is ample liquidity in both currency and asset markets. The relevant derivative contracts have grown, and so provided hedging opportunities. As we point out in a forthcoming article, Australia as a whole has for some time had a long foreign-currency position. That is, we have more foreign-currencydenominated assets than foreign-currency-denominated liabilities, a far cry from our position in the early post-fl oat period. I want to conclude now by briefl y revisiting the subject of why economies, including our own, have exhibited more stability than in earlier periods. Is it because policy-makers have become better forecasters and more adept at timely adjustment to the levers of economic policy? It would be tempting to answer yes to this, but I suspect it is only a small part of the answer. A more plausible explanation is that our economy has become more resilient. That is, we have systematically modifi ed our institutional framework so that it is more fl exible and more able to adjust to economic shocks than formerly. What I have described above is a good example of this process at work.

r060217a_BOA

australia

macfarlane

It is a pleasure to be back here again in front of the Committee, and to be having this hearing in Canberra for the fi rst time in a number of years. I note that the membership of the Committee has changed again, particularly on the Government side. That is something that has happened pretty well continuously in the nearly ten years I have been reporting to it under the current arrangements, but it has not interfered with the Committee's effectiveness. As you know, we had our February Board Meeting last week and we issued our quarterly earlier this week. This document spelled out in detail how we see the current situation in the economy, and why the stance of monetary policy is where it is. This morning I would like to take the opportunity of looking at the broader trends in Australia's economic situation and examining the implications they have for the stance of monetary policy going forward. I will take as a starting point Australia's current economic expansion. For years I have made the point that progress in winding back economic slack is made not by high growth in any individual year, but by maintaining an expansion over a sustained period. Australia's current expansion began in late 1991 and is now in its fi fteenth year. This means that it is already signifi cantly longer than its predecessors in the 1960s, 1970s and 1980s. The expansion has been marked by good growth in GDP, which has averaged 3 3/4 per cent per annum over this period, one of the best performances in the developed world. A consequence of the sustained expansion is that the economic slack generated in the last recession has been gradually used up. One indicator of this is the unemployment rate, which has trended down from a peak of 11 per cent in 1993 to be currently just over 5 per cent. Other indicators of the economy's capacity utilisation are also at cyclically high levels. Business surveys report that businesses are operating at close to their highest levels of capacity utilisation since the late 1980s. The surveys have also been reporting high levels of labour scarcity. For the past year or so, many businesses have been in the unusual position of reporting that scarcity of suitable labour was a bigger constraint on their activities than their traditional concerns about the adequacy of demand or sales. Given the maturity of the expansion it should not be surprising if the average growth of the economy is now less than it was in the earlier stages. As a general principle, it is easier for an economy to grow quickly when there is a large pool of unused resources to be re-employed, and in Australia's current position in the cycle, that source of growth is now much more limited. So, in the absence of a signifi cant lift in trend productivity growth, we should expect to see annual GDP growth rates mainly in the 2s and 3s, rather than in the 3s and 4s as was typical for most of the expansion. It is not surprising therefore that growth of the economy over the latest year for which data are available was 2.6 per cent, or an annualised rate of 3 per cent for the latest half-year. Business investment has been a major driver of growth in recent years, expanding by 18 per cent over the past year, and at an average annual rate of 14 per cent over the past three years. The upswing in business investment is being stimulated by high commodity prices and favourable fi nancial conditions. With strong investment growth and an expected improvement in exports, our forecast for the economy overall is that annual GDP growth will pick up modestly during 2006 to about 3 1/4 per cent. While strong business investment obviously contributes to capacity expansion, the sorts of outcomes envisaged for GDP growth would imply that the economy will continue to operate close to full capacity. While the overall growth of the economy during the current expansion has been good, there has been concern expressed about its composition. In particular, the growth of the economy over the past few years has been more than fully accounted for by growth in domestic spending, while Australia's export performance has been disappointing. In consequence, Australia's current account defi cit has remained high at around 6 per cent of GDP recently, despite a strong international environment and rising commodity prices. Notwithstanding these concerns, it needs to be emphasised that monetary policy cannot be expected to target a particular composition of growth or current account defi cit. Any attempt to do so (for example, by running a much tighter policy in order to constrain domestic demand) would be counterproductive and would detract from the Bank's broader macroeconomic goals. Australia's economic situation should also be viewed against the backdrop of the global business cycle. In broad terms, business cycles across various countries have tended to move together, at least among countries in the developed world. That is, there has been a reasonably high correlation in the timing of recessions and expansions among developed countries over the past few decades. Most of the advanced countries experienced recessions in the mid 1970s, the early 1980s and the early 1990s, and many did so in 2001. It is relatively unusual for countries in this group to experience what might be termed a 'home-grown' recession, that is, a recession not shared by the major industrial countries. Similarly, it is fairly unusual for countries to skip an international recession, though Australia and some other countries have recently done so, as did Japan in the early 1980s. This is not to say that domestic conditions and policies are unimportant. Nevertheless, as a general rule, when the world economy as a whole is in a sustained expansion, there is a good chance that an expansion will also be continuing in an economy such as Australia. Currently the world economy is expanding strongly. The recovery from the global downturn in 2001 is now well established and, on past experience, the expansion should still have some way to run. While growth to date has been led mainly by the United States and China, there have been encouraging signs over the past year that growth is becoming very broadly based, with conditions improving in Japan as well as in a number of other economies. Assessments of the risks to the global growth outlook have focused mainly on the effects of higher oil prices and on the possibility that the US current account imbalance will have a disruptive effect on the world economy. However, there is little sign that these forces are restricting growth at present. World GDP growth in 2005 is estimated to have been above average, and most observers expect this to continue in 2006. This growth performance has been accompanied by generally subdued infl ation outcomes. One factor behind this was the increased focus on infl ation control by central banks around the world, after the high infl ation of the 1970s and 1980s. Many central banks have now adopted numerical infl ation targets and others have clearly become more focused on infl ation control even without adopting explicit targets. At the same time, the importance of structural factors, and particularly the industrialisation of China, should be recognised. The huge pool of low-cost labour that this has brought into play has put sustained downward pressure on a wide range of prices of internationally traded goods. One consequence of these developments has been a marked upswing in Australia's terms of trade, defi ned as the ratio of our export to import prices. Currently Australia is benefi ting from the largest cumulative increase in our terms of trade since the early 1970s. The main factor driving this has been the rapid growth in global demand for resources, with China in particular contributing strongly. As a result, world prices for a wide range of resource commodities have been increasing sharply. Over the past three years Australia's terms of trade have increased by around 30 per cent. This is estimated to have added 1 1/2 -2 percentage points per annum to the growth in national income over this period, a signifi cant expansionary force for the economy as a whole. The economic effects can be seen in a number of areas including strong growth in business investment, company profi ts, share prices and imports. Increased export prices also tend to boost government revenues through company taxes and a range of federal and state royalties. Although Australia avoided the recession that engulfed many developed countries at the start of this decade, it was not totally unaffected by world events, and the Bank found it necessary in 2001 to cut the cash rate to 4.25 per cent in a series of steps. While that was a new low for Australian offi cial interest rates - the previous low had been 4.75 per cent in the late 1990s - it was a relatively muted response compared with the very large cuts in interest rates that occurred elsewhere in the world. In mid 2002, with both domestic and global economic conditions improving, the Bank began the process of restoring offi cial interest rates to more normal levels. It did this in fi ve steps over three years - two in mid 2002, two in late 2003 and one in early 2005 - a more gradual tightening cycle than normal. At the current level of 5.5 per cent, the cash rate is in line with its average over the low infl ation period since 1993. There is therefore a sense that the current level is relatively neutral in terms of its impact on economic activity and infl ation. One complication in assessing the level of interest rates, however, is that competition in the fi nancial sector has seen margins between the cash rate and institutions' lending rates narrow over recent years, so the interest rates faced by borrowers are still a little below average. Australia moved to restore normal interest rates well ahead of other developed economies. All the major countries had reduced interest rates to unprecedented levels in the early part of this decade - 0 per cent in Japan, 1 per cent in the United States and 2 per cent in the euro area - and they maintained this position for a prolonged period. Of the major countries, the United States was the fi rst to raise rates, with the Fed beginning to tighten in mid 2004. The European Central Bank has only just started the process in recent months and the Bank of Japan is not expected to start lifting rates for some time yet. Thus, even though the Fed has now restored the funds rate to a relatively normal level of 4.5 per cent, world policy interest rates on average remain well below normal. Another unusual aspect of current global interest rates is that long-term rates, which are set by the demand for and supply of funds in capital markets, have remained quite low in the face of rising offi cial interest rates. Although various explanations have been put forward for this unusual behaviour, the most likely cause is an ex ante excess supply of savings relative to investment around the world, with Asia accounting for a large part of the excess global savings. For equity markets, the combination of low interest rates, strong economic growth and low infl ation has proved very benefi cial, with global share markets rising solidly in each of the past three years. This has been underpinned by strong growth in profi ts so that, notwithstanding the rise in share prices, P/E ratios have been declining on average. It is worth noting that the Australian share market has behaved quite differently from the global market over the past decade. It was affected much less than most markets by the tech bubble and the subsequent collapse, and in recent years has been rising faster than average. Along with the Canadian share market, it is the only major market that is currently above earlier peak levels, whereas in Europe and the United States share markets are still about 20 per cent below their early 2000 peaks. The Australian dollar has remained in a relatively steady range over the past couple of years, at levels that are a little above average against the US dollar and about 10 per cent above average in trade-weighted terms. Some people have found this steadiness puzzling against the background of very strong rises in commodity prices and the terms of trade, as such episodes in the past have been associated with strong rises in the currency. A key to understanding the different behaviour on this occasion is the change in the interest differential with the United States. This has narrowed appreciably over the past 18 months because the Fed has tightened much more than we have. In recent years we have given a lot of attention to the growth of household debt and its possible effects on the macro economy. I would like to say a little more about it today and will divide the subject into two aspects: the shorter-term cyclical fl uctuations in household credit growth, and the fact that various debt ratios have trended upwards over time. Regarding the fi rst of these issues, the most recent cyclical peak in household credit growth occurred around the end of 2003, when it reached an annual rate of over 20 per cent. Since the bulk of household borrowing is housing-related, it is not surprising that this phenomenon was closely associated with a sharp run-up in house prices. Nationwide house prices increased strongly for several years up to late 2003, reaching a peak growth rate of around 20 per cent in that year. The increases in credit and house prices were inter-related, with credit availability fuelling the price rises, while rising house prices meant people had to borrow larger amounts to achieve home ownership. Much of this behaviour was driven by expectations, particularly in the investor market, of future price gains - the classic defi nition of bubble-like behaviour. In the period since late 2003, both the housing market and the demand for credit have cooled. Nationwide house prices have been broadly fl at over the past two years and prices have fallen in Sydney. Household credit growth has eased back to an annual rate of around 12 per cent. Although this might still be regarded as quite high in absolute terms, it is towards the lower end of the range in which it has fl uctuated in the past two decades. While there are some tentative signs that credit and housing market conditions have fi rmed a little in recent months, the risks to the economy posed by the over-heating in housing and credit markets in the period up to late 2003 have eased. Households now seem to have entered a period of greater fi nancial caution, and this may act as a restraining infl uence on the growth of household spending for a while to come. The second issue is the high average growth rate of household credit over an extended period. This is a longer-run issue and one on which it is more diffi cult to make fi rm judgments. For more than a decade, household indebtedness has grown at a rate well in excess of the growth in household incomes. This has meant that the aggregate ratio of household debt to household income has trended upwards, as has the proportion of household income required to service the debt, and the gearing ratio (debt to value of household assets). Simple rules of thumb would suggest that this cannot be sustained indefi nitely. Yet there are a number of reasons why these ratios may rise further. In a low-infl ation environment, nominal interest rates are also low, and households are able to service much higher levels of debt than they could in the past. A signifi cant proportion of households still carry little or no debt, and in the years ahead might choose to borrow more. Attitudes towards borrowing appear to be changing, with people becoming more willing to borrow against assets later in life. For these and other reasons, it is quite possible that the rise in household debt ratios could go a good distance further. The risk, of course, is that the process goes too far and that a painful correction ensues. There has been much debate around the world about the role of monetary policy in these circumstances, with the consensus being that the best it can do is to continue to pursue the general objectives of macroeconomic stability and low infl ation. We should also not forget infl uences on the supply side. Banks and other providers of credit to households have been competing vigorously to expand or protect their market share. In the process, lending standards have been progressively eroded so that lenders are now engaging in practices that would have been regarded as out of the question fi ve or ten years ago. These are matters in which prudential regulators are taking a strong interest. While the growth of household borrowing has been relatively high throughout the current expansion, business borrowing on average has been more restrained. This is the reverse of the pattern that was observed in the 1980s and, as a result, the business sector generally is in good fi nancial shape with low levels of debt. In the past two or three years businesses have begun to take advantage of that position by again expanding their borrowing and lifting the rate of growth in their investment spending. Business credit has thus strengthened quite markedly, so that it is now growing at a rate of 16 per cent, well above that for the household sector. Australia's infl ation performance over the past decade or so has been consistent with the Bank's medium-term target. Since 1993, when the 2-3 per cent objective was fi rst articulated, average CPI infl ation (excluding the one-off GST effect) has been 2.5 per cent. Of course, the infl ation rate has inevitably fl uctuated quite a bit from year to year, including periods where it has been above 3 and below 2. But it should be remembered that the Bank's objective is expressed in terms of average outcomes, and should not be thought of as a rigid commitment to eliminate short-term fl uctuations in infl ation. In the latest year, infl ation in underlying terms has been close to 2 1/2 per cent, though the headline CPI fi gure is higher, principally refl ecting the effect of rising fuel prices. While infl ation has remained contained over the past decade it is important, as always, to consider how infl ationary pressures might evolve from here. At the current stage of the expansion there are a number of factors that might be expected to put upward pressure on infl ation. The economy is operating at a high level of capacity utilisation, the labour market is relatively tight, and there have been some large increases in raw materials costs. Aggregate wages growth has picked up over the past year, and businesses generally are reporting diffi culty in attracting labour. These conditions underpin the current forecast of a modest rise in underlying infl ation over the year ahead. Based on the current level of oil prices, this forecast implies that headline CPI infl ation would remain close to 3 per cent in the short term. This outlook is, as usual, subject to signifi cant uncertainty. One area of uncertainty relates to wages growth, where there is a risk that current labour market tightness will result in higherthan-expected wage increases. This will be an important area to watch in the months ahead. On the other hand, the latest CPI fi gure was a little below expectations, and may indicate that global disinfl ationary forces are stronger than had been expected. There are also some tentative signs that conditions in the labour market are easing. The issue over the period ahead will be whether these latter forces prove suffi cient to contain infl ation in an economy operating with little spare capacity. In these circumstances, the Board at its recent meeting judged the current policy setting to be broadly consistent with the economy's requirements for the time being. Looking ahead, however, it felt that on balance, based on the considerations I have outlined here today, it is more likely that the next move in interest rates would be up rather than down.

r060428a_BOA

australia

macfarlane

Some of you might be asking what am I doing here four days before a Board Meeting talking at an luncheon. That is a good question. It started about two months ago when Joe Hockey, who was talking to me about a different subject, asked whether I would be prepared to speak to the Humpty Dumpty Foundation. I said that I would. The Humpty Dumpty Foundation is a really good charity raising money for children at the Royal North Shore Hospital. I went to a dinner they had several years ago and it was great fun. Caroline O'Connor sang, Ray Martin was the MC, Phil Kearns spoke and I handed out the prizes. That was the sort of thing I was expecting when I said yes to Joe Hockey. So, back to my original acceptance. The next thing I know is there are advertisements appearing in the saying that I am going to talk about leadership or something like that. That was a surprise to me. The sponsorship by the is due to the entrepreneurial efforts of Paul Francis, who is the main driving force behind the Humpty Dumpty Foundation. Well done, Paul. Anyhow, I am very happy to be here today talking to such a distinguished gathering of people whose attendance is furthering the work of the Humpty Dumpty Foundation. But I hope you do not think you are going to get a dissertation on the state of the economy or the priorities for monetary policy because, if you do, you will be very disappointed. Instead, I thought I would talk about a different subject in a more light-hearted manner and so my talk today could be titled I hope this does not sound like a roast for the and its editor, Michael Gill. It is not meant to be. In any case, Michael is a good sport and he said he was happy for me to talk on this subject. Many people, including me, have remarked on how much economic coverage there is in Australian papers - not just on the business pages, but on the front page and the editorial pages. Not only are the newspapers and magazines full of economic news, television news is saturated with it, there are special television programs devoted to it and radio programs as well. Partly it is a worldwide phenomenon and you can turn on a television set in the morning in a hotel in Europe or North America and be surprised to hear someone holding forth on the latest movement in exchange rates or bond yields in much the same way as you can here. Not just CNN and CNBC. While it is a worldwide phenomenon, it is more pronounced in Australia than elsewhere. I have often heard foreign visitors express surprise at how much coverage economic news gets in Australian newspapers, especially on the front page, compared with other countries. It is helped in Australia by the frequency of doorstop interviews that Treasurers, Ministers for Employment, Ministers for Trade and so on seem to be so keen to give every time a monthly or quarterly economic statistic is released by the ABS. Incidentally, when asked why they are so keen to give these interviews, they say they have to, or the newspapers and radio stations will seek out the Opposition spokesmen and quote them instead. I accept that explanation. One reason that I have heard for the dominance of economic news in the Australian media is that there is not much else to report. We are not engaged in a civil war, we do not have a royal family, not on our own soil at least, few earthquakes, our politicians do not have private lives as lurid as the British ones, or some American Presidents. So, instead, our papers are taken up with balance of payments statistics, national accounts, unemployment rates and Budgets (and, of course, interest rates and monetary policy). With the media competing so strongly against each other with their economic stories, there is inevitably a bias towards sensationalism. While Australia has some experienced and thoughtful economics commentators who are unquestionably of world class, it also has a multitude of eager beavers who are mainly concerned with tomorrow's headlines. They try to extract the maximum dramatic effect out of each ephemeral piece of news - monthly or even daily figures are invested with significance well beyond their actual information content. Interest rates do not merely rise, they soar, the exchange rate dives or plunges and Budgets 'blow out'. The reader can be left with an impression of constant action and turmoil. There is a good side to this over-exposure to economics and a bad side. The good side is that there is quite a high degree of economic literacy in Australia compared with many other countries. My guess is that the average Australian voter is more familiar with concepts like inflation, unemployment, the balance of payments, fiscal policy and monetary policy than their equivalents overseas. I have no proof of this, it is only my impression. They are also quite unforgiving if their leaders appear to lack economic awareness, as a former Treasurer who was caught out not knowing that GOS stood for Gross Operating Surplus, will attest. A consequence of their general economic awareness is that it probably contributed to making economic reform easier in Australia. We can see it most clearly in fiscal policy. We have been running surpluses for many years now, as you should in a sustained economic expansion. Most continental European countries have not got near that performance, nor has the United States. I think our ability to introduce a lot of the productivity and competition enhancing policy reform also benefited from this economic awareness. And as for labour market reform (or the lack of it), we only have to look at France where they have been rioting in the streets in favour of that great revolutionary cause - maintaining the status quo. The bad side of all this economic news is that it tends to make people gloomy. So much of it focuses on things going wrong, policy stuff-ups, conspiracies and so on that the public is led to believe they are in a permanent state of crisis. I will say more about this later, and at the moment merely note that this used to be a bigger problem than it is now. Nearly fifteen years of economic expansion has finally reduced this tendency. So far I have made a lot of generalisations without any empirical support. I would like to remedy that deficiency by reporting on a little survey we conducted about a year ago in the Reserve Bank comparing media coverage in Australia, the United States, and the United Kingdom. We looked at newspaper coverage the day before, the day of and the day after monetary policy announcements by their respective central banks over two consecutive policy meetings. In each country interest rates were raised at least once in these two meetings. We chose three newspapers in each country - one financial newspaper and the other two quality dailies. We added up the number of articles mentioning monetary policy that had appeared in the three newspapers in each country in the days surrounding these two consecutive policy meetings. The equivalent for the number of front page articles: My only purpose in mentioning this is just to support my general conclusion that media coverage of economic news is much more intense in Australia than in these two major financial cities overseas. I could give other examples too - the Budget coverage is an obvious one - but I do not think I have to, as I have made my point. I now want to move on to another aspect of economic news that makes for frequent coverage. Many private sector associations conduct surveys and publish the results of such things as business confidence, consumer confidence, hiring intentions, house prices and so on. Much of this data is very useful in helping to get a handle on what is happening in the economy and I do not want to dispute its usefulness. Recently, however, I have noticed a new tendency whereby useful and respected quarterly surveys have chosen to augment their results with monthly updates. They have done this purely in the interests of being helpful. So now the journalists have four times as much data to report on - the original quarterly result and the three monthly updates. But has this extra data helped us understand the economy any better? Let me show one well known quarterly survey which has proved useful over the years. Now let us see what extra information we get if we superimpose the monthly data that has become available in recent years. Has this made us better informed? I doubt it. But it has given the reporters more stories to cover, so they can report how it soared one month, then plunged the next one before soaring again. This is not the only example. Here is another one. One can hardly blame the media for this, nor the bodies that produce the surveys - they were only trying to be helpful! Let me finish by going back to the subject of whether the reporting of economic news unduly emphasises the negative. I think there has been a tendency for this to happen and there are several reasons that could be put forward. Ross Gittins has drawn attention to this on a number of occasions over the years, and his latest explanation, based on evolutionary psychology, appeared a fortnight ago. The story is as follows: When our ancestors lived in caves, the fearless ones got eaten by bears and bitten by snakes and tended to die early and not leave many heirs. The timorous ones, who shirked danger, managed to survive and leave plenty of heirs. So over the thousands of years, evolution has led to the proliferation of timid genes. As a result, "responses to threats and unpleasantness are faster, stronger and harder to inhibit than responses to opportunities and pleasure". According to this theory, it explains how the media select news. "News is anything the public finds interesting. But the stories the media judge to be newsworthy are preponderantly negative - bad news about natural disasters, accidents, crime, problems in the economy, stuff-ups by governments, arguments with other countries and all the rest." Gittins concludes by saying: I do not know whether Ross is trying to defend the media here or attack them. Is he blaming the readers or the media for this bias? Whichever way, I think he has a point. My guess is that for a given change in an economic statistic, an adverse movement is more likely to bring a headline than a favourable movement. But there is also a very simple explanation in many cases. If, instead of being economists, we were in the airline industry, we could hardly complain that crashes attracted more publicity than safe landings. Or if we were politicians, we would expect that conflict within the party would be more likely to hit the headlines than harmony. So my conclusion is that a tendency towards highlighting adverse developments and conflict is inevitable. There is nothing we can do about it. But that still leaves us without a convincing explanation for my main point. Why do we have such a preponderance of economic news in Australia compared with other countries? I do not know the answer - maybe one of you does.

r060818a_BOA

australia

macfarlane

The present arrangement whereby the Reserve Bank appears before this Committee every six months was put into place by the current Treasurer ten years ago. During that period, I have appeared eighteen times, with two meetings being missed because of clashes with elections. This will be my last appearance, and I have to say I will miss this regular half-yearly event - perhaps I should come and sit in the bleachers at future meetings. I have always thought that it is a very good principle for the central bank to have to report regularly to Parliament, and to be subject to questioning by members. The practice has, I believe, been a valuable form of communication and has contributed to improving monetary policy in Australia. Since this is my last appearance, I would like to seek the Chairman's indulgence to start by covering some medium-term considerations before proceeding on to the current economic situation. As you are aware, Australia's current economic expansion is now in its fi fteenth year. There is a general recognition that this is a good thing and, as a result, there has been a notable increase in the degree of optimism about Australia's economic performance. This is in marked contrast to the general pessimism that prevailed in the 1970s and 1980s and even later, when people were worried that we were falling behind other countries. After such a long expansion, it should not be surprising to discover that the economy has been experiencing some capacity constraints. But I think a lot of people are disappointed to hear this, and regard it as a bad thing. So I would like to spend a bit of time discussing this issue, which incidentally we fi rst began raising eighteen months ago at the February 2005 meeting of this Committee. First, being at what is termed 'full capacity' is not a bad thing - it is a good thing. It means, for example, that we have low unemployment and that our incomes are higher than they might otherwise be. What would be a bad thing is if, after fi fteen years of growth, we still found ourselves with signifi cant excess capacity (that is, with signifi cant resources of labour and capital that were not being utilised). Economies are meant to operate somewhere around the zone of full capacity, not permanently below it. Second, there is no sensible alternative monetary policy that would have prevented us from entering the zone of full capacity. The only way monetary policy could have prevented this is if it had kept the economy 'semi-comatose'. That would have meant growing so slowly on average that, even with the passage of fi fteen years, it did not use up the excess capacity. Third, full capacity is not a brick wall that you suddenly hit - approaching it is something that happens in stages. It is a rather patchy process, with some sectors reaching it early and some not at all. That is why I called it the zone of full capacity. Sometimes it is an industry that becomes a bottleneck, sometimes a type of capital equipment and often it is a type of skilled labour. The situation that attracts the most attention is when it is a piece of infrastructure such as a port or a railway. But normally when the Bank talks about capacity, we are not talking about the specifi c pieces of infrastructure but about the economy's overall availability of labour and capital resources. It is also worth keeping in mind that it is normal for the capacity of the economy to grow over time. This is because the labour force grows and investment and economic reforms lift output per worker, or productivity. There are limits, however, to how quickly capacity can be raised, though increased investment, as is taking place at present, will boost the rate of increase. But it takes time. In the meantime, it is helpful if demand can slow suffi ciently to allow capacity to 'catch up' and perhaps get ahead a little. If this fails to happen, then there is a risk of a generalised pick-up in infl ation. Some rises in prices and wages in the areas where bottlenecks exist are unavoidable, but a generalised infl ationary process is avoidable. This is why last year I started saying that we should get used to GDP growth with a 2 or a 3 in front of the decimal point, rather than a 3 or a 4 as we had become accustomed to throughout most of the expansion. In light of what I have just outlined, I would like to review our progress to date. The fi rst thing to note is that over the past two years the economy has slowed from its earlier fast pace of growth. The last time we had GDP growth of over 4 per cent was in the year to June 2004. Since then, the growth rates have had a 2 or a 3 in front of the decimal point. There are a number of indications that growth has picked up again over the past six months, but our forecasts do not have it going back to the four plus rates of a few years ago. Also, domestic demand has slowed by more than GDP. If you remember it was running at about 6 per cent in 2003/04, but is now growing at about 3 1/2 per cent. More importantly, the composition of domestic demand has changed for the better - the driving force behind demand growth for a long time was consumption spending, but that has now clearly slowed. Two years ago, consumption was growing at more than 6 per cent per annum, but over the past three quarters, it has been growing at slightly less than 3 per cent. There is some evidence to suggest that the slowing in consumption was due, in part, to the fact that household spending was no longer being stimulated by the apparent wealth increases associated with the house price boom. The gradual tightening of monetary policy, which began in 2002, no doubt also played a role. At the same time as consumption and overall demand have been slowing, investment has grown strongly. This is important because investment in plant and equipment and in construction is crucial to the process of increasing the economy's capacity to grow. Over the past three years, the Capex Survey shows that investment has grown by nearly 16 per cent at an annual rate. Much of this has been in the resource sector, but even if we take this out of the fi gures, the remainder has grown at 12 per cent per annum. Even in manufacturing, which many people assume has fl oundered, investment has grown at a similar rate, although it has been held up by resourcerelated activities. In the long run, this strong investment performance increases the economy's supply potential, and hence puts downward pressure on infl ation. In the short run, however, it is pushing up the prices of many inputs and wages in the construction and resource sectors. The capacity constraints caused by shortages of labour are harder to remedy in the short term. Interstate movement of labour can help to provide skilled and unskilled labour to the areas that have greatest shortages, mainly in the resource sector and its supplying industries. At the same time, increased immigration has helped to expand the overall supply of skilled labour. But clearly more has to be done to attract people into the occupations where skill shortages are most acute, and to train them without unnecessary delay. I do not profess to be an expert in this important area and do not want to lecture the Federal and State Governments on this issue, which I know is already absorbing a lot of their attention. This process of slowing demand and expanding capacity has been going on for several years, but it has not prevented some general upward pressure on producer and consumer prices. This was brought home to the public with the publication of the June quarter CPI. The increase of 4 per cent over the year to the June quarter made headlines, even though many observers were quick to point out that more than half of the June quarter increase was due to petrol and bananas, the latter infl uence giving the cartoonists of Australia great opportunities for mirth. They were correct to downplay these two infl uences which, in all probability, will either reverse or revert to zero in the coming quarters. But there is also a danger in simply taking out the two fastest growing components and looking at the rest of the CPI basket. At the Bank, we tackle the problem of lumpy, and possibly one-off, price movements by looking at various measures of underlying infl ation. Our preferred measures show that underlying infl ation is running slightly below 3 per cent per annum. This has picked up moderately since the start of the year, after a period when it had been fairly stable at around 2 1/2 per cent. The Bank's mandate is to keep infl ation averaging 2 to 3 per cent over the medium term. This does not mean that it is never to exceed 3 per cent or fall below 2 per cent - it clearly has done both during the infl ation-targeting period. We need to be confi dent, however, that it will return to the 2 to 3 per cent range. Viewing all of the available evidence that has accrued over the six months since we last appeared before this Committee, the Board came to the view that infl ation was likely to exceed earlier forecasts and that corrective action was therefore needed. As you know, the cash rate was raised by 25 basis points in May and again by the same amount earlier this month. In making these decisions, the Board was conscious that the global economy remains very strong, with output expanding at an above-average pace for the fourth year in a row. It also noted that global infl ationary pressures have been rising. This is in part the consequence of the very accommodative monetary policies that the major countries ran over 2003 and 2004. While the English-speaking countries have generally returned interest rates to more normal levels, the continuing low level of interest rates in Asia and Europe means that global interest rates on average remain low. This is continuing to stimulate global economic growth and infl ation. Domestically, there has been a pick-up in the pace of economic growth after a mild slowing in the second half of last year. While the pick-up has not been excessive, the general message from the growth of employment and consumer spending was that the household sector is still in good shape, and has not retreated into its shell as a result of the rises in petrol prices and the May interest rate increase. The fact that borrowing by the household and business sectors had accelerated over the past six months or so confi rmed this general picture. But as indicated earlier, the most important consideration was that our forecast of underlying infl ation has had to be progressively revised upwards over the past six months. Before closing and moving on to question time, I would like to thank the Committee again for the work that it has put in during the years I have been appearing before it. Not only has it kept an eye on monetary policy developments, it has also done a valuable job looking at payments system developments. The recent two-day hearing on payments system reform shows how willing the Committee has been to devote time to important issues, and how effective such public inquiries can be. I will, of course, be willing to answer any questions on the economy, monetary policy, fi nancial system stability or payments system matters that you wish to ask. Alternatively, you may wish to look to the future and address them to the next Governor of the Reserve Bank - Glenn Stevens. I am sure he will be as forthcoming with you as I hope I have been.

r061011a_BOA

australia

stevens

It is nice to be back at an ABE-Economic Society function in a new capacity. Thank you for the invitation. Tonight I will take the opportunity to make some brief remarks about the monetary policy framework, then go on to the current state of the economy and the associated issues for monetary policy. I would like to conclude briefl y with a longer-term perspective. As you know, my predecessor on his appointment in 1996 reached a formal agreement with Treasurer Costello on the conduct of monetary policy. This was updated in 2003 at the time of his reappointment. These Statements featured a numerical infl ation target, to be achieved over the medium term, for consumer price infl ation, and noted an appropriate degree of fl exibility in the conduct of policy over the short term. They emphasised the independence of the Reserve Bank, as provided under legislation, in the conduct of monetary policy. They provided for accountability to Parliament and provision of information to the public. And they recorded the commitment both of the Governor and of the Government to the arrangements. These arrangements have come to be well understood and widely accepted around the country, and around the world. Preserving the purchasing power of money is the most important contribution that monetary policy can make to sustainable prosperity. Having a medium-term numerical target for infl ation - in our case, 2-3 per cent on average - operated by an independent central bank, remains for Australia (and many other countries) the most straightforward way of giving practical effect to that overall goal. To date, moreover, the system has worked well. For a start, the target has been satisfactorily achieved. In 1995, a colleague and I wrote about Australia's infl ation target that: From the vantage point of 2006, we can look back and see that the average infl ation rate has indeed had a '2' at the front. The number can be calculated a few different ways, but all give an answer of about 2 1/2 per cent over the past decade. Infl ation has been outside the 2-3 per cent range about half the time. That degree of fl exibility was always intended because infl ation cannot be fi ne-tuned over short periods, and shocks occur that will push it away from target. But, importantly, there has been no systematic tendency for the deviation to be one way or the other. At the same time, variability in real GDP has tended to decline. Several factors have contributed to that but it is important to state that, over the long run, controlling infl ation does not harm growth; on the contrary, it leads to an improvement in growth prospects. With this record of success, the desirability of continuing the system is obvious. At times of changing personnel , moreover, it is worth stressing continuity: there was no case for a discrete change to the system just because a new Governor was being appointed. The Treasurer and I issued a new 'Statement on the Conduct of Monetary Policy' on September 2006, the day my appointment became effective. The language was identical in almost every respect to the 2003 Statement. The changes were limited to those necessary to update the document and refl ect a new incumbent. What this says is that the well-understood framework of infl ation targeting, central bank independence and accountability will continue over the years ahead. I shall turn now to an evaluation of trends and prospects for the global and local economies in turn. It is apparent that demand in the US economy is now growing more slowly than it was a year or two ago. Recovery from the shallow 2001 recession is, by 2006, fairly mature and there has been some rise in infl ation. So some slowing in demand is welcome and necessary. At the present time, the debate is over the extent of that slowing - whether it will be enough to take the pressure off prices, or whether it might in fact be too great, resulting in unduly weak economic activity. Observers have had a hard time this year deciding which of these problems was the larger concern. Early in the year, a string of biggish monthly CPI readings had everyone very worried about infl ation. More recently, declining forward indicators of housing construction and softness in housing prices have seen markets and economists more concerned about a weak economy. Long-term interest rates have retraced about half their rise in the fi rst part of the year. With the effects of a buoyant housing market thought to have been an important expansionary force in the US in earlier years, the recent change in sentiment in that market is understandably regarded as signifi cant. Australian experience suggests, as does that of the UK, that the end of a housing price boom can have noticeable effects on aggregate demand. But those experiences also suggest that such effects are manageable. In Australia's case, the resources boom coincided with the housing moderation and helped to dampen its effects, but that has not been the case for the UK, which has had broadly similar economic outcomes to our own. On this basis, one would think that there are reasonable prospects for moderate growth in the US economy in the period ahead. But this is obviously an area of uncertainty, and even a favourable outcome involves slower growth in US aggregate demand in the future than we have tended to see over most of the past decade. A slowing in the US economy is coinciding with a more positive picture in the euro area and Japan than we have seen over recent years. Japan looks more and more like it is fi nally escaping the stagnation that followed the excesses of the late 1980s and early 1990s. China has continued to grow with remarkable strength. To the extent that these and other areas are able to generate growth in domestic demand, as opposed to simply being pulled along by the US, the world economy could be expected to continue growing pretty well during 2007, though most likely below the 2006 pace. The consensus of forecasters at present seems to be that such an outcome is the most likely. Of course, forecasts can be wrong. The US might slow more than expected, perhaps because of larger dampening effects of the housing downturn. Another way it might eventually slow more than expected, as pointed out by the IMF's recent , would be if persistent infl ation pressures required further monetary tightening. The US remains suffi ciently important that, if this occurred, other regions would probably fi nd that their economies slowed too as a result. These days, we should also contemplate the outlook for China. Periodically people worry about a possible slump in China's growth, understandably given China's impact on the global economy over recent years. But we are also at the point where we probably should give some thought to price pressures in China. Even China must have some limit to how quickly it can grow without causing infl ation, and there are certainly anecdotes of rising wage costs in the major coastal industrial centres, on top of the higher costs of energy and raw materials. It appears that Chinese export prices are no longer declining. Were this trend to continue, the rest of the world, hitherto experiencing the effects of defl ation in prices for various manufactures, might at some point notice some mild impact on infl ation rates. No discussion of the global economy is complete without some mention of fi nancial trends. Here the main factor at work is still, it seems to me, the search for yield. Although the Fed has more or less normalised the short-term rate structure in the US, short rates in Japan and, to a lesser extent, mainland Europe remain unusually low. Long-term rates remain on the low side as well. Appetite for risk has been a little more variable this year, but overall risk spreads remain pretty low, especially considering some of the events which have occurred over recent years. Of particular note recently has been the marked increase in leveraged buy-out activity around the world. This refl ects a combination of low funding costs and high levels of confi dence about the potential future productivity and profi tability of corporate assets. Whether or not such confi dence is well based remains to be seen. But for the past decade or more, much of the action has been in household balance sheets - with a trend towards larger gross balance sheets and higher levels of debt. If we now are moving to an era in which corporate balance sheet developments are, once again, to the fore, then economists, prudential regulators and other policy-makers will need to be alert to any economic implications that would fl ow from such a change. After 15 years of more or less continuous expansion, we have an economy which is as fully employed as it has been for a long time. That's a good thing - full employment is one of the objectives of macroeconomic policy after all, and is set down in the . But high rates of resource utilisation affect the conduct of policy: we need to be more alert to the risk of infl ation than in periods when the amount of spare capacity was much larger. The international environment is one of strong growth, and rising costs of materials. Infl ation in Australia has risen, and not just because of prices of petrol and bananas. Those are likely to show declines anyway over the next couple of quarters, but measures of consumer price infl ation that are not distorted by these factors have picked up. That is not surprising. Input costs have risen across a range of areas. We have a tight labour market, and despite the steadiness recently of offi cial measures of wages growth, there is still pressure on labour costs, including the kinds that do not show up in wage statistics. At the same time, there are some puzzles in the picture painted by the various pieces of data on the Australian economy. On the one hand, real GDP growth is estimated to have declined to about 2 per cent over the 12-month period to June 2006, after having grown by just under 3 per cent in the preceding year. Growth in domestic demand has moderated from its earlier heady pace, though it still seems to have been running at 3 1/2 to 4 per cent over the year, which is probably a bit above the economy's sustainable capacity to increase production. Yet growth in employment has remained quite strong, and the rate of unemployment has, if anything, edged down over the past year. This sort of unemployment result would normally suggest that output growth had been at or slightly above trend, which most people would these days put at 3 per cent or a little above. Meanwhile, the rate of growth of tax revenues over the past several years has been well above what historical relationships suggest should have been expected, given the recorded growth of nominal GDP. At face value, the output and employment results suggest a marked change in the trend in productivity in Australia over the past few years. The various measures of GDP per hour worked suggest there has been approximately zero growth in productivity since the end of 2003. This compares with an average annual pace of growth of 2 per cent or more in the preceding decade. So what's going on here? One possibility is that the level of nominal and real GDP is really higher than is being captured at the moment by the statistics. That would mean that growth over the past few years has been higher than, and productivity has not slowed by as much as, the published data suggest. Tax revenues would, in this scenario, look more in line with historical relationships. This outcome would seem more in line as well with the unemployment trends. A second possibility is that it is the labour market data that are out of line - perhaps due to lags, or sampling effects - and that they will sooner or later come back into line. If that is the story - if the economy really has grown below trend of late - we might expect some rise in the unemployment rate to emerge before much longer. But this story still needs to explain the strength of tax receipts. Or maybe both productivity and output growth really have slowed, as the published estimates suggest. The question then would be why productivity slowed so much. One hypothesis we hear from time to time is that average productivity might be reduced by adding the workers with the lowest productivity after a long expansion. Perhaps this is not altogether surprising at this stage of the cycle - and if we are now seeing employment of workers whose lesser skills and productivity kept them out of contention in the past, that in itself is to be welcomed. But this addition of less productive workers isn't enough to explain the extent of the slowdown in overall productivity. If the fi gures are correct, the productivity growth for the existing workforce must also have declined noticeably. For had it continued at the pace seen over the preceding decade, the workforce that was employed two years ago could have accounted for virtually all the output growth which has occurred since. That would suggest the productivity of the additional workers employed over that period would not just be lower than average, it would actually be (approximately) zero. Surely employers would not have taken on people with productivity that low. Other hypotheses have been advanced for a slowdown in productivity growth. Among them are that higher levels of labour turnover in a tight market disrupt productivity performance across fi rms; or that changed regulations (e.g. new accounting standards, tougher requirements to demonstrate appropriate corporate governance and so on) are using resources without adding to output. At this point, however, these don't seem suffi cient as an explanation for a productivity slowdown of the magnitude we observe in the data. Hence it appears that, for the moment, we are left with something of a puzzle. That means that, as usual, monetary policy is being made under conditions of uncertainty. If the GDP data are correct, then the economy grew more slowly than earlier thought in the fi rst half of 2006, potentially with some moderating impact on the outlook for infl ation. (Even then, we would still have to ask the further question of whether the slowing was driven mainly by lack of supply or lack of demand. Only in the latter case would it mean that spare capacity in the economy will have been increased.) If, on the other hand, there really has been more growth than the GDP accounts suggest - more in line with the rise in employment and the trend decline in unemployment - then capacity probably remains pretty tight. In that case, upward pressure on infl ation remains a distinct possibility. Alternatively, if both sets of data are correct, then productivity actually has slowed down considerably. But if that is true, unless it is a temporary phenomenon, then potential GDP growth is not 3 per cent or a bit above any more. It will be less, and our growth aspirations would have to be adjusted accordingly. In this scenario, infl ation pressure in the near term could well increase and demand growth may need to be further restrained for infl ation to remain under control over time. In trying to assess which of these possibilities, or which combination of them, is in operation, one of the pieces of evidence to which we will be looking for guidance is the behaviour of prices themselves. An economy with genuinely sub-potential growth over two years ought, other things equal, to start putting some downward pressure on infl ation fairly soon. An infl ation rate that continued to increase, on the other hand, would presumably raise questions about either the apparent rate of growth of demand and output, or of potential output or both. You do not need me to tell you, therefore, that the price data to be released over the next couple of weeks will be important in evaluating the outlook and the balance of risks facing policy. Before I leave the current state of the economy, a remark about the differences in performance by region is appropriate. As everyone is aware, spending growth is strongest in Western Australia, as resource producers seek to put in place more capacity and the income gains from the boom are partly spent. But the differences in spending overstate the differences in actual economic performance between the regions. Not all the demand generated in Western Australia is being supplied from there: some of it is being supplied from the rest of the country, and some of it from outside Australia. It is partly for that reason, presumably, that the differences in employment growth and unemployment trends across states are much smaller than the differences in spending. In fact, the extent of the differences in output growth across states, while noticeable, do not appear at present to be unusually large. They also appear to be well within the sorts of differences experienced over time by other comparable countries or regions, like the United States, Canada or the euro area. At the same time, there is some tendency for labour and capital to move to the resource-intensive areas. That is exactly what is supposed to happen in a fl exible economy when relative prices change: labour and capital respond to incentives. Moreover, as the Secretary to the Treasury pointed out a couple of months ago, if the current set of relative prices persists, there will be more such adjustment in the years ahead. Before concluding, it would be useful to lift our eyes from the immediate ebb and fl ow of the short-run data and to ask, taking a medium-term view, what will be the most important task for monetary policy over the period ahead? It should be obvious that, over the next little while, the main job is to ensure that the infl ationary pressure we have been experiencing of late is successfully resisted, and that expectations of future infl ation remain well anchored. That will be a key part of maintaining an average infl ation performance of 'two point something'. We could hardly overstate the importance of maintaining that general environment where, as famously characterised by Alan Greenspan, infl ation is suffi ciently low and stable that it does not materially affect economic decisions by fi rms and individuals. A stable overall price environment assists in resource allocation and preserves the value of savings. It also provides monetary policy with more scope to be fl exible in the face of shocks. The past decade has seen no shortage of challenges, often of a fi nancial nature: the Asian crisis, the LTCM episode, the dot com mania and subsequent downturn, and so on. When conditions in the real economy were threatened on those occasions by contractionary forces, central banks in a range of countries were able to respond with reductions in interest rates, or by retaining already low rates for an extended period. Some people would be inclined to argue about whether or not such actions were in every case ideal. But the more important point is that, without a background of low and steady infl ation and well-anchored expectations, they would not have been feasible at all. Were the recent higher infl ation rates of the past year in Australia and some other countries to persist, and to start affecting behaviour, such a degree of fl exibility for monetary policy might not be present in future moments of economic diffi culty. Acting as needed to keep infl ation in check in the near term, on the other hand, preserves future fl exibility. It is that strategic requirement to which central banks should be, and I believe are, paying close heed. As we do so, of course, we will be bearing in mind the lagged effects of the policy adjustments already made. If we can successfully see off the higher infl ation of the past year or so, we will have done a lot to establish the conditions needed for ongoing growth.

r061212a_BOA

australia

stevens

It is a great pleasure to be invited to address the Annual General Meeting of CEDA, continuing a long tradition of such addresses by Governors of the Reserve Bank of Australia. CEDA - the Committee for Economic Development of Australia - began in 1960, an initiative of D.B. Copland. Copland, one of Australia's most remarkable economists of the Depression era, was a member of 'Giblin's Platoon', whose history is recorded so nicely in the recent book of that name. CEDA has over the years made a substantial contribution to debate in a number of fi elds, from trade policy to taxation policy, from indigenous affairs to infrastructure. Interestingly enough, the list of publications on CEDA's website does not include any which are overtly fi nancial in their focus. I do not say this as a criticism - perhaps the reason you have invited central bank governors to speak so regularly is to cover that very set of issues! But it seems appropriate, given CEDA's core focus on economic development, to address the questions: what is the role of fi nance in economic development and growth? How does the fi nancial system contribute? How can fi nancial events sometimes be detrimental to economic growth? What can be done to ameliorate those risks? What risks do we face at present? The growth we take for granted in the modern world is actually a fairly recent phenomenon in human history. Prior to the industrial revolution in western Europe, living standards rose, if at all, very slowly. According to Angus Maddison's data, the real per capita GDP of the United Kingdom rose between 1500 and 1820 at an average rate of only 0.27 per cent per annum. that pace, living standards doubled about every 250 years. In other words, a person would not live all that much better than their grandparents - assuming they could discern any difference. From 1820 to 1913, the rate of increase rose to 1.15 per cent. That's a very big change. At that pace, living standards doubled in about 60 years. In the 20 century - despite wars, the Great Depression, the Great Infl ation and various other problems - growth per head rose further. Australia's per capita growth was 1.70 per cent in the 20 century, according to the same data set, for a doubling in living standards about every 40 years. The difference between my living standards and those of my grandparents in the mid 1940s when they were as old as I am now - a trebling - is remarkable. There is a vast literature on what accounts for this growth, and there has been a long debate in economics about whether the development of fi nancial institutions and markets followed or led the developments in the real economy. Some, such as Joseph Schumpeter, Sir John Hicks and Walter Bagehot argued that fi nancial development actively fostered innovation and entrepreneurship. Others, including Joan Robinson, argued that fi nance passively followed in the wake of real-side development. both components were necessary, and neither alone would have been suffi cient. Technological advance provided the potential for a marked acceleration in productivity. In the early age of industrialisation, the steam engine and electricity were two obvious examples. Without those opportunities, such fi nancial capital as was available for deployment would probably have struggled to fi nd a useful outlet. But equally, the potential technological advance would have remained just that - potential, rather than actual - had there not been a capacity to mobilise the fi nancial resources needed to invest in the equipment embodying the new technology. The capital required for an economy based on agriculture and artisan-based manufacturing had been in the form of land, seed, basic tooling and the like. Traders needed working capital in order to purchase goods in one place and move them to another for sale, and various fi nancial devices arose to assist this. The need to sink very big sums into large-scale machinery, however, called for capital on a different scale, and fi nancial development was key to providing it. The economic historians suggest that a number of innovations were important. The development of the limited liability corporate structure allowed proprietors to take risk without facing complete personal ruin if the venture failed. Banking corporations effi ciently pooled the resources of a large number of savers, the more so as they developed into joint-stock ownership structures, as opposed to purely private ones. These organisations also provided, before central banks developed fully, circulating monetary assets for the community, which facilitated exchange. Markets for the trading of claims against future income fl ows - what today we know as stock and bond markets - allowed the providers of capital to retain their wealth in a more liquid form, thus encouraging them to commit more capital to long-term ventures. In other words, the development of fi nancial markets and institutions was an integral part of the industrial revolution. It remains a key facilitator of the growth we enjoy today. Yet such progress was not without its occasional problems, in the form of periodic panics. Commodities markets had a certain tendency towards occasional instability. Optimism and greed could push prices to extreme levels, following which a loss of confi dence typically precipitated a crash. The Dutch tulip bubble of the 1630s occurred without the aid of the highly developed set of fi nancial intermediaries that came later, though it did achieve considerable added fi zz via a futures market for tulip bulbs - derivatives allow leverage, which is almost always a key element of the latter stages of speculative manias. But the growth of a modern banking system in England by the late 18 century, whose liabilities were effectively fi nancial claims against assets that could not be quickly realised if suddenly called, brought heightened risks. Banking is, after all, a business that involves leverage and liquidity and credit risks. There was always the possibility of a fi nancial panic that could, if unchecked, threaten not only the fi nancial institutions but also the course of the real economy. The question facing public policy, then, was how to fi nd a set of arrangements that would allow the necessary credit extension to support capital investment in pursuit of new technological opportunities, yet provide a stable monetary standard and a fi nancial system in which the public could have confi dence. We should record that in the same era, questions of a qualitatively similar nature arose in the fl edgling colonies of the Antipodes, even if they were, to begin with, at a lower level of sophistication. The Colonies needed both a system of mobilising capital and a means of making payments other than circulating paper claims over goods - be it rum or something else. We are all aware of Governor Macquarie's ingenious attempt in 1813 at keeping metallic money in the colony of New South Wales, by making two coins out of each Spanish dollar, thus rendering them at once more useful in New South Wales and much less useful elsewhere. But Macquarie's initiatives in granting a charter to the Bank of New South Wales in 1817, and those of Governor Darling in rescuing it from disaster in 1826, were perhaps more important milestones in the early fi nancial development in this country. According to Trevor Sykes' account, both of these actions were contrary to the policy of the British Government. These appear to have been occasions when the lags in implementation of offi cial policy - measured by the time taken for a request for instructions to reach London by sailing ship, be considered and then answered by return ship, too late to infl uence the decision - helped to produce a superior Around the world, governments groped towards a sustainable solution for combining the benefi ts of fi nancial intermediation with stability. Progress was not necessarily always steadily in the right direction, but one of the key developments was the gradual evolution of the institution we would today recognise as the central bank. In a number of countries, these institutions had begun life as a means to fi nance military expeditions by governments of not altogether unquestioned creditworthiness, but they gradually became central players in the efforts to foster stability in normal times, and to restore it after something went wrong. Bagehot's classic, , remains one of the best accounts of this in the case of the Bank of England. The notion of the lender of last resort, and the idea that the central bank should look to the interests of the system rather than any commercial interest of its own, were slowly developing. It was, of course, to be some time before the central bank had fully evolved into the current form, even in the most advanced economies. In our own case, the central bank did not really have a fully developed public policy mandate until after the 1930s, and arguably was not a purely policy institution until the separation of the Reserve Bank from the Commonwealth Bank in 1960. century, of course, views about the appropriate role of a central bank changed a good deal, as did views about the appropriate extent of offi cial intervention in fi nancial markets and institutions generally. The Great Depression of the 1930s occasioned new ideas about macroeconomic policy, which envisaged more offi cial intervention in economic matters. This was followed by a very large increase in the government sector's command over economic and fi nancial resources, of necessity, to conduct the Second World War. Hence by the end of the 1940s, the landscape had changed a great deal in comparison with 1930. The fi nancial systems of many countries found themselves subject to much more regulation, and central banks with more regulatory powers and more explicit mandates for macroeconomic stabilisation, than had previously been the case. Initially, this arrangement held great promise. The instability of the 1930s had apparently been banished. But as time went by, other problems emerged. As explained eloquently by Ian Macfarlane's recent Boyer Lectures, macroeconomic policies became overly ambitious, and neither the policy frameworks nor the governance arrangements under which they were implemented were up to the challenges posed by the shocks of the 1970s. Nor, we might add, was the structure of fi nancial regulation, with its emphasis on governments or central banks setting most fi nancial prices and even seeking to decide who should and should not receive credit. Many of us here will recall the debates at the time of the Campbell Inquiry in the late 1970s. By then, the problems of the extensive regulatory regime had become all too clear. It was ineffective (or even counterproductive) at a macroeconomic level, it distorted resource allocation at a microeconomic level and it fostered the rapid development of a more dynamic fi nancial sector operating beyond the regulatory net. This wasn't sustainable, and something had to give. There was large-scale liberalisation of the fi nancial sector through the 1980s, winding back many of the post-Depression, World War II era restrictions. Efforts at prudential supervision were beefed up, but these progressively became focused on ensuring adequate risk management in individual fi nancial institutions rather than the more direct controls of the earlier era. In more recent times, fi nancial system stability - as distinct from the solvency of individual institutions - has become more prominent as an explicit focus of central banks, many of which publish regular detailed assessments of system stability. This is a natural response to the circumstances, but it is really a refocusing on one of the key original purposes of the central bank. All of that history is a backdrop to the fi nancial trends of the past decade, to which I now turn. The most prominent fi nancial development of the past decade has, of course, been the change in the structure of the balance sheets of households. Much has been said about this and so any description here can be brief. The essence of the story is that in the early 1990s, two decades of chronically high infl ation in Australia ended. Interest rates declined as a result. In fact, they returned to levels last seen in the low-infl ation period in the 1960s. But in the intervening period, of course, the Australian fi nancial system had changed out of all recognition, a result of liberalisation, competition and innovation. No longer was the potential borrower for housing on bended knee to a stern-faced bank manager, the way they had been in earlier periods of low rates. Now, lenders were under more competitive pressure to grow their balance sheets. Having pursued the corporate borrowers in the 1980s, with rather mixed success, they were now looking to households as a source of growth. We can all recall the advertisement for one major bank in which the formerly stern manager practises saying 'yes' in the mirror each morning. So by the mid 1990s, we had a household sector more able and more inclined to demand housing fi nance, and fi nancial institutions more willing to supply it. It is hardly surprising that this should ultimately result in households carrying much more debt, as well as higher levels of assets, than they had before. It might have happened earlier had the course of infl ation and interest rates been different. Nor is it surprising that such an expansion in fi nance over a relatively short period of years should be associated with higher prices for dwellings. I fi nd persuasive the arguments that changes to planning and development regulations have raised the cost of new building - that is, the cost of adding to the dwelling stock. It is plausible that this, in turn, adds to the price of those existing dwellings that could reasonably be substitutes for new dwellings. But if we are seeking an explanation for why the prices of the 8 million existing dwellings across the country have increased so much, we surely have to give a very prominent role to the halving of the cost of debt and its easier availability. These trends also added to aggregate demand in the economy, via additional construction and renovation spending, and the generally expansionary impact of rising asset values on broader household spending. Whereas dwelling investment averaged around 5 per cent of GDP through the 1970s and 80s, it reached a peak of nearly 7 per cent of GDP in 2003/04. Households also expanded their consumption faster than their income. For a time, these trends were helpful in periods when adverse shocks from abroad were having their impact. Over the past two or three years, these effects gently faded. We have seen some decline in spending on housing, and a slowing in the growth of household borrowing and consumption spending, but these changes have been fairly modest compared with earlier episodes, partly because there are regions of the country where the resources boom has continued to boost house prices and household demand. The run-up in household borrowing has also raised, on occasion, and quite naturally, questions about how sustainable all this was, and whether there was a build-up of exposures in the household sector and the fi nancial system that could impair fi nancial or macroeconomic stability at some future time. Considerable attention has been given over recent years to this set of questions, both in the Reserve Bank and elsewhere. We did not believe that the rise in debt was, in itself, likely to trigger an economic downturn. That said, higher leverage would, in the event of an economic downturn that occurred for some other reason, probably make at least some households' spending behaviour more responsive to declines in income than it would have been in the past. Precisely this set of issues has recently been addressed as part of the IMF's Financial Sector Assessment Program (FSAP). That program was a very wide-ranging exercise, as all FSAPs are, but from our point of view a key component of it was a macroeconomic stress test. The Reserve Bank, through our Financial Stability Department headed by Keith Hall, co-ordinated this exercise, which involved the IMF team, APRA, the Australian Treasury and the risk-management areas of the fi ve largest banks - for whose co-operation we express our thanks. The results were included in our September , and also released by the IMF as part of the FSAP report in October. In brief, the test involved a scenario featuring: a very large fall in house prices, a recession, a big rise in unemployment, a sharp depreciation of the exchange rate and a rise in the funding costs of fi nancial institutions. This was designed specifi cally to test the resilience of the fi nancial system when several of the key elements underpinning business strategies over the past decade were removed. In such a scenario, only some of the adverse effects would come directly through mortgage portfolios; a good deal of it would come through business portfolios. Faced with a loss of income, indebted households would be likely to cut back consumption sharply in order to keep up their mortgage payments. Hence, businesses supplying into discretionary consumer markets would feel the effect quite quickly. In the tests conducted, the result was an estimated decline of around 40 per cent in the banks' aggregate profi ts after around 18 months, and by the end of the three-year scenario, profi tability remained 25 per cent lower than its starting point. That said, the institutions remained not only well and truly solvent but with capital positions above regulatory minima. In part, this refl ected the strength of business balance sheets. As the banks worked through the scenario, this strength meant that the signifi cant cutback in household spending did not cause widespread loan defaults in the business sector. Overall, the results are, within the limitations of this type of exercise, reassuring. Before we take too much comfort from them, however, we need to enter a few caveats. For a start, while the scenario seems a demanding one at fi rst blush, it is predicated on a recession in Australia but not in the rest of the world. That would be, if not unprecedented, at least very unusual, and a more realistic scenario in which Australia suffered a downturn simultaneously with, and largely as a result of, an international downturn could well be a more challenging environment than the one assumed for the tests. A second factor is that everyone taking part in the simulation knew that the scenario involved an economic recovery, by assumption. They could factor that into their modelling. But in a real recession, there always comes a point at which many people are not confi dent of recovery, and that affects their behaviour. It is not unknown for lenders to be suffi ciently lacking in confi dence that they are reluctant to take on the risk of new borrowers. That would feed back to the economy, deepening the decline and slowing the recovery. Thirdly, there were quite large differences in results across banks. While these differences may be partly explained by variations in the structure of individual bank balance sheets, they also appear to refl ect different approaches used by the banks to model their outcomes. There is nothing wrong with that - it is not that one approach is defi nitely right and another wrong. But the fact that varying techniques can produce signifi cantly different results means that there must be a fair bit of uncertainty around any individual estimate. Hence, while the results provide some comfort, we can have only limited confi dence that they would be replicated in a real-world downturn. We are, however, confi dent that the exercise was worthwhile, and would be worth doing again at some point. The Council of Financial Regulators, a body that brings together APRA, ASIC, the Treasury and the Reserve Bank under the chairmanship of the RBA Governor, is of the view that system-wide stress testing should be conducted on a regular basis, though of course the scenario would need to change through time. This was also the view of the IMF in its FSAP report. We have indicated to the CEOs of the participating banks that we would look to do this type of stress test roughly once every two years, and I look forward to their support for this. Looking ahead, the increasing prominence of private equity and leveraged buyout activity will be a point of interest. To date, this trend has probably caused a bit more excitement than the straight numbers would suggest is warranted, since LBOs accounted for a relatively small proportion of corporate mergers and acquisitions of Australian companies in 2006. But perhaps the reason for the attention is the feeling that the trend could continue for some time. In essence, many of these transactions are based on two fundamental premises: the return on equity is high, and has in recent years been unusually stable as well; and the cost of debt is low. Those offering high prices for businesses are essentially betting that, over the next several years, they can enhance returns by increasing leverage. To some extent, they may also feel that in a private-ownership structure they can do some things to improve long-run performance of the company that current shareholders would not tolerate because of short-term damage to earnings and share prices. But mainly, the strategy is one of leverage. If this analysis is correct, then corporate leverage, and the associated exposures around the fi nancial system, could be rather more prominent as an issue over the next fi ve years or so than it has been for a couple of decades. Going back to the FSAP stress tests for a moment, it is likely that the results would have been more worrying had the leverage of the corporate sector been considerably higher. But we shall have to leave a more detailed discussion of such issues to another occasion. For now, it is time to conclude. Finance and growth go together. It was no accident that the acceleration in growth in the industrial revolution was associated with the development of modern banking and capital markets. By the same token, disruption to the fi nancial sector is costly to the real economy, as is only too clear in history. The role of public policy is to respond to these disruptions forcefully if and when they occur to preserve the stability of the system, but in the good times to work hard at fostering a climate of careful risk assessment in the relevant institutions and markets. For the past 15 years or so, the fi nancial system in Australia has worked remarkably smoothly to assist the economy. A very large change in the household sector's balance sheets has made households more sensitive to changes in their circumstances, but fi nancial institutions have continued to perform strongly. The challenge remains for these institutions, and all of us, to understand how risk is changing in this new environment, and to remain aware that we may at some stage face less forgiving circumstances than we have enjoyed over the past decade. We need also to be alert to the shift in the wind in the area of corporate leverage that seems to be occurring. I suspect we will be talking about that for some time to come. In the interim, I wish all of you a merry Christmas and a happy, prosperous - and stable - new year.

r070221a_BOA

australia

stevens

Mr Chairman, members of the Committee. My colleagues and I welcome the opportunity to appear before you today. I have attended most of these hearings since they started in their current form in May 1997, and have observed over that decade the way they have become a very important part of the monetary policy framework in Australia. I am sure that their importance will continue to grow in the years ahead, and I look forward to taking part in them. It is fi tting that this hearing take place in Western Australia, where the effects of some of the profound international forces affecting the economy are perhaps clearest. I refer of course to the rise in the relative price of natural resources, which has increased shareholders' and employees' incomes in the resources sector, increased the fl ow of labour and capital into that sector, and had a fl ow-on effect on a range of other industries. This has all fostered a generally very expansionary set of conditions in Western Australia in particular, though the effects have spread around the country. This change in relative prices is welcome, but such events are rarely uniform in their geographical or industry impact, and this one is no exception. In the south-eastern part of the country, where direct exposure to the resources sector is smaller, the positive impact is not as strong. In addition, the other dimension of the change in relative prices to which I refer - the relative decline in prices for many manufactured products as a result of the emergence of China and other low-cost producers - is affecting local producers. Not surprisingly, those parts of the economy, while growing, are experiencing less strength than seen here in the west. Nonetheless, the rise in Australia's terms of trade of over 30 per cent over the past three years, taking them to their highest level for 50 years, is expansionary overall. The real incomes of Australians are higher and, other things equal, this adds to demand. For macroeconomic policy, it is a matter of ensuring that the economy adjusts to the change as smoothly as possible. That task is easier today than it once was. A more fl exible economic structure, a fl oating exchange rate and a better macroeconomic policy framework mean that the adjustment is proceeding much more smoothly than it did on some other occasions in history when the terms of trade moved by large amounts. As a result, such adjustments to monetary policy as have been required have been gradual. When we appeared before you in August last year, the economy was in the midst of a mild pick-up in infl ation. This was something that we had anticipated would occur, and to which monetary policy had already begun to respond, with adjustments to interest rates in May and August. As you know, there was a further adjustment in November, taking the cash rate to 6.25 per cent, somewhat above its medium-term average. The background to the rise in infl ation, and the associated adjustments to policy, is fairly well known. After a long period of solid economic growth, we have approached what for practical purposes can be called full capacity, at least for the moment. The evidence for this is quite widespread. In the labour market, we are as fully employed as we have been at any time in the past 30 years or more. The share of the working-age population employed is at a record high, the rate of unemployment is at its lowest for a generation, and wider measures of 'underemployment' are also comparatively low. It may well be possible for these trends to go further yet, but a wide array of business enterprises the Bank talks to have been saying for some time that it is harder and more costly to fi nd appropriate staff, and that the factor most constraining further expansion is not insuffi cient demand, but insuffi cient capacity, either of labour or capital or both. Approaching full employment is, of course, something to be welcomed. It is a goal of macroeconomic policy. If full employment is a 'problem', it is the one you would rather have than the problem of chronic unemployment. When we do not have full employment, it is appropriate - infl ation considerations permitting - for growth in demand to be faster than normal in order to use the unemployed reserves of labour and capital. In the recovery from a business cycle downturn, that is typically what macroeconomic policies seek to achieve. But by the same token, once full employment is more or less achieved, the pace of expansion in aggregate demand that was earlier desirable will now be too fast. It has to slow a bit, to be more in line with the rate of growth of the economy's productive capacity. Otherwise, we would face the problems of overheating, infl ation and eventually another downturn. It is that adjustment to more moderate outcomes for spending and output growth which we have been seeking in Australia in recent years. That this is necessary is confi rmed by the fact that infl ation has picked up somewhat. CPI infl ation in 2003 was 2.4 per cent. In 2004 it was 2.6 per cent, and in 2005 2.8 per cent. In mid 2006 it was nearly 4 per cent. To be sure, the consumer price index was affected by the rise in oil prices, and most spectacularly, the effects of Cyclone Larry on the Queensland banana crop during March of last year. But the rise in prices was more widespread than just those items. Measures of underlying infl ation, less infl uenced by specifi c price shocks, suggested a pick-up, albeit a much more modest one, from about 2 1/2 per cent to about 3 per cent by mid 2006. A short-lived pick-up of that magnitude is not necessarily a major problem in itself. But in an economy with limited spare capacity, continuing signs of quite solid growth in demand, and experiencing a substantial external stimulus, that gradual trend rise in underlying infl ation was worrisome. A continuation of this trend could have seen infl ation exceeding the 2-3 per cent target over a more sustained period, even after temporary factors had disappeared. It was this risk - not banana prices or petrol prices per se - to which monetary policy had to respond. It was intended that the rise in interest rates, by restraining the growth of demand, would allow the supply side of the economy some time to catch up, and so act to contain infl ationary pressures over time. How, then, do we evaluate the current situation and outlook? Most indicators suggest the economy expanded at a moderate pace through the second half of 2006. While housing construction remained a bit below average, engineering and non-residential building have been very strong. Consumer demand picked up a little pace, and at present it is being assisted further by the decline in petrol prices. At the same time, the very serious drought has strengthened its grip on the rural sector, and farm production and incomes will be sharply lower this fi nancial year as a result. The demand for labour has remained very strong, with higher-than-average increases in employment and some further decline in the rate of unemployment through the turn of the year. Data on job vacancies and from business surveys suggest little moderation in this area in the near term. Looking abroad, the world economy continues to post a strong performance, led by the US and China. Many commentators have for some time pointed to the possibility of a sharper-than-expected slowdown in the US economy, due most likely to a weakening housing sector pulling down activity elsewhere, as a key downside risk. To date that risk does not seem to have materialised, and recent data suggest growth has been close to trend for the US economy, even with a weak housing sector. At the same time, recent infl ation outcomes in the US show some moderation. There is little sign that China's rapid expansion will end any time soon and recent growth in the euro area has recently been the strongest this decade. So, while forecasts made by the IMF and other institutions for the world economy have for some years been qualifi ed by statements about downside risks, it appears that current trends are, once again, at least as strong as the forecasts. While prices for some commodities have retreated from their peaks, others have remained very high. The prevailing levels of prices will, in all likelihood, continue to prompt high levels of investment in the resources sector both in Australia and abroad. No doubt the resulting expansion in supply will, in due course, dampen prices for commodities to some extent. Even so, it appears likely that Australia's terms of trade will be higher on average over the years ahead than they were through the 1980s and 1990s. International fi nancial markets remain remarkably supportive of growth. Long-term interest rates are not far above their 50-year lows of a few years ago, even though short-term rates have risen in most countries to be much closer to normal levels, the main exception being Japan. Share prices have been rising steadily, appetite for risk is strong, and volatility in prices for fi nancial instruments has been remarkably subdued. To some extent, these trends in fi nancial pricing may well refl ect a genuine decline in some dimensions of underlying risk. Variability in economic activity, and in infl ation and interest rates, has clearly diminished over the past 15 years in a number of countries, including Australia. The associated prolonged period of attractive, steady returns on equity investment and low cost of long-term debt funding certainly seems to have set the stage for a return to somewhat higher leverage in the corporate sector. This is most prominent in the rise in merger and acquisition activity and the re-emergence of leveraged buyouts around the world. Corporate leverage had been unusually low after the excesses of the 1980s, so some increase is probably manageable. Nonetheless, after more than a decade in which the main action in many countries has been in household balance sheets, this trend in corporate leverage will bear watching. For the time being, at any rate, fi nancial conditions are providing ample support for both corporate investment and household spending around the world. Turning to the outlook for domestic demand, the very high rates of growth of business investment are now probably behind us, but the current high levels of investment are adding to the capital stock in a way that should, in time, ease capacity constraints. Governments in several states, conscious of the need for public infrastructure, are also looking to expand investment. There appears to be considerable competition for the resources needed to complete all these projects. A gradual expansion in residential construction activity will probably get under way over the next year. We expect household consumption will grow at about trend in the period ahead. In both these areas, our expectations take into account the fact that the impact of the monetary policy adjustments made last year are still working their way through the household sector. All of this should mean that domestic demand will rise at, or slightly below, trend pace over the coming year. With some export sectors expanding as additional capacity comes on line, our central forecast is for growth in non-farm GDP to pick up to about trend during the next couple of years. Total GDP growth will be lower in the near term because of the drought's effect on the farm sector. If rainfall patterns improve in the months ahead, there would presumably be some recovery in farm production during 2007/08, though the likelihood of that, let alone its strength, is inevitably highly uncertain at this stage. So far as the outlook for infl ation is concerned, at the time of our November 2006 , after the three policy adjustments made last year, we believed there were grounds to think that the higher infl ation outcomes observed up to that time would moderate a little in the period ahead. We were, admittedly, a little tentative in that judgment, but based on that assessment, the Board elected to leave interest rates unchanged in December. At our most recent meeting two weeks ago, we felt we could be a little more confi dent in that infl ation forecast. We will, of course, see some large movements in CPI infl ation in the next few quarters. It will probably fall noticeably below 2 per cent on an annual basis, as falling petrol and banana prices have their effect. After that, it will rise again, as those temporary factors fade, and we currently expect that CPI infl ation will be around 2 3/4 per cent by early 2008, remaining around that rate thereafter. That is, it appears likely to be lower than recent outcomes, but closer to the top than the bottom of the 2-3 per cent target range. With that outlook, the Board decided in February to maintain the existing setting of cash rates. We will be maintaining a close watch on what incoming information tells us about the prospects for infl ation. The apparent softening in underlying infl ation in the December quarter was certainly very welcome, but it is not as yet clear to what extent it signals a persistent, as opposed to a temporary, phenomenon. Most of the indicators we have available still suggest a very fully employed economy. So there would be some risk of infl ation remaining uncomfortably high were demand growth to be unexpectedly strong in the near term. Hence the outlook for demand, and the extent to which capacity constraints are easing in a range of sectors, must be key elements in forming a judgment about the outlook for infl ation, and the appropriate stance of monetary policy. I turn now to payments policy, which I know is of interest to this Committee. You conducted a very extensive set of hearings last year into payments issues and we believe that was very useful as a way of airing the views of the various participants. In 2002, when the Payments System Board announced the credit card reforms, it committed to reviewing the outcomes after fi ve years. We will meet that commitment with a review that will take up this year and part of next. The review will be broad in scope and will include all the Bank's reforms to date. I know that some industry participants have expressed reservations, including to this Committee, about the Bank, rather than another body, conducting the review. I note that the Committee was not convinced by their arguments and concluded that the Bank should conduct the review. From our point of view, having publicly committed to carry out such a review, we feel we could hardly do otherwise. Moreover, it would be very odd indeed for the Payments System Board, which has been charged by the Parliament with making payments policy, to ask some other body to review its policy decisions. It is, of course, open to the Parliament, including via this Committee, to review the reforms in any way that it sees fi t and to ask the Payments System Board to account for its decisions. In December last year, the Payments System Board announced the outline of the review, after inviting input from industry participants. The formal part of the review will begin mid year, when the Bank releases an issues paper, which we hope will form the basis for an initial round of consultations. As background to the review, we will also be undertaking some detailed research into costs and usage patterns of the various payments methods, including cash. This will update and broaden the study on costs carried out seven years ago. The review will be an open process, which will include a conference towards the end of this year bringing together policy-makers, specialist academics and industry practitioners. We plan to release our preliminary conclusions in the fi rst part of 2008 and then we would again consult widely before making any changes to the current arrangements. We expect the review to be completed in late 2008. This is a lengthy process, but it has to be if the discussion is to be based on the facts, everyone with something to say heard, their views considered carefully and the Payments System Board to undertake proper deliberation. It is important to add that while the Payments System Board's reforms to retail payments systems have attracted a good deal of attention, the Board is concerned with a much broader set of issues, including the stability of the payments systems. The Board's main focus here is the operation of the high-value payments systems. These systems continue to operate with a high degree of reliability and security, but continued attention and investment on the part of the principal players, including the RBA, is needed to ensure that this remains the case over the years ahead. Mr Chairman, that concludes my introductory remarks. My colleagues and I are here to respond to your questions.

r070614a_BOA

australia

stevens

The last time I gave a speech in Brisbane was three years ago, in June 2004. The key themes of that address were a world economy growing faster than average, rising oil prices, narrow pricing for risk in global fi nancial markets, an Australian economy enjoying a long expansion, and a Queensland economy growing faster than the national average. You might be forgiven for saying that not much has changed in the interim. The global economy has continued to grow faster than its long-run average, oil prices have risen a lot further, compensation for risk in fi nancial markets remains remarkably skinny, Australia's economic expansion has continued and Queensland is still experiencing stronger economic conditions than the average for Australia. But the fact that all those things are still occurring is quite remarkable. The Australian economy is on the cusp of the seventeenth year of the expansion which began in the second half of 1991. There is, at the moment, moreover, a high degree of confi dence about the future, with share prices near record highs, property markets fi rming again and borrowing proceeding apace. I shall begin with some remarks about the global economy, and then talk about Australia's recent performance. I will make some observations about how the Reserve Bank Board, responsible for monetary policy, is seeking to manage the risks which we judge the economy faces. The most recent outlook released by the IMF in April forecast global GDP growth in 2007, measured on a purchasing-power-parity basis, at just under 5 per cent. This is down a little from about 5 1/2 per cent in 2006, but that was the fastest growth for over 30 years. The projected 2007 outcome is still well above the long-run average growth rate of around 3 1/2 per cent. Between regions, there are some important divergences under way. Europe has been enjoying an acceleration in economic activity, recording over the latest year its strongest outcomes since the beginning of this decade. This has been led by Germany, which after some years of rather indifferent performance has emerged more effi cient, competitive and confi dent. Growth in Asia remains strong, led by the remarkable pace of China. The US economy, on the other hand, has slowed down over the past year or so. So one question for the period ahead is whether the slower US growth portends a softening elsewhere, or whether other regions are big enough and internally vibrant enough to carry on growing reasonably well in the face of the US slowdown. To a large extent this will hinge on how widely the slowing extends within the US economy itself, and how long it lasts. To date, it has been largely confi ned to a reduction, albeit a pretty large one, in construction of dwellings, after a period of unusually strong activity in that sector. People have been asking whether it will spread further, especially given the recent travails in the sub-prime mortgage market, which had at the peak accounted for about 15 per cent of mortgage loans made to US households. A decline in credit standards during 2006, as lenders sought to keep business growing in the face of the slowing demand for loans and a change in trend in house prices, has since resulted in a rise in loan arrears. In turn, this has resulted in a blow-out in spreads on the low-rated tranches of the securities issued by some of the US lenders active in this market, and a number of loan originators in the sub-prime space went out of business. There was understandably a concern that this sequence of events could prompt a pulling back by lenders for housing generally, which would deepen the downturn in construction. There was also a possibility that there would be a more widespread reassessment of risk and a tightening in credit across the US economy, so dampening growth more generally. But so far, the US economy and fi nancial system seem to be absorbing the sub-prime problems pretty well. There has been a signifi cant tightening in credit standards in the sub-prime area, as there had to be, but no widespread withdrawal by lenders more generally. While the US housing sector has yet to show much convincing sign of a pick-up in construction, the softness in the US economy does not seem to have spread to consumer spending, as incomes have been supported by ongoing gains in employment. That does not necessarily mean we have seen the last of concerns about US weakness but, at the moment at least, adjustments to the growth outlook are at the margin, rather than amounting to a wholesale rethink of economic prospects. It is also noteworthy, and very important from a global perspective, that underlying infl ation appears to have come down in the US somewhat over the past six months, having drifted higher for the previous six months. Low and stable infl ation has been a key underpinning of US and global economic expansion for the past decade and a half. Policy-makers around the world are rightly on alert for threats to that stability. If the US authorities have managed to turn infl ation back down, then the foundations for future growth will have been strengthened. But US policy-makers themselves would still say, I think, that such remains to be seen, and we have recently seen some shift in market pricing in recognition of the fact that the risk of higher infl ation has not yet disappeared. Around Asia, Japan is growing again, but the big story is of course China. According to the offi cial fi gures, China's GDP grew at about 11 per cent over the latest year, even faster than the preceding period. Just about every statistic on the Chinese economy paints a picture of dazzling growth, though there are also several areas where the Chinese authorities have expressed concern. There is more than a hint of froth in Chinese asset markets, especially the share market, which has increased by around 50 per cent this year. Rises in prices for soft commodities are also fi nding their way into food prices, which is a pretty big share of the cost of living in China and a number of other like countries. In response, China has tightened its macroeconomic management policies, and taken taxation measures aimed at dampening speculative excesses in the share market. We can expect, however, that China will seek to remain on a pretty rapid growth path for some time to come. To do so will require continuing efforts to fi nd domestic sources for growth, with not quite so much emphasis on export-led growth, if only because China will be too big for the rest of the world to accommodate an export-led strategy either comfortably or willingly. It will also involve increasing attention to environmental issues, especially as Chinese living standards continue to rise towards those elsewhere. But the Chinese authorities are aware of all that, and have shown an impressive capacity for economic adjustment over the years. Hence, I remain reasonably optimistic about China's long-run growth potential, and by extension the growth potential of those parts of Australia's economy that are complementary to China's growth needs. That said, it would be imprudent to assume that the recent consistency of exceptionally strong Chinese growth is normal. It is more likely that there will be occasional bumps along the road, and some of them could be pretty big. In the near term, were the US slowdown to become deeper and more protracted, Asia would probably be affected. It is true that direct trade linkages with the US have become relatively smaller as a share of total Asian trade in recent years. But while a larger share of Asian exports is now going to China, most of this trade is just part of the regional chain producing fi nal goods for sale outside of the region in the major countries, a big part of which is still accounted for by the US. So higher intra-Asian trade does not of itself mean that Asia is more independent of the US. The power of linkages via fi nancial market prices and attitudes of risk-takers should not be underestimated either. Hence a bigger US slowdown would still be a big deal, if it occurred, and keeping good global growth going would increasingly depend on policy responses in other parts of the world. But provided the weakness in the US economy remains largely confi ned to its housing sector, as seems to have been the case to date, the spillover effects to the rest of the world through trade and fi nancial channels are likely to remain small. There is some historical evidence in support of this point of view, with other moderate US growth slowdowns in the past having had a relatively modest effect on world growth. This seems to be the most likely outcome as we look forward over the next year or two. The trends in the global economy have imparted a very large expansionary impetus to the Australian economy. The rise in resource prices (and to a lesser extent a decline in global prices for manufactures) have increased Australia's terms of trade by about 40 per cent over the past four years, to their highest level since the 1950s. Despite the various other factors that are affecting the economy - like the drought - this is a boost of fi rst-order importance, with real national income nearly 8 per cent higher than it would otherwise have been. Some of that additional income accrues to the foreign shareholders of companies but a good deal of it stays in Australia in the form of profi ts and dividends, taxes, wages and so on. There are then indirect effects as that income is partly spent on domestically produced goods and services. Assuming the change to the terms of trade is not just temporary, there are further effects as fi rms respond to the prospect of higher profi ts in future by investing in greater capacity in the relevant sectors, though investment could well decline in other sectors of the economy where relative prices look less attractive. Typically, in such episodes the exchange rate rises because capital tends to be attracted to Australia by the same prospects of profi table investment, and also because markets anticipate that the expansionary forces at work will require higher interest rates. This tends to dampen activity in some parts of the traded sector, distributes the benefi ts of the higher terms of trade more widely across the economy, and gives a price signal for labour and capital resources to shift, over time, to the parts of the economy with the strongest prospects. It also assists to keep infl ation under control by lowering prices for tradable goods and services. The national income accounts show the broad contours of the effects. It is usually hazardous to base a story heavily on any one quarter's statistics, as these data can display considerable volatility over short periods. But taking the trend over the past year, growth in real GDP was around 3 3/4 per cent, half a percentage point higher than in the preceding twelve-month period. Business investment spending is high, suggesting a substantial increase in the nation's capital stock is occurring. Consumer spending gathered pace, on the back of large gains in employment and disposable incomes. Final spending by governments (that is, spending that directly affects demand, as opposed to transfer payments and taxation measures) has also risen at an above-average pace over the past year. Together these pushed domestic fi nal demand up by about 4 1/2 per cent over the four quarters to March. Some of the growth in demand was satisfi ed by imports. Exports picked up on the preceding period, but were held back somewhat by the drought, and in the case of some bulk resources, continuing capacity constraints. This is a strong result considering that the effects of the drought and rising interest rates were also at work. But these data seem at present to align reasonably well with other information. Business surveys have consistently pointed to buoyant conditions. The labour market survey shows strong growth in employment, and measures of surplus labour, whether the standard unemployment rate or various measures of underemployment, have all declined further. Tax revenues, a rough cross-check on the growth of the nominal economy, have continued to be very strong. Looking ahead, there does not seem to be a high likelihood of the world economy slowing abruptly in the near term. Hence, the external forces at work will in all likelihood continue to be pretty positive. Australian households overall appear to have plenty of disposable income and the confi dence to spend it. Business profi ts are in good shape, and fi rms will be well placed to continue their high levels of investment as needed. They are also displaying a strong propensity to borrow, with business credit growth at its highest for nearly two decades. Meanwhile, the number of dwellings being built looks to be below what is normally thought to be underlying demand arising from population growth and household formation. At some stage, therefore, it will probably need to pick up, adding to demand for labour in the construction sector and to demand for raw materials. There are nearly a million people working in construction, broadly defi ned as by the ABS, a rise of about 50 per cent from six years ago. Perhaps there is some further supply of labour available, but realistically there could well be a need for other types of private construction activity to tail off, so as to release some productive resources to accommodate (no pun intended) higher rates of dwelling construction. The intended further step-up in public infrastructure projects at the state level could also put some pressure on the engineering sector, unless private infrastructure projects also tail off. That is just one manifestation of the point that we need to pay attention to the economy's supply side, as well as to the demand side. Observers conventionally assess the outlook for growth by looking at the prospects for demand components, adding them up, and then assuming that supply will respond. Anything that stimulates demand is thought to be 'good for the economy'. But over recent years, we have increasingly been reminded that it is the economy's supply side performance - the quantity and quality of the capital stock, the availability of labour and the productivity with which both those factors are used - that ultimately determines its rate of growth over the long term. Demand management policies - monetary policy and government spending and taxation measures designed to have a broad economic impact - can usually ensure that there is adequate expenditure to use the economy's productive resources. But while we can, in most circumstances, create additional demand, it is much harder to create additional supply. Unless additional supply is somehow forthcoming, however, expanding demand just produces overheating and infl ation. Infl ation did pick up in Australia during the middle years of the current decade, from 2.4 per cent in 2003, to 2.6 per cent in 2004, 2.8 per cent in 2005, and 4 per cent by mid 2006. That peak in the CPI infl ation rate was affected by some temporary factors, which have now reversed. But measures of infl ation designed to extract the underlying trend showed a pick-up too, from about 2 1/2 per cent to 3 per cent during the fi rst half of last year. The most recent data for infl ation, however, showed a more welcome trend, with underlying measures of infl ation running at a reduced pace and the CPI rate on its way down as well. In our released about six weeks ago, our judgment was that underlying infl ation would probably run at about 2 1/2 per cent for the year 2007, which was a slight downward revision to earlier expectations. Data on labour costs received since then add credence to that forecast. Compared with what we expected a year ago, then, growth has turned out to be stronger, employment higher, but underlying infl ation a little lower, and wages growth has been steady in the face of unanticipated labour market strength. This is quite a favourable set of outcomes, and should prompt us to ask how it all fi ts together. One possibility is that all we are observing is lags at work. Earlier national accounts showed a weakening in growth from mid 2005 through to mid 2006. Perhaps this led, with a lag, to the slowing in prices recorded in recent quarters. If this is the story, the recent apparent acceleration in growth will presumably before long lead to a noticeable renewed pick-up in infl ation. While we should not completely discount this possibility, one shortcoming of this story is that the earlier slowing recorded in the GDP data was by and large not so apparent in other pieces of information, especially labour market information. The recent acceleration in GDP likewise is not so marked in other indicators, though neither is it entirely absent. But my guess at present is that at least some of the explanation for these better-than-expected outcomes probably has to do with changed behaviour in the labour market. Despite, on most counts, the tightest labour market conditions for a generation, growth in most measures of labour costs has remained well disciplined for the past two years or more, after a mild acceleration earlier. Wages are rising quickly in some areas, but quite slowly in others. That is, relative wages are changing, adjusting to the forces at work on the economy, but without, so far at least, a serious infl ation of the whole economy-wide cost structure. This looks like a textbook case of adjustment. We could note as well that, even though fi rms have been saying for some years now that labour is hard to fi nd, they seem in many cases to have found it nonetheless. A rise in immigration has helped to accommodate the strong demand for labour (though immigration, of course, itself also adds to demand to some extent). Rising labour force participation across a number of groups, especially among those aged over 55, has also been quite important. In economist-speak, the supply side of the labour market has recently been more 'elastic' than it used to be. It is a very different environment from the one that was in place last time we had a terms of trade event of this magnitude, testimony to the host of changes to the way the labour market functions that have occurred over the past two decades or so. To this we can add globalisation, where for some products at least, the 'elasticity' of the global market is available in response to short-term demand fl uctuations in Australia (or any other country). Australia is open to trade, which means not only that we have recourse to imports to meet demand if domestic supply is short, but since we are small in the world economy our demand per se has relatively little effect on the world price of those goods. The rise in the exchange rate would also be acting to dampen, at the margin, the rate of infl ation for tradables. All these factors presumably help to explain the recent pattern of moderate price increases in the face of stronger demand and output growth. But it would be a mistake to rely too heavily on these infl uences over a long period. While domestic supply has been reasonably elastic of late, it is surely not infi nitely so. And while global sources of supply are steadily becoming more important for many products, large parts of demand are still overwhelmingly supplied from domestic sources. It follows that persistent rapid growth in demand for non-tradables would eventually start to be accompanied by more pressure on prices and wages than we have seen lately. We must, furthermore, be closer to the point where that will occur today than we were a year ago. If strong demand growth persists, risks will increase. Nor can we assume that a rising exchange rate will exert a consistent dampening force on infl ation of traded goods and services over the longer term, since exchange rates do not keep rising indefi nitely. The ability to supply an increasing proportion of additional demand from imports probably also has some limit, though it is hard to tell where that might be. Hence, as things currently look, infl ation is more likely to rise during 2008 than to recede. This probability is something which was embodied in the medium-term part of the outlook we released six weeks ago. Data becoming available since then have given more credence to that part of the forecast. These are the considerations the Reserve Bank Board is seeking to balance as it meets month by month. On the one hand, the medium-term concerns about infl ation remain, for the reasons I outlined a moment ago. That is cause enough to err on the cautious side in setting policy, and to ask whether current settings are restrictive enough. On the other hand, the somewhat lower short-term infl ation outlook means that the starting point for a future pick-up in infl ation is likely to be a bit lower than earlier thought. This has afforded some additional time in which to assess trends in demand and the economy's capacity to meet them, while still leaving scope to implement a further response by monetary policy as and when needed. Weighing all this up, the Board has decided at each of its recent meetings to maintain, for the time being, the settings which have been in place since November last year. The fact that a number of timely adjustments to monetary policy had already been made gave us some confi dence in adopting that approach. In fact, a lot of the work needed to keep infl ation on a reasonable track was done in the period from 2002 to 2005, when unusually low interest rates, which had been appropriate for the earlier part of the decade, were gradually lifted towards normal. They were raised a bit further, to be slightly higher than normal, during 2006. Without that sequence, we would today have been in a much less comfortable position. Whether or not further instalments in that sequence will be needed is a question the Board will continue to address over the months ahead. The Board's judgment will, as usual, be informed by all the relevant data and an assessment of the risks we face over the coming couple of years. We are living through a period of profound change in the world economy, which is offering a rare chance to improve further the economic success Australians have enjoyed over the past decade and a half. Historically, Australia often did not manage periods of prosperity very well, as our institutional and policy structures were not suffi ciently fl exible and long-term in their orientation. The chances of success are much higher on this occasion, and the evidence so far is that we are doing much better, but the situation is not without risks. I trust that on some future visit to Queensland we will be able to look back and fi nd that the risks had been effectively managed. If so, then monetary policy will have played its part in furthering the prosperity and welfare of the Australian people.

r070718a_BOA

australia

stevens

Thank you all for coming out today to support the Anika Foundation. Since a similar function last year the Foundation has continued to build up its capital, and this year will be making its fi rst grants by way of scholarships, called The Anika Foundation Depression Awareness Scholarships, as a part of the NSW Premier's Teacher Scholarship Program. These will enable teachers and counsellors in our schools to travel, study responses to adolescent depression in other countries and return to NSW to raise awareness and improve responsiveness to depression among school students. Your interest in being here today will help us to build further over the coming year, when we hope to expand this same sort of scholarship to other Australian states. In time, funding permitting, we would also like to establish a PhD-level research scholarship in the fi eld of adolescent depression. Thank you also to Macquarie Bank for providing the venue and food for today's event, and to the Australian Business Economists for their logistical and advertising support. Ten years ago this month, the Thai baht was allowed to fl oat. It There were danger signs before then, but if we were looking for one event that marked the start of the Asian fi nancial crisis, this would be it. By the end of the year, the crisis had engulfed Thailand, Indonesia, countries with a combined population of around 400 million. It had very pronounced effects on neighbouring countries like Singapore, serious fi nancial contagion effects on Hong Kong, and had a discernible impact on the global economy. More fundamentally, perhaps, the crisis brought to an end a period of extraordinary economic growth in Asia, and seriously defl ated optimism about future growth. It has proven very diffi cult to recapture that sense of optimism. While that earlier ebullience may, of course, have been overdone, the scars of the crisis remain fresh in some respects even a decade later. With the passage of time it is of some value to revisit the crisis, to ask what has been learned, what steps have been taken to strengthen national, regional and international arrangements against a recurrence, and what remains to be done. That is the task that I shall begin today, though it is probably too big a task to fi nish in one session. I start with the question: what happened? There are many detailed treatments available elsewhere of what occurred, and I cannot do full justice to the literature or to the events themselves, which were fairly complex. must be mindful, too, that 'Asia' is not some homogenous mass, but a group of countries and economies that have considerable variety in their historical development and their approach to some economic policies. Nonetheless, I have to generalise for the sake of brevity. Asian economies grew rapidly through the mid 1990s. Average rates of GDP growth were between 7 and 10 per cent in most cases over the decade up to 1996 (Table 1). Rates of investment were high, and current account positions in several cases showed substantial defi cits. Put another, and more illuminating, way, there was substantial capital infl ow. In the case of Thailand, capital infl ow amounted to about 10 per cent of GDP per year between 1990 and 1996, though that was at the high end of the range in the region. In Indonesia's case the corresponding fi gure was 3 1/2 per cent. From an Australian viewpoint, that does not seem all that big, actually, but it had the Indonesian authorities concerned at the time. Capital markets in the region were underdeveloped, so the capital infl ow tended to be intermediated through the banking sector. Exchange rates were heavily managed, and the counterpart of the infl ow was a large build-up in money and credit in the domestic fi nancial sectors, an associated infl ation of asset values and some rise in prices for goods and services. Foreign currency risks associated with these fl ows were large, and were being incurred by domestic entities rather than being shared around the global markets. In many instances, neither borrowers nor their bankers were managing these risks at all well, in part due to weak risk- management capacities and ineffective supervision and, in part, no doubt, because the exchange rate regimes were assumed - wrongly as it turned out - to be robust. Foreign counterparties also seemed insuffi ciently attuned to the likely diffi culties that could be experienced by the Asian borrowers and fi nancial institutions, and their own limited ability to exit collectively what were quite small markets in the event that things went wrong. Pressures on the Thai currency began late in 1996, with early signs of some problems in local lenders coinciding with a rise in the effective exchange rates (and hence a decline in competitiveness) of some Asian countries owing to the rise in the US dollar and a downturn in the semiconductor market, which had been an important source of growth. For a time the Thai authorities were able to resist these pressures but they had to give up by mid 1997, as foreign exchange reserves were exhausted. The baht was fl oated on 2 July. It fell by 13 1/2 per cent that day and ended the month 23 per cent lower. Intense pressure quickly fl owed to currencies of neighbouring countries. A period of stability following the announcement of the support program for Thailand in early August was short-lived and by early October the currencies of Thailand, Malaysia, the Philippines and Indonesia were again under intense pressure. Attention then shifted to the economies of north Asia, which up until then had been only lightly affected. There was tremendous pressure on the Hong Kong dollar peg, where overnight interest rates soared and the share market slumped. As corporate and banking problems intensifi ed in Korea, foreign lenders cut back credit lines, and in November Korea approached the IMF for assistance in meeting foreign currency obligations. Political and economic uncertainty in Indonesia became extreme in the fi rst half of 1998, and the rupiah lost 85 per cent of its value. Even today, the rupiah trades at a 75 per cent discount to its pre-crisis level. In recent years, we have lived in an environment of unusually subdued volatility in international fi nancial markets, so we tend to forget just how discontinuous price movements can sometimes be. But the uncertainty and fi nancial skittishness that encompassed the global economy in 1998 were pervasive. It was not confi ned to emerging markets either. By August 1998, we had the Russian default, followed by the LTCM crisis in September. Around that time, the US dollar/yen exchange rate moved 30 big fi gures in three months, and at one point nearly 15 per cent in one day. Now that's volatility! One observer later described the international fi nancial system in the late 1990s as having endured perhaps its 'greatest stress in the post-war period'. In Asia, as the fi nancial market prices adjusted, some of the underlying vulnerabilities came more clearly into focus. The unhedged foreign currency positions meant that the authorities in the crisis countries faced a huge dilemma: as the exchange rate fell, the borrowers or their bankers, or both, went under water owing to the valuation changes on the debts. But raising interest rates to support the currency damaged capacity to repay as well. It was this fi nancial dimension that made the Asian crisis so costly. And costly it certainly was. Per capita real GDP fell by about 9 per cent in east Asia excluding China and Japan (Table 2). The fall in Indonesia was 15 per cent. On the best available fi gures, non-performing loans (NPLs) reached nearly half of all loans in Indonesian and Thai banks, and NPL ratios reached double-digits in several other countries in the region. The process of sorting out banking problems of this magnitude required, as it usually does, extensive public funding. The net fi scal costs of the banking crises are estimated to have been over 20 per cent of a year's GDP in Korea, 35 per cent in Thailand and about 40 per cent in Indonesia. We sometimes read that Asia quickly recovered. I am not so sure. In due course, recovery in Asia did take hold, but it was very slow in some cases. The pre-crisis peak in real per capita GDP was regained within two or three years in Korea, Kong. But that achievement took fi ve years in Thailand, six years in Malaysia and seven years in Indonesia. To put that in perspective, after the 1982 recession in the United States, real per capita GDP took about two years to regain its previous peak. In Australia after the 1990-91 recession, it took about three years. As I recall, those episodes were widely seen as serious. Even accepting that the pre-crisis situation was unsustainable, it is clear that the cost of the Asian crisis was enormous, and the recovery slow. In fact, the average rate of per capita GDP growth in east Asia post-crisis was a little more than half what had been seen in the decade up to 1996. Years to Per cent recover We learned a good deal about the nature of crises from these events. This was a different sort of crisis from the ones that had often been seen in earlier periods. It was not a standard example of a currency crisis resulting from lax macroeconomic policies, in which large budget defi cits (often funded from abroad), easy money, high infl ation and so on lead to a loss of confi dence in the policy regime and capital fl ight. In those cases, the standard remedy is mainly macroeconomic tightening to restore discipline and investor confi dence. In Asia, by contrast, fi scal and monetary policies had always been reasonably conservative. Infl ation rates were low by developing country standards, budgets were reasonably controlled in most cases, and government debt levels were At its heart, the Asian crisis was a banking crisis brought on by banks and their customers taking on too much foreign currency risk. No doubt macroeconomic policies were not always perfect, but the real problems were in the fi nancial structure more than the macroeconomic settings. This is now well understood, but it was not fully appreciated at fi rst by many outside observers, even though some Australian commentators, to their very great credit, understood it very quickly. A period of learning about how this type of crisis was likely to unfold and what needed to be done was inevitable, but it delayed recovery. Macroeconomic tightening was always going to be some part of the response, but far from suffi cient on its own, and if carried too far would be counterproductive. General structural reform of the economy's supply side, moreover, however desirable from the point of view of raising long-run growth rates, was always likely to play little role in the immediate recovery from a crisis of this nature, in which demand collapsed. In fact, recovery depended on addressing the fi nancial burden of the debts as directly and quickly as possible. The biggest problem that the countries of Asia had was that they had not developed the fi nancial infrastructure needed to provide resilience to swings in mood before becoming more open to fl ows of international capital. In drawing lessons, much discussion focused on the diffi culty of maintaining relatively infl exible exchange rates in an environment of relatively open capital accounts. While the early tendency to conclude that only corner solutions - hard pegs or unfettered fl oating - were viable has softened over time, I think most observers would say that a degree of fl exibility is needed, in most cases, to build resilience to swings in capital fl ows. But it was not just exchange rates that were the problem. The capacity of fi nancial institutions and corporations to manage risk, and of the supervisors to enforce better management, were far too weak. The markets required to manage such risks - to hedge foreign currency exposures, for example - were small or non-existent. More generally, capital markets were underdeveloped, especially local-currency denominated ones. Hence, not only were the risks concentrated in the banking system, but when the banks could no longer extend credit there was no other channel to make up the difference. As the countries concerned and the international community came to grasp these lessons, the nature of the debate changed. We began to hear much more discussion about 'capital account' crises, and the proposed responses became much more nuanced. Hitherto seldom-disputed notions about the optimality of rapid opening-up to international capital fl ows became more widely questioned. Capital controls - anathema in the world of the early 1990s - became respectable under certain circumstances. Much more focus was placed on developing bank supervision, and also such supporting frameworks as bankruptcy laws, corporate governance standards and so on. In international circles, there was considerable discussion about the need for some sort of international counterpart to domestic commercial bankruptcy procedures - 'standstills'. The countries most affected by the crisis drew their own particular conclusions too. One was that while the international fi nancial institutions might come to their assistance, there would be a lot of strings attached, and the assistance might prove to be neither timely nor suffi cient. From this judgment, whether it was correct or not, about the international mutual insurance arrangements embodied in the IMF, two things followed. First, the countries of Asia decided to self-insure, by building larger foreign currency reserves (Graph 3). In the face of speculative attacks in future they would be better armed. Ironically, the IMF itself encouraged this reserve build-up initially. Second, the countries of the region re-doubled their efforts towards building regional-support arrangements. There had been much discussion of this prior to the crisis, and some largely symbolic arrangements had even been put in place. But after the crisis, there was much more activity in this space. What then has been achieved in the area of strengthening the countries concerned and the international system since the crisis? At the risk of over-generalising, several common themes emerge at the national level. First, as one would expect, there has been an even greater emphasis fi rst on pursuit of sound macroeconomic policies. Of some note is that in several countries monetary policy frameworks have moved towards infl ation targeting. This is a natural progression when the exchange rate is no longer available as an anchor for policy. Thus far this framework has been operated with a fair degree of success. Fiscal positions in most countries have been improved, after a period post-crisis when some countries showed large defi cits. Countries in the region have also done a lot of work aimed at making their fi nancial intermediaries stronger. The frameworks for dealing with impaired assets in the immediate aftermath of the crisis have, together with the economic recovery, resulted in a gradual improvement in the shape of balance sheets of the core institutions, though more progress is needed yet in some countries. One World Bank report puts the average ratio of NPLs to total loans in the fi ve initial crisis economies at 6 per cent in 2006 - still a high fi gure by industrial country standards, but down from close to 30 per cent in 1998 (Table 3). participation in local fi nancial systems has increased in several countries, which brings both capital and expertise. Emphasis has been placed on beefi ng up bank supervision and fostering a stronger culture of risk management in the private sector. This is an area, however, where rapid progress is very diffi cult, and several countries still have diffi culty meeting the relevant international standards. Developing and maintaining a strong supervisory apparatus is a challenge in any country at any time, no less so in the Asian region. Countries have also pursued stronger requirements for disclosure, better accounting and auditing standards and so on. That said, progress towards improving the broader regulatory and governance arrangements that condition the 'investment environment' has, in the view of at least some commentators, been mixed, at best. A good deal of work has also been done, particularly of a co-operative nature between countries, aimed at fostering deeper, more resilient Funds, initiated by the regional central banks, established crossborder mutual-fund type structures allowing regional investors to hold obligations issued in local currency by regional governments and quasigovernment authorities. The ASEAN+3 group has encouraged the issuance of local-currency debt by the multilateral institutions. The development of securitisation and credit guarantee markets in the Asian region has been promoted through a number of regional fora, and securitisation in east Asia has grown quite rapidly since 1999, particularly in Korea, Hong Kong and Malaysia. These sorts of initiatives typically involve trying to remove the various small impediments that individual countries have (sometimes unintentionally) put in the way of investors, and progress towards the mutual recognition of regulatory frameworks in differing countries. These have been very useful examples of practical co-operation - and of how much work is involved in giving practical effect to general ideas agreed to so easily in international meetings. More ambitious ideas for mutual support have also been pursued, of which the Chiang Mai Initiative (CMI) is probably the most concrete. CMI provides for the countries in the ASEAN+3 group a series of bilateral swap lines, with the amounts committed being increased progressively. Recently, an in-principle agreement was reached to make the lines multilateral rather than bilateral, which would presumably make for more effi cient activation in a crisis. As a result of these developments, I imagine that today few countries in Asia would, if they got into trouble, consider an early approach to the international fi nancial institutions for assistance. But while the regional initiatives are all useful, they remain to be tested under less benign conditions in the global fi nancial system. In fact, it is open to doubt whether they would necessarily prove suffi cient as a defence mechanism, were really big changes in sentiment about the region to occur in international markets the way they did in 1997-98. If most countries in the region were under pressure at the same time, there would surely be questions as to whether regional counterparties could meet all the commitments for support. In any case, few fi nancial crises are confi ned to one region: even those that start with a regional focus have a habit of spilling over quite quickly, as events after the Asian crisis demonstrated. So while everyone has an interest in regional crises being effectively dealt with at the regional level, we surely still need global mechanisms for dealing with crises, and preventing them as far as possible. That prompts the obvious question: what has been done since the Asian crisis to improve the global arrangements? A good deal of effort has gone into crisis prevention. There has been a step-up in national and regional level surveillance by the international offi cial bodies, and an emphasis on more timely and accurate data being made available by governments. A stronger focus on fi nancial sector soundness is another key element, with a number of countries undergoing Financial Sector Assessment Programs, in conjunction with the IMF. These and other efforts represent serious attempts to use what was learned from the Asian and other crises to reduce susceptibility, or at least to get an early warning of regional-level problems, in future. But as useful as these things are, no-one could say that they will defi nitely prevent future crises. Hence, crisis management arrangements have still been given attention. One of the key elements is calming behaviour in capital markets once a crisis occurs. The private sector has contributed with a code of conduct, known as the 'Principles for Stable Capital provides a fl exible framework for co-operative discussion and action between private-sector creditors and emerging-market sovereign debtors. A complementary initiative was the introduction of Collective Action Clauses (CACs) in emerging-market bond contracts. This is intended to lessen the problem of getting collective action when a debtor needs to reschedule, by preventing minority hold-outs from derailing the rescheduling. The use of such clauses is now widespread. A more far-reaching idea is that of standstill provisions. This is, conceptually, the international equivalent to bankruptcy proceedings, where, once a creditor cannot repay in full, there is a temporary cessation of all payments while an orderly process works out how much creditors can collectively expect to receive, rather than a disorderly and ultimately very costly rush to the exits. This idea found concrete expression in the proposed Sovereign Debt Restructuring Mechanism discussed at the IMF, but did not attract suffi cient support from major countries and has not gone forward. There has been some evolution in the architecture of international groupings over time. The formation of the G-20 had its genesis around the time of the Asian crisis. Its membership is more representative of the global economy and fi nancial system of the 21 century, as opposed to the mid-20 century, and it has become more prominent over recent years. In parallel, the G10 seems to be diminishing in importance. With no crises of any magnitude in the past few years, the G-20 has turned its attention to other matters, including issues on the structural side. We should hope, though, that the G-20 will retain a capacity to talk frankly about urgent issues in the highly informal but effective way it did at fi rst, should some new crisis erupt. The Financial Stability Forum (FSF) was another creation of the more crisis-prone era, and is a useful body for getting key offi cials together regularly to identify potential threats to global stability. But while these architectural changes are helpful, the G-20 remains a work in progress, and the FSF is a consultative group, not a decision-making one. The reality is that if there is to be collective international action in the face of a crisis, international fi nancial institutions, with formal mandates and balance sheets, will remain very important. Focus on adapting the IMF to 21 century needs has intensifi ed in recent years. Questions of governance have been to the fore, in particular relating to representation and voting power for emerging-market countries. A small but signifi cant step was made last September with increased quota allocated to four important emerging-market countries which had been under-represented. The more laborious work of getting agreement on longer-run and more far-reaching changes is now under way and has some distance to travel. But it is critically important too that resolution of the questions about the IMF's mandate - what we want it to do - accompanies the governance reform. It will not be suffi cient for the emerging world simply to expect more say in how the international fi nancial institutions are run, without being part of a clearer shared understanding of what the institutions are seeking to achieve. That is a topic for another speech, but suffi ce it to say that constructive engagement by the emerging world, and especially Asia, in fi nding an agreement on mandate will be a key prerequisite for genuine progress. After all this, then, how would we sum up the way things have changed since July 1997? Is Asia, or the world, less vulnerable to a crisis than it was then, or not? Were we to ask policy-makers in the countries concerned, I am pretty sure they would say they remain acutely conscious of theirs being small countries in a world of large capital fl ows, with the attendant possibility of being overwhelmed by those fl ows - in both directions. Suspicion in the region of some of the larger players in international markets remains strong, as does the desire for regional co-operation in handling the fi nancial ebbs and fl ows. That said, vulnerability to a 1997-style crisis must have been reduced. The build-up in reserves means that speculative outfl ows could now be handled more effectively. Furthermore, the fact that most exchange rates have some more fl exibility now, even if they do not fl oat completely freely, also means that the authorities would be in a much stronger position because they can allow that price to bear some of the adjustment before they intervene. The various regional initiatives have contributed to the development of capital markets and stronger mutualsupport arrangements. The former still has some way to go and the latter have not been tested, but certainly progress has been made. But maybe the question of whether Asia could withstand 1997 better if it occurred again is not the right question. A future crisis could be of quite a different nature. It is at least as likely to be truly global as to be regional, and just as likely to originate in the developed world as in the emerging world. A generalised re-assessment of risk would no doubt test the resilience of the countries of Asia, along with everywhere else. That being the case, it is in Asia's interest that international efforts to manage risks more effectively on a global basis be continued. It would also be important therefore for Asia to be sure that Asian regionalism does not become inward-looking. Asia has mostly benefi ted from engagement with the global economy, and that will continue to be so. Another question is whether some aspects of the approaches being taken to avoid 1997 recurring are themselves starting to become a problem. In particular, the build-up in reserves has gone a long way past what seems suffi cient for self-insurance purposes, and has surely complicated monetary policy in some cases, not least in China. The associated capital fl ows are big enough, moreover, to have a signifi cant effect on global markets and potentially to rebound onto the Asian region. The rising size of sovereign wealth funds, and what risk profi le they will have, is also a question that is likely to be important to countries receiving the capital fl ows. For the Asian crisis countries, we should ask: is it optimal for so much saving to be funding investment in the developed world when the social return to investment at home surely ought to be higher? While investment prior to the crisis may have been unsustainably high, in some of these countries it is now arguably too Given that many changes over the past decade have been implemented to try and improve the stability of the region, do local investors still perceive the risks to be so great that they are unwilling to invest in their home countries? If so, why? Does that point to the need for further efforts at improving governance frameworks and regulatory environments, deepening capital markets and so on? The reason to address these issues has something to do with avoiding crises in future, but it has more to do with improving Asian living standards. To see how relevant that is, moreover, we need only look at the sorts of per capita growth rates post-crisis compared with the decade leading up to the crisis. They are much lower. The growth is not as easy to get as it once appeared, which puts the focus squarely back onto policy frameworks. The Asian crisis was an extremely costly event for the countries concerned. The crisis is now a decade in the past, but those costs continue to be felt today in a number of countries. The crisis dramatically changed thinking in Asia, and around the world, about the nature of economic and fi nancial crises, the policies appropriate to dealing with them, and the role of the various regional and global bodies charged with fostering economic and fi nancial stability. It is important that the passage of time, and the apparently benign environment we have recently enjoyed, do not prevent us from pressing on with the as yet uncompleted regional and global efforts to develop more resilience. Were we to slacken efforts there, we would surely come to regret it.

r070817a_BOA

australia

stevens

Mr Chairman, members of the Committee. Since we last met in Perth, economic conditions in Australia have strengthened. At the same time, fi nancial markets globally have recently become extremely skittish and there has been a very sharp reassessment of risk and a sudden desire for liquidity. I will come to the fi nancial market turbulence shortly. Before I do, however, it is worth recounting how the real economy has performed over the past six months. Given the uncertainty being felt in fi nancial markets at present, it is important to keep a clear sense of the economic fundamentals. According to the national income accounts, growth picked up sharply in the December and March quarters. Over the year to March, real GDP is estimated to have expanded by about 3 3/4 per cent, despite the impact of the drought. The non-farm economy was reported as having grown by about 4 1/2 per cent, equal to its fastest pace for four years. Gauging the true extent of acceleration is not straightforward given the inevitable noise in the data over short periods, but a wide range of survey evidence and other indicators also suggest that conditions picked up in the fi rst half of 2007. Domestic spending is rising, with robust rises featured among most of the components. The exception is residential construction, where commencements remain fl at at slightly below-average levels. Demand for credit also appears to have fi rmed, most particularly among businesses. Household fi nances, like corporate fi nances, are generally in strong shape. Demand for Australian exports is rising too. Success in transporting higher volumes of resources has been mixed, varying by location and industry and according to disruptions caused by weather, efforts at adding new capacity, and port and rail delays in some cases. But the trend is upward and tonnages are set to increase over the next several years as capacity comes on line. Agricultural exports will benefi t from the improved rainfall in some parts of the country. Not surprisingly in light of the above, the demand for labour has continued to expand. The recorded rate of unemployment is at its lowest for a generation. Job vacancies are high and surveys suggest that many fi rms see the diffi culty of fi nding additional labour as among the biggest, or the biggest, impediment to expanding production. As yet, though, the pace of growth in labour costs overall has remained relatively contained. In thinking about why growth has picked up somewhat more than had been expected, we should not overlook the fact that the global economy has surprised, once again, by its strength. The most recent forecasts for global growth made by the IMF were revised upward only a few weeks ago, with growth now thought likely to be over 5 per cent in 2007, close to the 2006 result. The US economy has slowed but greater strength elsewhere has, to date, more than outweighed the US softening. Australia's terms of trade have kept rising and stand at a fi ve-decade high. This has added about 1 1/2 per cent of GDP to the annual growth in Australia's national income over the past couple of years, which is quite an expansionary force. Some of the resulting demand spills abroad, but there is also a stimulus to spending on non-tradable goods and services arising from the income gains being experienced. The rise in property prices in Western Australia is a case in point. It would be imprudent to assume that this trend will continue indefi nitely. Nonetheless, it has already gone considerably further than most observers anticipated. When we lift our gaze beyond the conventional forecasting horizon, the big picture is that the emergence of potentially very large economies like China and India, at such a rapid pace and with such consistency, is unlike anything we have lived through before. We cannot be confi dent, therefore, that the cyclical experience of the past few decades is necessarily a reliable guide to how things will develop. In its policy deliberations over several months, the Board has weighed confl icting trends. When we were last before you, we were observing an apparent moderation in infl ation. We were, as you know, at that time still of the view that there could be a need to tighten monetary policy further at some stage. But having made three adjustments in 2006, we believed that the improving short-term trend in infl ation afforded us time to watch developments. Information that came in over the ensuing period suggested stronger-than-expected demand in the economy. This meant that the longer-term risk of higher infl ation was increasing, not diminishing. Hence, the likelihood that interest rates would need to be increased at some stage was rising. Moderate price and wage outcomes continued, however, for some months, suggesting that, at least temporarily, the supply side of the economy was managing to respond to stronger demand. It was doubtful that this could continue over an extended period, but taken together, the weight of evidence suggested that the best course for monetary policy was to maintain the existing setting for the time being, but to be ready to tighten should signs of a strengthening of price pressures emerge. The June quarter CPI data, available for the August meeting, showed some pick-up in infl ation. Together with a stronger growth outlook, this information led us to expect a somewhat higher path for infl ation over the horizon of the coming one to two years. The judgment we reached was that the risk of unnecessarily damaging growth with a modest rise in interest rates was small, whereas the cost of not responding to a deterioration in the outlook for infl ation could well, in the longer term, be substantial. On straightforward macroeconomic grounds, therefore, there was a clear case to make an adjustment to monetary policy. As our statement on Wednesday of last week set out, the Board considered the recent events in international credit markets in coming to our decision. Here, Mr Chairman, it is worth taking a few moments to set out some history. For some years now, many long-term observers, market participants and offi cials have been troubled by very narrow pricing for risk. In other words, it has been easier and cheaper than had been normal in the past for risky borrowers to access funding. Investors were prepared to take more risk in pursuit of returns in a world of low global interest rates. Somewhere or other, returns were eventually bound to disappoint someone. As it turned out, the problems emerged in the US housing sector. Lenders into the so-called 'sub-prime' market attempted to keep the pace of business up as the US housing sector slowed during last year. But they could do this only by lowering lending standards. Before long, arrears began to rise as some borrowers struggled to meet their commitments. Once this deterioration in underlying asset returns had occurred, those with exposures inevitably began to see losses. Because this type of lending was via securitised structures sold into global capital markets, losses have been coming to light right around the world. In most cases, the losses are embarrassing rather than fatal for the institution concerned. The exceptions have been where particular funds invested mainly or solely in these types of risky assets, and especially where leverage was involved. Several hedge funds have borne large losses, including some in Australia. All of this created a climate in July and early August in which investors retreated and pricing of risk started to return to levels that could be regarded as more reasonable based on historical experience. A number of capital raisings that had sought to take advantage of the earlier very generous terms were postponed. Volatility in some fi nancial markets increased, share prices declined somewhat and a general sense of heightened uncertainty was evident. In considering the implications of all this for our decision on monetary policy, there were two questions to ask. The fi rst was whether there was information to suggest that fi nancial developments were likely to make a suffi cient difference, over the relevant horizon for policy, to the global economy, and therefore the Australian economy and the infl ation outlook, to remove the macroeconomic case for a 25 basis point adjustment to cash rates. On balance, we judged that there was not. Downside risks to the US economy do appear to have increased over recent months, but in other parts of the world the growth outlook has, if anything, been marked higher recently. The second question was whether a rise of 25 basis points in Australian cash rates would, in itself, be fi nancially destabilising. No credible case could be made for that idea. In fact, it would probably have been more destabilising to expectations not to have carried out a policy adjustment that most people could see was needed. Accordingly, as you know, monetary policy was tightened last week, taking the cash rate to Subsequently, towards the end of last week there was a period of stress in some major country money markets. Because the exposures to the mortgage problems in the US are still coming to light, fi nancial institutions are uncertain over the standing of other market participants. Objectively, it is extremely unlikely that the sub-prime mortgage exposures could signifi cantly damage the core banking system in any signifi cant country. The exposures are spread far too widely for that to occur. But precisely because they are spread widely, and because the associated fi nancial structures are opaque, information on who is exposed and by how much is incomplete. Hence people remain wary. At times of uncertainty, market participants naturally get more cautious and want to hang on to cash, rather than lending it in the interbank market. In such circumstances, central banks typically respond by being prepared to make additional cash available, through purchases of high-quality assets from market participants, in suffi cient quantities to keep the cash rate at the level required by monetary policy considerations. Several major central banks made very substantial injections in this way on Thursday and Friday last week in the face of an abrupt shift in cash market conditions. While the likelihood of a signifi cant problem of this sort arising in the Australian money market was low, last Friday the Reserve Bank as part of its normal dealing operations purchased more assets, hence adding more cash to the system, than it otherwise would have done. The intent of this was to ensure that the cash rate remained at the target level set by the Board. The market operated normally and overnight funds were available in the market at 6.50 per cent, exactly as intended, and this has remained the case subsequently. Of course, the Reserve Bank remains ready, as always, to ensure there is adequate liquidity for markets to function normally in the period ahead. The broader credit market issue is that the losses arising from the US mortgage problems are still being assessed and absorbed. That is producing a degree of uncertainty that is affecting fi nancial markets around the world, leading to tougher borrowing conditions for the moment, and considerable volatility. The fact that the global economy has been so strong, that core fi nancial institutions after years of strong profi ts are well capitalised, and that real sector corporate profi tability in most countries is very sound, will be helpful in coping with tougher credit conditions if they persist. Indeed, global growth has of late been suffi ciently strong that some moderating effect would be welcome. An adjustment to investor behaviour needed to occur, and was almost certainly overdue. Such adjustments often are not entirely smooth, and are frequently triggered, as in this case, by the realisation that credit terms had been too generous for too long. Sometimes, however, the ensuing retreat can go too far, resulting in a widespread withdrawal from the provision of credit that unnecessarily crimps the pace of economic expansion. We will, therefore, have to continue to watch carefully how this unfolds over the period ahead. released a few days ago contains our most recent assessment of the outlook. It takes account of the change in interest rates as well as the recent fl ow of data at home and abroad. There are, of course, various assumptions on which the outlook is based, and these parameters could shift over time. The credit market developments add a further degree of uncertainty about the outlook. Subject to that uncertainty, the picture is one of growth close to trend and the economy remaining close to full employment. Under such circumstances, infl ation is likely to be around 3 per cent over the coming year, and near the top of the target zone in the following year. As far as risks to that forecast are concerned, the possibility that the world economy might end up being weaker than assumed, due to a persistence of credit diffi culties, is one that everyone will have in mind at present. At the same time, there is also the possibility that ongoing strength of demand in a fully employed economy might leave us with infl ation pressure that is harder to manage than expected. These possibilities, and other things that could come along unexpectedly, will be issues that the Board will have to assess each month. For now, my colleagues and I are here to respond to your questions.

r070918a_BOA

australia

stevens

As you would all be aware, 2007 is the 10 anniversary of the Asian fi nancial crisis. The crisis is usually dated as having begun with the fl oat of the Thai baht in July 1997, though the problems had been building for some time before that. The events of 1997 and 1998 profoundly affected the region's economic growth. In a speech earlier this year, I reviewed the key events of the crisis. Rather than go over that ground again today in detail, I will address the question of how Asia is coping with the recent distinct change in global fi nancial market conditions, before talking about how the same events are affecting Australia. I want, then, to turn to issues for the future and, in particular, what interests the Asia-Pacifi c region has in the ongoing efforts to renovate the post-war offi cial architecture of the international fi nancial system. For a number of years now, many commentators have expressed concerns about the under-pricing of risk in fi nancial markets, with investors increasingly willing to purchase risky assets at high prices and often with considerable leverage. Easy credit conditions accommodated and encouraged these trends. Over the past couple of months, we have witnessed something of a reversal. The initial trigger was the deterioration in the US sub-prime mortgage sector, itself a result of declining credit standards and a slowing US housing market. Since the exposures to these risks had been spread via securitisation into global fi nancial markets, losses are being borne in most parts of the world, including in Australia and some countries in Asia. Those losses have been coming to light only slowly, however, in part because the complex and opaque nature of some of the fi nancial instruments in use makes valuation diffi cult, or even impossible under adverse conditions. In some cases, there simply is no market for, and hence no way of providing an objective valuation of, the claims in question. In the ensuing climate of uncertainty, investors rapidly have become quite risk averse, and some parts of the global capital market have suffered severe dislocation. In turn, institutions that rely heavily on wholesale capital markets, either for balance sheet funding or to securitise assets they have originated, have experienced diffi culties. So-called conduits, credit arbitrage funds and various other vehicles often issued short-term commercial paper to fund their assets. This strategy, which was in some cases designed to avoid capital requirements for loans held on banks' balance sheets, can carry signifi cant maturity mismatch and hence funding risk. When investor attitudes changed abruptly in early August, asset-backed commercial paper markets around the world virtually came to a standstill, forcing many of these vehicles to tap lines of credit they had with banks. This, of course, transferred the funding pressures to the banks. Since there is a great deal of uncertainty about the likely demand on their own liquidity, banks have been conserving liquidity and have been reluctant to commit to lending to others for anything beyond a very short horizon. Institutional investors, which are now in a much more powerful position than a few months ago, have behaved cautiously and are demanding higher yields to accept bank paper. Hence, short-term funding rates have moved higher in a number of countries. In some cases, even overnight rates spiked sharply higher. Changes in attitude to risk also spilled over to other markets. The diffi culties have spread beyond sub-prime mortgages per se to include the broader range of instruments euphemistically labelled 'structured products'. As investors have looked for more secure and liquid assets, yields on government securities have declined, share prices have fallen and there has been some signifi cant readjustment of exchange rates. Volatility across a range of markets has increased signifi cantly. So risk is being re-priced, and strategies that looked like easy ways of making money in good times are being tested. The episode is also a reminder of the key role still played by the core banking system, despite the growth of capital markets. Banks were the fi rst line of liquidity support when capital markets stumbled. For the time being at least, more of the fl ow of new credit needs to be done on, and to remain on, the balance sheets of the core intermediaries than has typically been the case over recent years. It is helpful, then, that in most countries, those core institutions are profi table and well capitalised, since there may be quite a considerable process of re-intermediation to be undertaken over the months ahead. There are several potential channels through which these events could have an impact on east Asia. Asian investors could be exposed to the underlying problem assets; Asian institutions and markets could be affected by the backwash of liquidity and funding issues in the major markets; and Asian economies could be affected by broader macroeconomic effects. Let's consider a few of these channels. At this point, disclosed exposures of Asian fi nancial institutions to the US sub-prime mortgage market per se have been limited and look small relative to the total assets of the institutions concerned. Actually, to digress for a moment, for most holders of such exposures, losses should be suffi ciently small as not to fatally undermine the solvency of the holder, unless the holder is leveraged. The biggest problem thus far has not been that exposures are large, but that they are not transparent. The sooner they are all on the table, the sooner the uncertainty will be lessened and the sooner market participants can discriminate sensibly among their counterparts. This is not easy to achieve given the pricing issues, but at the moment, there is widespread suspicion in the absence of clear information. It would be very damaging for that lack of information to lead to a lengthy period of severely reduced credit fl ow to perfectly good borrowers simply because investors cannot tell who is sound and who is not. More information is needed. Against a backdrop of rising global risk aversion and increased demand for liquidity, investors sold off emerging Asian equity holdings in late July, resulting in noticeable movements were not especially large, however, compared with numerous others seen over the past couple of decades. Asian sovereign debt spreads to US Treasuries have risen over recent weeks, though by less than the spreads on low-rated American corporate debt. Indeed, the absolute level of sovereign bond yields in Asia The sharp increases in short-term money market rates in developed countries do not seem, as yet, to have been a widespread feature of emerging Asian markets. There are a couple of reasons for this. Mortgage lending via securitisation plays a relatively small role in most Asian housing fi nance markets, which means that the region's banks have not had to fund warehousing of loans. This, along with the fact that most banks in east Asia tend to rely less on offshore or wholesale sources of funding than many of their developed country counterparts, means that it is unlikely these banks have been under much additional funding pressure as a result of tighter global credit conditions. In fact, foreign bank claims on the 1997 crisis countries in total, as a ratio to GDP, have declined substantially The rapid growth that we have witnessed in east Asian equity markets may pose a risk. Despite the Asian region being a net creditor, net private capital infl ows have been positive over the past few years, partly refl ecting strong equity infl ows. If conditions in global fi nancial markets deteriorate further and risk aversion becomes more entrenched, there is always a possibility that equity capital could fl ow out of the region reasonably quickly. But Asian equity market valuations are generally not that high, with solid corporate earnings keeping P/E ratios down despite the sharp rise in equity prices recorded in recent years. More generally, in my judgment, structural changes and reforms to Asia's banking and corporate sectors over the past decade leave the region in better shape than it was a decade ago to cope with any potential problems which may occur. Bank balance sheets are typically stronger, a result of improvements to the quality of supervisory oversight and risk management practices, and reduced fragmentation and government ownership in the banking sector. A range of indicators also point to a healthier corporate sector in Asia. There is also generally more fl exibility in exchange rates today. That, combined with the large build-up in foreign exchange reserves, means that capital outfl ows, were they to occur, could now be handled more effectively than in the past. Of course, the region could still be affected by international events through the trade channel. The ratio of exports to GDP has increased for all Asian countries over the past decade. While it is true that intra-regional trade has expanded a great deal, it remains the case that a considerable part of this activity is ultimately aimed at delivering goods to outside the region. So a major slowdown in the US economy would still be important for east Asia, the more so if the slowdown also extended to Europe. China is growing strongly, which will help the region to expand even in the face of weaker conditions elsewhere. But, the Chinese authorities are trying to slow their own economy to avoid overheating. So, Asian nations will need to assess the overall economic fall-out from the current episode in formulating their own policies. In summary, the impact of the recent tightening in global credit conditions on Asian fi nancial markets has, so far, been reasonably well contained. In comparison with the extreme volatility experienced in fi nancial markets during the Asian crisis, recent market movements are minor. This is not surprising, really, given that the nature of the shock we are experiencing today is very different from that of a decade ago. In 1997, the epicentre was in Asia, with inability to distinguish between countries resulting in regional contagion. In contrast, the shock we are experiencing today originated in the developed world, with events in the US housing market the catalyst. The relatively lesser degree of international integration of Asian capital markets with the global system has, in this instance, probably been a blessing. It would appear from this analysis that the main risk to most of the east Asian economies lies not so much in the area of direct fi nancial contagion, as in the ordinary macroeconomic impacts of, potentially, a slower US and world economy. Australian fi nancial markets are part of the global fi nancial system, and have become progressively more integrated over time. This has had many benefi ts, not least of which has been improved access to global capital markets for Australian investors and borrowers. By the same token, when there are major events in global markets, Australian markets can expect to be affected. Recent weeks have offered a clear demonstration of that fact. As I noted earlier, international commercial paper markets have had a very diffi cult time over the past month. For some weeks, outstanding paper was not able to be rolled over, and it was almost impossible for many entities to issue new paper. The same was true for residential mortgage-backed securities. Some Australian entities have been signifi cantly affected by these disruptions. The underlying asset quality in Australia is clearly sound. Loans that could be called 'sub-prime' in Australia are about 1 per cent of the stock of total mortgages, compared with around 15 per cent in the US, and arrears rates on these loans are considerably less than those on US sub-prime loans. The securities backing these Australian loans continue to perform. For the housing loan portfolio as a whole, arrears rates remain exceptionally low by global standards; and for securitised loans in particular, arrears rates have been steady, at about 0.4 per cent, for about the past year and a half. But at times like this, investors are often unable, or unwilling, to discriminate between different underlying credit risks. In such a climate, issuers have understandably been cautious about offering new paper because of the likely higher cost involved. In other words, uncertainty on both sides led to a drying up of the fl ow of funds in capital markets for several weeks. In recent days, there have been some encouraging signs of new credit beginning to fl ow again. But conditions are still diffi cult and this may remain the case for a while yet. In the meantime, the same sorts of pressures on term-funding costs for fi nancial intermediaries observed elsewhere have been seen in Australia rates for three month A$ loans have recently been about 50-60 basis points above the overnight index expected cash rate). The normal margin is around 10 basis points. Bank bill rates in Australia have been as much as 40-50 basis points above OIS, compared with 5-10 basis points normally. These gaps are smaller than seen in other comparable countries but are nonetheless signifi cant. It is important to note that this is not due to a shortage of overnight liquidity. The system is amply supplied and settlement balances are, in fact, much higher than normal. The RBA has supplied as much cash as the market requires for the cash rate to remain at the level set by the Board, and that rate has indeed remained within a couple of basis points of the target throughout. Other rates are determined, as they always have been, by market conditions based on participants' expectations about how the cash rate might move as well as term, liquidity and credit premia. Sometimes, as now, those premia have been known to move. It should go without saying that loan rates are decided by the intermediaries making the loans on the basis of their costs, risk assessments and competitive considerations. The RBA does not set these rates, though we can and do take account of how the margin between these rates and the cash rate alters. As markets work to re-price risk and individual participants grapple with uncertainty about their own possible future liquidity needs, lending and borrowing have been kept very short-term. The RBA has acted to assist market functioning by extending the pool of acceptable securities for repurchase agreements. The intention of this is to give market players some additional confi dence that quality assets can be turned into cash if needed, so they can get on with the job of re-pricing risk. From our point of view, this means accepting a little more private credit risk in our operations, but we have been moving in that direction anyway for years, if for no other reason than that there is no longer a suffi ciently large stock of government securities on issue in which we and market participants could transact in volume. Provided the transactions are conducted on proper commercial terms with appropriate margins, we judge these credit risks to be manageable. Helping fi nancial markets to function as they undergo a re-pricing is, of course, one role of a central bank. But it is also important that we do not lose sight of our other role, of making monetary policy in pursuit of sustainable growth with price stability. From that perspective, we observe that funding costs for intermediaries have risen beyond the adjustments associated with the rise in the cash rate on 8 August. Some borrowers are being asked to recognise this higher cost in the rates they pay for their loans, a trend that will continue if the higher funding costs persist. Hence it appears, at this stage at least, that we may well observe a further tightening of fi nancial conditions in the Australian economy in the months ahead. In assessing that prospect, the Bank will need to take note of two forces. The fi rst is that, going into this episode, the economy was travelling very strongly, with the outlook for growth and infl ation being revised higher over recent months. The data since the August decision to lift the cash rate indicate an economy at least as strong as the Board's assessment at that time, with few signs of that momentum slowing. The second factor is that the outlook for the US economy has been weakening and will presumably be affected to some extent by the credit market events themselves. It is conceivable that some European economies could be affected as well, given the credit diffi culties in those markets. To this extent, global growth, which has continually surprised by its strength in recent years, could, other things equal, turn out to be a bit weaker than expected a few months ago. Given the macroeconomic situation of the Australian economy thus far, some additional restraint would perhaps not be unwelcome. But just how much such restraint will occur as a result of a market tightening in credit conditions is not yet clear. Assessments of how much is warranted could be affected by changes in the international environment as well as by developments in the domestic economy. These are matters the Board will need to grapple with over the period ahead. I turn now away from recent events, as absorbing as they are, to offer a few observations about the Asia-Pacifi c region in the international fi nancial system over the longer run. It is commonly observed that the 'centre of gravity' of the global economy is shifting east, away from the Atlantic and towards Asia - which, for this purpose, should be defi ned to include India. There is naturally a discussion about how best to recognise this greater importance of Asia in the 'architecture' of the international system, including in the offi cial institutions. Some initial progress was made in the small increases in quota allocations in the IMF to four emerging countries, two of which were in Asia, late last year. The much harder task of fi nding agreement for more far-reaching changes over a longer timeframe is now under way. That is very important work. But the point I would like to offer here is the following. In parallel with the efforts to reform governance of the international institutions, there will need to be efforts to fi nd agreement on mandate questions - that is, about what it is we want the IMF and other bodies actually to do, and not do. It will not suffi ce for Asia (or other regions in the emerging world) to expect more say in how the institutions are governed without being part of a clear consensus as to how they will use that increased infl uence. What is their vision of the IMF's role? What are the limits to that role? Those who will ultimately have to cede some of their current infl uence to accommodate the developing countries will surely be reluctant to do so unless there is clearer mutual understanding on those sorts of questions. Asia must be prepared to contribute to this discussion. This requires meaningful engagement on the key issues such as: how can different national policies, including exchange rate regimes, be made to co-exist within the international system? what are the respective responsibilities of the various nations to foster that compatibility? what is the proper role for the IMF and other supra-national bodies, not just as occasional lenders to individual nations, but as custodians of the international system all the time? The recent 'review' of the '1977 Exchange Rate Decision' by the IMF is a start on this discussion. It revises an agreed set of words from 30 years ago to form a more up-to-date basis for guidance to IMF members about exchange rate policies, and provides a framework for surveillance by the IMF membership of those policies. This is a good start, but only a start. The key will be the way the surveillance is actually implemented. That is in the hands not just of the IMF's staff and management but also its membership. The membership from this region will need to be ready to play its part. By this I mean that the countries of Asia will need to be ready to defend their policies robustly, but also to work with others in understanding and mitigating unintended consequences of their policy choices. Asian countries should, of course, expect the same from other regions. It is worth adding that, in other fora, Asian countries have a potentially strong voice if they can coalesce. In the G-20, for example, China, India, Indonesia, Japan and Korea are all at the table, as is Australia. If that group of countries could speak in a united way on issues of key mutual interest, it would be a powerful force in a globally signifi cant group. It is not easy to fi nd a common position, of course, and it will not be possible on some issues. We need only to look to Europe - a continent that has been working at this for a long time - to see how national differences frequently limit collective regional infl uence. But to the extent that Asian countries can agree on some things, they have the potential to be quite infl uential. Recent events are putting fi nancial systems to the test around the world. For years people have worried about the so-called 'global imbalances' leading to trouble because Asian investors might refuse to buy dollars. Others have feared some sort of repeat of the 1997-style 'sudden stop' crisis in the emerging world. But, in fact, it has been a domestically generated credit event in the world's most sophisticated economy, the United States, that has triggered the recent reappraisal of risk. The resulting fi nancial strains have been most acute in the developed, rather than the developing world. This episode may have some time to run. But the sooner the exposures to problem assets are accounted for and disclosed, the sooner markets can get back to pricing risk prudently and providing credit on sensible commercial terms. At present, without enough information, they are operating on an impossibly short timeframe, out of fear of what tomorrow might bring. Asian countries appear, to date, to be weathering the storm fairly well, as is Australia in my view. But the episode reminds us all of the importance of working to improve the resilience of our own domestic fi nancial systems and policy frameworks, and of the task, as yet uncompleted, of building better international arrangements for the future.

r071211a_BOA

australia

stevens

This evening I would like to talk about central bank communication. There are plenty of people who probably think that 'central bank' and 'communication' are not expressions that are normally thought of as belonging together. Yet communication has become steadily more open, and more important, in the central banking world over the years. At one time, overnight interest rates used to be adjusted without announcement or explanation - 'snugging' was a popular term of the late 1980s. The market would generally take a few days, and the general public considerably longer, to work out what was happening when monetary policy was changing. They usually had to wait longer again for an explanation of why it was changing. That is no longer the case. These days, central banks say they are moving the interest rate, and say why, very openly. This particular form of transparency was adopted quite early at the RBA, back in 1990, under Bernie Fraser. Not only do they announce policy changes in a forthright fashion, most central banks set out their detailed assessment of economic conditions in published material. In a number of cases, they publish minutes of their policy discussions. Governors and others give speeches, appear before parliamentary committees and are frequently quoted by various commentators in the media. For central banks, historically quite discreet organisations, this is quite a change. I want to examine the reasons behind that change, and the case for openness. I want also to talk about the limits of openness. Finally, I will elaborate a little on our own recently announced changes in this area. To begin with, it is worth asking the question: why do central banks communicate? There are at least two reasons. The fi rst arises from the principle of accountability in an open and democratic society. The central bank is charged with some important responsibilities - maintaining the purchasing power of the nation's currency, pursuing 'full employment' and fostering stable and reliable fi nancial and payments systems, among others. It is endowed with substantial powers - in the RBA's case, to buy and sell fi nancial assets, commodities, real property, to lend money and to make certain regulations - in fact, to do anything that could be thought to come within the remit of 'central banking business'. It stands to reason that the central bank should expect to account for the way in which it has used its powers to pursue its statutory goals. The framers of the nearly 50 years ago very wisely placed the Parliament squarely in the centre of accountability arrangements. In recent times, the has required annual reporting of the relevant agencies, of which the Reserve Bank is one, but from the very beginning the RBA was required to issue an annual report to Parliament. Yet the requirements for more frequent communication have grown over the years. In part this refl ects the increased development of capital markets and the speed and force with which they respond to economic developments. Markets crave information, and the central bank's assessment of the state of the economy is one part of the information set. In part, the demand for communication accompanies increased operational independence for central banks. When the central bank is making an important policy decision under an authority delegated by the Parliament, as opposed to implementing a decision made by a minister - and that is what we are doing in the case of monetary policy - there will naturally be an expectation for accountability. It also refl ects the general development of the community's expectation to be more informed about important matters. That is a natural concomitant of a more affl uent, educated and mature society. As such, it is something to be welcomed. There is also the role of the media. Our political leaders are expected to answer questions from the media much more frequently, and across a much broader range of issues, than once was the case. Some of this spills over onto other institutions, including corporations and central banks. The media is responding to market demand for information here, but as in any other competitive industry, media organisations are also seeking to create new markets by supplying more intensive, more frequent coverage of more issues, including economic policy. The second rationale for more communication is the desire for more effective policy. Some policy actions have as much effect through conditioning expectations as by constraining current behaviour. This is very much true in the case of monetary policy. A change in the cash rate of modest size has only a pretty small impact on the economy. But expectations about a sequence of possible future interest rate changes can often be more powerful. What a central bank says, as much as what it does, affects those expectations. Even more important are expectations of future infl ation. When people expect prices to rise rapidly, they bring forward purchases, put up their own prices, demand higher wages and so on. That helps to create the very infl ation they expect. On the other hand, if people are convinced that infl ation will be contained - perhaps because they believe that the central bank will do whatever is required to achieve that - they behave accordingly. In that case, their price-setting, wage and purchasing behaviour helps keep infl ation controlled. Expectations are more likely to be helpful in fostering economic stability when the public has a clear understanding of what the central bank's goals are, how the central bank thinks the economy works and how in general terms it is likely to respond to various events, particularly pressure on infl ation. That is why most central banks spend a good deal of time talking about their objectives and their policy framework. It is why they publish exhaustive analyses of economic conditions and offer such assessments as they can about likely future developments. Of course the world is highly uncertain, so central banks cannot spell out exactly what they would do in response to every conceivable scenario. There will always be the potential for some surprises. But if people understand the framework and the goals of policy, then their own response to that knowledge will usually be helpful in achieving the policy goal. Hence, communication is an important part of the policy process. So much for the rationale for communication. What are the channels central banks use? There are several. Most central banks have a program of publications. Australia's central bank has been publishing the every month since 1937. In most cases central banks publish the results of research of their staff. The views in these papers are those of the authors alone, but much of the research is part of the knowledge base available to the policy-makers and hence is usually of interest to those seeking an understanding of policy issues. The RBA has been publishing Over the past 15 years or so, many central banks have upgraded their regular economic reporting, giving a more in-depth account of economic conditions with a more analytical fl avour. In some countries with formal infl ation targets, these are called 'infl ation reports', though they are about much more than infl ation. These documents set out the factual background in a way which shows how policy-makers account for economic and fi nancial conditions in their decisions. In the process they usually reveal a good deal about how the central bank thinks the economy works - its 'model', if you will. In many, probably most, cases, these documents contain forward-looking material. Forecasts for infl ation (and often for other key macroeconomic variables), the assumptions on which the forecasts are based and the extent of uncertainty surrounding the forecasts are, to varying degrees, spelled out. A few central banks even publish a future interest rate path - albeit one heavily conditioned by assumptions which are almost certain not to be realised, for one reason or another. The RBA has progressively upgraded its own regular report. The appears in the mid month of each quarter. This is a very comprehensive treatment of the local and global economies, fi nancial markets and considerations for monetary policy. It contains the Bank's infl ation forecast, a sense of the risks surrounding the forecast, and a discussion of the forces conditioning the outlook for the economy. It also offers an account of the policy decisions the Board has made in the preceding period. Central bankers give public speeches on issues of the day. In our case, we typically will take questions from the fl oor on such occasions as well. Sometimes the questions are even about the topic of the speech! The speeches, and the answers to questions, are routinely sifted by economists, the media and others for hints about the central bank's intentions. That is not surprising, though sometimes readers are remarkably inventive in their efforts to read between the lines. I have certainly marvelled at some accounts of what I am supposed to have said. Nonetheless, these occasions do give the central bank the opportunity to talk about the issues it thinks are important, and to signal, if necessary, any changes to its view that might occur between the formal assessments of the economy appearing on the regular timetable. Central bankers make appearances in front of Parliamentary committees. As you may know, in our case, the Governor has been appearing twice yearly in front of the House of Representatives Economics Committee for about a decade now. Other offi cials of the Bank appear in front of various other committees as appropriate. These hearings give elected representatives the chance to ask questions at length. They are a key part of accountability and offer a useful opportunity for communication. They can also play, if used well, an educative role, developing a better understanding of policy issues than would be achievable in many other fora. Of course, there is always the risk that in such sessions the questioning can tend to aim more at political point-scoring. Public communication is, however, a two-edged sword. For every occasion when there is something important to say, there is another at which a central banker fi nds him or herself giving a speech, or releasing a formal document, which has little new to say on the economy, in an environment in which markets and observers already have a good understanding of the central bank's assessment. On those occasions there is always the risk that further communication will inadvertently dislodge perfectly sensible expectations - which is one reason why speeches and documents are often, quite deliberately, a little on the unexciting side. Colour and movement are not necessarily useful in the central banker's case. It is for this reason that the RBA was, for a long time, somewhat ambivalent about the practice adopted by some other central banks of making a statement of reasons for the policy decision even when the decision is to leave rates unchanged. While a decision to change rates has for many years been accompanied by a pretty detailed explanation in our case, a decision not to change rates often meant that we had little new information to impart. We adhered to the old adage 'when you have nothing to say, keep your mouth shut'. These reservations were valid. But an increasing number of other central banks have managed to construct these statements and issue them regularly, without apparently doing much harm. More importantly, while there are plenty of occasions in which no change in interest rates is widely expected, and hence perhaps needs little explanation, there are others in which a no-change decision does require careful explanation. Having refl ected on this for some time this year, the Reserve Bank Board came to the judgment that the downside risks of such statements no longer outweigh the likely benefi ts. Accordingly, we have adopted the practice of issuing a short statement after every meeting, explaining the policy decision, whether or not the cash rate is to change. The fi rst 'no-change' statement was issued last week. Last week's decision was a good example, in fact, of one where no change to the cash rate needed explanation. The statement noted the concern the Board had about the outlook for infl ation, given the recent price data and the apparent strength in demand. It also noted that the outlook for the world economy looked a little weaker, and that trends in fi nancial market pricing, over the preceding month, were likely to result in a rise in borrowing rates for Australians. In other words, fi nancial conditions were shifting in the right direction for containing infl ation, even without a further adjustment in the cash rate. Hence the Board decided to leave the cash rate unchanged, for the time being. In a further change to communication arrangements, commencing at the February 2008 meeting, our statement will be made on the day of the meeting, at 2.30 pm, rather than the next morning. Any change in the cash rate will still take effect the following day. This schedule will inform the markets during the Australian day, but will limit the time period between the decision being taken and it being publicly announced. The previous practice of delaying the announcement until 9.30 am the following day was originally adopted for logistical reasons, but they have long since disappeared. It is much better practice, and less risky, to announce the decision as promptly as possible once it has been made. That brings me to the one remaining area of central bank accountability and communication that I would like to talk about, which is the treatment of the minutes of policy-making meetings. publishing minutes for many years. It was prompted initially by Congressional pressure for more openness, but before long moved beyond minimum requirements to a fairly full set of minutes including voting records of individual members. The Bank of England's Monetary Policy Committee (MPC) is required by statute to publish its minutes. The MPC's culture is expressly, by intention of its creators, one of individual accountability. Hence the minutes include voting records of the members, and it is not uncommon for a signifi cant proportion of members to differ from the majority - including two cases where the Governor was in the minority. MPC members hold a second meeting, subsequent to the policy meeting at which the interest rate decision is taken, for the purpose of approving the minutes, which are then released prior to the next policy meeting. reasons is that the presidents/governors of national central banks sit on the Governing Council of the ECB but are required to make decisions for the euro area as a whole, as opposed to decisions that might suit the particular circumstances of their own countries. It is argued, not unreasonably, that publication of minutes and voting might prejudice the capacity of the national governors to take a euro area, rather than national, perspective. The ECB does make additional efforts at communication of other kinds, including a regular press conference. Clearly there are views on both sides of this question, which refl ect the different institutional arrangements across countries. This is why we have argued over time that, in the pursuit of the optimal degree of transparency, it would not make sense to 'cherry pick' the high transparency aspects of every other system and assume that they should simply be grafted onto the Australian system. The nature of the Reserve Bank Board - a majority of whom are part-time members, drawn from various parts of the Australian community, but seeking to make decisions in the national interest as opposed to any industry, geographical or sectional interest - needs to be considered when thinking about disclosure practices. It is also important, I think, to articulate the point that there are reasonable limits to transparency in any system. It is not the case that releasing more material is always, by defi nition, going to lead to better-informed public debate or better policy decisions. In contemplating the release of minutes of meetings in particular, and the form any such release might take, we need to balance a legitimate desire for information and accountability against the need to maintain a frank, open discussion at the meeting. At many meetings I have taken part in over the years, people have considered various arguments that ultimately were found to be unconvincing, but which did need to be examined in the interests of reaching a balanced decision. People also change their minds in the course of a meeting - and one would hope that that happens occasionally, since one of the key benefi ts of having a meeting is to learn from and respond to the views of the other participants. It is unlikely that these dynamics of a meeting could be sustained if every utterance were disclosed. The incentive could easily arise for people to be much more cautious in what they said, and to come to the meeting with a pre-written statement, rather than to engage in a genuinely interactive discussion. That would reduce the quality of the discussion and, ultimately, of the decision. And it is the quality of the decision, after all, which we should be seeking to maximise. What all of this means is that a decision to release minutes should not be taken lightly. Such documents have to be written carefully, taking into account the institutional structure, including the nature of the Board, and the need to preserve an environment of candid discussion. That said, there is no reason why, with careful drafting, a set of minutes that strikes the right balance cannot be compiled. Indeed, for a while now, we have been writing the minutes in just that way. After discussion among the Board members, we recently decided that there is no longer a strong case for not being prepared to release minutes of the monetary policy discussion. Accordingly, as announced last week, we will in future release the minutes of the monetary policy meetings with a lag of two weeks. The minutes from the November meeting were released last Wednesday. The minutes from the meeting held last week will be released on December 18. In addition, with the agreement of the Board, I am releasing at this time on the website the minutes from all meetings since I have been the chairman of the Board (that is, commencing with Those who are interested to read these documents - which will, outside the media and economic and fi nancial professionals, be relatively few, I expect - will fi nd the following features. First, there is an account of the main factual material available to the Board and the issues arising from that material that came up during their discussion. There is nothing particularly startling there - the information available to the Bank is pretty much known by everyone else. The material does not cover every single indicator the Bank tracks - there are too many. So if your favourite statistic is not mentioned, that doesn't mean we are ignoring it. Equally, those statistics that have been prominent in recent sets of minutes should not necessarily be seen as all-important for future decisions. The Board will always strive to form a comprehensive picture of the whole economy in assessing the economic outlook and the prospects for achieving the infl ation objective, and in coming to its decision. Second, there is an account of the policy discussion that occurs towards the end of the meeting, which outlines the key considerations involved in the decision. Sometimes these considerations are quite straightforward. On other occasions, they may point in different directions in terms of their implications for interest rates, in which case the Board has to make an 'on balance decision'. The minutes will set out as clearly as we can the logic behind the decision. Third, there is a record of what the decision was - that is, what target cash rate the Bank is to maintain in the period until the next meeting. Readers will note that comments are not attributed to individuals. The material is not a transcript - indeed we do not keep a transcript - and it is not an edited version of some other set of more detailed minutes. No other record of the monetary policy discussion exists. The minutes do not attempt to provide a 'blow-by-blow' description of every comment made. But nor do the minutes released by other central banks, and it would not be sensible to do so, for the reasons I articulated a few moments ago. Readers will also observe that the pattern of votes of individuals is not recorded, only the outcome. That is a point of difference with other central banks which publish minutes. But in those cases the decision-makers are full-time appointees, in some cases in systems with expressly individual, as opposed to collective, responsibility for their decisions. That is not the system Australia operates, and our pattern of disclosure refl ects the institutional arrangements. In the interests of clarity, let me also state that these minutes do not cover issues other than monetary policy. Other matters that the Board considers from time to time - such as the Bank's accounts, audit processes, issues concerning subsidiaries and other governance questions - are not recorded in these published minutes, because there is no public policy case to do so. There is proper disclosure on these matters, but through the appropriate vehicle, which is mainly the annual report. This is in line with practice in other central banks, and with common sense. Our view is that minutes of the type we are now releasing, in combination with the regular statement after each meeting, and the large volume of other material released by the Bank, meets the legitimate claim of observers to know the basis of the Board's policy decisions. It is consistent with arrangements that prevail in the countries to which we would look for examples of good practice. At the same time, this approach should preserve the candour of discussion at the meeting and recognises and respects the basis on which the non-executive members of the Board serve. As such, it strikes the right balance. Communication has become a more important part of the central banker's tool kit. While we will rarely be found courting publicity, neither will we shirk the responsibility to explain what we are doing and why. That is a requirement of good governance, but also it will usually make policy decisions more effective. There are limits to transparency. More is not always better, and because the decision to disclose additional information is hard to reverse once made, it should be made with care. Nonetheless, after refl ecting on our own experience and evaluating experience around the world, we recently judged that the time had come to move Australia's arrangements to conform with normal practice elsewhere. I was very pleased to learn when I met the new Treasurer a couple of weeks ago that he supported the changes. This material will not compete too well with the best-seller lists, and almost everyone will (I hope) have better things to read while on the beach over the summer than the Reserve Bank Board's minutes. But for the professionals, this will hopefully make a modest further contribution to their understanding of the Board's decisions. And for any of the rest of you who are having trouble getting to sleep ... Whatever your preferred reading material, I wish you a pleasant festive season and a happy and prosperous New Year. Thank you.

r080119a_BOA

australia

stevens

It is a pleasure to be here in London to speak with you today. As Australians recharge their batteries over the summer break, after a long year of coping with an economy operating at full stretch, people in this part of the world are hard at work trying to assess the outlook for the world economy. The year 2007 as a whole was another one of pretty good growth in the world economy, with the PPP-weighted IMF series for global GDP thought to have risen by 4 3/4 per cent, compared with an average of about 4 per cent per annum since the beginning of this decade. For the G7 economies the outcome was a bit below average but the emerging world continued to grow strongly. Yet as the year closed, and the fallout from the risky practices in the US housing market was becoming clearer, questions were arising over the outlook for 2008. There is no shortage of opinions on the outlook for the US economy. Hence I will be brief on that question. The question I would like to address at more length is what the implications of any change to the US outlook might be for the world economy, and for the Asian region in particular, which of course is important for Australia. I would like to conclude with some observations about infl ation. In the face of the large downturn in housing construction and a fall in house prices, the US economy has in fact done remarkably well so far to keep growing. Reasonable growth in consumption, strong capital spending by businesses and a turnaround in the trade accounts have been key factors. The decline in the US dollar is presumably assisting the latter. In other words, the fl oating exchange rate is playing its proper role of responding to the differences in macroeconomic circumstances between the US and elsewhere. Nonetheless, it is a reasonable presumption that the US now faces a period of below-average performance as the problems in the housing market are digested. The excess stock of dwellings has to be worked off; the bad loans have to be recognised and written down; and to the extent that the recognition of all this damages the balance sheets of major fi nancial institutions (not all of which are American), repair work is in order. It has already commenced, with a number of the most signifi cant globally active banks seeking signifi cant capital injections from cash-rich investors. Arguably, these banks are now putting in place belatedly the capital that should have been devoted to these activities all along. Even if we accept that there were some genuine advances towards more optimal risk-sharing through the development of securitisation and its associated structures, it cannot be denied that there was a capital saving associated with the conduct of business through off-balance sheet entities: banks had to put up less capital ex ante than the risks really warranted. That earlier business advantage is now being unwound as much of the credit risk comes back to the banks. It seems a reasonable bet that more capital will be required over the years ahead. So the US economy is in a period of adjustment, as is the banking core of the international fi nancial system. Even with the renowned fl exibility of both, and good policies, this will take a bit of time. Just how long remains uncertain. The question then is how much impact a period of US weakness will have on the global economy. I think it makes sense to think about the answer along two dimensions. The fi rst is 'spillovers' - essentially sequential causal connections whereby slower activity in a major country like the US affects its trading partners via reduced US demand for goods and services in international trade. This would, other things equal, slow economic activity in those trading partner countries, which in turn would slow their demand for goods and services, and so on. Of course, all else may not be equal - other shocks and adjustments might be occurring in the other direction in other countries. An obvious possibility is economic policy: it may be open to policy-makers in those other countries to respond to weaker US demand by running more expansionary policies at home. Whether it is or not would depend on their overall macroeconomic situation and their policy regime. The second dimension is the extent of commonality in the originating event that triggers the whole adjustment to begin with. So if, for example, it were the case that a 'credit crunch' occurred simultaneously in many countries, there would be a contractionary impact around the world even before any spillover effects via trade got going. Obviously, that would be a much more serious situation, since policy-makers in each country would be seeking to combat declining domestic demand as well as declining foreign demand. Combating credit crunches in particular can be very diffi cult. I think we can take it as given that there will be trade spillovers from the weaker US economy to the developing world and to other developed countries in due course, even though there is not a lot of evidence of such an effect in the data we have as yet. The spillovers will not just be from the US either. The fact that the euro area appears to be slowing a bit, with the UK also expected to slow before long, means that the core industrial countries as a group may, over the period ahead, impart noticeably less impetus to global growth than they have in recent years. How big a difference that will ultimately make we cannot know for sure, given the apparent increased internal dynamism of much of the emerging world, and given that we do not know what policy responses those countries may make. But the bigger question is the extent to which a range of countries also experience the same shock as the US. It is in answering this question that we need to consider the fi nancial events of the past year or so. The essential elements are well known by an audience in this city. Over some years, the availability of credit increased in many countries. In the US in particular this phenomenon saw a large extension of credit into the sub-prime space in the housing market. This was all aided by the securitisation process and the search for yield, which had its genesis in the high saving rates in other parts of the world. While most of these sub-prime borrowers have in fact been servicing their loans quite adequately, fl aws in the process saw standards slip towards the end of this cycle. As the problems came to light, pressure came to bear on various entities. Institutions with exposure to sub-prime mortgage assets, holders and intending issuers of structured products in general, SIVs, conduits and other intermediaries that relied on wholesale funding were all tested. Core banking institutions that sponsored off-balance sheet entities very quickly found funding pressures transferred back to them. Doubts over asset quality, uncertainty over funding and generally reduced appetite for risk suddenly erupted last August into a scramble for liquidity. These pressures have been seen in most of the developed economies, though they have been most acute in the US, the UK, the euro area and Canada. For at least some of the G7 economies, then, these events would appear to have the characteristic of a common shock, in the form of a rise in the market cost of fi nance and, in some cases, perhaps, the possibility of a wider withdrawal of credit. Even though it was American borrowers who could not repay, lenders much further afi eld were affected. It is against this backdrop that forecasters are bringing down their growth estimates for 2008 in some of the major countries, and policy-makers there are growing more concerned about downside risks to growth. Suppose then that the G7 group faces the prospect of softer growth in 2008 due at least in part to these fi nancial factors. There will be spillovers from this via trade. But is the fi nancial shock also common to the emerging world, and to Asia in particular - a region that has been a spur to global growth in recent years? To date, at least, it would appear not. Asian investors appear to have relatively small exposures to the sub-prime loans per se . Banks in the region typically rely less than their developed country counterparts on wholesale funding, so the liquidity squeeze has been less of a problem for them. The cost of debt to Asian borrowers, as measured by sovereign bond yields, has not risen much at all. Nor has the cost of equity capital, if the levels of Asian share price indices are anything to go by. The economic growth of most of east Asia has to date remained pretty solid as well. None of that is any guarantee of plain sailing in the future. Nonetheless, it is a good start to weathering whatever the effects of slower growth in the developed world might be. If the fi nancial shock that some of the G7 economies have experienced, and which they fear could intensify, has not been replicated in Asia, then the effects on Asia should be limited mainly to those coming through the trade channel, and perhaps via general business confi dence linkages. The trade channel remains important, of course, for some key Asian countries. There has been a big rise in intra-Asian trade over the past decade, but much of that trade is basically a production chain whose output is still destined for the major country markets. So developments outside the region are still very important. But some moderation in the externally generated part of growth is a manageable issue for Asian policy-makers. In countries where infl ation has been a little on the high side, they can allow it to reduce pressure on prices. In other cases, they would be in a position to allow more expansionary settings for domestic demand. Much hinges on events in China, an economy that now has a very prominent effect on conditions in the Asian region. Over the past couple of years the Chinese economy has continued to boom, asset prices have surged and the authorities have struggled to contain the ebullience. Some of China's growth has been courtesy of a rise in exports but, even if that contribution to growth diminished, China would still be growing very strongly as domestic spending has been rising rapidly. With very high saving rates at present, there would appear to be plenty of scope for further rises in consumption spending over time, as the Chinese people become accustomed to higher incomes. A slower pace of growth in the G7 will presumably trim this growth to some extent. But my guess is that China can cope with that. The Chinese authorities may even welcome some moderation in growth. If China does suffer a serious interruption to growth at some point - and all economies do from time to time - it is more likely, in my judgment, to be caused by some domestic problem than by the sort of events we are witnessing in the developed world at present. For Australians, it will be just as important over the years ahead to keep an eye out for imbalances in the Chinese economy as to watch the problems of the US economy. All told, it seems likely that, after several strong years, global growth will be noticeably slower in 2008. Much of this slowing will be driven by weaker outcomes in the developed world, particularly in countries facing tighter credit conditions. Some of the G7 economies are likely to experience a period of growth well below trend. It seems likely that this will affect emerging-market and other economies mainly via trade linkages. At this stage, it is not clear how signifi cant this effect will be, but it seems prudent to assume that we will be moving from a position where growth in the global economy has been well above trend to one where it will be no more than trend. moderation in the pace of global expansion is welcome, given the pressure on prices for energy and raw materials we have seen in recent years. But the full picture for this phase of the international cycle will become clearer only over time. What then of the outlook for Australia? The continuing rise of Chinese and other incomes through those levels at which resource usage intensifi es signifi cantly has meant strong and persistent demand over recent years for the mineral resources with which Australia is abundantly blessed. At this point, there appears to be a widespread expectation that contract prices for some key resources will rise in 2008. If they do, Australia's terms of trade, which have already risen by about 40 per cent over the past fi ve years, would move higher still. Perhaps this general set of forces at work is behind the striking difference in confi dence one encounters when travelling from the Pacifi c time zone to the European one. It is not as though Australian investors and borrowers have escaped completely unscathed from the turmoil abroad. While their direct exposure to the US sub-prime market has been limited, we have seen additional demand for liquidity put upward pressure on term funding rates for fi nancial institutions, though to a smaller extent than in Europe or the US and the pressures are now easing somewhat. Firms whose business models relied on short-term debt funding have been tested; a couple have, for practical purposes, left the scene. Yet these events have been absorbed thus far with little disruption in the broader economy. The availability of credit to sound borrowers has not been impaired. It costs a bit more, but that is in the context of a fully employed economy struggling to meet demand. The key banking institutions are strongly capitalised, have adequate liquidity and relatively little exposure to the problems in the US housing market. Business and consumer confi dence both remain high. In the local housing market over the past year, we have seen prices accelerate in several cities in the eastern states. The economy grew signifi cantly faster than trend over the same period. As a central bank, while we have been careful to ensure ample liquidity in the money market at a time of international uncertainty and re-pricing of risk, we have remained concerned about the outlook for infl ation, which is likely to be uncomfortably high in the near term. Based on what we can see at present, my judgment is that the direct fi nancial effects of the global turmoil on Australia are likely to be confi ned mainly to the impact on borrowing costs of the liquidity squeeze of recent months, which has pushed up the cost of wholesale fi nance a bit in addition to the effects of monetary policy changes. Taking into account the strength of demand, this increase in borrowing costs does not seem likely to pose a particular problem for the economy as a whole. There is no evidence, moreover, of a 'credit crunch' in the domestic fi nancial sector. On the contrary, thus far the core elements of the domestic system have stepped into the potential gap left by the capital markets. All this could change if the credit tightening abroad takes a serious turn further for the worse. But failing that, over the horizon of the next year or so, the main further impact of international events is likely to be through two channels. The fi rst is the effects on global economic growth, and particularly the growth of China. The second channel is the potential intangible effect on business confi dence, which could operate to the extent that Australian business leaders take a cue from their counterparts in the US and Europe. In both cases there is, thus far, no evidence of any signifi cant impact, but it may be too soon to see it yet. As we consider the potential risks for economic activity over the year ahead, it is important to keep infl ation in the picture too. The rapid pace of global growth in recent years has seen a pick-up in some key prices. Prices for foodstuffs, energy and raw materials for industrial processes are quite high. The synchronised nature of the increases has been quite marked as well, in a fashion eerily reminiscent of the early 1970s. What is different on this occasion is the way that labour costs have behaved. In the early 1970s, labour costs exploded in many countries as infl ation expectations began to rise, economic policies were too ambitious on growth, and labour unions reached the peak of their power. By and large, labour costs have been quite contained in the present episode, even in cases of tight labour markets like Australia's. This owes something to the openness of the global trading system and also to the way labour market institutions have evolved. The fact that infl ation expectations have been low and pretty stable has also helped. Central banks have played a key role in anchoring expectations. One risk is that the effect on CPIs of rises in commodity prices could disturb the balance. It is customary in many parts of the developed world to strip out the effects of food and energy prices on CPIs, on the assumption that such movements are usually due to temporary supply disturbances and hence will reverse. But the predominant reason for many of the commodity price rises is demand - not just developed country demand, but that in the developing world. The demand has proved to be persistent, rather than temporary. In the event that labour costs begin to respond to the headline infl ation price rises that have already occurred, it would prove more diffi cult to contain underlying price infl ation in the industrial countries. In developing countries, moreover, where food is a big share of the basic consumption basket, the rise in food prices may present a particular challenge. While slower growth in global demand, led by the major countries, and possible supply responses may ease pressure on some commodity prices, most of them remain very high at this stage. It is conceivable, therefore, that a somewhat less favourable short-term relationship between economic growth and infl ation than the world enjoyed over the past decade might be experienced for a time. This outcome, were it to occur, would make for a more challenging environment for macroeconomic policy-makers. It would limit the extent to which monetary policies could respond to the downside risks to economic growth in the short term without risking a rise in the trend rate of infl ation and a pick-up in infl ation expectations. I believe that central banks everywhere are acutely conscious of this. I would venture, however, that the tolerance among some parts of the investment community for a cautious approach by policy is not high, if some of the commentary we read is any guide. This, too, adds to the delicacy of the tasks facing policy-makers. But it is important to stress that, were trend infl ation to rise as a result of too ambitious an approach to supporting short-term growth, fi nancial prices would actually be among those most vulnerable to adjustment as long-term interest rates rose. 2008 opens with the fi nancial turmoil of the second half of last year fresh in our minds. Those events, and the deeper issues that triggered them, have mainly affected some of the G7 economies and have cast a shadow over their growth outlook in the near term. Emerging-market economies have been less affected; in fact, in parts of Asia the main policy challenge has been to deal with the threat of overheating. Will growth performance for these different parts of the world continue to diverge? Or will they converge again - and if so, how? And how successful will we - all of us - be in containing the infl ationary tendencies which have been evident up to now? These will be among the key economic questions for 2008. At the moment, we do not know the answers. One way or another, 2008 could turn out to be an interesting year. On that note, I wish all of you a happy new year and good judgment in the period ahead.

r080314a_BOA

australia

stevens

When I was originally approached to speak to this audience, I was asked to give a Reserve Bank perspective on the economy. That was a fairly general brief. Given the current state of affairs, it makes sense to fulfi l it by talking specifi cally about infl ation and monetary policy. There is extensive commentary around at the moment about 'blunt' instruments, concerns over the effect of rising interest rates on particular indebted sections of the community and the appeal in various quarters for some other way of dealing with infl ation. Hence, it seems a sensible moment to re-visit just how monetary policy works. It is also important to have a realistic assessment of the extent to which other instruments are available to help in the job that monetary policy is charged with. But before tackling either of those issues, there is a prior set of questions that have to be addressed, about what is actually happening to infl ation. Unless we are clear about that, then the subsequent discussion about monetary policy's role in controlling it is not well based. If there is not actually an infl ation problem, then presumably monetary policy should proceed differently than it would if there is, in fact, a problem. So the plan of these remarks is as follows. First, I will address the questions about what is happening to infl ation and why. Then I will turn to questions of what monetary policy can do about it, and what other instruments can do. In both instances, the way I propose to do this is to recount some of the questions that we have seen raised in various places. In some cases, these are reasonable questions. But there are reasonable answers, and I would like to offer them. Finally, I would like to step back from this approach focused on the particular details of the current situation to give some broader historical perspective. It is important to keep that perspective in mind, not just to be clear how big the challenge is, but also to be clear how well the economy has done, so far at least, in meeting it. One argument which has been around is that there isn't much infl ation . On the face of it, this is not an unreasonable starting point. The latest CPI headline rate is, after all, only 3 per cent. If that is as high as it gets and it comes down at some point before long, then presumably there is not that much of a problem. It would, in fact, be quite consistent with the infl ation-targeting framework we have been operating on for well over a decade now. The average infl ation rate over a run of years would still be 'two point something'. Unfortunately, the situation at present is not quite as benign as that. The headline fi gure owes quite a bit to the unusually low result in the March quarter of 2007, which was affected by some unusual and temporary effects. When we get the March 2008 fi gures towards the end of April, we will most likely fi nd that the rise over the four quarters is more like 4 per cent. That result itself will have various temporary factors affecting it, so it is not necessarily an immediate guide to how concerned we should be. To get a better feel for the component of infl ation that is likely to be more persistent, we look at various measures of underlying infl ation. As you know, there is more than one way of doing this, and in my judgment it is not sensible to be doctrinaire about any one underlying measure. But what is clear is that these series have all picked up, with the exact extent varying by measure. Overall, the Reserve Bank, in its , put the pace of underlying infl ation over the past year at about 3 1/2 per cent. That is no disaster as a temporary phenomenon either, but monetary policy has to be set with a view to winding that increase back within a reasonable period. Now I need to be clear about the status of these underlying measures. The target for monetary policy is set in terms of the consumer price index. The objective is to achieve an average rate of CPI infl ation of between 2 and 3 per cent. The 'on average' specifi cation is used precisely because the CPI is sometimes affected over short periods by factors that will not be there in a year or two's time, when the effects of any monetary policy changes will still be coming through. For policy to chase those short-term fl uctuations would risk making the economy less, rather than more, stable. So we need to look ahead to where the CPI is likely to be in future, as well as where it is now. For that purpose, we employ analytical devices to help us detect what the ongoing trend in infl ation is likely to be, and this is where the underlying measures are useful. They are not, themselves, the target variable. But a policy that targets future CPI infl ation, using underlying infl ation as an analytical tool and/or as a predictor of the headline CPI, would probably look very similar to one that was targeting underlying infl ation per se . So, in this sense, if one is trying to assess what economists would call the Bank's 'reaction function' using particular price series, underlying measures would probably be more helpful than the headline rate. Another argument we hear is that infl ation is higher, but that is due to a few things on the supply side that we cannot help, and that cannot be infl uenced by monetary policy . There are some prices that historically have been subject to large but temporary supply disturbances. Agricultural produce is a classic example - with droughts, fl oods or other phenomena sometimes having signifi cant, and even large, impacts. But these effects should be expected to be only temporary - when weather conditions change, prices should revert back to trend. So there is no need for monetary policy to respond to them, and the various underlying measures help us to abstract from their effects in the short term. When Cyclone Larry devastated the banana crop in early 2006, the effect was to help push the CPI infl ation rate up to 4 per cent. That impact has now been reversed. Contrary to what was asserted in some quarters, monetary policy did not respond to this event at the time, nor has it since. There are certainly some food prices that have been pushed up because of the recent drought (though others have been pushed down). It is less clear, however, that some of the other unusually large price movements currently affecting the CPI can be passed off as temporary supply disturbances. Global oil prices have certainly risen sharply, but not because the supply of oil has been reduced. In fact, the supply of oil has never been higher. The biggest reason for the rise in the price of oil (measured in US dollars) has been the rise of demand. Of course it is not Australian demand (though that has risen), but demand in Asia, and especially in China, that accounts for much of the rise in global demand. So the rise in energy prices is not 'our fault', so to speak, but nor is it temporary. Higher Chinese demand is not going to go away. So we have to adjust to higher energy prices. People have also pointed out the prominent increases in rents in the CPI as a special factor, and it is certainly true that rents are rising quickly. The reason that is happening is pretty clear too: there is strong demand for that type of accommodation, and rents as a yield to the supplier have been unusually low. Hence, rents are bound to rise. Interestingly, this shows the lengthy and rather complex connection between asset price changes and consumer price infl ation. A key factor behind rental yields being very low was that the price of residential property rose so strongly - far faster than rents - in the earlier part of this decade, and has stayed high in most places in the country. While capital gains were occurring, it mattered little to many investors that rents as a running yield were low. But this was not sustainable. Once capital gains slowed, the low rental yield mattered a great deal. Low yields also prompted more demand for rental accommodation than otherwise. That combination was bound to lead to an adjustment in rents, unless property prices actually declined to restore the yield. Since, in most locations, they did not, an adjustment something like the one we now see became very likely. It seems likely to continue for a while yet, until either rental yields regain more attractive levels or some other factor raises the effective return for investors. Suppose, though, that we did take out some of the 'special factors' that people nominate. Let's, for the sake of argument, remove from the CPI rents and petrol, as well as the calculation of deposits and loan facilities. If we do that, the rate of infl ation of the remaining items over the year to December 2007 is 2.1 per cent. No problem, right? Well, not exactly. To assess the trend in infl ation objectively, you cannot just take out items that rise in price, which is why we typically use underlying measures, which trim both extreme rises and falls . Suppose for the current purpose, then, that we also remove fresh fruit, as a very volatile item and one that happens to have held down the CPI over the past year, due to the unwinding of the great banana episode of 2005/06. Let's also remove the effects of the child care rebate changes, treated as a price fall in the CPI, but which we know is a one-time effect and which reduced the If we do all that, we get a rate of infl ation of 3.0 per cent over the year to December 2007. A little elementary fi guring and a look at the quarterly profi le, moreover, will tell you that, when this calculation is done for the year to March 2008, the answer is likely to be higher again. This is not all that far from what the statistical underlying measures, which dampen the effects of large rises and falls in a more systematic way, are telling us the trend infl ation rate is now. So, unfortunately, it will not do to say that just a few items explain it all away. What is really going on is that price rises across a pretty wide range of items have picked up. About two-thirds of the items in the CPI by weight have risen at more than 2 1/2 per cent over the past year. Normally, we experience about half the price rises at that pace (which you would expect if average infl ation is 2 1/2 per cent). In essence, to explain away the rise in infl ation we have seen, the list of special factors to which we have to appeal is growing rather long. At the same time, there is no question that aggregate demand in the Australian economy rose strongly through 2007, and indeed in recent years generally, at a pace well above the economy's likely growth of potential supply. Nor is there much serious argument against the proposition that usage of capacity in the economy is very high - business surveys uniformly tell us that, as does the measured level of real GDP relative to trend, and the low unemployment rate and high level of vacancies. Firms have struggled to fi nd the additional workers to expand their activities - that is what they tell us. In short, it is hard to avoid the conclusion that there has been genuine pressure on prices, caused not just by temporary supply shortfalls in a few areas, even though there have been some of those, but also by persistent strength in demand. The next argument that I want to address is that wages have not picked up . Some people object to our message on infl ation, including references we have made to labour costs, because they seem to think that we are somehow 'blaming' wage earners for infl ation. We are not saying that. This episode has not been caused by some exogenous 'break out' in wages. Until recently, it was, in fact, possible to say that wages growth had been remarkably steady at an aggregate level in the face of a very tight labour market, with relative wages across industries and regions doing what one would expect given the shocks hitting the economy. At one stage, I described this as a textbook case of adjustment , in a labour market made much more fl exible by a long sequence of reforms. Private-sector wages growth may be picking up a little now, and businesses we talk to say that they are having to fi nd ways to raise compensation, and in ways that may not immediately be evident in the offi cial data. But we have certainly not claimed that labour costs are leading the way. It seems to me that if labour costs are starting to accelerate, this is mainly a symptom of infl ation pressure in a very strong economy. Infl ation problems do not have to start with wages. Sometimes in Australia in the past they have started that way, but it should not be assumed that it will be that way on every occasion. On the other hand, should people come to expect that infl ation will be higher for a long time, and wage claims and price setting start to refl ect that, we will have more trouble getting infl ation down again. One of the most important jobs of monetary policy is to condition expectations. To achieve that, people have to believe we will do what is required to control infl ation over time. The fi nal argument I want to tackle is that the infl ation target is too low . This view accepts that infl ation has increased, and that it is not just a few factors that are responsible, but argues that 3-4 per cent infl ation is acceptable, and that it is unrealistic to expect to return to the 2-3 per cent standard. I do not think that the 2-3 per cent average infl ation target is too ambitious. We have achieved it for the past 15 years, and we achieved average outcomes of that order for long periods in the 20 century. If we accept that the target could slide up to 3-4 per cent, to match actual infl ation, how long would it be before we were debating 4-5 per cent as a goal? If the analysis of the economy that we have set out is correct - that overall demand has been growing faster than can be sustained - it would not be long. Ongoing demand growth above sustainable rates would not mean steady infl ation at a higher level, it would mean a continuing increase in infl ation. If that is the situation, then demand has to be curtailed to stabilise infl ation at any level. Revising the target higher would provide only very temporary respite from the measures needed to control infl ation, unless we were prepared to revise it higher every year. Furthermore, the argument that we could accept a higher trend infl ation rate ignores how much the structure of the economy has adapted - in good ways - to 'two point something' infl ation. The structure of nominal interest rates, to name just one thing, has been predicated on that being the medium-term anchor. If that anchor were allowed to drag, higher average interest rates in the future would be the result. This is a result amply demonstrated in history: the surest way to higher average interest rates is to accept higher infl ation. To put it simply, if the community wants sustainably low interest rates, we should choose a low infl ation target, not a high one. So accepting a rise in trend infl ation because of the short-term moderation in demand growth needed to contain a pick-up in prices would be a very short-sighted policy. It would very likely condemn us to a repeat of the problems of the late 1960s and 1970s, when we mistakenly thought we could live with a bit more infl ation, and all the attendant diffi culty we had in the 1980s in fi xing the infl ation problem, all over again. It is far better to resist rising infl ation now. I turn now to arguments about monetary policy and infl ation. The fi rst one that I want to address is the assertion that monetary policy, in adjusting interest rates, is ineffective in controlling prices, because it is failing to restrain demand . More than once I have seen people state that the rises in interest rates seemed not to make much difference. But if it were really true that the sequence of adjustments that took place to raise the cash rate from its low of 4.25 per cent in 2001 to 7.25 per cent today made no difference to the economy or infl ation, it would follow that we could reduce the cash rate by 300 basis points tomorrow and nothing would change. If we put it like that, surely not many people could seriously believe that the changes to interest rates have made no difference. More realistically, people might think that it is the changes in rates that matter, more than the level , and that the changes were too small . In this view, interest rate changes should perhaps have been bigger, so as to give more of a 'shock' to behaviour on each occasion (though they should presumably also have been less frequent - otherwise the level of rates we would have reached would have been much higher). I suppose it is possible that a different sequence of changes, including some bigger ones, would have changed behaviour in the economy. We cannot know because that alternative scenario cannot be run, but as everyone knows, the Board has on occasion in the recent past considered larger movements. So the idea of larger changes is not absurd. Yet it is hardly as though interest rate changes were so small that no-one noticed. There are few issues reported at more length than interest rates; no-one could say they were unaware of what was happening. Beginning with the March 2005 rate change, moreover, the extent of coverage in the media has been far more intense than it had been prior to then, and far more intense than is the case in other comparable countries. We could debate the reasons for that, but they do not matter for present purposes. On every one of those occasions, there was no shortage of dramatic media coverage, and no shortage of predictions of serious consequences for indebted households, the economy and so on. If we were looking for announcement effects, surely they should have been at work through this period. My own view is that monetary policy is most effective when actions are seen to be consistent with the factual evidence available on the economy, a sensible assessment about future risks, and a framework that has a clear medium-term objective for policy. Apart from that, we have to accept that the likely effect of any one move of 25 or even 50 basis points is, while uncertain, probably only modest. It is the combination of changes, and more particularly the level reached, that will do most of the work. A second version of the 'ineffectiveness' argument holds that (1) the price rises are coming from factors beyond the control of any Australian policy, and particularly from abroad, from which it follows that (2) monetary policy cannot do anything about them . For some people, it follows that it is therefore (3) futile, and unnecessarily disruptive, to try . I have already addressed the question of whether all the price rises can be put down to a few special factors, obviously not under our control. The fact is that the price rises are broader than that. But even if all the initial impetus for higher prices comes from events abroad, we still have to decide how we will respond to that shock. In the case of energy prices, while the world price of oil in US dollars certainly is completely outside our control, it is the dollar price of oil that actually matters for the Australian motorist. That price is lower at present than it might have been, because of the rise in the exchange rate. Insofar as interest rates have a bearing on the exchange rate, they can affect petrol prices, indirectly, and have done so. Looking across the economy more generally, we can all see that the main external event of recent years is the rise in the terms of trade, which is obviously completely exogenous as far as Australia is concerned. But higher resource prices generate additional income, which then affects demand for goods and services at home. That is expansionary, and puts pressure on prices for non-traded goods and services. Even though monetary policy cannot stop the initial shock - of course we cannot stop the Chinese demand for resources - we can, and should, seek to condition the economy's subsequent response to that shock, rather than simply letting domestic overheating go unchecked. Tighter policy will dampen domestic demand and contain the pick-up in non-traded prices as well as raising the exchange rate, which makes imports cheaper, exports less competitive and fosters a move of productive resources into the parts of the economy where more production is needed. That is an appropriate form of adjustment to such a shock, particularly if the shock is likely to be fairly persistent. So even when events beyond our control occur to put pressure on prices, we should still respond, and that response can be quite effective. Another line of argument takes quite a different tack. It argues not that monetary policy is ineffective, but in fact that it makes the problem worse by actually raising prices. The logic here is that interest payments are a cost to business activity, and that raising this cost will simply result in businesses passing it on. It is obviously true that interest is a cost, and for a business to stay solvent it has to cover that along with its other costs in its selling price. But when interest rates rise, can business just pass this cost on without losing sales? It might be possible initially, but since higher interest rates do eventually slow demand, it will get more diffi cult to raise prices in due course. So when some people say that higher rates will just push up prices, I think the answer is that it is the strength of demand that allows that, and the rise in interest rates will, in time, dampen demand. All the historical evidence is that monetary policy is quite effective in that regard. I turn now to other arguments, not that monetary policy is ineffective, but that it is not terribly precise. One common expression is that it is a blunt instrument . People rarely defi ne what they mean by that term, but I think they have in mind two things. First, if infl ation is rising because particular prices are moving a lot, monetary policy cannot focus precisely on exactly those particular prices, or those particular features of economic behaviour causing the price rises. It is a general, rather than specifi c, instrument in that sense. Second, I think that when people say 'blunt', they mean 'unfair' - particularly that when interest rates rise, this affects households who owe money on a home loan. (Presumably the same argument would mean that it is equally unfair to savers to put interest rates down when the economy is weak.) As I noted before, it is not actually true that the recent rise in infl ation is confi ned to just a few items. To that extent, the use of a general instrument would seem quite appropriate. But there are also a couple of other quite important points to make in regard to the 'blunt instrument' critique. The fi rst is that the transmission channels for monetary policy are much wider than just the impacts on households with home loans. Most businesses have debts, too. Floating rate debt costs more for them to service as interest rates rise, which presumably causes some of them to reconsider some things they might have been doing or planning. So the 'cash fl ow' channel of monetary policy affects business. Monetary policy also affects what economists would call inter-temporal decision-making. Incentives to save, as opposed to consume, alter. It is commonly observed that many Australians save rather little, but the household saving rate has in fact risen noticeably in recent years, largely unnoticed by conventional opinion. I do not claim that the increase is mainly due to rising interest rates, but I do not think we should assume that these incentives do not matter. Despite Australia's extensive use of foreign saving to build up our economy, the bulk of our productive investment is fi nanced via domestic saving of one form or another. Changes in interest rates affect asset values over time, through effects on discount rates, expected earnings growth and so on. These feed through into behaviour in several dimensions - via the cost of capital to fi rms, wealth effects and so on. Through complex channels, monetary policy can sometimes also affect the non-price terms of credit, particularly if it manages to affect expectations about future growth, creditworthiness and risk appetite. Then there is the exchange rate, as I have already mentioned. Numerous factors affect exchange rates, and the relationships are hard to pin down. However, interest rate differentials between countries do matter to exchange rates, along with expectations about how those differentials may change (a function of growth expectations), factors affecting trade positions (such as commodity prices in our case), investor risk preferences and so on. I have already discussed the case of petrol, but there is surely little doubt that the prices of tradable goods and services generally are lower today than they would have been if the exchange rate had been at its long-run average level. This is the case even with much more muted short-term pass-through of exchange rate changes than we used to have. In other words, changes in the exchange rate alter the terms at which the rest of the world supplies goods and services to Australia in a way that is stabilising for prices. All these are channels for monetary policy's effects. They operate at different speeds, and to differing extents in different episodes - but they are all there, and I would say that they are all working at present. The transmission of monetary policy is not just about home loan rates, as important a channel as that is. Secondly, to say monetary policy is a blunt instrument begs the question: where are the sharp instruments? It is not obvious that there are all that many. People mention supply-side reforms of various kinds and unquestionably these have been extremely important over the years. To the extent that more can be done, that is all to the good for Australians' standard of living. But they are long term. It is hard to deploy them in a hurry. And many of them are very general - 'blunt' even - rather than specifi c. Many people will appeal, perhaps not unreasonably, to the possibility of using fi scal policy to counter infl ation pressure. For some time now, fi scal policy has not been actively deployed to manage the business cycle. The focus has mainly been on achieving and then maintaining a structurally sound, long-run fi scal position and, subject to that, making tax and spending decisions aimed at various other objectives that governments have. This does not preclude allowing the budget's 'automatic stabilisers' to operate over the cycle (though it might be observed that, with an elongated upswing like the one we have been having, it is getting more diffi cult to decide what should be thought of as a temporary rise in revenue and what can be assumed to be permanent). It strikes me that in the popular discussion about fi scal policy, many participants talk past each other because they are looking at different time dimensions. It is not unreasonable to say that if the budget is perpetually in surplus, there is no debt to speak of and no other looming large unfunded liability, taxes should probably, over some long-run horizon, be lower. This, it seems to me, is the economic case for structural reductions in taxes, which some observers articulate. Others argue that such reductions should be delayed, for cyclical reasons, given that demand needs to slow to contain infl ation. So there is a structural case for taxes to fall, and a cyclical case for them not to. It is no doubt diffi cult for any government to reconcile these two, equally valid, points of view, the more so if the same tension persists for a number of consecutive years. Leaving that aside, let us give some thought to just how effective an instrument budgetary policy is likely to be. If infl ationary pressures were just due to specifi c, narrow issues (which, as is clear above, I doubt), precise targeting of the sources of infl ationary pressure via tax and spending measures could nonetheless be exceedingly diffi cult at a technical level, let alone politically. If it is accepted, on the other hand, that infl ation is suffi ciently general that overall demand has to slow, the amount of slowing has to be the same regardless of whether it comes via monetary policy or fi scal policy. It would be somewhat differently distributed across sectors and regions, as the impact of interest rate and exchange rate effects obviously would not overlap exactly with the tax or spending measures that would occur in their place. I would hazard a guess, though, that a good many people who are today paying higher interest rates would instead pay higher taxes in a world where fi scal policy was used more actively to manage the business cycle. We are unlikely, I submit, to witness a situation where income taxes are raised only for those without home loans, or only for those living in Western Australia and Queensland, or those working in the mining sector. Then there are the time lags in implementing fi scal measures. The Budget occurs once a year, and has a very long and gruelling process in the lead-up. I am not expecting to be stampeded by people in this room wishing to do that more often. The economy could conceivably look rather different in mid May when the Budget occurs than it did when the budget processes began, and different again by the time the measures actually take effect. Monetary policy has its full effects with a long lag, but we at least get to reconsider each month, and if need be we can reverse direction quickly. Don't get me wrong. I am not arguing that fi scal policy does not matter to the cyclical outcomes, or that fi scal policy should not be made with an eye to the cycle as well as to the structural position. To the extent it can be, of course that is welcome. I am not here to offer any particular suggestion on what fi scal policy should do at present. I am simply saying that the task of fi ne-tuning fi scal policy for stabilisation purposes, if that were thought desirable, is unlikely to be any more straightforward than that of using monetary policy. Fiscal policy, in its own way and for its own reasons, is also likely to prove a fairly blunt instrument. Inevitably, even with fi scal policy ideally calibrated for the conjunctural position, monetary policy would still have a lot of work to do managing infl ation. The above remarks address some reservations about the conduct of monetary policy that I have seen of late. Some of these reservations are understandable, but there are reasonable responses to them. It should also be observed that it is not the fi rst time we have seen most of these arguments: they tend to recur each time we reach the top end of the infl ation cycle and monetary policy has to control it. Having said all that, it is important to keep some perspective about the situation in which we fi nd ourselves. We have been living through one of the largest transformations in the structure of the global economy, as far as Australia is concerned, for a century. The rise in the terms of trade over the past fi ve years is the biggest such event since the Korean War boom in the early 1950s. But while the Korean War event was a temporary one, all the indications are that the rise of China is not just a cyclical event, but a structural change of the fi rst order. China certainly has a business cycle, like all other economies, and will slow at some point. Even so, it is highly likely that, short of some catastrophic event, China has many years of strong growth still ahead. It will not be at the 11 per cent per annum pace of the past couple of years, and there will be periods of weakness and instability. But the rise of China is not a fl ash in the pan of economic history. In essence, we are seeing a very large change in relative prices in the world economy, and a relative price change that is more important to Australia, in particular, than to almost any other country. These sorts of events will always produce stresses and strains, including signifi cant divergences in performance across industries and regions (though these are often exaggerated in popular discussion). Because the event is, overall, very expansionary, it was always likely to be associated with some risk of higher infl ation. But given the magnitude of the shock, when all is said and done, the economy has coped pretty well so far. Yes, infl ation has risen. This is a problem, and requires a suitable response from monetary policy. But compare the outcomes on this occasion with those in the commodity price booms of the early 1950s or the mid 1970s. In the early 1950s, CPI infl ation reached 25 per cent, then fell back to zero within a few years, associated with quite a pronounced recession. In the mid 1970s, infl ation reached about 18 per cent, and took a very long time to come down to acceptable levels. This time, we are grappling with a peak CPI infl ation rate that looks like it will be around 4 per cent in CPI terms, and trying to assess how soon it can reasonably return to 2-3 per cent. This is a far cry from the problems of yesteryear. The reason we are doing better this time around is not hard to fathom, either. As work in the Treasury has argued persuasively, a fl exible exchange rate, a reformed and fl exible industrial environment, better private-sector management and much stronger fi scal and monetary policy frameworks have made a lot of difference. The fruits of those decades of effort of reform are an economy that, for all its strains, is doing well under the circumstances. The offi cers of the Treasury, past and present, have played a key role in achieving that. That legacy has been handed to you, and to all of us. Our challenge is to keep those improved structures in place and to develop them further, in the period in which we have the privilege of having some infl uence.

r080327a_BOA

australia

stevens

Welcome to Sydney. It is a pleasure to be here to make some remarks at the opening of your conference. The opportunity this forum provides to exchange ideas and participate in vigorous discussions is undoubtedly valuable, not least at this particular juncture. The past nine months have certainly been a very challenging time in international fi nancial markets. We have seen a signifi cant reappraisal of certain categories of risk and considerable fi nancial turbulence in key international markets. Economic prospects in the United States, in particular, have taken a signifi cant turn for the worse. The extent of disengagement in some core markets, which hitherto had been thought to be extremely liquid and reliable, has been quite unsettling. The fact that your conference has a focus on innovation is apt as well. It will not have gone unnoticed that diffi culties associated with some particular innovations of the past decade have been prominent in the recent period. It has been remarked by others that the complexity of some new instruments meant that they were not well enough understood by investors, and perhaps even by those promoting them. Complexity is also the enemy of liquidity, which proved to be much less reliable than had been assumed. Perhaps future innovations will need to take account of the diffi culty people inevitably have in grappling with complexity, and the dangers of illiquidity. In the end, though, human nature, with its propensity initially to underestimate risk in good times, then to over-react when risk materialises, is probably a permanent feature of the landscape. I will organise my remarks today under three headings: How did we get here? Where are we now? And what policy issues arise for future consideration? I should be clear that my remarks are principally about global events. They are not directed towards the Australian fi nancial system in particular. The local fi nancial community has certainly been affected by the global turmoil but, on the whole, as the Reserve Bank's being released later this morning sets out, is weathering the storm well. Profi tability remains very strong and capital sound. There is very little direct exposure to the US sub-prime problems, but the main reason for the resilience is many years of robust economic growth, sound regulatory foundations and prudent risk management. The Reserve Bank has been carefully monitoring access to funding, including offshore funding. We judge it to have been more than adequate, even if more expensive, though, of course, we will continue to watch the situation closely. But the centre of recent developments has been offshore, so my remarks today are about the global scene, not the Australian one, unless specifi cally noted. Although the headlines of the past year have been dominated by stories about the sub-prime loans in the US mortgage market, in fact the genesis of the problems was much earlier. For much of the preceding decade, international capital markets were characterised by the search for yield. An excess of saving over investment in Asia was a feature, resulting partly from the reaction to the late-1990s crisis and the determination to avoid a repeat of it. The rapid growth of Chinese incomes and the lag between that trend and a corresponding rise in consumption was also a factor. These trends, associated as they were with a surplus of internationally tradable goods and services, carried a degree of disinfl ationary impact for the rest of the world, which made strong growth in demand and low infl ation easier to combine. They also lowered the marginal cost of fi nancial capital in global markets. Somewhat later, oil rich nations also provided funds to the global economy and spurred on this search for yield, since mounting revenues from higher oil prices were invested rather than spent by governments that were now more fi scally conservative. In the major developed countries, interest rates at the short end were also lower than normal for a long period after the mild 2001 recession in some of the G7 countries, as monetary policies sought to manage the particular circumstances each country faced. This was associated with an unusually stable period for macroeconomic conditions. The 'great moderation' in volatility of output and prices had been under way in the United States since the mid 1980s but it became more obvious in many other economies in the 1990s and 2000s. In my mind, there is little doubt that this lowered perceptions of risk, and indeed it is a fact that default rates on corporate debt, even sub-investment grade debt, were unusually low through the past decade. They remain low even on the latest data, up to end 2007, though they will presumably rise somewhat over the next couple of years. In this environment, the search for yield continued. This saw end investors consciously begin to accept more risk in order to fi nd the returns they were seeking. Additionally, the easy availability of credit and benign macroeconomic environment led to an increase in the use of leverage to increase returns further. It also provided the demand side backdrop for the development of new instruments. The innovative fi nancial community obliged and provided ever more sophisticated ways of achieving the returns desired by investors. The innate complexity and, in some cases, opacity of these instruments made their properties hard to assess. With this reduced transparency, it was easy for investors to underestimate the risks that they were taking on. Observable compensation for risk declined over time, as evidenced by various market spreads, non-price terms of loans and so on. This was something about which numerous prudential supervisors, central banks and private bankers commented on over some years. Eventually, something was going to occur that would trigger a reappraisal of risk. It is remarkable that this took so long. Over several years, we had a string of events that could have, and in other times surely would have, triggered a reassessment: prominent credit rating downgrades of some major US corporations to sub-investment grade status; a default on foreign debt by Argentina, followed by rather rancorous negotiations over restructuring; political instability in several countries; a very large rise in the price of oil; signifi cant tightening of US monetary policy up to 2006; the list goes on. Through all this, fi nancial sentiment barely missed a beat. Then, in early 2007, the escalating losses on the 2006 vintage of US sub-prime mortgages fi rst started to come to light. It took some months for those losses to show up in certain hedge funds, structured investment vehicles and so on. But by July and August 2007, enough had emerged for there to be a marked change in sentiment. There is no need to give a detailed treatment here of subsequent events: they are well known, so it is enough to observe the broad outlines. As the scope of potential losses became clearer, the business models of some of the entities that were exposed came under pressure, particularly those which were reliant on short-term wholesale funding and/or securitisation. Markets for asset-backed commercial paper stopped the fl ow of new funding, and for a time were very reluctant to roll over existing funding for entities that were seen to have sub-prime exposure. Much of the resulting funding pressure came back to the balance sheets of the major international banks and investment banks that had initially sponsored these entities. Essentially, they took the responsibility for funding sub-prime assets. At the same time, these and other institutions found that a number of other markets had also become diffi cult to operate in. This saw them unable to shift loans originated from their balance sheets, even though these loans were unrelated to the US sub-prime mortgage market - for example, loans associated with merger and acquisition activity. In this climate of uncertainty over both credit exposures and funding needs, funding liquidity pressures became acute on occasion during the second half of 2007. Short-term market yields became much less closely connected to the overnight rates that central banks typically control. Central banks responded by expanding the scope and scale of their routine market operations, adding additional liquidity, accepting a wider range of assets in their operations and expanding the maturity of their lending facilities. There were also some internationally coordinated actions to provide foreign currency funding under swaps between some of the major central banks. Practices have continued to evolve. Over the recent period, disclosures of losses associated with various credit products have continued. Financial institutions and investors have continued to be wary of what credit losses may yet be unearthed. Institutions have generally made strong efforts to disclose exposures appropriately, but there are major diffi culties in valuing the relevant assets, not least because some markets have effectively ceased to operate - so no price can be observed. It appears that some very high-quality assets are valued at prices that embody extremely pessimistic assumptions about returns. Key segments of credit markets remain in diffi culty. There have been few, if any, issues of mortgage-backed securities in recent months, though the commercial paper markets have at least stopped contracting. It appears that the most highly rated corporate names can still access capital markets, but many corporates are approaching their banks for funding. Business credit provided by the banking system has accelerated in the United States over the period since mid 2007. This process of reintermediation is a very necessary one, if the fl ow of credit to the major economies is not to be seriously disrupted. For the time being, and perhaps for some time ahead, the fi nancial intermediaries need to fi ll some of the gap that the capital markets have suddenly left. With this comes, of course, the need for those intermediaries to have adequate funding themselves - one obvious reason for the pressure on term funding costs. They will also need suffi cient capital to take on the risks inherent in the lending, since capital markets apparently no longer wish to accept those risks. This is, in fact, a key element of the whole situation: more capital needed to be carried by the big international banks to support the risks they were taking, and that capital has to be found now. In addition, the risk capital that was available from markets is no longer there to the same extent. The intermediaries have found substantial capital over recent months. By curtailing share repurchases and reducing dividends, several intermediaries have generated some of the necessary capital internally. More crucial has been the fresh capital raised through selling stakes in their businesses to individuals, institutions and governments. These deals, however, have been costly, leading to a signifi cant dilution of the interests of their existing shareholders. Irrespective of this, with both these sources of capital, intermediaries have been able to maintain, and in some cases increase, their capital ratios - even when they have reported signifi cant losses. With this being the case, they have also, at least so far, been able to step in to fi ll the gap in corporate funding. In addition to reintermediation and the pursuit of new capital, we are seeing a signifi cant process of de-leveraging. Entities with high leverage and/or complex structures have come under signifi cant pressure in recent months as share markets question their resilience, and lenders seek a reduction in risk. We have seen some notable cases of this in Australia, but they are merely a refl ection of what is going on in the major markets of the world. Private equity fi rms, hedge funds and so on, all fi nd the environment much less accommodating than was the case a year ago. This process of balance sheet contraction has been an additional further factor disrupting markets of late, as asset sales have to be absorbed under already skittish conditions. In the meantime, real savings are still fl owing into pension funds, insurance companies and other institutional investment vehicles. This is genuine capital, seeking a productive use. But these investors appear to be taking a more cautious approach to risk, given the short-term uncertainty over asset valuations. It is a fair bet that they have higher positions in cash - overnight or very short-term highly rated securities - than would normally be the case. This is placed largely in banking systems, so the major intermediaries are, I expect, generally fl ush with very short-term liabilities, even though longer-term funding remains diffi cult. This means that these intermediaries may be undertaking more maturity transformation than they would ordinarily fi nd comfortable. Increasingly, there are good quality assets at prices that would, in normal times, be very attractive. At some point, investors who are currently on the sidelines will need to summon enough confi dence to take up the opportunities for profi table exposure to risk. It is impossible to say when this will occur, but we can perhaps outline what the pre-conditions are. Investors will want a reasonable level of confi dence that the bulk of the losses in the most important institutions have been accounted for and disclosed, that remaining 'excess' leverage has been essentially sorted out, and that any remaining downside risks to asset quality stemming from slowing growth in the major countries are manageable and within the set of normal parameter variation that their portfolios can cope with. This fi nancial instability presents a diffi cult set of challenges for policy-makers around the world. First, central banks have the obligation to maintain liquidity at the core of the system. In the face of repeated system-wide surges in the demand for liquidity, they have accommodated that demand. They have also been prepared to lend at longer terms than usual, and deal with a broader range of counterparties in order to foster a little more confi dence in the availability of funding beyond the very short term. The Federal Reserve has also facilitated the absorption of Bear Stearns by a stronger competitor, by being prepared to use assets from its own balance sheet in a collateral swap. This is, however, not a 'bail out' - the shareholders and managers of Bear Stearns have lost a great deal of money, but the system will be stabilised. Turning to the Australian setting for a moment, in the Reserve Bank's case, we have been prepared to increase the total amount of liquidity substantially, as required. We have widened the range of eligible collateral for repurchase agreements (we already had a pretty wide range of counterparties prior to last August). We have also been prepared to enter into repurchase agreements for six months and longer on occasion, given the pressure on market funding rates at that horizon. Even with that, however, the relationship between the cash rate (or, more correctly, the expected future cash rate) and rates on high-quality private paper at a three-to-six month term is much looser at present than it has tended to be over recent years. This means that the cost to banks of raising funds in the market has moved independently of the overnight rate. The presumption that their lending rates would and should move only in line with the cash rate, which had arisen in an earlier period when all these rates were much more closely related, has not been a realistic one in the recent environment. Of course, in setting the cash rate, the Reserve Bank has taken account of these shifting relationships, just as it does shifts in other relationships in the monetary transmission mechanism. Returning now to the global scene, central banks are continually assessing the potential impact on economic activity and infl ation from these events, as they evaluate monetary policy settings. In the United States, the Federal Reserve has responded to evident weakness in economic activity, and the risks posed by the possibility of a signifi cant disruption to credit provision, by lowering overnight rates quickly. Elsewhere, policy-makers are trying to assess the potential spillovers. The weak US economy and depreciating US dollar will have some impact via reduced trade in goods and services. But that channel is less important than the possibility of fi nancial contagion from a set of forces not confi ned to the United States but affecting international capital and money markets generally. What complicates matters is that policy-makers have to consider that possibility at a time when they are also confronted with a troubling level of infl ation in a number of cases. Longer term, a number of issues arise that are the subject of intense work in the central banking and supervisory community. Arrangements for the provision of liquidity by central banks have been changing in response to the events of the past eight months, but it is likely that there will be continued discussion about whether further refi nements might be sensible. These will include how to make arrangements suffi ciently fl exible and adaptive, including across borders, which may be needed given the globalised nature of markets. The discussion will also need to pay due regard to the potential for other consequences of changes to practice in this area, including the possibility that private entities become so confi dent that liquidity risk has effectively been removed that they end up taking more risk of other types. That could leave both themselves and their central banks in an awkward position at some point down the track. So in parallel with ongoing development of liquidity arrangements by central banks, there will need to be a focus in the supervisory community and the banks themselves on liquidity management. International fi nancial events over the past nine months have been a source of considerable instability. Risk that was always in the economic environment has belatedly been recognised. The ensuing process of assessing and disclosing losses, fi nding new capital and de-leveraging has been very diffi cult. Matters have not been helped by the opacity and complexity of some of the fi nancial instruments involved, and the associated problems in valuing them. For market participants and policy-makers alike, this environment has been challenging indeed. Those of you in the markets are dealing with heightened volatility and uncertainty. Policy-makers, meanwhile, are working hard to stabilise the present international situation. In some countries, especially the US, that involves being prepared to take measures quite aggressively, in an effort to avert a cumulative spiral of declining asset values and deteriorating creditworthiness feeding back on itself and doing great damage to the economy. In other countries, where fi nancial strains are also occurring though not always to the same extent, it has thus far involved signifi cant changes to liquidity management, while balancing the fi nancial risks against other macroeconomic risks in an effort to foster long-run stability. In all countries, though, policy-makers are also keeping an eye out for the potential low probability, but high cost, downside events that could emerge. It looks as though the environment will remain quite challenging for us all for a while but the strength of the Australian fi nancial system is, for Australia, a good basis for meeting the challenge.

r080404a_BOA

australia

stevens

Mr Chairman, my colleagues and I are pleased to be able to appear before this newly re-formed Standing Committee. I look forward to productive sessions with you over the life of this I shall begin by reviewing the economy's performance over the past year or so. I will then offer some comments about the current conjuncture, and some of the issues that we face in the period ahead. All this provides some context for our discussion about monetary policy. The Australian economy recorded another very strong year in 2007. Real GDP expanded by about 4 per cent. Growth in domestic fi nal demand was even stronger, at over 5 1/2 per cent. The rate of unemployment declined further, in the most recent readings reaching its lowest level since the mid 1970s. Indicators of capacity utilisation reached their highest levels for two decades, and fi rms continued to report considerable diffi culty in expanding operations, due to shortages of suitable staff. These outcomes for demand and output growth exceeded those in either of the preceding two years, and were stronger than was expected a year ago, particularly in the case of domestic demand. In explaining these trends, a noteworthy factor is that the global economy continued to offer a very supportive environment for Australia, notwithstanding the evident deterioration in the United States and the serious disturbances in international capital markets in the latter part of the year. The cumulative impact of the very large rise in Australia's terms of trade over a number of years continued to fl ow through the economy. Very high levels of confi dence in the business community saw robust growth, from already high levels, in capital spending. This was most pronounced in the resources sector, which is not surprising given the level of demand and the record prices being paid for its output, but the strength was not confi ned to that sector. To this was added the response of governments and associated enterprises to the need for upgrades to public infrastructure and other demands, which saw public fi nal spending rise at about twice its trend pace over the course of 2007. Finally, consumer demand also rose at a pace well above average, fed by a rate of growth of real household disposable income as high as anything seen in the past 20 years. The only major expenditure aggregate that was on the soft side was dwelling investment. While there continue to be differences in the degree of overall strength of the economy by region, those differences, if anything, narrowed during 2007. Unemployment rates in the big south-eastern states, for example, were at generational lows on the most recent reading. The pace of demand growth in 2007 well and truly exceeded any plausible estimate of the rate of growth of the economy's supply potential. Under these demand conditions, infl ation increased. Having apparently moderated a little late in 2006 and early 2007, it began to show higher readings around the middle of 2007 and by the end of the year had reached about 3 1/2 per cent in underlying terms. Measured by the CPI, the year-ended infl ation rate was 3 per cent, but as is well understood, the next fi gure is likely to be around 4 per cent. Faced with this combination - very strong demand growth in what was already a pretty fully employed economy, and infl ation moving higher - the Reserve Bank Board, when discharging its monetary policy duties, could draw no other conclusion than that growth in demand needed to slow. The Board had tightened monetary policy on three occasions during 2006. It then stayed its hand for a period in the fi rst half of 2007, as infl ation results available at that time suggested some moderation. But as the trends of 2007 and the likely risk they posed to longer-run performance emerged, the Board tightened policy further during the second half of the year and in the early months of this year. The cash rate was raised on a total of four occasions, with the aim of achieving a moderation in demand, which is an obvious necessary condition for reducing infl ation over time. In reaching these decisions, the Board naturally took careful account of the unfolding events in global fi nancial markets. I will not recount the details of those events again now - I and many others have talked at length about them before. I am sure we will return to them in question time. As a daily participant in fi nancial markets, the Reserve Bank was in a position to observe developments very closely. Our senior offi cers have been in frequent contact with all the signifi cant fi nancial institutions operating in Australian markets, with our colleagues at APRA and other regulatory agencies, and with our counterparts abroad. The RBA Board spent considerable time at its meetings examining market developments and considering their possible implications. The RBA responded to the unusual demand for liquidity on a number of occasions, and made early changes to its practices for open market operations to accommodate dealing in a wider range of assets and over longer terms. These market pressures were, and remain, overwhelmingly a fl ow-on of international forces. They were not mainly a result of local factors. But it is appropriate, in our judgment, to foster confi dence to the extent we can during periods of global stress such as we have been experiencing. Despite those actions, a fi nancial system such as ours cannot be entirely insulated from these global events and, inevitably, the Australian fi nancial system has been affected to some extent. The rise in the wholesale cost of term funding has meant that many non-bank and some bank lenders have had to slow the growth of their businesses. The closure, more or less, of securitisation markets for the time being also has made life much more diffi cult for those lenders which relied heavily on that avenue of funding. Capital market raisings are much more diffi cult for some corporates as well, and many of these entities are turning to their bankers. By and large, the major banking institutions have been able to provide support for sound borrowers, and have stepped into the gap left by the withdrawal of funding from the capital markets. They have been able to do this because of their own balance sheet strength, something which is clear from the analysis in the Bank's recently released . While some of their customers have been excluded from capital markets of late, banks have themselves been able to access segments of the capital markets in suffi cient quantity to keep their balance sheets expanding. This has come at a time when wholesale funding costs have been rising by more than the offi cial cash rate, and that has been passed on to end borrowers, while conditions on lending for some borrowers have tightened in response to higher perceived risk. But this outcome is preferable to the alternative of lending drying up. At present, the international environment remains very diffi cult. The US economy is experiencing very subdued conditions, as the weakness that had for some time been confi ned to the housing sector has spread to other areas over recent months. Losses incurred by major international fi nancial institutions associated with previous risky lending have continued to come to light, even during this week. Valuing certain classes of assets remains very diffi cult and some quite sound assets appear to be priced currently at less than their likely underlying value. A process of deleveraging is continuing among hedge funds and other complex fi nancial vehicles, as the retreat from risk by their lenders forces a winding-in of positions. While all this has been occurring, participants in fi nancial markets have understandably remained very nervous, and day-to-day volatility in a range of markets has been much higher than participants had become accustomed to over recent years. In the meantime, real savings are still fl owing into the accounts of institutional investors - pension/superannuation funds, insurance companies and so on. Given the present level of uncertainty, those responsible for investing these funds are remaining very cautious, fearing further write-offs by the large international banks and declines in asset values. Hence, they are sticking to very large positions in very short-term liquid investments. There is little appetite just now to commit funds to more risky or longer-term uses. The normal functioning of capital markets can really resume only when these sorts of investors regain the confi dence to make those commitments. As a result, the outlook for the United States, where credit concerns are most acute, where capital markets are most important for the fl ow of credit, and where house prices are falling, is for weakness in the near term, and most forecasters have been revising down their numbers for 2008. Considerable stimulus has been applied by the US authorities to this situation, with policy interest rates declining sharply and a fi scal stimulus package imminent. The US Federal Reserve has also taken some forceful actions to stabilise the fi nancial system. Growth in the euro area appears to be moderating as well, though at this point not by as much as in the US, and the euro area authorities continue to express concerns about infl ation. Japan's economy is also weakening, partly as a result of international forces but also partly due to purely domestic events. Economic conditions in the rest of Asia, on the other hand, have continued to be quite solid. Growth in industrial production and exports has been strong in the fi rst couple of months of 2008. Weaker US conditions are affecting Asian exports to that country, but to date exports to other countries have compensated for this. The Chinese economy, with its demand for natural resources, has continued to expand strongly. The impact of the global turmoil via fi nancial linkages has affected share markets in the region, but there does not appear, so far, to have been any noticeable effect on the capacity or willingness of Asian banks to extend credit. In fact, domestic fi nancial conditions in Asia remain quite expansionary, which is contributing to considerable strength in domestic demand. Infl ation remains a concern in many of these countries and, if anything, that concern could be said to be growing. The net effect of all these forces is such that Australia's trading partners as a group is likely to record below-average growth in 2008, refl ecting weak outcomes in the developed world, and slower but still pretty good growth in Asia. But at the same time, expected higher contract prices for coal and iron ore, which are about to take effect, will, all other things equal, lift Australia's terms of trade by perhaps a further 15 per cent, adding some 2 to 3 per cent to national income over the next year or so. This expansionary impetus comes after the earlier rise of some 40 per cent over the previous fi ve years. So the world economy presents some considerable cross-currents for Australia. The biggest terms of trade boom for 50 years is coinciding with one of the most serious malfunctions in developed country capital markets for a long time. Looking to domestic conditions, most indicators of actual economic performance for the early part of 2008 have remained quite strong. Employment has been very robust, and survey-based measures of actual business conditions have remained strong, even if off their late-2007 highs. We do think, however, that demand growth in Australia is now in the process of moderating. The demand for credit by households has also been weakening over recent months. Measures of confi dence have declined. While those measures can provide false signals, our assessment is that a change in trend is occurring, and we are hearing that from businesses we talk to. A tightening in fi nancial conditions, lower share prices and heightened concerns over the global fi nancial problems will all have played a part in this change. The likely extent and persistence of this slowing in demand is quite uncertain, as these things usually are. There remain powerful confl icting forces at work, so we can expect that diffi cult issues for judgment will remain with us for some time. These are issues with which the RBA Board has to grapple. At its meeting this week, the Board reached the view that, for the time being, policy settings should remain unchanged. The current rate of infl ation is clearly uncomfortably high, and were expectations of high ongoing infl ation to take root, it would be even more diffi cult to reduce infl ation again. Hence, policy-makers are obliged to have in place a policy setting that represents a credible response to evident infl ation pressures. But the signifi cant tightening in fi nancial conditions that has occurred since mid 2007 is a strong response. Short-term interest rates are towards the top end of the range experienced during the low-infl ation period. The Board is also conscious that some non-price tightening of credit conditions is probably occurring at the margin. These factors should be working to slow demand. There is at least some evidence that a moderation in demand is occurring. That, if it continues, should in due course act to slow prices. We will be receiving a round of prices data in a few weeks' time, which will afford another chance to review both recent performance and the outlook. As I noted earlier, the headline CPI rate is likely to be high. We will naturally examine the outcome for new insights about the extent of infl ation currently occurring. But as well as that, it will be important to make continuing assessments of the extent both of the likely moderation in demand and its effect on infl ation over time. This will by no means be an easy balance to strike. But if, by restraining demand for a while, we can secure a gradual reduction in infl ation over the period ahead, then an important foundation of Australia's good macroeconomic performance over the past decade and a half will remain in place. That, in turn, will offer the prospect of good sustainable growth into the next decade. That is the goal of monetary policy. My colleagues and I are here to respond to your questions.

r080415a_BOA

australia

stevens

It is a great honour to be invited to deliver the Melville Lecture. Sir Leslie Melville is one of the revered father fi gures of the economics profession, and of central banking, in Australia. I cannot claim to have known him, or ever met him. But it does not take long in reading about his contribution to the economic life of the nation to see what a remarkable man he was. There are a number of people who have spoken eloquently of Melville's life, including previous speakers in this series. I cannot improve on those words. The interested reader can do no better than to consult a number of biographical essays written by Selwyn Cornish, Ian Macfarlane's Inaugural Melville Lecture in 2002, and the fi rst-hand, and rather poignant, My topic today is one that I think Melville would have been interested in, namely, the role of central banks as providers of liquidity and as lenders of last resort in times of crisis. I say 'would', because there is nothing about it in his writings that I have been able to uncover. Perhaps this is because in the 1930s depression there were few bank failures in comparison with that in the 1890s, and other macroeconomic issues were more to the fore. But there was some discussion at the Commonwealth Bank during the 1930s about supporting other institutions. Melville must have seen at least some of that discussion though it would have been very early in his time there. By the mid 1940s, moreover, Melville was intimately involved in the international discussions that led to the establishment of the IMF, which in many respects was intended to address the same issues in an international setting. Had he been working in the circumstances in which we have lived recently, I am sure Melville would have been very engaged in discussion about the role of the central bank. So it seems an appropriate occasion on which to review our thinking on this important matter. With that assertion then, let me proceed. I shall begin with the question: what do we mean by liquidity? I will then talk about the role of the central bank in supplying it. I will then go on to talk about the role of lender of last resort, why we need it, and the complications that arise in carrying out this role in the modern era. Through all this, my motivating question is: what lessons do we draw from, and what new questions are to be asked as a result of, the events of 2007 and 2008 for the central bank's role in managing liquidity for the system, and (perhaps) supplying it to individual entities? I wish to state clearly at the outset that these remarks are prompted by what we have observed internationally over the past year, not by anything at home. The Australian fi nancial system remains in good shape, as set out in the Reserve Bank's recent . Nothing said here should be taken as carrying any implication to the contrary. The term 'liquidity' is widely used but rarely defi ned. Until quite recently, the noun 'liquidity' was often found to be preceded by the adjective 'excess'. That expression - 'excess liquidity' - simply became shorthand, I think, for the low structure of global interest rates, the associated ease of obtaining credit and the tendency for leverage to rise. Of course, at a global level, that process is now in reverse. For my purposes today, it is important to be more specifi c. There are several senses in which the word is used. liquidity is the ability to buy and sell assets without signifi cantly affecting the price. The market for government debt in most advanced countries is usually thought to be pretty liquid in this sense. Some other markets can be rather less liquid. In the recent turmoil, such transactional liquidity as there had been for many complex fi nancial products disappeared very quickly. A second concept is funding liquidity, which is the ability of an intermediary to raise the necessary cash to fund, or continue to fund, its chosen set of assets. This sort of liquidity can also be pretty fi ckle. Over recent years, some fi rms' business models had been based on the assumption they could obtain liquidity easily and cheaply in wholesale funding markets. These models ended up being quite vulnerable to a disruption in market conditions. In these cases, managers needed to be very nimble, and probably a bit lucky, to re-engineer their model quickly enough when conditions changed abruptly. Some were not that lucky. The past year has reaffi rmed, contrary to some earlier predictions, the importance of the large core banks even in a world of more developed capital markets. Banks are a key source of funding liquidity for other institutions operating in fi nancial markets - securitisation vehicles, structured investment vehicles (the so-called SIVs), conduits, non-bank intermediaries and so on. Funding pressures on those vehicles were quickly transmitted back to the core banks in numerous countries. When shocks to markets occur, it is therefore doubly important that banks be able to manage their own funding needs. In many instances, this proved to be more diffi cult over the past nine months than bankers had anticipated. Not surprisingly, the recent turmoil has prompted many calls for the regulatory community to devote more resources to ensuring that banks strengthen their liquidity management. The reviews under way will be most useful if they address liquidity issues under conditions of market disruption, when everyone is scrambling for liquidity, not just fi rm-specifi c events. Regulators will also be reviewing arrangements to facilitate the smoother functioning of markets at the national and international levels. But there is another, rather important, sense in which the word 'liquidity' is used, and in which I will use it today. Here I am referring to funds at the central bank - what we in Australia call exchange settlement funds, though they have differing names in various other countries. These balances are used by banks and other participants in the payments system to settle their obligations with each other and with the Reserve Bank. Individual institutions can borrow and lend these funds in the overnight market but, for the system as a whole, the only source of these funds is the central bank itself. I turn now, therefore, to a discussion of central bank liquidity operations. In normal times, liquidity operations are pretty straightforward. The central bank forecasts the infl ows to and outfl ows from the system resulting from its own transactions and transactions by the government, and makes arrangements to offset these fl ows with new dealings that meet the system's demand for cash at the price - the interest rate - thought to be appropriate for monetary policy purposes. On occasion, however, the private sector can experience considerable mood swings insofar as its demand for liquidity is concerned. Just this sort of thing happened at the beginning of August 2007 when, around the world, concerns about creditworthiness and general uncertainty in the wake of the US sub-prime problems saw participants in money markets suddenly pull back. They became, individually, much less inclined to lend to others and much more keen to borrow and hoard funds, for fear of what might eventuate tomorrow. The upshot was that the system as a whole suddenly had a much higher demand for liquidity at the central bank than it had before. In the face of a sudden fl ight to liquidity like this, it is the central bank's job to supply the necessary cash to meet the demand. This is a straightforward application of Bill Poole's (1970) result that when the shocks are predominantly to the demand for money, the central bank best stabilises the economy (admittedly a pretty simple stylised economy in the model) by meeting that demand. Technically, that is achieved by exchanging cash for other assets, through open market operations. This should, in my view, occur elastically at a constant interest rate. All of this assumes, though, that the private sector has enough assets that the central bank regards as being of acceptable quality to take onto its own balance sheet in exchange for the cash the private sector desires. The question then is how big a pool of such assets the fi nancial system (and, by extension, individual institutions) should carry in normal times, and the extent to which central banks should be prepared to widen the eligibility criteria for its own operations under unusual circumstances. There is a big philosophical issue here, and it has come more into focus as a result of the recent fi nancial turmoil. Central banks' liquidity operations have traditionally been in a limited range of securities, often conducted with a select group of institutions, relying on them to 'distribute' the liquidity to the rest of the system as needed. But capital markets have developed in ways never contemplated when those traditional approaches were established. It is much more likely than in the past that disturbances will originate in markets and involve counterparties which are several steps removed from the central bank's traditional sphere of direct operation. How should central banks respond in this world? One approach, which has already been adopted to some extent by many central banks, is to widen the pool of eligible assets for central bank transactions - in effect liquefying more of the assets on the balance sheets of the intermediaries with which central banks already deal. This has been complemented by being prepared to deal with a broader range of institutions (the RBA was already prepared to deal with quite a wide range of counterparties even before the recent events). A more radical step, which some people (though no current central bankers, to my knowledge) have proposed, would be for the central bank to transact directly in the markets where the problems originated, addressing them 'at source'. Willem Buiter and Anne Sibert (2007), for example, have proposed that central banks might be prepared to transact in instruments like collateralised debt obligations - which have been at the core of the recent questions of liquidity and asset quality - in order to provide transactional liquidity. These ideas raise signifi cant questions. What would be the consequences were the entire balance sheets of a large set of institutions to, in effect, become highly liquid because any of the assets could be sold to the central bank at short notice (at a market price, assuming that could be determined, and a suitable over-collateralisation of course)? One view is that this would be a good thing, because, for the private sector, holding large amounts of low-yielding assets in order to guard against occasional spikes in liquidity preference is costly. Arguably, this cost is unnecessary since the central bank can provide liquidity to the system on those occasions as needed, at little cost, against any asset it deems suitable. On this view, a reduction in 'unnecessary' holdings of low-yielding liquid assets would lower costs of intermediation and result in a higher real capital stock, raising per capita income over time. But such ready provision of liquidity would trouble many people including, I suspect, most of my central banking forebears. An asset can be illiquid for several reasons, including genuine uncertainty about its underlying value. If private institutions took on additional liquidity risk, confi dent that the central bank would always help them out if liquidity conditions tightened, they could easily end up taking on more of these other risks as well. This would leave both them and the central bank in an awkward position at some future time should things take a turn for the worse. And for the central bank to act as a market-maker of last resort in markets for more exotic instruments would be a very big step, potentially with many unforeseeable consequences. These are pretty big questions. I suspect that they will increasingly be debated over time. My own view, given what we know at present, is that in periods of particularly unusual market duress, central banks should be prepared to move beyond the normal scope of operations to provide liquidity against a broad range of assets and over a longer maturity than might normally be considered. There are two provisos. First, the central bank has to be able to make a reasonable valuation decision about the underlying asset, and take suffi cient excess collateral (a 'haircut') to protect its own position. This probably rules out exotic instruments except under the most dire of circumstances. Second, a preparedness for forceful intervention in a crisis situation has to be balanced with some thinking about ways of restraining developments in the other direction when risk appetite is high. That, needless to say, is no easy matter. Having talked about normal liquidity operations, we must then turn our attention to the role of lender of last resort, where the central bank lends to one specifi c entity, when no-one else will. The fi rst question is: why do we need it? The reason is the possibility - albeit a very remote one - that a panic could put overwhelming pressure on a perfectly sound institution that, though prudently managed, cannot possibly hold enough liquid assets to withstand the pressure unaided. Some entity has to be prepared to lend in such a situation if the market will not, otherwise the panic can imperil the institution concerned, and perhaps the fi nancial system as well. The notion has quite a history. The earliest use of the term seems to have been attributed to Sir Francis Baring, who in 1797 referred to the Bank of England as 'the dernier resort' , able to provide funds to an entity when all other sources had been closed off. Early writings on the idea came from Henry Thornton (1802) and Walter Bagehot (1873). Thornton, writing in the late-18 and early-19 centuries, saw the Old Lady of Threadneedle Street as playing a stabilising role in times of crisis, to prevent a rapid reduction in credit caused by a shrinkage of the deposit base of the banking system. Bagehot's classic appeared in 1873 with what has ever since been seen as the consummate statement of the responsibility of the lender of last resort. For Bagehot, it was clear that the Bank of England should lend substantial liquid resources on a secured basis to a fi nancial institution that had reasonable asset quality (i.e. was solvent) but which faced short-term funding diffi culties. Bagehot's dictum was 'Lend freely against good collateral at a high rate of interest'. It is frequently quoted still, and has been referenced more often over the past year than for a long time. The question is how to put it into practice. Even leaving aside the obvious potential diffi culties in assessing solvency in real time, the Bagehot formula leaves open two important questions: * what is 'good' collateral? and * what is an appropriate rate of interest? The collateral involved is not necessarily going to be the standard sort of liquid assets. By defi nition, much of that collateral may already have been used before the bank reached the point of needing a loan of last resort. So the assets in question are likely to be some part of the bank's loan book, or some physical asset of the bank. Presumably it is 'good' if it is priced at a value that could be realised if necessary under 'normal' market conditions. But for some assets, valuations are notoriously diffi cult, especially in periods of economic and fi nancial distress where there is a large amount of uncertainty about where market pricing might eventually settle. As for the interest rate, Bagehot's formula is often invoked with reference to a 'penalty rate', even though he did not actually stipulate that. It is customary to motivate the need for the penalty by pointing to moral hazard: the possibility that banks may behave imprudently if they expect to be 'bailed out' inexpensively should they get into trouble. That is an important point. But how does one decide how much penalty is enough? Should it, like most penalties, be related to the extent of the misdemeanour? If the bank has just been incredibly unlucky, should the penalty be lighter than if it has been imprudent? Would we always be able to distinguish between those two cases? Clearly, since the intention is to keep the bank operating, the penalty should not be so big that it leaves the bank's interest spread between assets and liabilities negative, since that would actually hasten insolvency. Some aspects of the penalty are also likely to be non-pecuniary for the institution per se , but nonetheless not ineffective. The price of offi cial assistance may, for example, involve the departure of the CEO, some other executives and some or all of the board, and losses for shareholders. Apart from these issues, other potential complications can be noted. One is disclosure. In almost all circumstances, disclosure is highly desirable: an informed market is a fair and effi cient one. But the communications surrounding emergency liquidity assistance are critical in determining the chances of success. It would appear that it was information that the Bank of England was about to offer assistance to Northern Rock - which, objectively, should have strengthened its position compared with the alternative - that precipitated the queues in the streets. Wholesale lenders to that institution would have already known that it was under pressure, but the news of offi cial assistance told retail depositors, in effect, there was a problem and they reacted accordingly. The design of the UK deposit insurance system may also have been a contributor, in that less than full insurance and the possibility of a delay in receiving insured funds can add to the incentive for a run. In this complex situation, the UK authorities found it diffi cult to stabilise things, until the government issued a strong guarantee of Northern Rock's obligations. A fi nal issue is the re-fi nancing of the last resort loan in the private sector once the situation has stabilised. If there is ongoing general market turmoil, as in the case in question, then it can be diffi cult for a private fi rm to replace the public funding at a price that allows the bank in question to remain viable. In such an instance, the government faces the choice between providing the institution with longer-term support - either a long-term loan or taking ownership -, subsidising a takeover or closing it. In the UK case, Northern Rock is being taken into public ownership for a time. In the US, the takeover of Bear Stearns - which, of course, is not strictly a bank - by JPMorgan Chase is being assisted by a long-term facility provided by the Federal Reserve, which carries some credit risk for the Fed. In each case, there is ongoing discussion about what value the previous shareholders can reasonably expect to get from the resolution. The prospect of legal action is, of course, a potential further complication. All this illustrates that the role of lender of last resort is actually quite challenging in the modern world. Thankfully, observations in the time series of large fi nancial near-failures are few, and recent ones have been in other countries. But when they do occur, it is important to learn as much as we can from them. Central banks and supervisory authorities around the world are seeking to do just that. No doubt very thorough evaluations and recommendations will appear in due course. At this point, I would summarise the general lessons from the recent events as follows. First, well-designed regular facilities that allow adequate access to central bank liquidity in times of pressure - either generalised or fi rm-specifi c - are helpful in avoiding the authorities fi nding themselves in the position of needing to contemplate the extension of a loan of last resort. Second, if fi rm-specifi c assistance beyond the normal channels is required, the central bank has to have very quickly a clear idea of the solvency of the entity concerned, and of the quality of collateral available in order for the terms of any assistance to be set. A good deal of that information has to come from the prudential supervisor. Where that is not the central bank itself, this means that an effective relationship between the central bank and the supervisor is essential. Third, the government needs to be involved early on, for several reasons. Apart from the fact that it owns the central bank and would therefore ultimately carry any risk the central bank might take on in these transactions, there is a need for clear and consistent communication by all the authorities at an early stage. Further, any decision to extend support to an insolvent institution on systemic or national interest grounds would be one properly taken by a government under advice, not a central bank itself. Fourth, if support for an institution in diffi culty were to turn out to be more than just temporary, the public sector would face diffi cult issues of how to structure that support. Any such support should, however, come at considerable cost to the private owners and managers of the troubled entity. Public-sector support should not be used to 'bail out' private shareholders or those who were responsible for running the troubled institution. Australians have been observing the major fi nancial events of the past year mainly from the sidelines. While there have been some pressures coming through to our system, the most dramatic outcomes have been offshore. We can, nonetheless, draw some conclusions from these events. We have learned, or perhaps re-learned, a good deal about the nature of liquidity, markets and the role of central banks over the past year. One key lesson is the importance of liquidity in markets and to institutions, something that perhaps had not been emphasised as much as it should have been in regulation, where the emphasis has been very much on capital. We have further learned that, under conditions of great uncertainty, liquidity pressures can erupt in markets that had seldom been affected in the past. Central banks have responded quickly and fl exibly to such events, but it has proven diffi cult to contain the pressures fully. Some quite important questions remain for the longer run, which central banks will be considering. A second lesson is the diffi culty in resolving a problem with an individual institution under strained overall conditions. Bagehot's formula provides only the most general of guidance; making it operational requires considerable judgment. If and when such an event comes, it tends to have its own unique elements and a particular set of circumstances as backdrop. Speed and fl exibility in response are essential. So is consistent and early communication, since disclosure of support, if not managed very carefully, could turn out to make the situation worse rather than better. A third lesson is that a loan of last resort is, in the end, probably simply bridging fi nance while a takeover or major re-structure of the recipient institution is organised. The recipient would very likely see a change in its business model, management, board and ownership structure. It could well require a pretty clear statement of temporary government support. All of this would need to be organised very quickly. To be in a position to help, central banks have to keep an ear closely tuned to market developments - a sceptical one in the years of good times, and a sensitive one in periods of duress. A very good working relationship with the prudential supervisor, where that is not the central bank, is also essential. This is the case in Australia. I am not sure exactly what Sir Leslie Melville might have made of these conclusions. But we know that he responded practically and effectively to the issues of his day, which were concentrated around the role of policies in preserving economic and fi nancial stability. I imagine he would expect those of us in the fi eld 70 years later to be equally practical in the light of the experiences of our own time. These demonstrate all too clearly that for all its apparent sophistication, the modern fi nancial system still needs the occasional stabilising hand of a government and/or central bank. Melville would certainly have recognised that very quickly. To meet these challenges, we will need to continue to adapt our own thinking and practices.

r080515a_BOA

australia

stevens

Economics and Business, distinguished guests, ladies and gentlemen. I think the last time I was in this Hall may have been for my graduation. If not then, it was probably for an examination. Either way, tonight's occasion is far more convivial and I thank the University for the invitation. One of my classmates of old suggested that a good topic for this conversation might be a comparison of the Australian economy of the late 1970s, when we were students, with that of today. The more I thought about that suggestion, the better it seemed and so that comparison is exactly what I propose to offer. In the moment-by-moment focus on the economic data, and all the wiggles and ticks up and down of this indicator or that, we can often neglect to stand back and look at the big picture. So let us rectify that for the next 25 minutes or so. The approach is to use graphs and tables to compare two decades - the 1970s and the 2000s, so as to offer some perspectives on how things have changed and, perhaps, on how they are similar. Table 1 gives a comparison of the structure of the economy by industry then and now. The two most striking changes are the decline in the share of output provided by manufacturing, and the rise in fi nancial and business services. This trend has occurred in all developed countries. Agriculture is smaller than it was then, though 2007 was a drought year, which affects that comparison. services have become more important (the mobile phone was not invented in 1977, Financial, property and business services Wholesale and retail trade Education, health and community services Utilities and transport Government administration and defence Communication services of course. What did students do is larger today, though not by much. Beyond these shifts, not all that much has changed at the broad structural level. even 30 years ago had quite a substantial services sector, and still does. But the opening up of Australia to international trade, as a result of the policies of tariff reform and product market liberalisation since the mid 1980s, has been a signifi cant trade patterns has been substantial 60 per cent of Australia's trade was conducted with the United States, major European countries and Japan. While these countries continue to be important to Australia today, their share of Australia's trade has fallen by a third and is now eclipsed by our trade with China and emerging east Asia. This feature refl ects the growing importance of China and emerging east Asia more generally - together, their share of global GDP has trebled to almost 18 per cent since the end of the 1970s. External infl uences on Australia are also refl ected in our terms of trade 1970s was the spike in our terms of trade as supply disturbances pushed up world commodity prices. Today, rising commodity prices are again a feature of the global economy. However, this time around, much of the rise in our terms of trade appears likely to be more sustained, resting as it does on the demand arising from the long-term emergence of large economies like China and India. The more open economy today also means we are more exposed to these forces. In addition, the opening of the capital account in the early 1980s has led to a degree of integration of the Australian fi nancial system with the world in a way which offers a much larger choice set to savers and investors. My next set of comparisons is of major macroeconomic aggregates. The fi rst is growth in real non-farm GDP. I use non-farm GDP simply because farm GDP can be highly volatile due to droughts and fl oods. That, as rural producers know only too well, has been a constant feature of the Australian experience. On average, growth in the economy in the two periods under review was very similar, at about 3.4 per cent (Graph 3). But there was a marked change in the middle of the 1970s. After a number of years of very rapid growth, the economy encountered much more adverse circumstances from 1974 onwards. That was true for most countries, though Australia's relative performance on some metrics deteriorated. From 1975 to 1979, the average growth rate was a full percentage point lower than in the period from 1971 to 1974. The period was also noteworthy for the close proximity of two episodes of cyclical weakness, in 1974-1975 and 1977. There was also a recession in the early 1980s. The current decade so far has seen average growth of 3.4 per cent, though the next couple of years will probably see growth noticeably lower than that. What is quite noticeable from the graph is the relative stability of growth in recent years, something that was a feature of the second half of the 1990s as well. This pattern was observed in many economies over the same period. Of course, the 1970s makes for a fl attering benchmark in that it was the most unstable period in macroeconomic terms in the entire post-War period, so even average performance will look better than that. But, in fact, the period since the mid 1990s has been very stable by any standard. Those who have looked into this in detail have posited several possible contributing factors, including better macroeconomic policy frameworks, a wide range of microeconomic reforms in labour and product markets, and luck. The weak growth of the latter 1970s was associated with an upward trend in unemployment (Graph 4). From a low of 2 per cent in the early 1970s, it rose to about 5 per cent in the recession, and then drifted higher over the remaining part of the decade. Similar trends were observed abroad. The big rise in real wages in the mid 1970s, part of which was exogenously imposed as a result of government policy at the time, also had a fair bit to do with higher unemployment. The trend in unemployment in the most recent decade has generally been downward. Following a rise of a percentage point in the economic slowdown in 2001, it has fallen to the lowest levels since the mid 1970s. The long expansion, with occasional temporary pauses, has done a lot to foster lower unemployment. But the changes in labour market arrangements over the past 20 years or so have also been very important. Indeed, I would argue that they are a key contributor, not least because they have facilitated the longer length of economic expansions. difference in infl ation rates between the two decades is a central banker I suppose I would say that, but I think it is too easy to forget the corrosive effect that high infl ation had on the economy in those days. Until the mid 1960s, Australia had been a low-infl ation country. The seeds of the 1970s infl ation were sown in the latter part of the 1960s, they took root in the early 1970s and then the events of the early and mid 1970s pushed infl ation up steeply. From the end of 1970 to the end of 1979, the average rise in the CPI was 10.7 per cent a year, which meant that the value of money fell by 60 per cent over that period. The peak infl ation rate in any one year was 17.6 per cent, and the lowest achieved was just under 5 per cent. In contrast, the current decade shows a pretty fl at line for infl ation when put on the same scale as the 1970s. We still have our cyclical ups and downs, but the average rate has been 3.0 per cent since the beginning of 2001. Even with the recent surge in consumer prices taking the infl ation rate to a bit over 4 per cent, things are not like they were in the 1970s. That's just as well, of course, because with entrenched high infl ation would come lots of distortions and wasted resources as people in the economy adjusted their behaviour to live with high infl ation. One of the adjustments would be that savers would demand higher nominal interest rates, higher than the ones we currently see, to part with their money. So the period between about 1973 and 1983, when the economists of my generation were studying and then getting their fi rst jobs as economists, was a pretty poor one for macroeconomic performance. The past decade, in contrast, has been much better. Once again, a more favourable international environment has been a factor there, but so have better economic policies. Let me turn, then, to economic policies. When we were students, we were taught about the four arms of economic policy, which were fi scal, monetary, exchange rate and wages policies. We still have fi scal and monetary policy, about which I will say something in a moment. But by the early 1980s, enough people had accepted that you could not really choose the exchange rate and monetary policy settings independently. You either allowed fi nancial conditions to adjust to whatever was dictated by a given exchange rate, or you set domestic fi nancial conditions according to the needs of the economy and let the exchange rate adjust to that. The decision to fl oat the exchange rate, made in 1983, was a decision to do the latter. Of course, there have been subsequent occasions when, via intervention, we have sought to infl uence the exchange rate, but they have been confi ned to fairly brief periods and have become less frequent as time has passed. Wages policy was important for the wrong reasons in the 1970s, in that government pushed up minimum wages too quickly for a while. In the 1980s, wages policies negotiated in the ACTU were effective in containing wages growth and allowing some restoration of the share of national income accruing to profi ts. This did a lot to generate employment and growth. It seems unlikely that such a degree of infl uence over wages as an instrument of macroeconomic policy will return. These days, policies over industrial matters are more structural in nature, aimed at making arrangements in the labour market reasonably fl exible, balancing economic effi ciency and fairness, and providing a safety net for the lowest paid. So that leaves monetary and fi scal policy. When I was a student, furious debates had long been boiling away in the halls of academia over questions like: does money matter? Was monetary or fi scal policy more effective as a stabilisation tool? Was the apparent trade-off between infl ation and unemployment, which appeared so tantalisingly in the data, something that could be exploited systematically, or would it prove ephemeral? Was discretion best in the conduct of monetary policy, or should some sort of rule be employed? The 1970s and early 1980s provided important real data and experience in the resolution of these questions. Friedman and Phelps had already long argued that there was no long-run tradeoff and that attempts to reduce unemployment below some structural level by accepting higher infl ation would simply result in accelerating infl ation and no lasting gain on unemployment. The 1970s seemed to demonstrate that this was right. More strident derivatives of the Chicago tradition, however, which insisted that there was not even any short-term trade-off, were found to be wide of the mark. Money did seem to matter, since the big rise in infl ation in the 1970s had been preceded by a large increase in money growth. A lot of people not only accepted that monetary quantities were the key thing to look at, but concluded that central banks had failed to control them, so that some sort of step away from unconstrained discretion towards monetary rules was advisable. As a result, targets for those quantities were adopted, including in Australia. That was the language of discussion when I was a student and when I fi rst started work at the Reserve Bank in 1980. These days, we have infl ation targeting, an arrangement that provides a measure of constrained discretion to the central bank within a medium-term framework. It emphasises the control of infl ation over time, but does not seek to fi ne-tune infl ation over short periods. That allows a reasonable accommodation for trends in economic activity and employment over periods of a year or two, about which the Reserve Bank is required to have concern by its Charter as well as by common sense, but preserves the value of the currency over the long run. In the language of trade-offs, this system accepts there is a short-term growth/infl ation trade-off, but also accepts there is no long-term one. Infl ation targeting does not ignore fi nancial quantities, but does not elevate them to the status of an intermediate target and does not see them as an instrument. Infl ation targeting is not perfect and, on occasion, still leaves policy-makers with some quite diffi cult decisions to make. It is, however, the best system that has been devised as yet. The fi scal debate of the 1970s was dominated by the budget defi cits of the period, and the need to reduce them. On contemporary fi guring, the Commonwealth's budget defi cit reached about 4-5 per cent of GDP in the middle years of the decade. Using fi gures comparable to those in use today, which measure the underlying cash balance of the Commonwealth general government sector, the defi cits of the mid 1970s amounted to only about 2 per cent the Australian general government sector had recorded more or less continual signifi cant surpluses, so the turn to defi cit in 1975/76, for the fi rst time since the early 1950s, was substantial and, at the time, quite controversial. Reducing the defi cit in the sluggish economy of the late 1970s was hard. Defi cits grew much larger in the recessions of the early 1980s and early 1990s. Since 1997/98, in contrast, the federal budget has been in surplus continually, apart from a very small defi cit in one year. The government's net debt has been retired. Gross debt on issue is maintained at a small size in order to facilitate a functioning bond market so as to allow effi cient risk pricing more generally. As with monetary policy, there is a medium-term framework for fi scal policy emphasising balance over the business cycle. There is much less inclination today than there once was to use fi scal policy as a counter-cyclical stabilisation tool. Signifi cant fi scal challenges in the long-term include health spending and responding to population ageing, as the very important work by offi cers of the Australian Treasury has made clear. But there would be very few countries, if any, which would not envy Australia's fi scal position. The capacity to respond, if need be, to developments in the future is virtually without peer. This seems light years from the situation in the late 1970s. I have said little here about the changes to microeconomic policies, which do so much to determine the economy's supply-side responsiveness. That is because my fi eld of interest and expertise is in the macro sphere. But these microeconomic changes were equally as important as the macro ones, maybe even more important. I mentioned the change in labour market policy, but this was accompanied by a host of other changes to factor markets (like fi nancial liberalisation) and product markets (tariff reform, competition policies and so on). It is actually these policies that have done most to improve the living standards of Australians. The contrast between the Australian economy of 1977 - heavily regulated, suffering poor productivity growth, sheltering behind high barriers to foreign competition - and the much more open and productive one of today is striking. The fi nal comparison I offer is in the teaching of economics. Of course I do not sit in lectures or tutorials, so I am unable to judge whether or not the face-to-face teaching has changed since the late 1970s. But one interesting exercise is to compare the text books used today with those in the past. I understand that at the University of Sydney a popular text is the Australian edition (co-authored with Robert Frank, with the Australian edition adapted by Nilss Olekans). When I studied macroeconomics in 1977, the text in use was Fred R Glahe's , published in 1973. One interesting difference that is obvious immediately is the less formal layout. I think it is fair to describe Glahe's text as rather formidable and austere, and perhaps not a particularly inviting read. In contrast, the book by Bernanke et al is much more welcoming, challenging students with thought-provoking questions and illustrations on how economic theory relates to tangible real world events. Perhaps the less formal presentation style says something about how society has changed over the past three decades, but I think it also refl ects an economic force at work, and that is competition. There is a proliferation of new macroeconomic textbooks, many by highly regarded economists. This competition seems to have spurred authors to try to produce the most appealing text for students and lecturers in order to capture market share. To the extent that these texts may help to cultivate an interest in economics, this has been a positive development. On content, both include discussion of the 'money multiplier', as an introduction to the theory of fractional reserve banking. I suppose students have to learn that, and it is easy to teach, but most practitioners fi nd it to be a pretty unsatisfactory description of how the monetary and credit system actually works. In large part, this is because it ignores the role of fi nancial prices in the process. et al do, however, discuss some aspects of fi nancial markets, and I note that in the most recent US edition of the text this has expanded to cover asset prices, the diversifi cation of risk and the role fi nancial markets play in ensuring savings are allocated to their most productive uses. In the shadow of the current dislocation in global fi nancial markets, this is obviously a pretty valuable addition to the curriculum. Ben Bernanke has also, of course, made major contributions to academic literature in these areas over the years. The 1970s book was full of discussion about monetarists versus Keynesians, and of shortrun and long-run Phillips curves. The later book confi nes them to a section called from the Past . Whereas Glahe's 1970s text makes extensive use of the IS-LM framework from per se does not rate a mention in the modern undergraduate text book. But perhaps the biggest difference is in the treatment of the open economy, exchange rates and so on. In Glahe's 1973 book, the analysis is conducted entirely in a closed economy setting. The term 'exchange rate' is not one that appears in the index. Today, even the United States sees itself as an open economy, and the Bernanke et al book treats the issue carefully and even contains some international comparisons of data. What do we take from all that? At the risk of offering a set of sweeping generalisations, I would observe, fi rst, that some of the things which so preoccupied us in the 1970s about the role of monetary policy, the nature of trade-offs, both short and long term, between infl ation and growth or unemployment have been regarded by the mainstream of the profession as pretty much settled. At least, they have been as settled as things ever get. It is to be hoped, of course, that we do not have to re-learn those lessons, which is why I have been making the case to resist infl ation even though that is not comfortable or convenient in the short run. Second, the theory and practice of mainstream macroeconomics has become more international in focus. This trend will surely continue, in response to the course of events. Not only have the effects of bad loans to American home buyers had reverberations much further afi eld, but the rapidly growing size of the emerging world is affecting economic activity and prices far beyond their own borders. I would hazard a guess that the textbooks of 30 years from now (if we are still using books) will devote large slabs of material to that emergence, and to how well the 'old industrial countries' adjusted to it. They will also, no doubt, cover the economics of climate change and its abatement at some length. That is my thumb-nail sketch of the Australian economy, and economics generally, then and now. Of course, this is not a very rigorous treatment and many things have been omitted. But this is supposed to be a relaxed occasion. Re-reading some of the material, and looking at the data, takes one back. I should not mention many particular names, but Professor Warren Hogan, still active in developing policy thinking, was one fi gure of importance. Peter Groenewegen's courses in the History of Economic Thought were memorable, as was the course in Economic Classics that he taught with Colin Simkin. Those courses introduced me and others to Smith, Ricardo and Wicksell, as well as to the then-standard fare of Keynesians and monetarists. And who among the honours classes of the late 1970s will forget the aroma of coffee brewing in the corner of Prof Simkin's study, his desk clouded in cigarette smoke, the students sitting, terrifi ed, waiting for the interrogation ahead about the use of Kakutani's fi xed point theorem to prove the existence of general equilibrium? Some things are harder than monetary policy! It was an enormous privilege to attend the University of Sydney, to have made some very good friends (whom I have still), and to have encountered some remarkable teachers who introduced us to the study of economics. It was marvellous to have been a part, however small and fl eeting, of the life of this place three decades ago, and a great honour to have resumed that association in this way tonight.

r080613a_BOA

australia

stevens

Thank you for the invitation to address you in Melbourne today. I read that AmCham is the largest international chamber of commerce operating in Australia, and has been working to promote trade, investment and general business links between the United States and Australia since 1961. Over that period of nearly fi ve decades, the US and Australia have enjoyed a mutually benefi cial trade relationship, enshrined most recently in the Free Trade Agreement. During that time, a lot of other shifts have occurred, of signifi cance to us both. In 1961, nearly a quarter of Australian exports went to the United Kingdom, our number one trading partner. Trade with China was of inconsequential size. Japan had become a prominent destination for exports by then, but would go on to become by far our largest trading partner by the end of that decade, due to the expansion in the mining sector. In 2007, the UK was number six as a destination. The US was number three (little changed from 40 years earlier). China equalled Japan in fi rst place for two-way trade, and will easily outstrip Japan this year. Of course, the United States is still far and away the largest economy in the world, and will remain so for quite a while. Nonetheless, the change in the trade experience of Australia - and we are hardly alone in that - is an indicator of the way the weight in the world economy is gradually shifting to the Asian region. On the fi nancial front, in contrast, Asia remains in many respects underdeveloped, especially in terms of the prominence of its local-currency capital markets. US capital markets remain the largest, deepest and most infl uential, driving developments in stock, bond and money markets, and their various derivative offshoots, around the world. That contrast - the increasing economic weight of Asia and the continuing dominance of American behaviour in fi nancial markets - is in many ways at the centre of the set of challenges facing Australia, and I suspect other countries, right now. Before coming to that, however, it is fi tting to begin with some remarks about the US economy. I will then talk about the global economy more broadly, and particularly the effects of the US slowdown on the rest of the world before focusing particularly on Australia and the current challenges of economic management that we face. As you well know, the US economy is struggling with a period of weakness at present. Growth has slowed to a very subdued pace, and confi dence is well down. There continues to be debate as to whether or not what we are witnessing can be called a recession. In some respects, this is a rather silly preoccupation because there is no doubt that conditions are weak, and it is not worth spilling much ink over whether the growth rate is just above or just below zero. That said, the US economy has, thus far, done a little better than many people had feared. Of course the episode is not yet over; a period of adjustment still lies ahead. The epicentre of this adjustment is the housing sector, where deteriorating lending standards and a speculative boom in parts of the country a few years ago led to a build-up of excess physical stock and overstretched borrowers. Subsequently, the need to work off this overhang has seen construction rates for new homes fall by half, and prices for established homes in many major cities decline for the fi rst time in many years. Rising defaults and foreclosures are likely to dampen prices further. The non-recourse nature of mortgages in some US states is potentially a destabilising factor as well, since even people who can service a loan have an incentive to walk away once their equity falls to zero. Tighter credit conditions are a dampening factor for the US economy more generally, as lenders work to limit risk in order to repair their own balance sheets. So the real question is when the preconditions for a renewed expansion will come into place. It is perhaps a bit soon to conclude that we have reached that point. There are certainly some helpful dynamics at work: the worst fears of a serious fi nancial collapse have abated somewhat over the past couple of months, the process of balance sheet repair for key institutions is well under way, macroeconomic policies have been put into expansionary mode and initiatives to offer some modest support to the housing market are in train. Considerable uncertainty, nonetheless, surrounds the outlook for the United States over the next year or so. What is the effect of this on the rest of the world? In a previous response to this question, I suggested that there are two key channels to consider. The fi rst is trade spillovers, as the fall in US income means that the US demands less in the way of products from other countries. The decline in the US dollar also works in this direction. The second potential channel is fi nancial contagion, with the possibility that other countries may experience the same fi nancial dynamics as those which have been at work in the United States. My view was that this second channel was likely to be the more important one in this episode. The trade channel certainly is working - lower US demand is being felt in weaker exports to the United States from most parts of the world. But other forces are also at work, and the strength of some other regions has meant that many export-driven economies, certainly those in Asia, have continued to record quite solid growth into the early months of 2008. Some of these countries have also developed a good deal of momentum in domestic demand. So to date, trade per se has not been the major issue. But fi nancial exposures to the problem assets were spread around the global system. Creditrelated losses that have been disclosed by fi nancial institutions around the world to date amount to something approaching US$400 billion, of which about half is in institutions domiciled outside the United States. More losses reside in entities outside the core fi nancial system. So the pressure on balance sheets arising from the decline in credit standards in the middle of the current decade has extended beyond the US itself, at least to Europe and the UK. Given the integrated nature of fi nancial markets in the developed world, moreover, pressure on term borrowing costs for banks has been seen in many places over the past nine months, even if in a less acute way than observed in the countries at the centre of the crisis. These forces are contractionary in nature, and so global growth is widely expected to be lower in 2008 than the very strong result in 2007. According to the IMF, global GDP growth will moderate to about 3 3/4 per cent in 2008 and 2009, with slowing concentrated among the developed economies of North America, Europe and Japan. This forecast embodies a mild US recession during 2008. But while this outcome for global growth would be well below the exceptional pace of about 5 per cent seen in 2006 and 2007, it is actually in line with the average rate of growth for the world economy over the past 15 years. And although the IMF suggested in April that the shortterm risks surrounding this forecast were concentrated on the downside, with a 25 per cent chance of global recession (which it defi nes to be global growth at or below 3 per cent), recent developments do not suggest that those risks are any more likely to be realised than was the case a couple of months ago. To date, in fact, the fi nancial developments that have so occupied the minds of developed world policy-makers have not been as big an issue for many countries in the emerging world, at least not those most important to Australia. Banks in those cases have not had serious funding problems, perhaps in part because their own exposures to the bad assets were minimal. Capital markets, which are less important as avenues of funding than in many developed economies, have not been a source of signifi cant disruption. Admittedly, share markets in the emerging economies have declined noticeably, but credit expansion has continued unimpeded and, as I indicated a moment ago, economic growth appears to have remained pretty solid. In fact, around much of the emerging world at the moment, the bigger problem seems to be neither the near or actual recession of the United States, nor the credit crunch about which we hear so much in the discussion of the major countries, but infl ation. From Asia to Latin America to Africa, as well as in many of the industrial countries, we are hearing a lot more about infl ation now. Food price rises loom large in developing countries' consumer basket, so the big rises in grain prices over the past year have been very prominent. Several potential drivers of these increases have been nominated. One is the change towards a more protein-intensive diet as developing countries' incomes rise, which increases demand for grain to feed animals kept for meat. This is no doubt a factor, but it is a long-run trend and there is no evidence that meat consumption has exploded just in the past year. Another is the diversion of some grains towards production of bio fuels, with up to half the increase in the consumption of some crops in 2006/07 going to this source, thus constraining supply available for additional food production. But while this has played a role at the margins, supply disruptions have arguably been the most important cause of big price rises in the past year. In particular, supply has been disrupted by adverse weather conditions in key production areas, for example, the drought in Australia. To the extent that those effects are temporary, it could be expected that food prices will not continue to rise at the same pace. Temporary supply factors may, at the margin, also have been at work in pushing up oil prices of late. In addition, the infl ow of fi nancial capital into energy derivatives markets, as funds have expanded their asset universes to include commodities, has been another source of demand. This seems to be what people have in mind when they suggest that oil prices have been subject to speculative pressure. But it is surely impossible to avoid the conclusion that most of the trend rise in oil prices over a number of years now has been due to rising demand by end users. Supply has risen too, in contrast to what occurred in the OPEC shocks of the 1970s, but it has struggled to keep pace and the cost of supplying the marginal unit has risen. The same can be said, moreover, about other resource commodities, including thermal and metallurgical coal and iron ore - commodities that are very important to Australia as a producer. Chinese demand for these resources to construct fi rst-world standard cities has been extremely strong, and has accounted for a large share of the increase in demand over the past several years. Anyone who visits a Chinese city can see the results. Such visitors also tend, more often than not, to get a sense that this demand could continue, as a structural phenomenon, for quite a long time. At present, there is a strong sense of overheating in the Chinese economy. It would be even clearer in the statistics were it not for the administrative controls over many prices. As it is, China's offi cial CPI is rising at close to 8 per cent per annum. The effect of China on the rest of Asia, moreover, is expansionary. Coupled with fairly easy monetary policy settings in much of the region, which tends to occur in many emerging economies when US policy rates are very low because of the importance of exchange rate considerations to Asian policy-makers, this is likely to limit downside risks to growth in the short term. It does pose the risk, though, that infl ation will continue to pick up. This is not confi ned to Asia, either: infl ation pressures are evident in much of Latin America and South Africa, both regions where higher resource prices have delivered a terms of trade gain of substantial proportions. I would venture a guess, in fact, that the number of countries where infl ation is the major problem greatly exceeds, at present, the number where the predominant concern is inadequate growth. It may be that the slowing in growth in train in the major countries will lead to energy prices and some other commodity prices moderating. On the other hand, the forecast moderation in global growth is taking it back only to about average pace. With the bulk of new demand for energy and resources coming from countries which are yet to show much sign of cyclical slowdown, and whose energy intensity of demand is continuing to increase secularly, any nearterm softening in these prices might only be modest. Hence the fact that the low level of interest rates in the major countries results, de facto , in the setting of monetary conditions being pretty easy in many developing countries as well, is starting to raise warning fl ags among observers who can see infl ation pressures already building. This could pose some quite diffi cult choices for policy-makers, particularly in the emerging world, over the next year. Longer term, of course, the likely ongoing growth in demand for energy by developing countries will surely pose major adjustment challenges for the rest of us. The external environment certainly poses some big, and very immediate, challenges for an Australian economy which has experienced a long expansion and largely used up its reserves of spare capacity. The forces at work from abroad pull in different directions, to an extent seen on few occasions in the past. On the one hand, the seriousness of the sub-prime credit crisis, and the associated weak outcomes being experienced in the US, and thought to be in prospect in the UK and some parts of Europe, are well understood by Australian households and businesses. The fi nancial turmoil of the past nine months has also seen a market-driven tightening of fi nancial conditions in addition to that which resulted from the tightening of monetary policy. Combined, these developments are having a dampening effect on demand. Households have, over recent months, adopted a more cautious attitude to borrowing and spending, the evidence for which is a string of fl at results for retail sales, and a signifi cant decline in the fl ow of new loan approvals for housing. Credit approvals to businesses have also declined signifi cantly. While this partly refl ects the winding down of a process of rapid reintermediation that had been occurring as businesses turned to their banks and away from capital markets around the turn of the year, total business funding has slowed. In short, things are happening that suggest a moderation in growth in domestic demand is occurring, signs of which were beginning to appear in the national accounts data released last week. At this stage, inevitably, the extent and likely duration of the moderation remains uncertain. There is not much uncertainty, though, about the need for a moderation. Infl ation increased over 2007, and in underlying terms reached the highest rate for 15 years or more. It is true that it was boosted by the international rise in oil and other commodity prices, but Australia's infl ation rate has risen more than most of those in our usual peer group when measured on a comparable basis. It is also pretty clear that strong domestic factors were at work, with growth in local demand at a pace exceeding, by a large margin, any plausible estimate of the economy's long-run potential growth rate for output, at a time when capacity was already tight. Had not the rise in the exchange rate occurred over the past couple of years, moreover, the Australian dollar prices of energy and other raw materials (as well as other tradable goods and services) would be even higher. So infl ation has picked up, and needs, over time, to be reduced. Reductions of infl ation usually require a period of slower demand growth, and this episode is no different. At the same time as we are seeking this moderation in domestic spending, the rise in resource prices that is occurring courtesy of strong demand abroad has complex effects on the Australian economy. Since Australians pay world prices for their petroleum products, the rising global oil price adds to costs for businesses and consumers. This is infl ationary in its immediate impact, though it also acts as a brake on spending on other goods and services, unless people are prepared to reduce saving or borrow to sustain that other spending at previous levels. Other things equal, this brake dampens infl ation impulses in those other areas. But other things are not equal. also receive higher incomes as a result of higher resource prices. As shareholders they experience higher profi ts. Employees in the resource sector, as well as in the construction sector or the various areas that supply goods and services to mining, are receiving larger pay packets. Governments are receiving higher revenue fl ows, which in some cases they will spend, at least in part. So in net terms, this terms of trade effect is expansionary. In the normal course of events, it would add more to demand than the higher commodity prices would take out. With the rises in bulk commodity prices taking effect now, Australia's terms of trade will rise by about 20 per cent, on top of the very substantial lift that has occurred over the past several years. Since 2002, the total rise in the terms of trade will, by the end of this year, be of the order of 65-70 per cent. Some other countries are also experiencing signifi cant terms of trade rises (Table 1). But few will have seen anything bigger than Australia's over a fi ve-year period. There is an obvious contrast with the United States, whose terms of trade have fallen by about 6 per cent over the same period, owing to the importance of energy imports to that country. The strongest contrast, though, is with countries such as Japan or South Korea, which, unlike the US, have no signifi cant resource endowments of their own. Turning back to Australia, the effect of the 65-70 per cent increase in the terms of trade has been to lift the purchasing power of our GDP by around 13 per cent. In the terminology of the national accounts, this is the boost to real gross domestic income or real GDI. Of course, our resources sector has signifi cant foreign ownership, so a signifi cant part of the gains accrue to foreigners and the boost to the real income of Australian residents is not as large. Over 2008, the boost to real GDI is estimated at around 4 per cent, with the boost to national income somewhat less than this, but still substantial. The expansionary terms of trade shock occurring now obviously would have the potential, absent some other adjustment, to be seriously destabilising. By design, certain features of our macroeconomic policy framework help to handle the shock. A higher exchange rate plays a very valuable role in dampening the expansionary impact, lowering prices for traded goods and services and spilling some demand abroad. In the year ahead, the Government has said that the so-called 'automatic stabilisers' in the Federal Budget, which refers to the feature that the tax system withdraws more income from the economy the faster it grows, will be allowed to operate, which is also helpful. It falls to monetary policy to play its proper restraining role as well, dampening private demand not only because infl ation has already picked up, but seeking to head off further problems that could easily emerge given the expansionary effects of the terms of trade. This is why a tight monetary policy setting is essential. It is why the Reserve Bank has lifted interest rates, even as the Federal Reserve was reducing them. Not only does the overall pace of demand growth need to slow, but we are having to accept a change in its composition. There is a major process of investment going on, by businesses as well as by governments. Business investment is at very high levels relative to GDP, and businesses in aggregate say they intend to increase investment further next year. Governments at the State level intend a substantial infrastructure spend as well, though the experience of the current year is that they are having trouble implementing their plans because of the demands already being made on the engineering construction sector. In most economies, it is usually not possible, and certainly not prudent, to try to have a consumption boom at the same time as an investment boom. Of course, Australia can and does access the savings of foreigners to fund additional investment - a process of running a current account defi cit - so we do not have to fi nance the totality of the additional investment ourselves. This is something not unknown to the US economy either (in fact, it has been a common feature of most of the Anglophone market economies over the past decade). But even so, there are probably sensible limits here. Practically speaking, domestic consumption, together with housing demand, and some areas of business investment not linked to the resource sector, is being asked to make some room, for some period of time, for the rise in other forms of investment that will sustain higher incomes and living standards in the future. Given that the economy is pretty fully employed, total investment levels are already high, the nation's call on net capital infl ow from abroad is over 6 per cent of our GDP and infl ation is already 4 per cent, it is diffi cult to see any serious alternative to an adjustment of this nature. To try to absorb the expansionary terms of trade impact without any macroeconomic policy restraint is not really an alternative at all. In such an infl ationary scenario, I expect that we would still fi nd that the resources sector and the parts and regions of the economy that benefi t most directly from its fl ow-on effects would attract additional labour and capital, and become proportionately larger in the national economy over time. Other sectors and regions would, proportionately, still diminish in size. The process would simply be less effi cient: the price signals for resource allocation that are pretty clear at present would be more diffi cult to detect under conditions of higher infl ation. Indeed, that is one of the problems high infl ation brings. This course would also leave the rest of the economy with the legacy of embedded high infl ation, commensurately higher nominal interest rates and so on. That would be harmful for living standards over time. As such, allowing it to occur would be a policy mistake. Both the United States and Australia face signifi cant economic challenges. For the US, dealing with the fall-out of the fi nancial excesses of the earlier years looms large at present. This is not made any easier by the simultaneous lift in global commodity prices, which raises consumer prices but, in the US, also dampens economic activity. For Australia, the fi nancial fall-out has been less severe, mainly because participation in the earlier excesses was so much smaller, while the very large change in prices for mineral and energy resources is the most expansionary external shock to affect the economy for 50 years or more. It has occurred at a time when the productive capacity of the economy has already been stretched by the long expansion. Hence, the prospect of infl ation has presented a larger and more immediate danger to us than it has, thus far, to the US. One way or another, the near term continues to present challenges on both sides of the Pacifi c, as the two respective economies adjust to the shocks hitting us. But both of these economies are pretty adaptable. There is no reason why, with sensible policy frameworks, competitive and innovative fi rms, and capable and industrious workforces, they should not continue to prosper over the long term.

r080621a_BOA

australia

NO_INFO

no_info

Thank you to the Bank of Canada and the Haskayne School of Business for the invitation to be here today. There has been a lot of good analytical discussion of commodity markets over the past few days, and I do not propose to go over that ground. I shall confi ne myself to some fairly high-level remarks about general trends in commodity prices and the issues for economic policymakers that are arising from those trends. Naturally, I will do this from an Australian perspective. A Canadian audience is likely to hear some things that may resonate, but I am also conscious that there are some signifi cant differences in our experiences at present. Perhaps the biggest one is that the market for the bulk of Canada's exports, amounting to about 25 per cent of Canadian GDP, namely the United States, is currently very weak. In contrast, the economy of the country that is now Australia's largest trading partner - China - is running hot. I begin with some general observations about commodity prices. As we heard today, a range of commodity prices have risen sharply in recent years. In fact this is very widespread; it's not just oil (Table 1). A key question is whether these changes have been principally the result of supply reductions or increases in demand. In the case of food prices, it can be argued that supply problems have been important. To be sure, some important demand factors have played a role over time. As has been pointed out by several authors, rising living standards in the developing world have seen rising demand for a higher-protein diet and hence grain to feed animals. As a fl ow-on from higher oil prices, the desire to step up bio-fuel production is also a factor pushing up the demand for some grains. While the share of crops devoted to bio-fuel production is still very small, its impact at the margin may be considerable: on some estimates it accounts for almost half the increase in usage of major food crops in 2006-2007. Still, probably the most important factor at work raising prices of foodstuffs over the recent period has been supply problems, caused by unfavourable weather conditions in key grain production areas. In Australia, we have been living through one of the longest droughts in some parts of the country since modern records have been kept. I understand that drought conditions have also plagued Canada's Prairies in recent years. Such events are not usually thought likely to be permanent. They do seem, though, to have been reasonably persistent. While food prices may have been affected by unfortunate supply shocks, for many other commodities the main driver of higher prices has been strong growth in demand, not reduced supply. In the case of oil, global oil demand (and supply) has risen by about 13 per cent since 2000, to about 86 million barrels a day at present. This additional demand has come almost entirely from outside the OECD countries, which were traditionally the biggest users of oil. Chinese demand is the source of about a third of the increase, but the rest comes from developing countries around the world. Global imports of iron ore have risen by about two-thirds since In this case, the increase is more or less entirely accounted for by China. A qualitatively similar story can be told for coal consumption. Much of the increase in world demand for aluminium, copper, nickel and zinc can also be attributed to growing Chinese usage. Year average of which: Base metals of which: Selected commodities So this is not the same as the OPEC shocks of the mid and late 1970s, when large supply disruptions pushed prices higher and slowed global growth. In this case, demand, a function of strong global growth, has driven the price rises. Of course, it is not demand in the industrialised West that has been the most prominent in this episode; it is that of the developing nations which have so enthusiastically embraced globalisation and all the aspirations that it brings for an energy-intensive way of life. One can see how for the rich countries this presents as a 'supply shock', raising prices and lowering output. But to see it as just that misses the fact that demand and growth generally in the emerging world are quantitatively important enough now to matter to the global economy in a way that it did not only a decade ago. This is not to deny the continuing importance of the major industrial economies, or the potential feedback effects of slower growth in the major economies on commodity prices. But more is going on than just what is seen in the 'Atlantic' group of North America and Western Europe - and the price of commodities is the proof of that proposition. Moreover, this is probably a portent of ongoing adjustment over the long run. Substantial changes in commodity prices present important policy issues, both for macroeconomic policies working on the demand side of the economy, and for structural policies that work on the supply side. Responses would be expected to differ, moreover, between countries which are mainly commodity users and those which are also suppliers (like Canada and Australia). A key initial question is naturally whether the change in commodity prices is temporary or permanent. To the extent that changes are driven by temporary supply disturbances, most countries would expect not to respond to these with monetary policy, since it is likely that by the time any policy response has its effect the problem will have gone away. Monetary policy's job is to control the trend infl ation rate, not the very short-term one. However, when the changes are driven by persistent demand factors, policy-makers will need to give consideration to whether monetary policy needs to be adjusted. There is, of course, a very important distinction to be made between a permanent, but onetime, shift in the level of prices and a persistent increase in the rate of change of prices, though in practice it may be very diffi cult to tell the difference. A pick-up in the ongoing rate of change of prices obviously would require a tighter monetary policy setting (i.e. higher interest rates). The more interesting and diffi cult case is the one-time price level rise, which takes place over a year or two (or three or four). For the 'average' industrial country, a persistent rise in the price of raw materials or energy represents a negative shock to supply. The capacity of the economy to supply goods and services at a given price level has diminished. By itself, this will reduce output and push up prices. But the effect of the higher prices, assuming they are typically paid to suppliers elsewhere in the world, also acts somewhat like a tax on spending, hence aggregate demand falls. The net effect of these forces on the ongoing rate of infl ation in the medium term, once the initial effect has passed through, is unclear, though the effect on output will be unambiguously negative. Monetary policy may, or may not, need to be tightened to control medium-term infl ation. Two factors will be key for that decision: the behaviour of price expectations and whether or not the community accepts a decline in real purchasing power over the resources whose price has risen. If infl ation expectations remain anchored, and a decline in real purchasing power is accepted, then there is scope for monetary policy to 'look through' the temporary period of higher infl ation, because fi rms and consumers are doing likewise. Should expectations of infl ation rise, or an attempt be made to restore previous levels of purchasing power through higher prices and wages, then things get much more diffi cult for policy-makers. To my mind, the importance of expectations highlights the value of some sort of infl ation target that is well understood in the public mind and which provides a fi xed point around which infl ation expectations can coalesce. There is no doubt, as some have pointed out in recent times, that adverse supply shocks are presenting the most signifi cant challenge to the infl ationtargeting approach that it has so far experienced in a period of nearly two decades since New Zealand and Canada led the way in adopting it. But since expectations are key, I would rather go into an episode like this with a well-understood target, than without. Of course, current circumstances also point to the need for short-term fl exibility in meeting the target: there remains a trade-off between variability of infl ation and output over the short term, and that trade-off has shifted in an adverse direction. But a well-designed infl ation-targeting framework allows for deviations from target, for a while, in the face of shocks. Provided the framework retains credibility, that fl exibility can and should be used. All of the above holds for the 'average' industrialised country. But, of course, Australia is not the average country here. As a commodity producer , our terms of trade have risen. Whereas for a net commodity importer a rise in commodity prices acts analogously to a tax paid to foreigners, we are , or are among, those foreigners to whom those payments are made. That impact is expansionary. It raises real income and, absent some other mechanism to remove that income, aggregate demand. Some of the increment to demand will be met by imports, but demand for non-traded goods and services will also rise. Other things equal, it is likely that housing values will increase and, to the extent that people view that as increased wealth, that may add a further stimulus to consumption. At an unchanged real exchange rate, this extra demand, combined with a tendency for productive resources to shift towards the export sector, implies an excess demand for nontraded goods and services. So compared with the 'average industrial country', the case of an industrialised, commodity producer like Australia has more complex dynamics. Potential supply in some areas of the economy falls, but aggregate demand will probably rise rather than fall, due to the terms of trade gain, and it is more likely that there will be a problem of infl ation in the non-traded sector. Given these effects, it is more likely than it would be in other countries that something has to adjust to offset the expansionary forces. Obviously, monetary policy has to consider its response. One of the things that can help is an appreciation in the nominal exchange rate. That would mean that the higher demand resulting from the terms of trade gain can be partly met from abroad, which helps to contain the pressure on prices. If the nominal exchange rate does not adjust, then an alternative is for the real exchange rate to appreciate via a rise in wages and domestic prices. This would restore balance in the markets for goods and labour, but at the cost of considerable infl ation. The problems for monetary policy are therefore, in this instance, compounded. A different approach is to spread the effects of the terms of trade rise across time, through extensive state intervention in the resources and exchange markets. Some countries use a combination of tax and fi nancial measures to capture 'rents', preventing resource earnings from having a strong expansionary effect over the short term. Often, countries that do this put resource earnings into a long-lived fund, usually offshore, so that foreign currency earnings never enter the country and hence have minimal impact on the exchange rate or domestic demand. The governments of such countries then plan to spend the earnings of the fund over a long period of time. The effects on the economy, including changes on the supply-side structure, are dampened and spread over time. Even in some of these cases, though, pressure has been mounting on the currency pegs - e.g. in the Gulf states. In other cases - e.g. Norway - a fl exible exchange rate is maintained, with an offshore wealth fund, but monetary policy has still needed to be tightened in the recent episode. So countries with this approach are still facing adjustment issues. The second set of adjustment challenges for the commodity-supplying country is the extent to which the structure of the economy should alter in response to changed relative prices. Again, if the change is temporary, it probably makes no sense to start the process of shifting productive factors, since the gain to doing so would be short-lived and there may be signifi cant costs of structural change. But if the change is permanent, then it is presumably rational to shift factors to those activities which generate higher returns - especially if the resource has a very long life. In practice, no-one can know whether a change of this nature is permanent or not. So markets and/or policy-makers are often in the position of not knowing how much response to make. They may end up making or accepting a partial response in case it is permanent, but not, initially, the whole response, in case it is not. Indeed, one reason commodity prices across the board are so high is that producers did not anticipate the persistent nature of the stronger demand. But in either event, how smooth this adjustment is depends on the economy's structural characteristics - that is, the extent to which it is responsive to price signals (assuming these price signals are allowed to occur). The more fl exible the supply side of the economy - the easier it is to re-allocate labour and capital across industries and regions - the less disruptive the adjustment is likely to be. These factors are, of course, outside the realm of macroeconomic policy. But they matter a great deal in determining how easy it is for macroeconomic policy to manage the economy's response to the shock. These provide additional public spending power, which governments may choose to use to a greater or lesser extent. These same forces also mean that even though the resource extraction activities are concentrated in particular regions, the regional differences apparent in the initial shock tend to be reduced over time. It is true, for example, that Western Australia has the lowest unemployment rate of any Australian state, but also true that unemployment rates everywhere have recently been at generational lows. Australia has a fl oating exchange rate, so for us, as for Canada, a key question in adjusting to commodity price changes is how far the exchange rate will move. Of course, just how the exchange rate reacts to a change in commodity prices will depend, among other things, on how monetary policy is expected to respond. Here it is important, in my view, for policy-makers to encourage markets to form their expectations on the basis of the central bank behaving consistently with its announced infl ation objective. We have an infl ation target for monetary policy, aimed at achieving an average CPI infl ation rate of between 2 and 3 per cent over time. This specifi cation provides a clear benchmark as an anchor for long-term expectations - and the average rate of infl ation over the past decade was As pressure on prices has increased over the past couple of years, not just because of the direct effects of food and energy prices, but refl ecting a broader pick-up under conditions of strong demand, tight capacity and anticipated further expansionary infl uences of the terms of trade, monetary policy tightened. But monetary policy has still made use of the fl exibility allowed by the target at times of large shocks. Infl ation is currently running at over 4 per cent, and likely to be around that level for another year or so, on our most recent forecasts, before it comes down. The task of monetary policy is not to reduce it to 2-3 per cent immediately, but to do so over time. Australia also has had, for many years now, a focus on supply-side policies, which has sought to emphasise fl exibility and responsiveness to price signals so that productive resources move to their most profi table industry and location. Key policy directions have been trade liberalisation and a move away from the formerly rather regulated and centralised structure of wage determination. A much more fl exible labour market has been invaluable in adjusting to the shocks of recent years. The changes in relative returns in different areas of production have seen relative wages alter and patterns of employment change, with relatively little acceleration in aggregate wages growth, especially considering the overall tightness of the labour market. Compared with previous episodes of booming commodity prices, a fl oating currency, a sound but fl exible medium-term framework for monetary policy and a fl exible labour market mean we are doing much better this time than in the mid 1970s or early 1950s. Rising commodity prices pose challenges around the world. For both Australia and Canada, the current episode carries more than the usual degree of complexity. For all those complexities, though, I still believe that we will cope best with these shocks by sticking with a fl exible infl ation target, a fl oating currency and pro-fl exibility supply-side policies in labour and product markets. We should perhaps lift our gaze, however, from issues specifi c to our own countries for a moment, to consider how policy-makers globally ought to think about the rise in commodity prices. For most countries individually, it is plausible to argue that the rise in a wide range of commodity prices is exogenous - even if it is driven by global demand, our own contribution to that demand is small. Even the US, the euro area and, in the case of energy and resources, China appear to regard the rises as largely beyond their control. But if we had all the central bankers of the world around a table, could we collectively regard the rise in commodity prices as exogenous? Food prices aside, it is diffi cult to escape the conclusion that commodity prices overall have been rising because global demand has been strong. And the aggregate of monetary policy settings in the world has a major bearing on that demand. At present, monetary policy is expansionary in many countries. Interest rates in the G3 economies are fairly low in real terms, refl ecting their own circumstances. In Asia, real shortterm interest rates have been even lower, even though growth has been solid and infl ation is rising, since many countries place a high weight on managing their currencies relative to the US dollar and the Chinese yuan. People are starting to ask whether this is the right confi guration for the circumstances these countries face. Perhaps we will see differing circumstances given due weight, as the various countries formulate their individual responses over the period ahead. That would be a very desirable outcome in the case of each country taken in isolation, but also for all countries taken together. In the meantime, expectations of infl ation are going to be important. In the fi nal analysis, the important question is not what 'special factors' might have pushed up particular CPI elements in this country or that, but whether the populations of our various countries have confi dence in infl ation declining again once the shocks have passed. Sustaining that confi dence is our task.

r080709a_BOA

australia

stevens

It is a pleasure to be here in Bendigo this evening as you celebrate the sesquicentenary of Bendigo Bank. Your city is resplendent for the occasion, and one cannot help but get a sense of the history as one moves around here. And what a history it has been - from sheep paddocks, to gold rush, to prosperous modern city. You have much to show for the past century and a half. Like so many of our fi ne institutions, the beginnings of Bendigo Bank were actually rather humble. In the early days following the discovery of gold in 1851, the population of this town grew rapidly. People came in search of wealth and, as always in such a search, some had success and some didn't. The population - one in fi fty Australians lived here at one stage - was rather transient. Certainly many of them were far from well housed: thousands lived in tents. The prominent citizens who had decided to make Bendigo their home permanently wanted to encourage a more stable, home-owning society. The building society movement that had earlier taken root in Britain provided a model of how to go about it. And so, on 9 July 1858, the Bendigo Land and Building Society was established, with 150 or so individuals subscribing 5 pounds each in capital. This society, eventually re-constituted as a permanent building society became, in combination with some other entities, the nucleus of the entity whose anniversary we celebrate today. It grew with its community and by merger and acquisition with other building societies and fi nancial institutions, both locally and further afi eld. In 1995, then Australia's oldest and Victoria's largest building society, it took a banking licence and developed further into the institution that we know today. Following the merger with Adelaide Bank, the new entity has assets of around $50 billion, and is Australia's 11 largest bank. Though small in market share, its branch presence is considerably larger. If we were to compile a list of fi nancial institutions of the second half of the 19 century, we would fi nd that few of the names would be familiar ones. Not many entities of that time are still in existence today. Our major banks, of course, have a long history, in some cases dating back to the early convict era. But a great many fi nancial institutions of the 19 century, particularly Victorian building societies, succumbed to one or other of the busts that occurred in the 1890s, the 1930s and the 1990s. The 1890s episode was a particularly severe depression in Victoria, with a collapse in land values and widespread closures of fi nancial institutions. Nearly half the building societies closed. This, as always, followed a period of extreme euphoria. Consider the way the historian Michael Cannon describes the general scene in Melbourne in the 1880s: Those words, penned in 1966 about an event a century ago, carry a more-than-faint echo of more recent times in other parts of the world. If we may paraphrase Cannon, too many of the world's major fi nancial intermediaries thought that loans of dubious quality, originated by salespeople they knew little about, to borrowers whose credit standing, to the extent it was known, was very poor, could be sold in ever increasing quantities to investors looking for AAA security. One day the music stopped, as it always does, and they were left standing. The 1890s were tough for the city of Bendigo, as for most of Victoria. A number of banks in the city closed their doors. But its main building society remained sound. 'The Bendigo' had not ventured as far into Melbourne real estate as others, nor was it as highly leveraged. There are some lessons there. Moreover, the fact that 'The Bendigo' has endured so long being based in a town 'born of gold', as Tim Hewat put it in his history, is perhaps all the more remarkable. Mining towns have their ups and downs with the inevitable cycles of discovery and depletion of ore bodies, booms and busts in commodity prices and all the associated exuberance, risk taking and inevitable subsequent disappointment for some, that goes with them. Bendigo in the gold rush days was no different. For a locally based fi nancial institution to ride through such cycles, without itself being too swept up in events, something must have been working well. It is surely not chance - 150 years would be a rather long lucky streak. More likely, this success is remarkable testimony to generations of managers who had a good assessment of risk, plenty of common sense, a strong attachment to their core business and an ability to resist the temptation of exotic new opportunities. It sounds simple. Yet the managements and Boards of some of the world's largest and most sophisticated fi nancial institutions did not meet that standard during the past decade, and the fallout is now upon them (and the rest of the world). Much shareholder wealth has been destroyed and reputations of some major institutions damaged. The result has been one of the most acute withdrawals in confi dence between major institutions in living memory. Inter-bank borrowing rates at term shot up, as global banks, suddenly facing pressure on their own liquidity, became more cautious about extending it to others. Because fi nancial markets are globally integrated, these pressures were quickly transmitted across national borders. The strains on liquidity have extended, in more muted fashion, even to parts of the world where local credit quality is much higher. Australia has suffered less than the United States, Europe or the United Kingdom, but nonetheless term funding spreads increased and remain today higher than they were before the onset of the sub-prime crisis last August. Recent developments exposed the risks inherent in a business model involving heavy reliance on wholesale, short-term funding and securitisation of loans. For some institutions, events unfolded in devastating fashion. We saw a run on a signifi cant British bank for the fi rst time since the gold rush days in Bendigo. On the other hand, during this period, the virtues of a well-run, straightforward business model, reliable retail funding, strong knowledge of the local market, and a suite of attractive retail banking services came once again to the fore. Soundly run institutions have seen a rise in their market positioning relative to more risky ones. Soundness, however, is only one part of the equation. Of course we need the fi nancial system to be a safe repository for the savings of the population. But to play its full role in the economy, the fi nancial sector needs also to mobilise those savings, putting them in the hands of investors who are in a position to make effective use of them. Banks are in the business of risk management, not complete risk avoidance. Their job is to offer a secure savings vehicle on the liability side of the balance sheet, but to take a measured degree of credit, maturity and liquidity risk - very carefully managed! - to provide fi nance for sound investment propositions. Those propositions range from housing, to small business, to large-scale investment projects such as the ones that are happening apace at present with the commodity price boom. With capital markets struggling at present, this role is even more important than it normally is. In addition, the transaction services that banks and other authorised deposit-taking institutions offer their customers are key to facilitating the huge volume of transactions which occur every day in the modern economy. Historians point out that this function of the fi nancial system broadly defi ned - the effi cient mobilisation of fi nancial capital - is critical for economic growth. As the industrialised economy took shape, markets for capital grew alongside. Had it been otherwise, brilliant technological innovations would have remained in the laboratory, entrepreneurship would have been stifl ed, growth would have been slower and living standards lower. Debt and equity markets, together with banks and other fi nancial intermediaries, have been, and remain, key parts of the fi nancial infrastructure. The history of Bendigo provides a good example of this general principle. In the early years, prospectors sought alluvial gold, which was found in or around streams and for which the requisite capital equipment was a pan and a shovel. As time passed and prospectors increasingly turned their attention to quartz-gold deposits, in some places deep underground, more physical capital was required. Steam- and air-driven equipment made men working deep underground productive enough that profi t could be earned even when a great deal of rock had to be lifted to the surface and processed to fi nd an ounce of gold. The formation of company structures, and the establishment of a local stock exchange in the 1860s, facilitated the provision of fi nance for all this activity. Now, of course, this was not without risk. Moreover, one could hardly claim that the exchange was not given to occasional bouts of 'irrational exuberance'. Geoffrey Blainey's account of October 1871, with trading continuing on the streets into the early hours of the morning, with even the destitute seen 'pencilling [their] own share transactions', gives the fl avour. markets are prone to bouts of euphoria, which is why it is best if banks and other deposittakers keep a polite distance from the riskier end of the spectrum, and avoid lending against the more speculative assets. Nonetheless, for all their occasional dislocations, the development of equity and debt markets has been important in the advance of the modern economy. Today, the Bendigo Stock Exchange, like Bendigo Bank, continues, even if in slightly less colourful fashion, providing an equity market for small- and medium-sized fi rms. In the period ahead, at the global level, it will obviously be critical to restore the proper functioning both of capital markets and of major international fi nancial institutions. Losses need to be recognised, capital structures repaired where necessary, risk management processes rethought and managerial incentives more carefully structured. That process is under way, though it may have some way to go yet. The main Australian institutions are generally well placed, in my judgement, to prosper in this environment, if they continue to manage their businesses well. At the local and regional level, meanwhile, there is an ongoing role for the provision of fi nancial services. Bendigo Bank's community banking model, which seems to be a very successful one to date, is an innovative response to the demands of local communities for such services. The major banks tended to scale back their regional presence, in response to the cost pressures on them after the events of the early 1990s, and the changing economics of branch banking which became apparent as fi nancial liberalisation proceeded. This withdrawal left an opportunity, but to take it, someone had to devise a business model that could cover costs at a price which the community could accept. The Bendigo model seems to meet this test. In short, though I do not say this as a supervisor of banks, this model seems to have worked pretty well. It shows that not only is there an important role for regional banks in the modern world, but that well-run institutions can successfully fi ll that role. As we are constantly reminded, even in a globalised world, communities are still local in many important respects. So in conclusion, to the shareholders and managers of Bendigo Bank, and the broader community of Bendigo: 'Happy Birthday'. I wish you many more. I am sure John Laker, the Chairman of APRA who is here this evening, would join me in exhorting you to continue your wise and prudent management so that the City of Bendigo, its bank and its people will prosper for another 150 years.

r080716a_BOA

australia

stevens

Thank you all for coming along again to support The Anika Foundation at the third of these annual lunches. The Foundation is doing great work in supporting research and treatment of adolescent depression. Your being here today will do a lot to help. Economic policies face no shortage of challenges at present. Internationally, with economic growth slowing in the major developed economies, and the problems in international credit markets still serious, but infl ation rates rising in many countries, the task for monetary policies in the old industrialised world is as delicate as any seen in many years. But developing country policy-makers face some big questions too, which are rightly getting more attention. How they respond to those questions will be important for the global economy. At home, infl ation has been too high after a period of very strong demand, but demand is now slowing. At the same time, the Australian economy is experiencing a gain in the terms of trade the like of which we have seldom seen before. So we have plenty of challenges of our own, and in ways that are distinctive when compared with those of the major countries. I begin with some remarks about the international scene. To date, the US economy has been more resilient than many observers had feared. Real GDP has expanded, albeit very slowly, in the fi rst and probably the second quarters of 2008. Yet the cyclical episode is far from over, as housing activity continues to contract, housing prices fall and the labour market softens. Businesses and households now also have to absorb a recent sharp further increase in energy prices. That rise is made worse by the depreciation of the US dollar (in contrast to the case for Australians, who at least have had the benefi t of a high Australian dollar in dampening the rise in oil prices). Credit market conditions are still very diffi cult in the aftermath of the events of the last year, and pressure remains on key institutions - as shown clearly over the past week. First quarter GDP growth in the euro area surprised by its strength. The Japanese economy also performed better than some had expected. But the run of other indicators suggests that growth is slowing in those economies. Meanwhile, CPI infl ation has picked up noticeably in most of the major countries. Measures excluding food and energy have thus far remained fairly low. But, compared with last year, there is more concern about infl ation prospects. Some of the price rises for Australia's important commodities, for example, signal international pressure on steel prices and non-oil energy costs, and therefore a range of other prices. Monetary policy in the major industrialised countries taken as a group remains reasonably accommodative. There has, accordingly, been some discussion about how this sits with concerns that infl ation might prove to be more persistent than earlier expected. But overall fi nancial conditions are arguably a good deal more restrictive than suggested by policy rates, especially in the United States, where the interest rates paid by many borrowers have not declined much, if at all, and lenders have toughened their standards considerably. The same is true for the The bigger concerns about infl ation, in any event, are in the emerging world. These concerns are twofold. First, food and energy are a bigger part of CPI baskets in these countries than in the developed economies, so the impact there of the rises in commodity prices is larger. For the same reason, the risk of second-round effects must also be higher. Second, monetary policy has generally been fairly easy in many of these countries, because of the link - explicit or implicit - that they have to the US dollar. In some of the oil-producing Gulf states, where there are explicit dollar pegs, demand growth is very strong and infl ation has increased. Around much of Asia, interest rates are below infl ation rates, and in several cases even below infl ation measured excluding food and energy. That is to say, real interest rates are negative, whereas 'natural' real rates are likely to be high, refl ecting the potential growth opportunities in Asia. De facto , many of these countries have had monetary policy settings that have been infl uenced to a signifi cant extent by US monetary policy, but they themselves are not experiencing US economic conditions. To be sure, slower US growth is affecting trade patterns, but to date growth has remained pretty solid in many cases, helped by fi rmer exports to places other than the United States and strong domestic demand. Moreover, the fi nancial headwinds being experienced by the United States have not blown to the same extent in Asia. The danger for the countries in question is quite clear. Infl ation outside of food and energy is already rising in many cases and accommodative policy settings heighten the likelihood of it remaining high on a persistent basis. But there is also a danger for the global economy. The bulk of the growth in demand for energy and natural resources is coming from the emerging world. Continuation of such expansionary policy settings in emerging countries, apart from continuing the recent tendency to overheating in those countries, would presumably foster ongoing rapid growth in demand for natural resources. That would continue to hold up CPI infl ation everywhere, but also weaken growth in many industrialised countries. Policy-makers in many of the advanced countries, already facing a short-term relationship between growth and infl ation that has turned much less favourable, could face some very diffi cult choices in framing their responses to the circumstances they face individually. What is needed is for emerging countries to adjust their policies according to their circumstances. Without that, we risk a new manifestation of the 'global imbalances', in which too much of the burden of controlling infl ation would be placed on the major advanced countries, where growth is already slowing. Put another way, this is in some respects a problem of international policy co-ordination. Global monetary policy has been too easy in recent years and that is why we have seen such a major run-up in a wide range of industrial commodity prices. Any individual country might wish to treat those increases as exogenous, but they cannot be exogenous for the world as a whole if they are driven mainly by demand, which by and large they have been to date. So, as a number of commentators have been saying recently, global monetary conditions need to be tighter. But the adjustments needed really should take place more in the emerging world than in the United It is odd that, in such a circumstance, infl ation targeting should be attracting some of the criticisms that have recently been seen, because were it used more widely it would tend to alleviate this co-ordination problem. Imagine a world in which all countries of signifi cance had been following a medium-term, fl exible target for CPI infl ation, coupled with appropriate exchange rate settings. Most of them would have been tightening policy in a measured fashion in response to rises in headline infl ation over the past couple of years. The result would surely have been that resource and energy prices, and CPI infl ation everywhere, would now be lower than they are. Even now, the current situation could be handled quite well by widespread use of a fl exible infl ation-targeting approach. Regardless of the precise details of any particular framework, though, what is most important is for broadly good macroeconomic policy to be followed. At the moment, surely that involves emerging market countries playing their part in balancing global demand and supply, by responding to their own circumstances, so as to avoid prolonged and costly infl ation. Compared with past episodes, this part is a larger one now - and that is surely a portent for the future. This is not an original observation - a number of commentators have made these same points over recent months. And policy-makers in a number of emerging countries are now adjusting policy settings in the required direction. In fact, the list of developing countries that have recently tightened monetary policy is now growing quite long, and includes some of the big ones - like China, India, Brazil and Indonesia. Perhaps more tightening will follow. Inevitably, growth will slow in the regions concerned as a result. But a period of more moderate growth would be a better outcome than either allowing infl ation to go unchecked or expecting the major economies to do all the heavy lifting. These international challenges are considerable and, like all other countries in an inter-dependent world, Australia has a signifi cant interest in how they are met. We have, in the meantime, pretty signifi cant challenges of our own that we must meet. Even before the price rises for oil and other commodities seen this year, Australia had experienced a signifi cant pick-up in infl ation, in the mature phase of a long period of economic expansion. The rise in infl ation in 2007 and into the early part of this year was not confi ned to food and energy, even though higher energy costs certainly were at work. Nor could it be put down mainly to 'imported infl ation'. In fact, the evidence is that a wide range of prices picked up speed. Acceleration in the group of prices generally classifi ed as 'non-traded' was quite pronounced. The background environment was one in which demand in Australia - which grew by over 5 1/2 per cent in 2007 - outstripped, by a signifi cant margin, any plausible estimate of growth in potential supply. There certainly were international forces at work, but the key one was the expansionary effect of the rise in the terms of trade. It is perhaps worth spending a few minutes on the basic analytics of this issue. For the 'average' industrial country that imports much of its energy and raw materials, a persistent rise in commodity prices is a negative shock to aggregate supply. This will reduce output and push up prices. Since the higher resource prices are paid to suppliers elsewhere in the world, this also acts somewhat like a tax on spending, hence aggregate demand falls. So while CPI infl ation is likely to rise initially, the net effect of these forces on the ongoing rate of infl ation in the medium term is unclear, though the effect on output will be unambiguously negative. In this 'average' industrial country case, monetary policy may need to be tightened to control medium-term infl ation, or it may not. Much will depend on infl ation expectations. Australia has some additional dimensions, because it is not the 'average' country in this episode. As a commodity producer , our terms of trade have risen. Whereas for a net commodity importer a rise in commodity prices acts like a tax paid to foreigners, Australian entities are net receivers of such payments. That impact is expansionary. Just how expansionary depends on the response of the recipients of those income fl ows, who include local and foreign shareholders, employees and governments. But other things equal, aggregate demand will, compared with the 'average' case, be stronger, and it is more likely that there will be a problem of infl ation in the non-traded sector. Accordingly, it is likely that monetary policy in a country like Australia would need to be tighter than in the 'average' case. That is the analytical background. We can then observe that Australia stands out among developed countries in terms both of the extent of the rise in our terms of trade, and the strength of growth of domestic demand over the past few years. It is understandable, then, that pressure on underlying infl ation, particularly from domestic sources, has also been somewhat greater. Monetary policy had to respond to that. The challenge of judging how much response was necessary has been complicated by the global credit turmoil, which has had the effect of pushing up actual borrowing costs relative to the cash rate the Reserve Bank sets. In addition, banks are more careful in their lending (and businesses and households are now more cautious in general than they were six months ago). Overall, as the statements after the past fi ve Board meetings have made clear, the sequence of changes to the cash rate, other adjustments by lenders in response to the rise in term funding costs since mid 2007 and tighter credit standards have combined to produce fi nancial conditions that are tight. They have tightened a bit further in the past month. The effects of that will be working against the expansionary forces from the terms of trade and the broader pressures on infl ation from high resource utilisation. Inevitably, there is a lot of uncertainty about how these opposing forces will net out. But the forecast we released in our was that the net result would be a signifi cant slowing in demand and output growth this year. The evidence is pretty clear that some key components of private demand are now on a slower track. As always with such episodes, the extent of that slowing, and its duration, are uncertain. But to this point, something not unlike what was envisaged in the May outlook appears to be occurring. Moreover, it looks more likely now than it did a couple of months ago that this more moderate track for demand will continue. If it does, it will, in due course, begin to exert downward pressure on those elements of infl ation that had picked up in response to strong demand. That will probably take some time and it may be too soon yet to see much of that infl uence on the CPI fi gure due next week. Indeed, on a year-ended basis, CPI infl ation might rise further before it starts to come down, particularly given the recent further surge in global oil prices beyond what was assumed in our May projections. By the way, this surge in oil prices does not, in itself, amount to a rise in Australia's terms of trade. As such, it is likely to be exerting some further restraint on non-oil demand, which would, all other things equal, tend to dampen pressure on non-energy-related prices over time. On the information available at present, we still expect infl ation to fall back to 3 per cent by mid 2010, and to continue declining gradually thereafter. We will, of course, conduct a thorough review of the outlook after receiving the next CPI fi gure, which the Board will have available for the August meeting. The Bank will publish its outlook in the next , due for release on 11 August. But for today's discussion, I want to use the May projections as the basis for some remarks about the nature of the infl ation target. As you know, since 1993 the Bank has been framing its monetary policy around a medium-term target for infl ation of 2-3 per cent, on average, 'over the cycle'. The Reserve Bank remains committed to achieving that target. Apart from being consistent with the Bank's statutory obligations, it is what has been envisaged in successive formal agreements between two Treasurers and two Governors stretching back now over a dozen years. This framework has worked well. One of the reasons it has worked well is that it has two essential ingredients. The fi rst is the commitment to the mean infl ation rate being at the target. That has been achieved, with medium-term CPI infl ation rates averaging close to 2 1/2 per cent. The second ingredient is a sensible approach to variance of infl ation around that mean. The framework was designed to have the necessary fl exibility to cope with the business cycle, shocks that may occur, the inevitable errors in forecasting and lags in the effects of policy decisions. The framework does not assume that infl ation can be fi ne-tuned over short periods, nor does it require us to attempt rapidly to correct deviations from the 2-3 per cent range, which have occurred several times over the period since 1993. This fl exibility was envisaged from the beginning in our approach to infl ation targeting. The Reserve Bank quite deliberately eschewed the narrowly defi ned targets with 'electric fences' that were initially favoured in some other countries and that were at one stage proposed here. We have made use of that fl exibility repeatedly, and are doing so again now. The infl ation outlook I have just sketched out would be a pretty long period of divergence from the target. It is important to recall, though, that we have experienced reasonably lengthy deviations before. Annual CPI infl ation was below 2 per cent for 10 quarters between the middle of 1997 and the end of 1999. If the May 2008 forecasts turn out to be right, then the current episode would entail nine quarters with year-ended infl ation above 3 per cent. If we can achieve something like that outcome, that would still be consistent in every essential respect with the experience under infl ation targeting since it began 15 years or so ago. As always, the challenge is to combine the right degree of fl exibility in approach with suffi cient confi dence that the infl ation rate will be on a declining path over time as to keep expectations anchored. This challenge is not trivial on this occasion. We are, of course, fully aware of the possibility that people may fear that this temporary period of high infl ation could, in fact, turn out to be persistent. Expectations of high infl ation can be self-fulfi lling if individuals and businesses behave accordingly. One possible channel people have mentioned is that of higher wage claims, pursued as a result of the pick-up in CPI infl ation, which then add to costs and prices, and so on. But I think it should be stated that while there are some signs of that around the edges, growth in overall wages has thus far remained contained, even though the labour market has clearly been at its tightest for a generation. Relative wages are showing noticeable variation across industries and regions, as would be expected given the events in the economy. But overall growth of wages, as measured by all the formal statistics at least, has to date been pretty well controlled. Furthermore, if the recent signs of moderation in the demand for labour continue, which could be expected if overall demand remains on a slower track, that should help to contain any over-exuberance in wage setting. So I think that our chances of keeping infl ation low over the medium term are good. This outlook does involve a period of signifi cantly slower growth in demand in Australia than we have seen over the period up to the end of 2007. The Bank has been candid about that. But controlling infl ation has always involved being prepared to slow demand, for a while, when needed. Not taking adequate steps to that end would have costs. One is that were we to see infl ation become established permanently at higher levels, then over time the whole structure of nominal interest rates would refl ect that new reality. The mean interest rate would rise. In that world, the interest rates we see now would not look unusually high. They, or even higher rates, would look pretty common. That is what happened in the 1980s, as a result of the fact that we did not control infl ation in the 1970s and early 1980s as well as we should have. Needless to say, it is that world that we are seeking to avoid. By the same token, there will be a continued pay-off to control of infl ation. A stable currency is one of the foundations on which a well-functioning modern economy rests. It is a prerequisite for sustaining growth in living standards. On the interest rate front, moreover, containing and reducing infl ation over time will mean that we should be able, at some point, to look back to the current period as one of higher-than-normal interest rates. Interest rates, unlike many other prices in the economy, do not always rise. Provided infl ation is successfully controlled, interest rates go up and down around a fairly stable mean. I have dwelt today on challenges facing macroeconomic policies and particularly monetary policies, both abroad and at home. These challenges look more diffi cult than they have been for a while. Of course, the challenges are not limited to monetary policy. There is the question of how resource allocation in the Australian economy should evolve in response to the increases in the prices of minerals in recent years, if these turn out to be persistent. Monetary policy has only a modest role to play there - other policies will be much more important, and they will be tested. There is also the question of how all that adjustment will dovetail with policies towards climate change, which are in the formative stages at present. Those charged with constructing such policies are dealing with hitherto unimagined degrees of uncertainty and the challenges seem to be of an order of magnitude bigger than the ones faced by monetary policy. It is also important to keep in perspective the very real problems that beset our society in other respects, including adolescent depression and the terrible cost it can extract on young lives, on families and on all of us. Good macroeconomic policies can, we trust, make some difference at the margin by creating a stable environment in which others can carry out the important work to understand and address these real problems. But their work needs to be resourced, which is what The Anika Foundation is all about. So, once again, thank you for coming here today. Thank you to Macquarie Bank and the ABE for your support of this function, and thank you for your support of The Anika

r080908a_BOA

australia

stevens

Mr Chairman, thank you for the opportunity to meet again with the House Economics It might be helpful for our discussion if I begin by reviewing how things stood at the time of our last meeting, and what has changed in the interim. When the Committee met in April, monetary policy had been tightened in response to very strong growth in demand and a signifi cant pick-up in infl ation during 2007. The cash rate had been lifted by 100 basis points and fi nancial intermediaries were facing additional increases in the cost of their funds, which they passed on to borrowers. This amounted to a signifi cant tightening in fi nancial conditions. That was necessary under the circumstances: if infl ation was to decline over time to be consistent with the 2-3 per cent medium-term target, a precondition was to contain demand, which had run too far ahead relative to productive capacity. The fact that infl ation picked up noticeably at the end of 2007, with a strong likelihood that we were in for several quarters of faster price rises, only reinforced the need for a credible and prompt response by monetary policy. In April, there was considerable uncertainty surrounding the outlook given the powerful forces at work pulling in opposite directions. On the one hand, the tightening of fi nancial conditions, including some tightening of credit standards for more risky borrowers, was acting to dampen spending. In addition, developments in the global credit system were a likely dampener for the international and domestic outlooks. On the other hand, the rise in Australia's terms of trade that was in train was the biggest such event for many years. It was starting to deliver a very large further boost to income and, potentially, to spending. So while there were signs in April that a slowing in demand had begun, it was unclear what the extent and duration of that slowing would be. But overall, the judgment we had reached at that time, and subsequently spelled out in the May , was that growth in demand and GDP during 2008 would turn out to be considerably lower than had been recorded for 2007. This forecast was at the lower end of the range of private-sector forecasts made at that time. That in turn led us to believe that pressure would be taken off productive capacity and that infl ation would, in time, abate. It was on the basis of that judgment that the Board held the cash rate steady for six months, even though infl ation on both a headline and underlying basis continued to increase in the subsequent two CPI releases. The picture of moderating demand, at least on the part of households, has continued to emerge. Consumption spending grew modestly in the March quarter, then paused in the June quarter. This came after a very strong run-up in the second half of 2007, when consumption had grown at an annualised pace of almost 5 per cent, well above what was sustainable. Household demand for credit has slowed, and turnover in the market for existing homes and house prices have softened, though spending on the construction of new homes and renovations has thus far continued to rise modestly. Overall, households are at present much more cautious about spending and borrowing, after a number of years in which confi dence levels were very high and there had been strong rates of growth in borrowing and spending. Clearly, tight fi nancial conditions have played an important role in slowing household demand. An additional factor, around the middle of the year, was a surge in global oil prices. Of course oil prices had risen a great deal over several years - from about US$30 per barrel in 2003 to around US$100 per barrel in early 2008. This was a large increase, but it took place over a fairly long period and against a backdrop of strong global growth, and most economies had taken it more or less in their stride. But the surge from US$100 per barrel to nearly US$150 per barrel over a matter of weeks was a very sharp increase from an already high level. Accompanied as it was by forecasts in some quarters that the price could rise much further, this affected both purchasing power and sentiment among households in many countries, including Australia. It also made business conditions more diffi cult for many fi rms, and this - together with the effects of the increases in other costs, slowing household demand and tighter credit conditions - has been refl ected in the various business surveys over recent months. Confi dence in international credit markets has continued to wax and wane. Following the takeover of Bear Stearns by JPMorgan Chase in mid March, sentiment improved for some weeks. But that improvement, unfortunately, did not last. Concerns about major international fi nancial institutions re-emerged, as asset write-downs and losses related to the problems in structured products based on mortgages continued. A signifi cant tightening of credit standards has ensued in some major countries, due to the need for banks to conserve their own - suddenly scarce - capital resources. The soundness of the two large quasi-public US mortgage agencies, which carry rather little capital, has also come into question, necessitating support from the Meanwhile the US has seen house prices falling and house construction is at its lowest for many years. The US economy continued to expand in the fi rst half of 2008 due to solid business investment spending, the impact of the fi scal stimulus, and strong export performance, helped by the lower US dollar. In fact, the US was the strongest performing G7 economy in the June quarter, with other major developed countries showing a signifi cant weakening. But most forecasters continue to be fairly cautious about prospects for the US economy in the second half of the year and are now also concerned about the sorts of credit losses that are routinely associated with a period of weak macroeconomic conditions. Some fairly signifi cant changes of a fi nancial nature are also occurring in Australia. Share prices rose in April and May, but gave back all those gains in subsequent months and at present are down by about 30 per cent since the peak in late 2007. Corporate boards are taking a more cautious approach to debt and there has been a marked reduction in business credit growth. This seems to have been more pronounced in the case of loans to large companies, though growth in credit to smaller enterprises has also slowed. Entities with complex fi nancial structures and/or high leverage have come under pressure and are looking to deleverage their balance sheets. But overall, what we see in the Australian fi nancial scene is an order of magnitude less troubling than what we see abroad. This, Mr Chairman, is an important point to emphasise. The balance sheets of the bulk of corporate Australia are not over-geared. Australian fi nancial institutions continue to present a contrasting picture to their peers in the US, Europe and the UK. They have adequate access to offshore funding - albeit at higher prices than a year ago. They have tightened credit standards for some borrowers, particularly those associated with property development, and are holding a higher proportion of their balance sheets in liquid form. Some have had to make provisions for unwise exposures that had been accumulated earlier. But even in these cases, capital, asset quality and profi tability remain very sound. The money market is functioning more smoothly than it was six months ago, with short-term interbank spreads relative to offi cial interest rates down a little. There are also signs that the securitisation market, which effectively closed late last year, is moving closer to re-opening. In summary, the Australian fi nancial system is weathering the storm well. Furthermore, while growth in credit to business has slowed quite sharply, and surveys say that business conditions have softened to the weaker side of average, overall profi tability remains pretty strong. Businesses still are maintaining high levels of fi xed investment spending. Indeed, according to the most recent data released about 10 days ago, fi rms plan a signifi cant further expansion of investment spending in the year ahead, at a pace as fast as anything seen in a generation. Strength in mining is exceptional, but other areas actually look robust as well. I have spoken in the past of the rise in the terms of trade adding to income and spending power. These actual and intended investments are evidence of that effect. Whether all of the planned investment will come to pass - or whether it is economically feasible for it to come to pass - is a question open to debate. Nonetheless, the strength of those intentions at this stage - a year into the global credit problems, and many months into the more conservative fi nancial environment in Australia - is remarkable. In addition, State governments continue to look to needed infrastructure upgrades. So these areas, on the best available recent evidence, remain likely to be sources of demand growth in the Australian economy in the period ahead. This highlights again a theme that I have noted before, namely the contrast between household demand and other types of spending. Even with a pretty signifi cant slowing in household spending, total domestic demand in the economy rose at an annualised pace of about 4 per cent in the fi rst half of 2008. This was down from about 5 1/2 per cent during 2007, but is still quite strong. This same picture has been pretty consistent from the liaison the Bank does with its fairly extensive list of contacts, numbering about 1 500, around the country. Those exposed to household spending are fi nding conditions subdued, while those exposed to the infrastructure and mining build-up are often struggling to keep pace. Some of that demand has, of course, been supplied from abroad. So at the bottom line, we come to production and capacity utilisation. At this time of the year, with two quarters of national accounts available, growth in the economy is running at a pace slower than last year, and slower than trend. Growth in real GDP in the June quarter slowed, though this was affected by a large decline in farm production because of drought, and which most forecasters expect to be reversed in the coming quarters. Abstracting from those swings, non-farm product rose by 0.5 per cent, down a little from 0.7 per cent in the preceding quarters. There was nothing in those fi gures to cause us to revise signifi cantly the forecasts we published in the August . The international context is one of more subdued global growth than we expected six months ago. The world economy actually expanded a little faster than we had expected into the early part of 2008, but recent data for a number of countries have been weaker, and we are assuming that weakish performance will continue in the near term. Growth in China has slowed a little, but still looks strong. Some of our other Asian trading partners, though, are facing more diffi cult circumstances now. Turning to the outlook for infl ation, with pressures going through the system as a result of the rise in raw materials prices and strong demand over the past couple of years, headline infl ation fi gures will remain uncomfortably high for a little while yet. It is expected that annual CPI infl ation will reach a peak in the September quarter of about 5 per cent, and be similar in the December quarter. This is higher than expected six months ago. But with international oil prices below their mid-year peaks and signs that the pace of food price increases is abating, it is reasonable to expect that CPI infl ation will thereafter start to fall back. With demand growth slower, capacity utilisation, while still high, is tending to decline. Trends such as this usually dampen underlying price pressures over time, and those effects should start to become apparent during 2009 and continue into 2010. This assessment hinges to no small extent on growth in overall labour costs not picking up further. Relative wages have been shifting, as would be expected given the nature of the forces affecting the economy, but overall the pace of growth in labour costs, to date, has been fairly contained given the tightness of the labour market. With pressure coming off the labour market, an assumption that this behaviour will continue appears to be a reasonable one at this point, but it is a critical one. The outlook also hinges on the expectation that demand growth will remain quite moderate in the near term, so that pressure continues to come off productive capacity. On that basis, Mr Chairman, we believe that prospects for infl ation gradually returning to the 2-3 per cent target over the next couple of years are improving. An outlook like that is, of course, what the Board has been seeking to achieve with monetary policy. As that picture has gradually emerged over the past few months, the question has then arisen as to when the stance of monetary policy should be recalibrated as well. At its August meeting the Board believed, and stated, that conditions were evolving in a way that was increasing the scope to move towards a less restrictive policy setting - one that presses less fi rmly on the brake. At the September meeting the Board took a step in that direction. The logic of this decision was the same as the one that, some years earlier, had led the Board to begin raising rates from unusually low levels: the setting of policy designed to get the economy to change course probably will not be the right one once the change of course has occurred, and it will need to be adjusted. A further consideration was that conditions recently had actually tightened marginally as a result of rises in lenders' interest rates, which from a macroeconomic point of view was not needed. Accordingly, the cash rate was reduced by 25 basis points last week. The decision was quite widely anticipated, and less restrictive conditions in the money market had already been in place for about a month before the Board's decision. Since the end of July, key benchmark interest rates have fallen quite noticeably. The rate on 90-day bank bills has fallen by almost 60 basis points, while the 3-year swap rate has fallen by about 80 basis points. Various rates for fi xedrate loans had already declined before the Board's decision, while variable mortgage rates have quickly refl ected the decline in the cash rate. The exchange rate has also declined. While some of this change is really a US dollar story rather than an Australian dollar story, our currency has declined somewhat against other currencies and on a trade-weighted basis. Admittedly, we are probably six months away from seeing clear evidence that infl ation has begun to fall, and even then it has to fall quite some distance before it is back to rates consistent with achieving 2-3 per cent on average. A somewhat larger fall in infl ation overall is required on this occasion than was the case in either 2001 or 1995, which were the comparable previous episodes, since the peak infl ation rate this time is higher. Rather than trying to achieve that larger fall in infl ation by pushing it down more quickly, the Board's strategy is to seek a gradual fall, but over a longer period. This carries less risk of a sharp slump in economic activity, though it does require a longer period of restraint on demand. On the other hand, this carries the risk that a long period of high infl ation could lead to expectations of infl ation rising to the point where it becomes both more diffi cult and more costly to reduce it. Monetary policy has to balance these risks, which is why the fl exible, medium-term infl ation targeting system that we have been operating for 15 years now, and which has enjoyed strong bipartisan support in the Parliament, is so important. That framework will continue to guide the Board's decision making. My colleagues and I are here to respond to your questions.

r080917a_BOA

australia

stevens

Thank you for the invitation to speak to you today. We are living through challenging times for decision-makers in both private and public roles. The past year has seen a major change in international economic and fi nancial conditions. Global economic growth, having been well above average for a string of years, has slowed noticeably, especially in the major industrial countries - yet infl ation rates remain a concern. Large losses have been incurred by major international fi nancial institutions. Several household names in global investment banking have disappeared. Appetite for risk - which had been strong to the point of recklessness in some areas - has given way to risk aversion. Credit is harder to obtain, and more expensive. Australia has been affected by these forces, but much less than the countries at the epicentre. Our fi nancial system is weathering the storm well. Amid all that excitement, it is useful occasionally to step back from the high-frequency detail to focus on the bigger picture. Today, I propose to talk about four low-frequency, big-picture themes - all of which are nonetheless amply demonstrated in the course of events over the past year or two. * the emergence of China; * the economics of a fully employed economy; * the end - perhaps? - of the long period of households leveraging up their fi nances; and * shifting perspectives about the regulation of the fi nancial sector in the economy. I am not talking here about the notion of 'de-coupling' and so on. That term is actually unhelpful - nothing is ever really de-coupled; everything is connected. But the connections are complex, various forces are at work and reasonable people will have differing opinions about how things will play out over a year or two. At present, China is slowing, partly as a result of the slowdown in the United States and Europe, but partly by design of domestic policy. The Chinese policy-makers have been seeking some slowing because of evident overheating, and are now in the position to be removing some of that restraint. But the emergence of China as an industrialised economy is a fundamental long-term change to the economic, fi nancial and political landscape whose full consequences I suspect we can barely appreciate as yet. This has been happening for a couple of decades now, but the nature of its impact is gradually changing. For some years, it was too small to notice - even a country with a lot of people is small economically if their per capita incomes and productivity are very low. Then, some time in the 1990s, China became quantitatively important enough for the rest of the world to enjoy the disinfl ationary effects of added Chinese production capacity, as millions of low-cost workers turned out manufactures, in the process lowering global prices. More recently, we have been experiencing a new effect of that growth, namely the effect of higher Chinese living standards on the price of energy and natural resources. Of course, this is not confi ned to China - it is happening around the developing world to a greater or lesser extent. But China is the biggest example. Commodity prices are coming off their peaks at present, though key prices for Australia are still very high. Even if this marks a cyclical turn for such prices, in the longer term this new claim on energy and other resources will not go away. Other countries are having to adapt to that. The rise in prices for energy and raw materials has made it harder for those countries to combine the steady growth and low infl ation that had characterised the period from the early 1990s until about the middle of this decade. At the same time, this extraordinary increase in the demand for natural resources and energy has raised Australia's terms of trade by close to two-thirds in the space of fi ve years - the largest shock of its kind for fi ve decades. So the economics of this for Australia are therefore a bit different from those for the 'average' industrial country. Like others, in the energy-using parts of the economy, we fi nd it more diffi cult to combine steady growth and low infl ation. But in addition, we have had to absorb a massive income boost. Of course, there are worse problems to have! Nonetheless, signifi cant adjustments are occurring - to the structure of the economy, to where the population lives and how the national income is earned and distributed. Unless resource prices reverse a long way, these trends will continue. China's emergence is surely far from complete. China, like all economies, will have cycles. But its average growth rate is likely to be pretty high for years ahead, even if not as high as it has been recently. This is an opportunity and a challenge for Australian business and policy-makers, and not just in the resource sector. Over recent years, the Australian labour market has been as tight as at any time seen in a generation. The rate of unemployment in the past 12 months, at about 4 per cent, has been as low as at any time since 1974. In surveys and our discussions with fi rms, diffi culty securing labour has been a common problem. The term 'capacity constraint' has been a part of the Australian economic lexicon over recent years in a way not seen for a long time. Survey measures of capacity utilisation have been very high, and fi xed investment to increase capacity is running strongly. Let's be clear that full employment is a good thing. It is one of the statutory objectives given to the Reserve Bank in our Charter (though interestingly the authors of the Act never quantifi ed what they meant by full employment, nor for that matter, by 'stability of the currency'). But the economics of full employment are different from the economics of trying to get to full employment. This is a simple point, but an important one. When the economy has too much spare capacity - say, in the aftermath of a business cycle downturn - the aim of macroeconomic policies is to push up demand so that it catches up to supply potential. There may be several years in which demand growth exceeds the normal pace as it eats into the spare capacity. Once the spare capacity has been wound in, however, actual growth in demand and output has to slow, to match the growth rate of potential supply. That growth in potential supply is given by the growth in the labour force, the capital stock and the productivity of those factors of production. Typically we think of 'potential GDP' in Australia rising by something like 3 per cent a year, give or take a bit. This, as my predecessor Ian Macfarlane remarked a few years ago, means that once the reserves of spare capacity are pretty much used up, we should expect to be accustomed to growth rates for GDP starting with a 2 or a 3. There will not be many with 4s or 5s, as we had for some years through the 1990s and earlier this decade. Periods of growth noticeably above about 3 per cent will be roughly matched in frequency and duration by periods below - as we are having now. If we set our aspirations higher than that - if we try for above-average performance all the time - we will just get infl ation. That is the economics of full employment. Now you may feel that a growth rate for real GDP of something like 3 per cent on average is not that high. Is that the best we can do? Can't we lift it? The only way the potential growth rate can be lifted is by adding more factors of production - more labour and capital - or raising the growth rate of productivity. Over the long term, the key is productivity. On that front, productivity growth does seem over the past several years to have settled at a lower average rate than we had seen since the early 1990s. This may have several causes, and the experts debate them. But over the years ahead, as a community we must be sure not to let up on our efforts to keep productivity growing. I have no specifi c policy prescriptions here - only general ones - trying to sustain competition, to keep markets open, to maintain fl exibility and so on. But those general values are worth recounting from time to time. A feature of the economic landscape of the past decade and a half has been the long gearing up of households. In the early 1990s, household gross debt in Australia was equal to about 50 per cent of average annual household disposable income. This year, it reached about 160 per cent. Households' assets rose generally in parallel, though not quite as fast, with total assets rising from about 460 per cent of income in 1990 to over 800 per cent at the end of 2007. (Assets have fallen somewhat since then, with the decline in the share market and some softening in housing prices.) The ratio of debt to assets rose from under 10 per cent in 1990 to about 18 per cent in 2008. The ratio of housing debt to housing assets reached about 27 per cent. Very similar trends have been seen in a number of comparable countries around the world, so in thinking about the causes, we should not look exclusively for domestic causes. But in summary, the main factors behind this big increase in the size of the household sector's balance sheet were: * the general tendency for fi nancial activity and wealth to grow faster than income, which has been a feature of most economies since at least as far back as the 1950s; * an increased pace of fi nancial innovation - and, in particular, a lot more credit has been available, particularly over the period since the mid 1990s, to households. In recent years around the world, anyone who was creditworthy - and some who were not - have been able to access ample amounts of credit; * the big decline in infl ation. This lowered nominal interest rates dramatically. This happened in all countries, though the timing differed. In Australia it was a big factor after 1992; * a period of pretty low long-term interest rates globally, which encouraged borrowing around the world, though this was a bigger factor in the United States than here. This had a lot to do with the build-up of savings relative to investment in Asia; and * a desire to devote a higher share of a rising income to acquiring housing services. As people's income increases, certain goods and services will take a declining share of total spending - food, for example, or products, such as electrical goods or clothing, which have large falls in their relative prices over time. But other types of products take an increasing share of income. Housing has tended to be in that category. As we have become wealthier, our aspirations for housing in terms of position, quality and size have naturally enough increased. But for various reasons the supply is not very elastic - there is only so much well-located land, and other factors have affected the supply price of dwellings more generally. In the end, a lot more of our income is devoted to housing, acquired by servicing mortgages, than was once the case. The question is whether this long period of gearing up by households might now be approaching an end. Certainly household credit growth is much slower at present than it has been for some years, running roughly in line with income growth. Might we see this conservative approach to debt among households persist? It is hard to know the answer to this question. There is much more of the household balance sheet that could, in principle, be turned into collateral, so gearing up might resume once the current turmoil has passed. But there is also a good chance that households will for some time seek to contain and consolidate their debt, grow their consumption spending at a pace closer to income, and perhaps look to save more of their current income than in the recent past. It is possible that we are witnessing the early part of a new phase where the household spending and borrowing dynamic is different from the past decade and a half. Time will tell. But if that is the trend of the next several years, the growth opportunities for businesses and fi nancial institutions will be different. And whereas the household balance sheet has been the big fi nancial story of the past 15 years, some other fi nancial trend will probably be the bigger story of the next decade. There are some developments that suggest the balance sheets of governments might well be expected to expand a good deal. The need for support of the fi nance sector in countries like the United States and the United Kingdom is one. The build-up in public infrastructure in Australian cities and regions may point in the same direction, though to a lesser extent. If the sudden aversion to these sorts of assets by private investors continues for any length of time, governments may have to choose whether to fund the projects themselves, or defer them. Fortunately, public balance sheets in this country are in a very much stronger starting position than those in most other countries. All the issues surrounding the use, or not, of the government's balance sheet to support the fi nancial system have been on prominent display over recent months. We have seen the actions by the US Treasury to take over the running of the two large entities known as 'Fannie' and 'Freddie'. As Secretary Paulson commented, the ambiguity about who was bearing risk in these entities has been a problem for a long time, and it needed to be resolved. The US Government has shouldered the burden that investors always assumed it would, but has, quite appropriately, done so in a way that minimises the extent of bailout for private shareholders who had been profi ting from the risk-taking behaviour. Facing up to these problems where the entities concerned were regarded as effectively guaranteed by the government was one thing. The question of support has also arisen for entities which have always been seen as purely private, and hitherto not, at least explicitly, regarded as so central to systemic stability that failure could be costly. The events of the past few days illustrate how diffi cult these issues have become. In all these cases though, in the fi nal analysis there was not enough capital behind the risks that were being taken. The sophisticated fi nancial system of the 21 century was supposed to spread risk, but a lot of the risk ended up being concentrated on the books of highly leveraged institutions. High risk and high leverage proved to be a fatal combination. It always does. Some signifi cant questions arise from all this. The main one, put at its broadest and simplest, is whether something can and should be done to dampen the profound cycles in fi nancial behaviour, with associated swings in asset prices and credit, given the damage they can potentially do to an economy. This debate has been going on for quite some years. There are several points of view. One is that counter-cyclical regulatory measures using the power of the prudential regulator should be taken to dampen the so-called 'fi nancial accelerator'. This is the process where confi dence boosts asset prices, which then provides additional collateral for further borrowing, which then boosts asset prices further and so on - until at some point the whole process goes into reverse and there is a fall in asset values and deleveraging, as is occurring now. Use of prudential tools to work against these tendencies would be a departure from the way prudential supervision is conducted at present, where the goal is soundness of individual institutions, rather than managing the dynamics of system stability through time. A counter view is that it is not feasible to do this, for various reasons. One is diffi culties with tax and accounting rules. Another is that some of the key players are outside the regulatory net - hedge funds for example. This view holds that an effective response against the fi nancial cycles almost certainly involves monetary policy. This would mean raising interest rates in times of booming asset and credit markets, even if goods and services price infl ation was contained, in order to provide a stabilising infl uence over the swings in fi nancial behaviour. Some argue that this could be reconciled with standard infl ation targeting, though only if the central bank had a very long time horizon or a great deal of fl exibility. A third view is that it is not possible, with policy-makers' current state of knowledge, to know whether it is correct to lean against such booms, and that in fact it could turn out to be destabilising to try. On this view, the only thing that can be done is to respond to asset and credit collapses if and when they occur, protecting where possible the fi nancial system and the economy generally. That is, to clean up the mess afterwards, so to speak. This has tended to be the US offi cial view, at least up until now. This debate was quite active in the period following the collapse of the dot-com boom in the early 2000s. But those in favour of policy action aimed at moderating fi nancial cycles did not carry the day, I think mainly because the US economy recovered pretty quickly from what was a quite mild downturn in 2001. I sense now, however, that among many thoughtful people this question is once again up for discussion. It will be fascinating to watch how the debate unfolds. In the barrage of information with which we must all cope day by day, it is often hard to stand back and see the big forces at work. But those forces - and our responses to them - will ultimately do more to shape the course of our economy and fi nancial system than the short-term news. Hopefully, we can still fi nd some time for refl ection about such matters, even in the volatile conditions in which we all fi nd ourselves at present. It is in that spirit that I offer these remarks today. Thank you.

r081021a_BOA

australia

stevens

Turkish soldier is said to have asked some New Zealand prisoners why it was that they had come so far, voluntarily, to fi ght a war in Europe. They apparently replied that they had expected it to be rather like playing a game of rugby. It is not recorded how Australians answered the same question (perhaps they could not decide which code of football was most apt). But they certainly also went in a spirit of optimism. That optimism was soon a casualty of war. Optimism seems also to have been a casualty of recent fi nancial events abroad, as outcomes have been rather unlike what the sophisticated modern set of institutions and markets were supposed to have delivered. Many have observed that the world faces the most serious international fi nancial crisis since the 1930s. The world has, of course, experienced many crises, of various kinds over the decades, not least the one to which the ANZACs responded. These were often, in terms of potential and actual human misery, far more perilous than today's fi nancial dislocation. Nonetheless, the situation is very serious. It is up to policy-makers and private market participants to put the system back together, without the excesses that built up over the past years, so that it can serve its proper function: facilitating trade and genuine investment fl ows, in the process supporting economic growth. For this audience, I had intended to talk about the Australian and New Zealand economies - noting some of their similarities and differences, and common interests. Given the circumstances, I will touch briefl y on those issues, and then devote some time as well to talking about our shared interests in getting the global fi nancial system back into shape. It is stating the obvious that the two countries have a lot in common, dating back at least to James Cook. We share the British system of laws and custom, the historical relative geographical isolation from 'old' Europe, an increasing orientation towards Asia, and generally an outwardlooking mentality refl ecting small economic size. Notwithstanding that Australia's GDP is seven times that of New Zealand, we still see ourselves as small. There is a signifi cant amount of grassroots integration between the two countries which has occurred fairly naturally. Apart from the relative ease of population fl ows - which facilitates labour mobility - one is struck by the number of Australia-New Zealand Associations and Societies of one kind or another. Try an online search of the words 'Australia, New Zealand, association and society' to see what I mean. The industry structures of the two economies differ somewhat, refl ecting natural resource endowments (Table 1). Australia has more mining, but less manufacturing and farming, as a share of GDP, than New Zealand. But on the whole, the differences are perhaps not as striking as the similarities. The two countries do a good deal of bilateral trade, helped by the Australia New Zealand and Australia is easily New Zealand's largest trading partner. Interestingly enough, though, while growth in trans-Tasman trade has been faster than growth in trade with Japan, the United Kingdom or the United States, traditionally big trading partners, it is not especially fast. The most striking thing is that growth in trade with China and other east Asian economies has been much faster for both countries than growth in trade with each other, despite the CER. I am neither arguing that the CER restrains trade nor that it might not be amenable to improvement to facilitate further trade. I simply observe that the massive increase in the prominence of Asia in the global economy over Agriculture, forestry and fi shing Total of above Finance, property and business services Health, education and community services Wholesale and retail trade Utilities and transport Government administration and defence Communication services the past 25 years provided both countries with opportunities. We are both able to take those opportunities because of the open approach we have taken to trade generally. Both economies have a high export rate of commodities - relatively more minerals for Australia and more agricultural products for New Zealand. Not surprisingly therefore, both countries have had very signifi cant changes in our terms of trade over the past several years. New Zealand is a more open economy than Australia, so a rise in the terms of trade of any given percentage has a larger effect on incomes there. But the sheer magnitude of the terms of trade gain for Australia means that the gain in real domestic income over the past fi ve years was roughly double the size of the impact in New Zealand. In both cases, the terms of trade look like they are now starting to moderate. The two countries share structural policy features: * fl oating currencies and central banks with a medium-term, fl exible infl ation-targeting approach to monetary policy. New Zealand was, along with Canada, a pioneer of infl ation targeting; and a history of governments, of varying political persuasions, which have maintained a general commitment to market-opening, liberalising policies over the past generation, including fi nancial liberalisation. The two countries also share the same major banking groups, with the large four Australian banks having New Zealand subsidiaries and branches. The operations of these entities account for 90 per cent of the market for bank deposits and loans in New Zealand. For that reason, Australia and New Zealand have a common interest in sound functioning of the international fi nancial system being restored. Our fi nancial systems, like those of most countries these days, are connected to global markets and our large fi nancial institutions are active in international markets. So there are impacts on our systems of the extreme dislocation in international markets, even though the Australian banks have strong balance sheets with good asset quality. Moreover, these same disturbances are in the process of slowing down major economies and hence global growth, which obviously will have some impact on our own economies. It is time therefore that I turned to say something about those issues. The genesis of the problems - the search for yield in a lengthy period of low global interest rates, the associated disregard for growing risk, structural fl aws in the 'originate and distribute' model of fi nancing, the deterioration in lending standards - have been discussed at length over the past year. For today, it suffi ces to say that a lot of new risk was created and, far from being widely dispersed, a good deal of it ended up on the balance sheets of the most leveraged parts of the international fi nancial system - banks and investment banks. The problems of counterparty risk aversion and reluctance to lend at term - that is, a breakdown in trust - fi rst erupted in August last year. Term borrowing rates rose sharply relative to overnight rates. This intensifi ed through to the end of each calendar quarter as bank accounting dates approached, and lessened thereafter. This cycle was repeated several times through to the middle of 2008. While that was going on, a number of major international institutions accepted write-downs of their exposures to US mortgages, which were often via complex structured products whose prices proved to be very volatile - when they could be measured at all. They simultaneously sought new capital, though as fast as they received it, capital was being burned up in losses. Things proceeded in this way for over a year, without getting noticeably worse, but not getting noticeably better. Then during the months of September and October 2008, in a sequence of events historians will study at length for decades ahead, the international fi nancial landscape changed dramatically. In the space of six weeks: * the remaining four large American investment banks disappeared - into bankruptcy, merger or by taking a banking licence, which gets them closer to the support of the * one of the world's largest insurance companies, hit by a wave of margin calls on credit default insurance contracts it had written, had to take a loan from the Federal Reserve and is effectively in public ownership; * the largest participants in the US mortgage market, which had always been seen as implicitly government guaranteed, were explicitly nationalised; * the US Treasury brought forward a plan to purchase assets from lenders' balance sheets for a sum of up to 5 per cent of US GDP. A version of this plan was approved on the second attempt, after several anxious days in which confi dence was further eroded; * a number of European banks faced failure, including some quite large ones, and needed government support or were nationalised; and * governments in a number of countries felt the need to guarantee some or all of the deposit obligations of their banks. While this was occurring, global markets for equities, currencies and commodities saw extraordinary price movements, while yields on many short-term government securities fell sharply. Volatility in daily prices increased signifi cantly. Interbank and commercial paper markets, which had already been under pressure, effectively closed in a number of countries. (It is worth noting that most key markets in Australia have continued to function through this period, even if under some pressure.) The extreme counterparty risk aversion in markets saw the shortage of US dollar liquidity in the European and Asian time zones worsen seriously, to the point that the effective cost of borrowing US dollars via swap in the Asian time zone reached well into double digits in mid September, and on some days the market was, for all intents and purposes, not available. The fall in commodity prices brought pressure to some emerging-market countries, which saw falls in currencies and share prices, and which in some cases closed share markets. Since late September, many currencies have come under downward pressure against currencies like the yen, which was a favoured funding currency for various positions in higher-yielding currencies. The Australian dollar fell particularly sharply, in part because of the changes in interest rate expectations and commodity prices, and partly because its relatively liquid market sees it used by many managers as a device to change quickly their exposures to some other currencies and commodity-based strategies. In summary, what appeared for the preceding year to be a serious, but containable, problem of liquidity and concerns over creditworthiness turned suddenly into a very fast-moving crisis of confi dence in key players in the international fi nancial system, where questions of solvency came much more to the fore. It has presented fi nanciers, and policy-makers, with the most diffi cult set of challenges of its kind for generations. The question, then, is how to restore confi dence and stability to these important markets and institutions. The fi rst thing is to continue to provide liquidity. This requires central banks to expand their balance sheets if necessary, so that the private fi nancial sector can continue to fund its existing asset book for the time being, and so that the broader process of deleveraging can be accommodated with as little disruption as possible. Central banks have stepped up their liquidity efforts in a major way, with a number of them providing much more in the way of own-currency funding against a wider range of collateral. But the most visible impact is on the Federal Reserve's balance sheet, where assets have nearly doubled in the past six weeks as a result of increases in the Fed's various facilities. An increase in swap lines with other central banks, which allows the supply of dollar liquidity in Asian and European time zones, has been one large contributor to the expansion (and the RBA has participated in these lines). The most recent development has seen this liquidity operate on tap in several major countries - at a fi xed price, in any amount market participants require, for terms extending out to three months. As a result, there is now a huge amount of US dollar liquidity in the system. But while liquidity provision helps, it can, at best, ameliorate the impact of counterparty risk. It cannot eliminate it. The second thing that is needed is a restoration of confi dence in the key fi nancial institutions. Because the lack of confi dence is, ultimately, about solvency, re-capitalisation of the relevant institutions is required. The lesson of past banking crises, moreover, is that when there are really serious problems in private balance sheets, capital may be available in suffi cient quantity only from the public purse. This should of course come with appropriate conditions - private shareholders should absorb the losses from past problems, governments that put in new capital should share in the upside and guarantees that are offered should be priced. Governments should plan to divest their holdings in banks in due course. The UK Government's plan announced a couple of weeks ago, which seems to have become something of a template for these sorts of intervention, appears to have the key elements needed to restore health to the key international institutions. It increases further the supply of liquidity for the short term. It also provides for an increase in the capital of key UK institutions, from the public sector if needed, via the government underwriting capital raising. And it provides some confi dence for term funding markets by offering a guarantee of the debt obligations of the relevant banks for a period of time. This guarantee is not free to the banks - they will pay for it on commercial terms, which in the current environment are unlikely to be cheap. The intention is not to subsidise the price of borrowing but, by promoting confi dence of repayment, to allow the market to fi nd an appropriate price, which of late it has had trouble doing. The Australian response has taken careful note of the elements of this plan which are pertinent to our situation. The RBA's liquidity facilities had already been further expanded, to allow our counterparties to bring to us internally securitised mortgages as collateral, to get funding for out to a year. This is available at market prices every day. The additional eligible collateral available to the Australian system as a result of the most recent changes can support over $50 billion of additional liquidity (after allowing for haircuts), if needed. The Australian Government has announced a general guarantee of deposits, as a precaution to allay any public anxiety over security of their savings. It has also decided to offer to guarantee wholesale debt obligations of Australian authorised deposit-takers and authorised Australian subsidiaries of foreign banks, on commercial terms. This will ensure that Australian institutions, some of which are among the highest rated of the world's banks, are able to retain adequate access to term funding in an environment where banks of other countries are able, in effect, to use the rating of their governments when borrowing. Steps in these directions, in the context of what other countries were doing, were sensible and the Reserve Bank supported them. As is also the case in other countries, the design features of the various guarantees will be important. Little detail is available from other countries yet. Meanwhile, the Reserve Bank is working with our colleagues in the Treasury on the details of the Australian arrangements, including on how to maintain continued healthy functioning of Australia's short-term money markets. The element of the UK plan Australia has not sought to emulate is public underwriting of capital injections. The Australian banks have strong capital positions and profi ts, so they should be able to approach the market on normal commercial terms if they desire additional capital. At moments like this, it is hazardous to make predictions. However, it seems to me that the key elements of dealing with the root issues in the crisis are starting to come into place. Policy-makers in the major countries do 'get it'. The plans are not precisely uniform across countries - that is never achievable anyway - but we can, I think, see the shape of a broad common outline. It addresses the issues of liquidity, capital and confi dence. There is much more work to be done yet on the design details, and one area in which further international co-operation would be helpful is in the area of making these various guarantee arrangements broadly consistent. But the world is, it seems to me, getting on to a better path. As a result, the likelihood of a global catastrophe has in fact declined over the past couple of weeks. The question of the appropriate macroeconomic policy settings to help economies through this period will also be receiving attention around the world. In those countries where previous settings have been prudent, and where infl ation prospects permit, policies can be eased to counteract some of the contractionary forces set in train by the deterioration in global growth prospects resulting from the credit turmoil. Central banks in major countries, recognising weaker demand and the likelihood of easing pressures on prices, reduced interest rates in October. In Australia, the Reserve Bank made a substantial cut to the cash rate at its October meeting, bringing forward reductions that might ordinarily have taken place over several months. CPI infl ation is likely to remain high in the period immediately ahead, and yesterday's PPI data illustrate the concerns that the Bank has long expressed about infl ation. But looking forward to next year, forces seem now to be building that will start to dampen pressures on prices - even though we won't have evidence for that for a good six months. The Board sought, as always, to respond to the medium-term outlook for prices, not just the current data. The Australian Government has made a signifi cant change to the fi scal stance which will fl ow through the demand side of the economy during the summer. The decline in the Australian dollar by about 20 per cent against a trade-weighted basket also amounts to a signifi cant change for the trade-exposed sectors of the economy, though at the cost of some temporarily higher price rises. These changes will act to lessen the extent of the likely slowdown in Australia's economy, even as global forces work the other way. The Reserve Bank will publish its next update on the economic outlook on 10 November, so I will not say any more about that today. I shall fi nish with the question of what trends will be of importance beyond that horizon. As I have said before, the emergence of China is not complete and has many years to run. Right now, China's economy is slowing. This is a reminder that China's economy has cycles, like economies everywhere. But even if it slows a lot, it will pick up again in due course and will probably grow pretty strongly, on average, over many years. In countries like Australia, perhaps the long period of household debt build-up is now giving way to a period in which balance sheets will see some consolidation. If so, household credit growth will not be as fast as it was for the past decade and a half. Perhaps we will need also to get better at turning borrowing for housing into more dwellings rather than just higher house prices. Perhaps the fi nance sector globally will return to fulfi lling something more like its historical role of being 'the handmaiden of industry', with a bit less in the way of exotic innovation of its own. In such a world, a renewed focus on the processes in the real economy which generate growth in productivity could also be apt. In the case of Australia at least, it is now hard to avoid the conclusion that underlying growth in productivity has slowed over the past fi ve years, compared with what was seen through most of the 1990s and the early part of this decade. Of course, these things are notoriously hard to measure and there will be various opinions about the extent of the slowing, why it occurred and what might be done about it. Nonetheless, once the immediate crisis has passed, that might be a conversation worth having.

r081119a_BOA

australia

stevens

Thank you for the invitation to renew my association with CEDA, which goes back many years. CEDA has, for half a century, sought to promote informed discussion and balanced development of the Australian economy. That long-run perspective is never more important than at times like the present, when a cyclical event is under way and confidence tends, understandably, to wane. The global economy is at an important juncture. After a number of years of very strong growth, the latter part of 2008 and 2009 look almost certain to be characterised by the weakest international economic conditions for many years. Of course, global growth had already been slowing, after several years of very heady expansion that had stretched the limits of resource availability and pushed up commodity prices sharply. Inevitably, the slowing was initially uneven and some countries - notably the United States - had been battling economic weakness longer than others. But global growth prospects have been marked down significantly further in the space of just a couple of months, with the weaker picture led by the United States but by no means confined to it. The proximate trigger for the sudden deterioration in people's assessment of the outlook was a sequence of financial events. It was not that these events initiated the slowdown, but they have led people to think that it will turn out to be a bigger event than hitherto expected. What had been for over a year a serious dislocation in international financial markets, but one which seemed to be being managed, turned quite suddenly into a very serious crisis during the weeks following the failure of Lehman Brothers on 15 September. In a breathtaking turn of events, the financial landscape changed dramatically, with the failure or rescue and effective nationalisation of a number of systemically important financial institutions in the United States, the United Kingdom and continental Europe. Share markets slumped, currencies moved abruptly, commodity prices continued their sharp decline and investors' appetite for risk contracted further. Not only that, but the constraints on credit that periodically had been flaring up over the preceding year became more widespread, and are likely, if they persist, to have significant effects on economic activity in many countries and on trade between them. Until September, while the cost of borrowing for banks and low-rated corporates had increased, it had been the case that the most highly rated corporations had not experienced a significant rise in borrowing costs. That has now changed, with spreads for even AAA-rated corporates rising sharply. Likewise, spreads for emerging market sovereigns have increased significantly, for the first time in this episode. It is not surprising, then, that formal forecasts made by bodies such as the IMF have been in a state of almost continual revision. Their latest incarnation, as released for the annual meeting of G-20 finance ministers and central bank governors recently in Brazil, is for the weakest performance in the G7 group of countries for many years. In addition, emerging market countries, including China, are also being affected more now, and talk of 'de-coupling' has gone away. Actually, this was a very unhelpful term anyway, carrying as it did the implication than economies are either mechanically 'coupled' or not. Reality is more complex - everything is connected, but the effects across national borders depend on the nature and severity of the originating shock and what else is going on in the other countries around the globe at the time. Given a big enough shock, everyone ultimately is affected. What then is needed to address the situation? In facing the financial problems themselves, the most important steps have already been taken by countries at the epicentre of the crisis. Those steps address issues of liquidity, capital and confidence. In the area of liquidity, central banks have taken unprecedented steps over the past year, and especially the past few months, to add funds to their respective financial systems. This has culminated, through co-operative swap lines between many of the central banks, in the provision of virtually unlimited amounts of US dollar cash, against a wide variety of localcurrency collateral, across multiple time zones. This liquidity is on tap at a fixed (low) price: no quantitative limit has been set by the US Federal Reserve. As a result of this, and the expansion of other facilities, the Fed's balance sheet assets have more than doubled in the space of a few months. In the area of capital, the lessons from earlier crises have been heeded, chief among which is that when a country faces a system-wide question of solvency, the only source of sufficient new capital may be the public purse. Hence, governments in the United Kingdom, the United States, and Iceland are offering to take, or have taken, equity stakes in key financial institutions, up to and including full nationalisation in some cases. As far as confidence is concerned, measures have been taken by a number of governments to secure retail deposits by a guarantee, and to offer a guarantee of eligible wholesale obligations of banks willing to pay for it. This ought to alleviate concerns about riskiness of the institutions concerned, allowing them access to term funding. These measures are bearing some fruit. Markets are beginning to thaw. Spreads between expected central bank policy rates and term funding costs have come in from the extraordinary levels seen in September and October, though they remain high by historical standards. The actions taken to inject equity are stabilising a situation on solvency that could otherwise have unravelled quickly. There have been substantial issues of wholesale securities using the priced guarantee, mainly by UK banks, suggesting that term markets are opening again. What is needed now is for policy-makers everywhere to specify as quickly as possible the parameters of their various guarantees so that market participants have a degree of certainty about how things will work - while retaining, within reason, the capacity to adjust the parameters in the light of experience. So a good deal has been done already towards addressing the financial problems themselves. These measures cannot avert a significant slowing in the global economy - it is fairly clear that a recession in the major country group, the G7, is under way. That, in turn, means that credit losses will be incurred by the lenders in those countries as typically happens in a business cycle downturn. But the measures averted, in my judgment, potential systemic collapses that would have had massive repercussions throughout the world. That leaves an international business cycle event to be addressed. So what are the ingredients for doing that? The slower growth in demand occurring now, and likely to be seen over the coming year, has had the effect of lowering the most flexible set of prices, namely those for raw materials and energy. The price of crude oil has fallen, measured in US dollars, from nearly US$150 a barrel at mid year to under US$60 today. Prices for metals and soft commodities have also declined considerably. It now looks as though prices for iron ore and coal, critical cost components for steel and electricity, are declining too. Other prices around the global economy are typically slower to respond to the shifting balance between demand and potential supply, but with global output expected by the IMF to be growing during 2009 at its slowest pace for two decades or more, spare capacity is likely to be increasing, so we could expect these slower-moving prices to moderate over the next couple of years. This outlook has increased the scope for many central banks to reduce interest rates. Until quite recently, concerns about inflation saw a majority of central banks tightening monetary policy. Through to the September quarter of this year, those central banks raising interest rates had consistently outnumbered those reducing them, by a significant margin. There is now, however, a preponderance of reductions, in expectation of falling inflation. Some of the reductions have been quite large. So monetary policy is easing. In circumstances where the financial markets are seriously impaired, of course, the central bank reducing the overnight interest rate may not make much difference to the price of credit to ultimate borrowers. This is not a major problem in Australia, but in the United States rates paid by many borrowers have not fallen much, if at all, over the past year. It is also possible in some countries that, even at lower interest rates, neither the demand for credit nor the willingness of banks to supply it will be increased as much as would normally be the case. This does not mean that monetary policy in those countries has become completely ineffective - in many cases, it may simply lead policy-makers to lower overnight rates by more than usual. Nonetheless, it is handy in such circumstances to have an additional channel - namely, fiscal policy - that can affect aggregate demand if needed. Moreover, as the private sector in many countries is seeking to conserve wealth in the face of weakening incomes and lower asset values, it will presumably attempt to save more of its current income; this might be particularly so for households. The problem is that, for the economy as a whole, if everyone attempts this change simultaneously, the 'paradox of thrift' says that the economy will contract. So if that were indeed the situation that some countries faced, the stabilising policy would be for the government sector to decrease its saving, so as to accommodate the rise in saving by the household sector. So, in addition to monetary policy easing, fiscal policy adjustments are being made or contemplated in a number of countries. The question is how much scope the relevant governments have for such actions, before encountering the potential limits to credibility of their own balance sheets. Those who already had largish deficits - which will get bigger as economic activity weakens - and/or who had high levels of public debt, presumably have less scope for fiscal action. Calls for fiscal expansion around the world are accordingly being accompanied by calls for credible statements of how the long-run soundness of public finances will be maintained. There is an important point to make here, which generalises to monetary policy as well. It is that those countries which went into this episode having practised disciplined macroeconomic policies over many years, and I would include Australia in this group, will tend to be the ones which find themselves with the most scope to move in an expansionary direction, should they need to do so. And that, of course, is the whole point of the earlier discipline. That said, it is still important for fiscal measures to pass the 'good policy' test. Poor public policy proposals should not be accepted simply because they are presented as boosting shortterm aggregate demand. One of the countries of most importance to Australia is China. It has been said that the full emergence of China is a structural phenomenon that has many years to run and which is profoundly changing the world economy. I still believe that to be true. Nonetheless, as I have remarked before, the Chinese economy has a business cycle, like all economies, and it is apparent that this cycle is in the down-phase at present. While it is very difficult to get a full economic picture of China, it appears that the slowing may be much more pronounced than most people, including the Chinese authorities, expected. That change in trend has had major effects on prices for commodities, including ones important for Australia. But the Chinese authorities have now responded quite forcefully to the emerging weakening in their economy. Details of the recent fiscal package are still difficult to assess, but new demand may be as much as 2 per cent of GDP or more in each of the next two years; and monetary settings have been eased noticeably over the past two months. So I suspect that, while China is weakening at present, it will be strengthening a year from now. These various policy responses are acting to limit the downside risks attached to the outlook over the next couple of years. It will be six to nine months before their effects begin to be seen in the statistics. Whether enough has been done adequately to restore conditions for sustainable growth, it is too soon to know yet. But if not, it is a safe bet that more will be done before long, if the recent comments by the authorities in various countries are any guide. What then of the outlook for Australia? Thus far most indicators have suggested that the economy has been slowing, after a period of excessively strong growth in demand that had pushed up inflation. Absent the sudden recent deterioration in the global outlook, I think we would in due course have looked back and seen that the slowing had been similar to that observed in 2001, albeit with differences by sector. But with recent international economic and financial events, the economy will probably now experience a more significant slowing than was otherwise going to occur. That is barely detectable yet in some of the key official datasets. Employment, for example, remained quite solid, and unemployment very low, through into October, consistent with the gradually moderating growth of mid year, but not yet showing the effects of the more cautious mood in the business community that is now taking effect. Nonetheless, in the period just ahead, we are likely to see, for a time, growth at quite a slow pace. That is the outlook embodied in the Reserve Bank's released last week. This means that, over time, the extent of capacity utilisation will decline and pressure on prices will abate, though that could take some time to be apparent. The lower exchange rate will tend to push up prices for traded goods, though the weak global environment may mean this effect could be muted somewhat. Lower raw material prices will also be of considerable assistance in slowing manufactured prices - again subject to the exchange rate. Of course, many of the items pushing up inflation in Australia of late have been in the services sector, but the likely moderating trend in labour cost growth over the next couple of years should help here. Overall, our view is that after a fairly extended period of above-target inflation, we will see the CPI inflation rate moving back to its target over the next two to three years. Should demand in the economy weaken further than we expect, that would be likely to be accompanied by a downward revision to the inflation outlook. Given this outlook, the Reserve Bank has been lowering the cash rate. We have chosen to do so quite quickly, well before a decline in inflation is evident in the data, in recognition that the international circumstances had changed quite sharply, which have increased the risk of a more abrupt slowing in demand. That is, we have been pursuing the inflation target in a forward-looking way, and paying due account to economic activity considerations. In the period ahead, we shall be seeking to strike the right balance between, on the one hand, the need to have inflation come back down, albeit slowly, and on the other hand, the desire to avoid as far as possible an unnecessary weakening in demand. Looking beyond the near term, what needs to be done to make future growth less likely to be disrupted by the sorts of financial problems we have seen emerge over the past 15 months? Every episode of crisis provides some new lessons and these can be incorporated into regulatory and supervisory practice as appropriate. Various proposed reforms in the area of financial regulation are on the table, many of them developed under the auspices of the These include likely adjustments to the Basel II arrangements for the capital requirements of banks, including efforts to make them more anti-cyclical; more focus on liquidity risk management; attention to the conduct of credit rating agencies; the increased use of central counterparties to control the risks in some derivatives markets; and the establishment of cross-border supervisory 'colleges' for the largest internationally active banks. Much work remains to be done, and if past experience on finding international agreement on regulation is any guide, it will be hard, slow, grinding work. But the call of global leaders last weekend in Washington for this work to be expedited gives it an important additional impetus and a greatly strengthened focus. But we need to approach the task of reform with realism. The cycle of greed and fear cannot be regulated away. To assume that unrealistic optimism will not again, at some point, overwhelm the more sober instincts of investors, bankers, commentators and others would be a triumph of hope over experience. Regulation can be improved, but there will always be an unregulated part of the system, the more so the tighter regulations are; there will always be those who put at risk some of their capital in that sector; there will always be a business cycle, and there will always be some who take excessive risk near the peak of the cycle and get caught out. The genius of the market economic system is that so much of the risk that is prudently taken, much of the time, turns out to reward the risk-taker, and indeed all of us, with the profitable deployment of capital, jobs, more choice, higher productivity and better living standards. It will be important not to forget that in the next year or two. Nor is it realistic to assume that regulators and central bankers will always have the wisdom and prescience, or even the scope, to deploy their few instruments such as to ensure that an ideal combination of financial stability and high growth can be achieved consistently. The world will never be that perfect. Nevertheless, in addition to the many useful steps being planned by regulators, perhaps we could pay more attention to the low-frequency swings in asset prices and leverage (even if that means less attempt to fine-tune short-period swings in the real economy); we could have a more conservative attitude to debt build-up; and we could exhibit a little more scepticism about the trade-off between risks and rewards in rapid financial innovation. This would constitute a useful mindset for us all to take from this episode. To conclude, we face difficult circumstances. Policy-makers and regulators both here and abroad will need to stand ready to act promptly to provide any necessary support for the financial system and sustainable economic activity. In doing so, though, we need not, and should not, abandon the well-established and tested policy frameworks that are in place. In fact, it is these that have given Australia, in particular, ample scope to do what is needed in the current situation. Given that we have that scope, and given the underlying strengths of the economy, about the biggest mistake we could make would be to talk ourselves into unnecessary economic weakness. Yes, the situation is serious. But, as I suspect CEDA members know well, the long-run prospects for the Australian economy have not deteriorated to the extent that might be suggested by the extent of some of the gloomy talk that is around. If businesses remain focused on the long-term opportunities; if markets and commentators do the same; if banks remain willing to lend on reasonable terms for good proposals; if governments are able to so order their affairs as to continue supporting worthwhile - and I emphasise worthwhile - public investment (even if that involves some prudent borrowing); then Australia will come through the present period. We ought to go forward with some quiet confidence in our own abilities and in the opportunities that are on offer. I wish you all well in that endeavour.

r081209a_BOA

australia

stevens

It is a pleasure once again to address the Australian Business Economists. It was to this group that I gave my first speech as Governor, in October 2006. Tonight is my 23 speech since then. Between the two occasions, quite a lot has changed, globally and domestically (though I doubt the speeches have become any more exciting). Many people have said to me recently that the times are 'interesting'. My response has been that they are, perhaps, a little too interesting. I need not remind this audience of the international financial turmoil through which we have lived over the past almost year and a half, nor of the intensity of the events since mid September this year, in particular. I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a 'tail' outcome - the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it. In that spirit, I shall set out a few features of this episode that make it 'interesting'. The most obvious one is the prominence of financial events and particularly financial sector impairment in key countries. There have been other episodes where individual financial institutions or sectors, or even the whole banking systems of small countries, have needed recapitalisation. But the scale of capital needed, the number of countries where it is needed and the extent of counterparty risk aversion because of concerns over solvency have been outside the range of experience of the past half century. In the near term, financial stress brings the obvious concern about the ability of the financial system to provide credit to the economies in question. As one measure of this concern, the number of loans approved for housing in the United Kingdom in October was 65 per cent lower than a year earlier, and about 50 per cent lower than during the downturn of the early 1990s. The immediate need is to keep ample liquidity, strengthen banks' balance sheets by adding capital and to help confidence, including by lending the strength of the sovereign's credit rating where necessary. All this has been occurring. What may still be needed internationally is attention to the remaining problem assets, since if their prices continue to decline, the capital position of the banks will continue to deteriorate. So while the UK solution has emphasised new capital and the initial US approach emphasised excising the 'troubled' assets, the Swiss solution has been to do both: to recapitalise the banks, while getting the worst of the bad assets off their balance sheets. The United States has moved in this direction also more recently. Continued efforts to provide clarity on the state of balance sheets is also important. Surely the lingering counterparty risk aversion reflects uncertainty on this score. Longer term, some of the implications of the past year's events will be seen in the regulatory environment. In those countries where the public purse has had to be used to support bank solvency, it can be expected that there will be significant regulatory reform - and rightly so. The real trick, however, will be to make sure that the reforms are not just knee-jerk reactions to the symptoms of financial excess - as clear as they are - but well-considered, durable and tractable changes that appropriately contain, but do not crush, the financial system's capacity and appetite to take risk. Certainly, over the past five or so years, too much risk was taken, of the wrong sort. The danger in the next several years, however, will not be too much risk-taking, but too little. Regulators will want to avoid compounding that. While the prominence of financial events has been clear, there has also been a set of 'interesting' events in the real economy unfolding at the same time. The fortunes of the Chinese economy are increasingly important, particularly for Australia and other countries in our time zone. The most striking real economic fact of the past several months is not continued US economic weakness, but that China's economy has slowed much more quickly than anyone had forecast. Our own estimates suggest that Chinese industrial production probably declined over the four months to October. Some of this might be attributable to the effects of the Olympics but surely not much. Some of it reflects the weakening in Chinese exports to major countries. But more than that seems to have been occurring. I am not sure that many economic forecasters have fully appreciated this yet. There is every chance that the rate of growth of China's GDP is currently noticeably below the 8 per cent pace that is embodied in various forecasts for 2009. The Chinese authorities, having sought a slowing of their economy after it was clearly overheating, are now moving policies quickly in an expansionary direction. So there is a good chance that China's economy will be looking stronger in a year's time than it does today. It is important, though, that this is done in the right way - specifically by boosting domestic demand. China's slowing may be part of a third striking fact, namely, the simultaneity of the weakening in economic activity around the world during recent months. When this occurs, one is naturally led to look for a common shock. The noticeable slowing in many economies in the June quarter seemed at the time to be attributable to the sharp run-up in oil prices. That rise has now been more than reversed, but the slowing has, if anything, intensified during the past several months. The more recent weakening might be the result of more widespread and intense tightening of credit conditions that has occurred in some of the major countries. But the state of domestic financial sectors differs across countries. In Australia or Japan or much of east Asia or Canada, while credit conditions have become more difficult, the banks are in much stronger condition than in the United States or Europe or the One thing that stands out as closely related across countries, however, is the fall in share markets. These changes are to some extent themselves a reflection of a weaker set of expected economic outcomes. But with closely linked financial markets and rapid communication, changes in sentiment are transmitted very quickly across countries and it appears that those changes in sentiment are themselves affecting behaviour. People have, understandably, become very uncertain about the outlook and are correspondingly more cautious in their spending behaviour. In essence, we are now in a period when the essential nature of events is not so much a crisis in the financial system. It is a crisis of confidence on the part of households and businesses, and it is global in nature. Hence the need for actions that are internationally consistent to deal with the situation. On that score, a fourth 'interesting' feature is the speed with which official institutions seem to be reacting to the economic fallout now unfolding. To take one example, IMF forecasts, and associated policy advice, are being revised more often and faster than I can recall in the past. Perhaps this is simply because of the greater number of international meetings at which the Fund is asked for its view, but my sense is that international official bodies and their domestic counterparts are shifting their assessments unusually quickly as they attempt to grapple with the unfolding situation. Monetary policy is being eased aggressively around the world. So is fiscal policy. One of the striking features of the recent G-20 meetings was the way the need for fiscal stimulus, where debt levels permitted, was readily agreed between participants, and actively encouraged by the IMF. Of course, agreeing to things in general at a meeting is only the first, and the easiest, step. Actual policies have to be delivered and in a timely and effective - and hopefully consistent - way. I use the word 'consistent' because it is preferable, in my judgment, for action to be broadly consistent and timely, than for it to be precisely co-ordinated but delayed. It also remains to calibrate the extent of the measures appropriately for the circumstances, which is no easy matter. Nonetheless, it seems to me that all this is happening faster than on previous occasions. It would not be realistic to suggest that this response has been, or ever could be, so fast and so well targeted that significant near-term weakness in the global economy can be avoided. The data coming in by the day confirm that there is an international downturn taking place, and that it shows every sign of being a deeper one than the rather shallow affair of 2001. The question is whether we have reasonable grounds to expect that the combination of private and public efforts to address the financial problems, a subsidence of the sheer panic in financial markets and the use of macroeconomic policy to provide stimulus to weak economies will establish sound foundations for a renewed period of expansion beginning some time in 2009. The inauguration of a new US Administration is a key opportunity. The economic downturn has been deepening during the transition period. But if the new team can announce credible plans to accommodate the required adjustments in the US economy, confidence in medium-term prospects can be re-built. This would assist both the US economic recovery and conditions elsewhere. Thinking ahead, the next international expansion will no doubt have some different characteristics from the previous one. It cannot be based on a continual gearing up by consumers in developed countries and associated asset price escalation. For that reason, neither can it be characterised by the continued large build-up of balance of payments surpluses by the emerging world. The secular increase in living standards in emerging countries ought to play a bigger role in driving global demand - and that will depend on appropriate policies in both those countries and the developed world. It looks like there will be a fairly prominent role in the near term, in many advanced countries, for the government sector through the recapitalisation and/or guarantees of banks, or fiscal expansion, or both. But for sustained growth, there will also need to be a role for innovation and prudent risk-taking in the private sector - even though, at present, that is in retreat. Turning closer to home, the Australian economy has seen a significant change in circumstances over the past six months. The biggest terms of trade boom in half a century is over, and has partly unwound. I still think that China's emergence is far from complete and that, as a result, the terms of trade will be higher on average than they were until a few years ago. But over the next year they will be well below their peak. Our households, like those elsewhere, have observed financial turmoil and a decline in share prices and have become more cautious. Consumer spending, which slowed significantly in the period from about February to June as interest rates and petrol prices rose, has remained slow since, even as interest rates and petrol prices have fallen significantly. I think we can expect that households will be more cautious about debt over the next couple of years. Business investment and government spending have remained pretty strong - so that domestic demand was still 4 per cent higher in the latest data than a year earlier. But businesses are currently in the process of scaling back plans for investment and hiring. This is partly in response to slower consumer demand, but the dramatic change of view about international conditions and the general uncertainty reflected in financial market prices are surely playing a major role. So in the period ahead, private demand could look weaker than it has for some years. What then do we need to be doing to ensure as far as we can that the period of weakness is brief, and that prospects for longer-term sustainable growth are maintained? Of course, we cannot change the course of the world economy. But we can keep our own house in order to maximise our chances of good performance. On this score, as I have remarked before, Australia has scope to use macroeconomic policy to support the economy in the weak part of the cycle. That scope was earned by being prepared to run budget surpluses and run down public debt when revenues were strong, and by raising interest rates to contain inflation when the economy overheated. The scope to ease policies is now being used. On the fiscal side, the 'automatic stabilisers' will reduce the budget surplus as the economy weakens, cushioning the economy in the process. That is what they are designed to do. There has also been a front-loaded, discretionary easing that is starting to arrive in recipients' bank accounts this week. Of course, a good deal of this may be saved, but even if it is, that presumably takes the place of private saving that would otherwise have been done over a longer period, so it brings forward the point at which households become confident enough to lift spending. Also on the fiscal front, there is no reason why worthwhile public investment decisions that are currently planned should not proceed, as long as they really are worthwhile. On the monetary front, interest rates right across the spectrum have fallen. Some fairly elementary calculations suggest that, as a result of the decline in interest rates that has occurred already, the fall in the household sector's gross debt-servicing burden will be almost 3 per cent of household income. This is roughly equal to that seen in the early 1990s, when the cash rate fell from 18 per cent to 4.75 per cent. But on that occasion it took two and a half years; this time it will take place over about four or five months. The decline in borrowing costs for businesses has generally been smaller and slower to appear, but there has been some faster pass-through of the most recent reduction in the cash rate. These transmission channels of monetary policy are still operating in Australia, unlike in some other countries. In addition, the exchange rate is playing its normal role of adjusting to changed circumstances in a way that stabilises the economy. It has declined by about 25 per cent in trade-weighted terms since mid year, just about the largest movement we have seen in such a short period. These are quite big changes. They will take time to have their full effect, but they will be making a significant difference to conditions over the next year. There is scope to do more with macroeconomic policy settings, if needed, given the strength of the public accounts at the federal level, and the outlook for declining inflation. In assessing whether more is needed, and if so, how much, we will naturally need both to maintain a close watch on the data and to remember the extent of stimulus that is still in the pipeline as a result of past actions. Other supportive factors include the state of the financial system. This has been said many times but bears repeating. Of course credit conditions for some sectors, notably property, have tightened. And overall, credit to business is rising much more slowly now than a year ago. But even so, over the three months to October, credit provided by intermediaries rose at an annualised pace of about 12-13 per cent. On a broader definition, which includes capital market raisings, the pace was about 9 per cent. Both numbers are actually a bit higher than they were around mid year. In most developed countries, this would be considered a very satisfactory pace (if not a little fast). Credit growth to households has recently been very slow, by historical standards, at about 4 to 5 per cent. Margin loans in particular are contracting quickly as people reduce their leverage. Lending for housing is starting to pick up now, however, from the early impact of interest rate reductions. Australian banks, having raised very large quantities of deposits in the past couple of months, are now turning back to offshore markets, making use of the government guarantee. They do not appear to have had much trouble raising capital from private markets when they wanted it. Overall, while not without its difficulties, this situation remains a much better one than seen in a number of other countries. These are the key elements of handling the cyclical episode. Longer term, performance will depend on the quality of investment, both public and private, on productivity-increasing innovation and reform, and on getting the right balance on regulation. All that is hard, but at various times over the past couple of decades, Australia has made considerable progress in these areas, and has a pretty good record overall of responding to the need for change, especially in times of adversity. There is no reason we should not maintain that record. As I said at the outset, we are indeed living through 'interesting' times. They are tough times, for businesses, financial markets, households and policy-makers. Given the global situation, we have a very difficult period to negotiate. But we can negotiate it. The long-run prospects for the Australian economy have not deteriorated to the extent that some people may presently be feeling. We do have reasonable grounds for some quiet confidence about the future, however bad the storm at present may be. A period of reflection and recharging of batteries over the break will be helpful. At the conclusion of a hectic year, therefore, I wish all of you a Merry Christmas - and a much less interesting 2009.

r090210a_BOA

australia

NO_INFO

stevens

It is a great pleasure to be here in Kuala Lumpur at this celebration of Bank Negara Malaysia's 50 Anniversary. The two central banks actually have something of a shared history. In the late 1950s, the Commonwealth Bank of Australia, as Australia's central bank was then known, seconded officers to assist with the establishment of Bank Negara. One of them, Tan Sri W.H. Wilcock, became Bank Negara's first Governor in 1959. So it is a pleasure indeed to be renewing the relationship in this way here today. The subject for this session is 'The Nexus between Monetary and Financial Stability'. It is certainly a topical one. The global financial system has changed dramatically since Bank Negara's early days, both in size and complexity. Yet for all its supposed sophistication, the system is still characterised by cycles - as is the case with so much of human behaviour. Periods of strong growth, rising asset prices and investor optimism are still followed by sharp increases in risk aversion, falls in asset prices, investor pessimism and weak economic conditions. What is perhaps novel in recent experience is the scale with which risk appetite could be accommodated by the global financial system and, equally, the scale of the damage wrought by the ensuing shift to risk aversion. All of this has, of course, complicated the operation of monetary and other policies and, in some cases, threatened to overwhelm them. With the benefit of this experience, policy-makers everywhere are working on strengthening their frameworks. In doing so, however, we all need to keep in mind that our capacity to predict how financial behaviour will change in response to events, and to policy initiatives, will always be imperfect, as will be our capacity to keep pace with the latest innovations. Therefore, we need policy regimes that are robust enough to be effective despite this limited knowledge. These are the issues I will be discussing today. I wish to make clear at the outset that my remarks are about the general international issues, not specifically about either Malaysia or Australia. In the current cycle, it has been argued that complexity obscured risks that were embedded in certain financial instruments and activities. So what do we mean by financial system complexity? Three key aspects come to mind: Each of these elements has been important over the past two years. Financial innovation saw the development of a number of complex products, from asset-backed securities (ABS), to structured credit products such as collateralised debt obligations (CDOs) based on portfolios of ABS, and CDO-squareds (CDOs of ABS that hold CDOs as collateral) and credit derivatives. Only too late was it understood that the prices of these instruments move in a highly non-linear fashion in response to falling credit quality in the tranches underlying the securities. When that began to happen, moreover, there was little or no liquidity in markets where these instruments were traded. Opacity was also a problem insofar as the banking system was concerned because such instruments were often not accounted for on-balance sheet but were issued indirectly through special purpose vehicles. At the same time, the activities of financial institutions became much more closely intertwined with financial markets. There was a blurring of distinctions between different types of institutions and a shift in their relative sizes within the financial system. Banks moved beyond their traditional role as deposit-takers and lenders to offer a much broader range of financial products, including funds management and insurance. The growth of securitisation markets (until recently) enabled non-bank financial institutions to play a greater role in credit provision, and fostered the expansion of the so-called 'shadow banking system'. Financial institutions also became much more reliant on markets for their own risk management and funding, and in some cases found that disruptions in financial markets had a serious impact on their ability to operate. For example, in the United Kingdom, Northern Rock's heavy reliance on securitisation, and its inability to find an alternative source of funding when this market closed, was instrumental in its need for official support and subsequent nationalisation. Similarly, disruptions to markets for credit default swaps, or even simple foreign currency swaps, had a significant impact on the operations of institutions that relied on these markets to hedge their exposures and manage funding. Globalisation has also been important, with much economic and financial activity increasingly organised on a transnational basis. Hence, there is much greater interdependence between national financial systems - and one of the remarkable features of the recent global turmoil has been the speed at which problems have spread across borders at critical moments. This is true not only of financial difficulties, by the way, but also of the effects on the real economy. Modern management of inventories and shipments has probably transmitted weaker demand back up through the production chain, across countries, all the way to the raw materials sector faster than in the past. (This should, of course, be stabilising in the sense that it prevents the old-fashioned inventory cycle amplifying the effects of the swings in demand.) The slump in trade has also been exacerbated by dislocation in trade credit, which is but another manifestation of counterparty risk. But something more than just the usual effect of lower US demand via trade channels has been at work. The ubiquity of access to instantaneous 'news' - from globalised news organisations and via the screens on our desks, CNN and so on - and the pace at which households and businesses adjusted their expectations and behaviour based on this new information was surely a big part of the explanation for the highly synchronised slump in demand around the world during the final few months of 2008. I suspect that economists will debate for years ahead the nature of what has clearly been a common shock to all countries. My reading of the episode is that the extraordinary financial events of September and October 2008 - several large financial failures, large-scale rescues of major institutions, enough incipient systemic concerns about banking systems to lead governments to issue guarantees, investor panic on share markets - were all observed in real time by households and businesses right around the world. This caused a collapse of confidence, a disengagement from financial and business activity and a much more cautious attitude to spending. It has had very large effects on the real economies of most countries. How then has all this affected the task of conducting national monetary policies? Here I will take some liberties and define monetary policy more broadly than just the setting of the overnight interest rate, and include the full gamut of central bank operations in markets. The first point to note is the international spillovers of the crisis, stemming from the cross-border integration I mentioned earlier. The earliest evidence of this was the way higher term funding spreads in money markets were observed in many countries, even those whose exposures to the problem assets were trivially small (I include in this group my own country and some others in this time zone). In many short-term money markets, the spreads between overnight rates and 90- or 180-day rates rose significantly, even though not as much as in the United States, the United Kingdom or the euro area. These spreads reached extremes in most cases during September and October 2008, in the midst of the turmoil following Lehman's failure. In some cases, turnover in money markets dropped sharply, almost to zero, for anything other than overnight maturities. An important dimension of this phenomenon was the shortage of dollar liquidity for non-US entities trying to fund their US asset positions. The pressure this placed upon swap markets ultimately saw them effectively close for a couple of weeks during September. In response to these spillovers, central banks did two things. First, they adapted their own domestic policies for provision of liquidity, responding to the unusual term spreads by widening the classes of assets in which they would transact, being prepared to push the amount of cash in the system higher than normal, lending on a collateralised basis at longer terms and in some instances providing foreign currency from their reserves to swap markets. Second, central banks stepped up their collaboration in recognition of the mutual dependence of national financial systems. The Federal Reserve co-operated with central banks in a number of countries to provide US dollar funding against local currency collateral, with the central banks in effect acting as intermediaries. This alleviated the US dollar liquidity problems. Subsequent further expansions of these facilities in the United States and Europe have, for all practical purposes, made the dollar liquidity shortage a thing of the past. (Of course, counterparty risk aversion remains to some extent, which would explain the fact that term spreads remain higher than prior to the crisis - but that reflects questions over the perceived riskiness of the major institutions, rather than liquidity .) On top of this, there was also the co-ordinated interest rate reduction by the G10 central banks in October. And in Asia, there have been further developments of bilateral and multilateral swap agreements. The second complication for several countries is that some of the transmission channels of monetary policy are not working normally. In the boom, optimism and the search for yield pushed down the risk premia that were built into the interest rates offered to borrowers, and this may have diluted the effect of any increases in policy rates on the ultimate cost of funds. But lately, this dynamic has worked powerfully in the reverse direction, with sharply rising risk premia diluting the effect of lower policy rates. The most damaging instances of this have been in the United States and the United Kingdom, where despite quite aggressive reductions in the interest rates set by the central banks, rates paid by many borrowers have not fallen very much until quite recently. In addition, even where interest rates have declined, many banks display an individually understandable, but systemically damaging, reluctance to lend. Perhaps these impairments of the transmission process could be offset, to some extent at least, simply by pushing the policy rate further than would otherwise have been the case. But by now, the zero bound problem, which had been a theoretical curiosum until Japan's experiences over the past decade, is being faced also by the United States and Switzerland, and prospectively perhaps by one or two other countries. For this reason, so-called 'unconventional' policy instruments are starting to come into view in some countries. These essentially amount to direct purchases of assets by the central bank, so as directly to affect the price of that asset and/or the balance sheet of the counterparty, or to act as 'intermediator of last resort'. A third general issue is that the sheer interconnectedness of all of the major institutions and markets makes the framing of particular policy interventions aimed at fostering stability much more difficult. Because every linkage cannot possibly be known beforehand, the effect of any particular measure is almost impossible to predict with much accuracy. The current financial crisis has highlighted some of the risks associated with this financial system complexity - and the complications they bring for monetary policy are far from the only ones. Those charged with designing and implementing policies for prudential supervision, market conduct and deposit insurance, among others, are thinking hard about how to refine them. Obviously, each episode has its unique elements. In this one, the very low interest rates and macroeconomic stability of the past decade or so led investors to lower their perceptions of risk and allowed a greater range of borrowers much easier access to finance than before. Investor optimism and the search for yield provided the demand-side background that was associated with the development of complex financial products. These products, in turn, facilitated the build-up in leverage that allowed investors to achieve higher returns. The complexity and opacity of certain financial products and financial institutions' activities made it difficult for investors to develop a good understanding of their counterparties' business and their own exposures. There were no long time series of historical relationships that investors could use to estimate the probability of default associated with new instruments. Further, the new products and changes in the structure of the financial system resulted in a tight web of interconnections between institutions and markets that made it more difficult to determine the correlation of default probabilities across institutions. Information asymmetries were also associated with incentive and agency problems. The difficulties of assessing potential losses and limited transparency, in the presence of competition and investors' search for yield, may have encouraged some managers to take on greater risks than would have otherwise been the case. Rewards systems based on short-term performance added to these incentive problems. The difficulties involved in measuring risk meant that, during the buoyant conditions prior to mid 2007, investors were content to outsource risk measurement to credit rating agencies. Even then, investors did not fully understand the differences between different products with the same rating. But as important as all the new instruments and the various interactions between them, markets and institutions have been, it would be a mistake to conclude that fancy new instruments alone were the root cause of the crisis. Complexity was responsible for obscuring the risks associated with certain financial instruments, but many investors, if they were honest, would have to admit that they knew that they did not fully understand the instruments, yet they were not deterred from investing. In the end, the question remains: why were investors willing, eager even, to invest in such complex products they must have known they did not fully understand? Why did some financial institutions allow their business model to become so dependent on particular forms of market funding? Yes, the complexity obscured risk. But investors and institutions were not deterred by that. The simple point, surely, was that there was too much optimism combined with too much leverage. That is neither new, nor particularly complicated. I am prepared to assert that it will, periodically, recur. Policy-makers across a range of endeavours will need to keep that very much in view in the future. Turning to the implications for the future conduct of monetary policy, we have seen that financial system complexity and the financial cycle have affected both the overall environment in which monetary policy operates and the transmission channels through which it affects the economy. In response, policy-makers clearly have to work hard at understanding the effects of changes in economic and financial behaviour and the way they affect the transmission channels. They need to monitor a wide range of indicators to assess both financial conditions and the impact of their decisions on the economy. It is also important to monitor closely and respond to developments around the globe, as recent events have demonstrated that these can be rapidly transmitted across borders. In addition, monetary policy authorities need to work in collaboration with regulators and those responsible for financial stability to build their understanding of the financial system. In the short term, the situation requires flexibility and a degree of innovation on the part of central banks, and on occasion not a little boldness. I think most central banks have been prepared to embrace those principles, without abandoning the long-term foundations on which credible policy-making must rest. As challenging as the current environment is, however, some big challenges loom for the longer term, once the emergency has been dealt with. Complexity and uncertainty have always been defining characteristics of the economy. Economic behaviour and the structure of the financial system and economy are continually evolving. It will never be possible for central banks or others to work with full information, nor to predict exactly how their actions will be passed through the financial system, nor how they will affect the economy. The financial crisis may lead to a certain simplification of the financial sector for a time, with the closure of markets for many complex products, banks moving towards more narrow, traditional business models and the disappearance of some highly leveraged institutions with complex business structures. But the global nature of financial activity and the importance of markets to financial institutions are likely to remain, and the cycle of risk-taking will eventually turn. We certainly want this to be the case, in my view. The problem in the next couple of years will not be too many cross-border capital flows, but too few; not too much risk-taking, but too little. A retreat into financial autarky and wholesale shunning of risk would be even more damaging than what we have seen to date. So the challenge in the longer term is to construct a policy regime that handles all the complexity and cyclicality of the system. We need a robust policy regime that can operate effectively, that we will never have the full picture of the workings of the financial system and the real economy. We need policies that can be effective that private financial systems are periodically prone to 'irrational exuberance' - but without being predicated on the fallacious assumption that regulators will always know best. We need policies that steer away from a retreat to the financial repression of the 1940s and 1950s, but that have a more sceptical view of the latest financial innovations, and in particular maintain a much greater degree of distrust of leverage, in all its forms. And we need a system that is more robust in the face of occasional financial failures. This is a challenge, of course, for financial institutions, prudential supervisors and those responsible for seeking to maintain overall system stability alike. Indeed, these two perspectives have to be married more effectively than they have been to date. Assumptions reasonably made at the level of the individual institution when assessing prudential strength - say, about the availability and liquidity of various markets - may turn out to be collectively invalid. In the case of central banks, surely we cannot avoid another look at the question of monetary policy, asset prices and leverage. This has been a long-running debate - going at least as far back as the early 1990s, in my memory. Distinguished scholars have disagreed on the extent to which monetary policy should respond to movements in asset prices over and above their estimated impact on inflation via wealth channels, etc. Some argue in favour of 'leaning into the wind' of asset price swings, while others eschew that on various grounds, in favour of dealing with the aftermath of asset price busts if and when they occur. Several chapters have been written in the story, the most recently completed one being in the early 2000s after the 'dot.com' boom and bust. I think it could be said that, at that time, those advocating leaning into the wind did not get enough traction - I suspect mainly because growth in the United States was fairly easily restarted after the shallow recession of 2001 that followed the 'dot.com' bust. In the aftermath of the excesses of the subsequent period, a new chapter is now being written in this discussion. Knowing the next speaker, Bill White, as I do, there will probably be food for thought on the topic here today.

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stevens

Mr Chairman, thank you for the opportunity to meet again with the House Economics Shortly after the Committee last met, the global financial system took a serious turn for the the biggest actual failure of a major American financial institution for many years. While it had been widely known that Lehmans was under immense pressure, when it came the event was still a shock. It triggered a massive re-appraisal of risk, and ushered in a period of the most intense financial turmoil seen in decades. The worst of the turmoil was actually fairly short-lived - a matter of weeks. But in that time a number of events occurred that have had a significant bearing on the outlook for the global economy. These included the incipient failure and/or public support of a number of major financial institutions in the United States, the United Kingdom and continental Europe, effective closure of many important capital markets and a worldwide decline in equity values of a quarter, leaving them around 50 per cent lower than their peak. I believe that the extraordinary actions of governments and central banks in that period - in supporting key institutions, supplying huge quantities of liquidity and offering guarantees on various obligations of banks - helped to stabilise what could have been a catastrophic loss of confidence in the global financial system. This remains a work in progress, and sentiment in financial markets remains fragile. Nonetheless, since October we have seen term spreads in money markets decline (back towards the pre-Lehman, though still elevated, levels). We have seen long-term markets re-open to banks (by virtue of the guarantees), public confidence in the security of the banking system maintained and the exceptional volatility abate somewhat. Inevitably, however, the turmoil of September and October took a large toll on household and business confidence around the world. Observing those events in real time, people everywhere understandably became much more cautious. We are now seeing the effects. Consumers have pulled back their discretionary spending sharply, are more inclined to save and are looking to repay debt. Businesses have seen the fall in demand, and have responded very quickly to cut production and costs, as well as putting on hold plans for expansion. Nowhere is this more evident than in the automobile sector, where global demand has fallen by around 20 per cent since August and production has declined equally sharply. Global trade has fallen away, driven by these trends in demand and also a significant disruption in trade finance. For many of the world's largest economies, the contraction in output in the last quarter of 2008 was the sharpest in decades. Nor is the weakness confined to the major economies. Emerging economies around the world, relatively little affected by the problems in the major economies until September, are now suffering the effects of both the weaker demand in the developed world and the shock to domestic demand as their own citizens respond in the same way to the financial turmoil. Many indicators for Asian economies stepped down abruptly in the last few months of 2008. China's economy recorded little GDP growth in the last quarter, and industrial production declined for several months. There are some tentative indications of a turn for the better in China in some of the most recent data, though it is too soon to know yet whether this will continue. It is all this news that bodies such as the IMF have factored into their growth forecasts for 2009, which put global GDP growth at just half of 1 per cent, which would be a very weak outcome. As recently as October, the forecast was 3 per cent. Needless to say, this amounts to a very major change in the international environment for Australia. As one metric, our terms of trade, which rose by 65 per cent over five years, look like they will fall by up to 20 per cent during the next year. That would still leave them historically high, and several important commodity prices have stabilised over the past couple of months after steep falls. At these levels, the stronger mining companies will still earn good profits. But the confidence seen in mid 2008 has given way to a much more sober outlook, at least for the near term. Internationally, the availability of risk capital has declined. Local businesses are anticipating tougher times ahead. Measures of business confidence have diminished sharply. Firms are altering their strategies quite quickly, looking to conserve cash, pay down debt and reduce costs. They are also experiencing tougher credit conditions. Indications are that investment plans, which had been exceptionally strong in the middle of last year, are being quickly curtailed. Households, for their part, are affected by a significant loss of wealth, especially over the latter part of last year, and are understandably tending to save more and, in many cases, looking to get their debt levels down.That said, measures of consumer confidence and consumer spending in Australia have held up much better than in many other countries over recent months. Six months ago, our judgment was that Australia was experiencing an economic slowdown that would turn out to be not unlike that of 2001 in magnitude, and that inflation would gradually decline. Absent the events of September and October, that would still have been a reasonable expectation. But the financial turmoil, and the real economic impacts that have flowed from it, altered the balance of risks for the world and Australian economies significantly. The Board quickly came to the judgment that the gradual easing of monetary policy that appeared to be in prospect six months ago should be accelerated. It moved to reduce the cash rate quite aggressively. The total decline of 400 basis points since August - as rapid an easing as any in Australia's history - takes monetary policy to a clearly expansionary setting. The Government has also implemented a major discretionary easing of fiscal policy, and the exchange rate is significantly lower. The deterioration in international economic conditions was so rapid that no policy response could prevent a period of near-term weakness in the Australian economy. We are being affected by the global downturn, and cannot realistically expect other than weak conditions in the first part of 2009. But the very large reduction in interest rates, the lower exchange rate and the major fiscal initiatives will work to support demand, increasingly so as the year goes on. Inflation is likely to continue its moderation that began in the December quarter, and to do so faster than expected six months ago. Compared with the sorts of growth we enjoyed until fairly recently, this is a weak near-term outlook. But if the outcomes we see turn out to be even close to these, Australia will have done well in comparison with most other countries. We have claimed all along that Australia was better positioned than many countries to ride out the international difficulties. Credit standards do seem to have tightened further over recent months and banks are seeing the inevitable increase in bad debts as the economy slows. But our major financial institutions are still in a strong condition, have access to debt and equity markets, are still earning good profits, and are in a position to lend for sound proposals. Our housing sector is not overbuilt; instead there is considerable pent-up demand, and affordability is improving quickly. Most of the corporate sector is not over-geared. Going into this episode, the scope to use macroeconomic stimulus was bigger than for most countries - and that scope is being used. Moreover, our transmission channels are still working: interest rates paid by borrowers have fallen when the cash rate has been reduced. In contrast, mortgage rates in the United Kingdom and the United States did not fall through much of 2008, as margins rose by about as much as the central banks cut their policy rates. Only quite recently have UK and US mortgage rates begun to decline. So there are reasonable grounds at this stage to think that the Australian economy will come through this very difficult episode - certainly not unscathed, but well placed to benefit from a renewed expansion. Things will be difficult over the next year. But as I have said before, the long-run prospects for Australia have not deteriorated by as much as we may all be feeling just now. China's emergence, for example, has not finished. It has years to run and Australia will benefit from it. We should not lose sight of that or other positives. We can have confidence in our long-run future and in our demonstrated ability to adapt to changing circumstances. If we retain that, there is no reason for any downturn to be a deep one. The Board is, of course, continually assessing whether the stance of policy is the right one to foster a durable expansion, consistent with the inflation target. A very large easing of policy has been put in place, on the basis of the anticipated effects of the global downturn and more risk-averse behaviour at home. Those effects are yet to be seen in many of the figures, though they are being felt in businesses around the country. The effects of the policy adjustments are only beginning. So in evaluating the information we receive in the months ahead,our task will be to distinguish between that which confirms the anticipated trends to which we have already responded, and that which tells us something genuinely new about the prospects for demand and prices over the medium term. Our objective, however, remains the same: sustainable growth and low inflation. Perhaps I should also make one or two comments about payments matters, given the impending changes to arrangements for ATMs. The new arrangements seek to remove several undesirable features of the existing system. In particular, fees paid between banks when their customers use each others' ATMs - 'interchange' fees - are not transparent, and are not clearly related to costs; fees paid by customers using ATMs other than those owned by their own banks - so-called 'foreign' fees - are not always properly disclosed (and in many cases are higher than necessary); the earnings stream for owners of independent ATMs - about half the ATMs in Australia - are limited to the interchange fees paid by banks, which are of course their competitors; and access by new entrants is difficult, potentially limiting competition. Under the new arrangements, there will be no interchange fees. An ATM owner will be able to charge the customer directly a fee for the use of the machine, but must disclose the fee prior to the transaction. Banks will probably continue to allow fee-free withdrawals by their customers at their own machines, because they expect to cover those costs with the revenue earned across the entire customer relationship. Use of another bank's ATMs will presumably attract a fee by that other bank to cover the costs. But the only cost to a cardholder's bank associated with use of a 'foreign' ATM is the cost of processing the transaction electronically - a matter of no more than 10 cents. Given this, we cannot see any strong case for a 'foreign' fee. Independent ATM owners will charge for the use of their machines, but that will maintain an incentive to grow their network. Otherwise, it is likely that the independents as a source of competition would diminish over time, reducing consumer choice. Access to the system will be governed by a code, which caps the price of connections, so that new competitors cannot be unduly hampered by the incumbent players over-charging to connect. The essence of the changes is simple. People have always been paying, one way or another, to use ATMs. ATMs do have a cost of operation and somehow that cost has to be covered. Even where no explicit charge is levied, somewhere or other the financial institution is making up that cost. They do not provide services for free. Now people will know exactly what the price of an ATM transaction is, and they will know it before completing the transaction. There should be no 'foreign' fees of any significance. And competition will be maintained, by allowing the independent ATM owners to remain viable and new competitors to enter more easily. That is, in our judgment, an improvement over the arrangements of the past and is the best way of keeping costs down in the long run. My colleagues and I now look forward to your questions.

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stevens

It is a great pleasure to be here in Melbourne to deliver the Ian Little Memorial Lecture. I worked with Ian when we were both young recruits in the Research Department of the Reserve Bank in the early 1980s. I remember an easygoing young man with a cheerful disposition, and a mop of curly dark hair. Even then, Ian was a clear thinker with a strong commitment to good public policy. So it was not really surprising that, having left the Reserve Bank in the late 1980s and succeeded in the private sector, he returned to public service in the Victorian Department of Treasury. In that role, as many of you here know better than I do, he shone. I would occasionally run into Ian at conferences and he would always impress on me, a macroeconomist working in the central bank, the need to acknowledge the importance of microeconomic policy reforms in bettering economic performance. It is a simple, but important, point. While macroeconomic policies are to the fore right now around the world, as governments and central banks seek to foster recovery from recession, in the long term our living standards depend more on innovation and productivity, and less on the manipulation of interest rates or aggregate spending decisions by governments, than common discussion often admits. Real prosperity depends critically on the supply side of the economy - the realm of microeconomic policies. It is in that spirit that I wish to speak today about something that I have not addressed in public before, namely, the payments system. Although the Reserve Bank is best known for its macroeconomic policy responsibilities, it has, in fact, an important microeconomic responsibility, namely, the competitiveness and efficiency of the payments system, including at the retail level. This obligation was given to the Payments System Board of the Reserve Bank, as a result of the Wallis Committee process in the mid 1990s - hence, my topic this evening. We might begin by asking: why is an efficient payments system important? The answer is that the payments system facilitates all economic and financial activity, whether it be the day-to-day payments that you and I make, payments between businesses or transactions in financial assets. There are around 18 million transactions in Australia every day, with a value of around $230 billion. With so many payments, even relatively small inefficiencies can potentially have significant implications for the costs of the payments system. Part of the Reserve Bank's job, therefore, is to promote efficient arrangements in the payments system in the interest of the broader economy. Earlier reforms to the high-value payment system improved efficiency and safety, but in the retail payment area, progress has been slower. In fulfilling its responsibilities over the past 10 years, the Reserve Bank has in some fairly high-profile instances ultimately resorted to regulation. This has not been because we have had a strong predilection for regulatory solutions. On the contrary, the Reserve Bank has usually first sought to achieve improvements in competition and efficiency without direct regulation. In particular, it has sought to encourage the players in the payments space to identify potential improvements and to undertake reforms to achieve these. But such industry-led reforms have sometimes been difficult to achieve, and so the Reserve Bank has ultimately been required to take a stronger role, including by regulating. I want to examine why this is the case, both at a general level and by reference to a recent example. These observations are framed by the particular challenges the Reserve Bank has faced in promoting competition and efficiency in the payments system, but the conclusions apply to a number of other areas where regulators are working to spur improvements in efficiency and productivity. In payment systems, as with other networks, a certain amount of co-operation between participants is needed to ensure that the system provides benefits to users. For example, when you or I purchase something at a retailer, it should not matter with whom the retailer banks, or with whom you or I bank. We expect to be able to rely on the banking system to transfer money from us to the retailer. We expect that, when we pull out our debit or credit card to pay, it just works. That requires a detailed set of co-operative arrangements between financial institutions to accommodate payments between each other's customers. These same institutions are also competing with each other, however, to attract customers. A common way to compete is to offer products or features not offered by one's competitors. But if the ability to offer that new product relies on competitors making changes to their systems, innovation may be stymied. Why would other banks be willing to incur the costs of developing the relevant systems in order to help customers of their competitors? The tension between these two separate dynamics - the need for co-operation and the impulse to competition - means that the industry may have difficulty taking decisions in the interests of the system as a whole, and of the community more broadly. In such circumstances, someone - an industry group or a regulator - may need to play a co-ordinating role, to encourage improvements in the common infrastructure that benefit all, while still allowing competitive forces between the banks to ensure that the new products are priced competitively and packaged to meet customers' needs. Of course, these issues are neither new nor unique to the payments industry. It is well accepted in the economic literature that in industries that rely on networks of infrastructure (so-called 'network industries') there is an incentive to co-operate in order to gain efficiencies, but a socially optimal level of co-operation might not be achieved. One illustration of this point which has been cited in the network literature is the development of the rail network in the United States in the 19 century. The early US railway system consisted of a large number of individual links between pairs of destinations, often on different track gauges and designs. There was a clear public (and private) benefit in linking these 'networks' to allow goods or passengers to cross efficiently from one railway to another. But, nonetheless, railways were often designed to be incompatible, so as to prevent competitors from siphoning off traffic. Eventually, the commercial logic for some degree of co-operation was sufficient to ensure that standardisation occurred and this brought with it large productivity gains. For instance, in the space of a decade, the time for shipment of goods by rail from Philadelphia to Chicago was reduced from nine weeks to three days. Despite these pay-offs, standardisation was still not complete. In fact, the only way railways could reach an optimal level of standardisation was horizontal integration - merging competing railways. While all this sounds a million miles away from Australia's payments system in the 21 century, the parallels are quite strong. For example, like the linking of the railways, the realisation that a single, interconnected EFTPOS system was more valuable than a number of individual EFTPOS systems that could not talk to one another drove co-operation and standardisation quite early in the development of that system. But despite the benefits that brought, co-operation, standardisation and innovation in Australia's EFTPOS system have not progressed as far as is desirable. The EFTPOS system has essentially remained unchanged since its establishment in the 1980s. The fact that the system is built on bilateral links between all the major participants means that there is no one standardised communications protocol between the participants. Furthermore, co-operative efforts to innovate or upgrade the system are complicated because they require all bilateral relationships to be renegotiated. This is, in fact, a difficulty with many of Australia's payment systems - they are based on bilateral links, with no established mechanism to foster improvements and expansion in the network. So left to their own devices, networks may stop short of an efficient level of co-operation. Incomplete standardisation may result, and innovation or movement from one standard to a superior one may be difficult because of co-ordination problems, even where the benefits to society outweigh the costs. The literature points to several reasons for this potential outcome, some of which are evident from the example I have already given. The first is the classic economic externality. Firms within the network may be concerned that if they agree a common standard with a competitor, that competitor may be able to capture some of the benefits of moving to that standard. Why would I pay all the cost of converting my railway line to a gauge that can connect with another railway, when my competitor will gain as much of my rail traffic as I will of his? The implication is that competitors in a network might not individually make decisions that are optimal for the network as a whole. The second is the ineffectiveness of voluntary strategies for achieving co-operation in a network industry owned by competing firms. Establishment of industry bodies to agree standards is a common approach, but the success of these bodies has been mixed. Agreement tends to be delayed where there are vested interests and, in some cases, non-standardisation is used as a barrier to entry by competitors. Third, there is often a tendency towards 'excess inertia' in standards. Problems with co-ordinating the movement from an old standard to a superior standard (such as the movement to new system architecture in a payment system) may mean that the movement does not occur, or occurs very slowly, even where the benefits to society outweigh the costs of switching. These co-ordination problems may be caused by an uneven distribution of the costs and benefits of switching standards, or by uncertainty regarding the movement of rival firms to the new standard. From first principles, therefore, we might expect that achieving agreement among Australian financial institutions on development of the payments system might not be easy. So it has proved. There are a number of examples of this, but a recent one is the efforts by the industry at reform of the ATM system. As you may be aware, there have recently been some changes to the way ATM transactions at machines not owned by your bank are priced and paid for. Instead of paying a relatively obscure 'foreign ATM fee', that was charged to your bank account at the end of the month, people are now presented with the cost of the transaction in real time. These changes will, in our view, allow competitive forces to come into play in a way that was previously impossible. But it is the process of achieving the reforms, more than the likely benefits, on which I want to focus this evening. In particular, it required changes in the bilateral links between all the major players in the system. In this sense, the problems were akin to those of the US railway system - how do we get all the competitors to agree to change their bilateral links in a standardised way? Work by the industry on the reforms started as long ago as 2001. While some progress was made over the next few years, participants ultimately could not agree and asked the Payments System Board for guidance on the way forward. Finally, after much cajoling by the Reserve Bank, the new arrangements were implemented earlier this month - some eight years after discussions on the issue commenced. Ironically, the package implemented differs very little from the proposal put forward by the industry group itself in 200, which was subsequently abandoned owing to irreconcilable differences between some of the parties. Moreover, despite a firm desire by the industry to implement the new arrangements without Reserve Bank intervention, the industry ultimately asked the Reserve Bank to use its powers to help finalise the process. This is not a unique example. Reforms to most of Australia's payment systems including cheques, direct entry and EFTPOS faced similar challenges. As we have seen, this is not altogether surprising given the network nature of the payments system and the number of players which must co-operate, but also compete. The bilateral architecture that I have already mentioned is also a difficulty. Every large bank has an agreement with every other large bank about how to handle payments from one another's customers. The more banks there are, the more agreements are necessary and the more complicated the system becomes. To use the railway line analogy, the more customised tracks are built, the more difficult the task of ultimately converting all tracks to a standard gauge. This has two implications. First, while these bilateral agreements can be helpful in getting a system started initially, and may subsequently work well for those already in the system, potential new entrants face the prospect of negotiating numerous different connections. This can act as a barrier to entry, inhibiting competition. Second, because upgrading the network requires participants to agree, since they all must make changes, each participant therefore can effectively veto, or at least delay, any decisions affecting the network. Because different participants have different technology cycles and different strategic interests, there is a high probability that some participants will be unwilling to proceed at any given point in time. If a participant thinks a particular change may provide another participant with a potential competitive advantage, it will probably attempt to delay. Indeed, if one participant sees a potential competitive advantage in a change, it is almost guaranteed that another will see a disadvantage and, therefore, seek to block the change. This results in a significant co-ordination problem for the industry. The result is that, in the underlying architecture of the Australian payments system, very little has changed over the past 20 or 30 years, even though technology has evolved in the quarter of a century since the technology underlying the ATM and EFTPOS systems was first established. So while the payments system infrastructure has served Australia well, pressures for change are building. The network structure needs to be updated and services to customers are starting to fall behind those available in other countries. In the past, the Reserve Bank has identified real-time internet payments, business-to-business payments and online payment mechanisms as examples where progress has been made overseas but not, to date, in Australia. The resulting co-ordination challenges were very evident in the process of reform in the ATM system. With each of the parties having different objectives, consensus was hard to achieve. For example, small institutions would only consider a system that allowed them to form fee-free networks among themselves - otherwise they would be at a competitive disadvantage to the big banks with their large ATM networks. But larger institutions saw an opportunity to obtain a competitive advantage if smaller institutions could not form larger fee-free networks. There was also reluctance to liberalise access to the system. While improved access would serve to increase the benefits of the system as a whole and therefore the participants collectively, each bank tended to focus on the costs it would bear individually as well as the competition it would face. In short, there were problems because there was no participant in the system thinking of the benefit to the system as a whole with the power to effect change. Now in many countries, this role is handled by a single private sector entity that manages a system or systems. For example, the credit card schemes have a central body responsible for governance, innovation and promotion. Their incentive is to do things that expand the network, making its use easier and more attractive and increasing the number of participants. They have, in effect, internalised some of the externalities inherent in the network. While the credit card systems have had other elements that unduly limited competition in some respects, the centralised approach is arguably superior for network innovation and growth. That central body can determine standards and co-ordinate change. These arrangements are also more access-friendly in that a new entrant need only establish one, standardised connection to the system. Some private payment systems in other countries have such an entity - for example, LINK which manages the ATM system in the United Kingdom, Interac which manages the equivalent of the network. But that entity is missing in Australian payment systems. These considerations all suggest that there is an important potential role for public policy in promoting change in the payments system. While the academic literature is divided generally on the role of regulation in network industries, there seems to be support for careful regulatory intervention in industries with competing network components where sufficient standardisation or a move between standards cannot be achieved in a timely manner. There also seems to be considerable sense in having an entity with responsibility to consider the interests of the system (and society) as a whole and the power to achieve reform to that end. Indeed, the need to have a body responsible for promoting the public interest through competition and efficiency in the payments system was recognised by the Wallis Committee over a decade ago. It led directly to the establishment of the Payments System Board at the Reserve Bank and the granting of its current statutory goals and powers. The fact that the central bank fulfils this oversight role in Australia is unusual internationally - in many countries, issues of competition in, and efficiency of, payment systems fall to competition authorities. But it is nevertheless common to find structures in place in network industries to assist in promoting access and the efficient setting of standards - whether this is a body that merely assists with co-ordination or one that has powers to enforce or perhaps set standards. We see this in network industries in Australia, such as telecommunications, electricity and ports, where there is frequently some sort of public body with oversight of the network, perhaps operating in conjunction with an industry body or bodies. Of course, such bodies should not take a decision to regulate hastily. In most cases, a graduated approach to regulation in these areas is pursued, reflecting a reluctance to assume that a regulatory solution is necessarily superior, or that the government would necessarily be able to choose the best standard, particularly in a highly technical or rapidly changing field. The typical approach of network regulators is to prefer a co-operative industry approach to standard setting, to provide some suasion where this process is unsuccessful, but ultimately to set standards if necessary. Where intervention is required, the academic literature suggests that we might look first of all to ensure compatibility between competing standards - for instance, by rules governing access and interconnection between competing networks - before setting detailed standards themselves. So there is not a presumption that a black-letter regulatory solution will be adopted. In fact, at the time that the current regulatory arrangements for Australia's payment systems were established, there was an expectation that a co-regulatory model would be followed. In this view, industry would progress reform for the most part and the Reserve Bank's powers would be used only occasionally, as a last resort, where reform could not otherwise be achieved. As it has turned out, however, the Reserve Bank's powers have had to be used more often than I suspect was initially imagined. The Reserve Bank always explores ways that its statutory goals of competition and efficiency in the payments system can be achieved without resorting to its direct regulatory powers. But the history of the ATM reforms demonstrates how difficult it is for pure industry-based reform to move ahead without at least some push from a public policy body. Reflecting on that experience then, and looking to the future, the question is how best to strike the balance and to facilitate reform most effectively. There are a few possible approaches - each one more interventionist than the previous one. First, the Reserve Bank could agree targets and timelines with the industry, but without any explicit regulation or penalty for failure to meet those targets. This approach is similar to the approach that the existing industry payments body, the Australian Payments Clearing Association (APCA), takes with many of its projects. Provided agreement on the need for change can be reached (no small achievement), APCA plays a co-ordinating role in organising a project plan, providing some resources and setting timelines and targets, though in the past these projects have tended to focus on technical issues rather than strategic directions. In the absence of agreement on the need for change, however, industry-based projects - which, after all, rely on mutual agreement - tend not to proceed sufficiently quickly. That observation leads to the second option - the possibility of the Reserve Bank using overt regulation may be enough to forge agreement among industry participants. This is the path that was predominantly followed in progressing reform of the ATM system, and in a number of other reforms to the payments system. Where industry agreement on an issue was not forthcoming, the Reserve Bank has engaged the various sides to seek a solution with the clear possibility that it might regulate if agreement could not be reached. This approach was essentially behind the establishment of the Payments Council in the United Kingdom, and the development of the UK's - both of these initiatives were undertaken with the knowledge that, were something not done, there would be official intervention. While this can work, and emphasises the co-ordination role that the Reserve Bank can play in the industry, the experience with the ATM system suggests that it still may be a drawn-out process. Individual participants with a preference for the status quo have no incentive to push the plan along and so it relies on the Reserve Bank setting a timetable for agreement and implementation - a timetable that is invariably argued to be 'challenging'. A third, more intrusive, option is for the Reserve Bank to set explicit standards - what may be viewed as more traditional regulation. This is the approach that was taken when dealing with the credit card schemes, where the Reserve Bank set a number of standards dealing with the level of interchange fees and the imposition of surcharges. This approach could, however, also be used to achieve industry co-ordination around technical issues. For example, the Reserve Bank could set technical standards where the industry has been unable to agree on a common standard itself. Such an approach may yet become relevant in Australia's electronic payments system, especially where co-ordination problems are inhibiting innovation. As an example, some have suggested that the Reserve Bank could play a role in the further development of the EFTPOS system. The system was designed originally to transfer money from consumer accounts to merchant accounts. These transfers are initiated when an EFTPOS card is swiped through a merchant's terminal and the impact on the customer's account is immediate. In recent years, however, there has been demand to use the system in a different way, to send payments into consumers' accounts in real time. These demands flowed initially from the government looking to ensure benefit payments reach recipients as quickly as possible - for example, when providing emergency funds after a natural disaster. The EFTPOS system at present can accommodate these sorts of payments only in a limited way. While some participants in the industry have seen benefit in expanding the EFTPOS message format to enable such transactions, there has been limited progress. A requirement by the Reserve Bank that all participants in the industry be able to accept instructions conforming to a common message standard would facilitate access by new entrants, and thus competition. If the Reserve Bank chose to require use of an international standard, that could also facilitate more competition from overseas providers of payment-related services. A mandate from the Reserve Bank that EFTPOS message formats must be able to support credit transactions might likewise lay the foundation for innovation in the EFTPOS system based on these transactions more quickly than the industry might be able to achieve by itself. Notwithstanding its regulations with respect to card payment systems, the Reserve Bank has in the past preferred the first two of the above options. This is particularly the case with respect to issues relating to technical standards and system architecture, where the Reserve Bank has on occasion raised the issues but left the industry to drive reforms. We remain conscious of the risks that public intervention itself may be an impediment to innovation. As we have said a number of times, our hope is that the industry will deal with these issues itself. But we also know that if the industry fails to push ahead with improvements to the system, Australians will be denied the full benefits of a modern retail payments system. To a large extent, the future approach of the Payments System Board depends on the behaviour of industry participants. If industry agreement on further reforms can be reached relatively quickly, then the need for the Reserve Bank's co-ordinating role to be interventionist is limited. On the other hand, if, as on some past occasions, the industry is unable to carry forward reform and innovation by itself, the Reserve Bank would consider making more extensive use of the tools at its disposal. The economics of networks are complex, and the role of public policy is a delicate one. The aim is to ensure, as far as we can, that the correct balance is struck between the need for co-operation and the benefits of competition. Co-operation is required in order to ensure that the benefits of an extensive, and reasonably standardised, network can be enjoyed by the public, raising economic welfare. Competition is vital in the long run to make sure that costs are minimised and the incentive to respond to changing consumer preferences maximised. Policy has to recognise and fulfil its role in dealing with the externalities inherent in the set of decisions made by private market participants, while also respecting and maintaining the competitive dynamic. We recognise that the roles of the industry participants and the regulator are mutually interdependent. We trust that the industry does too. The Payments System Board is content to confine itself to encouraging industry solutions and being the occasional catalyst for agreement among the parties, where that achieves the goals the Board has been given. But it is and must be also prepared, if needed, to use regulatory powers more forcefully. In judging which approach is preferred, we will respond to the industry's behaviour, just as they respond to ours. The approach we adopt in any instance has to be tailored to the circumstances and we will ourselves on occasion need to innovate. What will be constant is the set of statutory goals given to the Payments System Board - controlling risk, and promoting competition and efficiency in the payments system. The Payments System Board is committed to those objectives and will be pragmatic, but determined, in pursuing them. We look forward to effective engagement with the industry in the process.

r090421a_BOA

australia

NO_INFO

stevens

The global economy is in recession. Virtually all of Australia's trading partners are contracting. In fact almost every country with which we would normally make comparisons is in recession, and for many of them it is a bad one. It is very rare for Australia to escape an international downturn and there is no precedent for avoiding one of this size. We, like most countries, have trade and financial linkages to the rest of the world. We are all aware of what happens abroad, and our own expectations and economic behaviour cannot but be affected by those events. Whether or not the next GDP statistic, due in early June, shows another decline, I think the reasonable person, looking at all the information available now, would come to the conclusion that the Australian economy, too, is in recession. These are periods of hardship for significant parts of the community. People lose jobs, businesses fail, loans go bad, and plans are unfulfilled. As such, they are to be avoided if possible and at least ameliorated when they occur. It is for the latter reason that most countries today have extensive social safety nets, so that when recessions do occur, we can avoid the extent of outright misery seen in episodes like the 930s. Policy-makers also seek to cushion such downturns with macroeconomic policy. They are usually more successful if they have managed to restrain the preceding boom. But no country's policy-makers have been able to eliminate the business cycle, much as they have all tried. Cyclical behaviour has always been a feature of market economies. It always will be. Should you see, at some future time, a claim to the contrary, it would be advisable to treat it with great scepticism and, indeed, as a possible indication that a cyclical turning point is in the offing. Most of the time, economic activity expands, as population growth, increasing wealth and aspirations to higher living standards lead to more demand, while a growing workforce, higher productivity and technological innovation push up supply capacity. That is the normal situation for an economy. But every so often - on average about once every seven or eight years, but not regularly enough to predict with accuracy - a set of conditions arise that see demand weaken for a while, output decline and unemployment rise. That is a recession. Usually, though not always, inflation tends to fall as a result of such episodes. Modern Australia has experienced a number of recessions - in the early 950s, the early 960s, the mid 970s, the early 980s, the early 990s, and now in 2008/09. There were also events that could reasonably be labelled brief recessions in 957 and 977. On that count, the current episode will be the eighth recession since World War II. Most of these events have been associated with international business cycles. There were significant mid-cycle slowdowns, which did not develop into recessions, in the mid 960s and very early 970s , the mid 980s, the mid 990s and 2000/0. In each of these periods, output slowed or even fell very briefly, the rate of unemployment stopped falling and/or rose, and inflation moderated. The 2000/0 episode was notable in that it coincided with a downturn in the major countries. It was very unusual for Australia not to have a recession in such circumstances, though as it was, the rate of unemployment rose by about a percentage point in the space of a year. One aspect that helped us on that occasion was that the downturn in many of the major countries was not an especially deep one. Another was the continuing strength in some other key trading partners, not least China. This time, the state of the global economy is much worse. The extent of that weakness was unexpected. Until the financial crisis escalated so dramatically last September, it appeared that some of the major countries would have downturns, but that the emerging world, including Asia, would not slow as much as on some other occasions. Although affected by weaker demand from the industrialised world, many of these countries appeared largely to be free both of the financial problems in the major countries and of the sorts of problems they themselves had experienced in past episodes. The growth of China seemed to be on a strong medium-term path, albeit with a cycle like every other economy. This was not 'de-coupling', simply the assessment that the net of competing forces would produce a significant slowdown, but not a slump. Hence, global growth was generally expected to slow to below average, after several years in which it had been unsustainably high. Then, things took a serious turn for the worse. The financial turmoil following the Lehman collapse was the most intense in generations. It was contained within about six weeks, and indeed over the past few months conditions have been gradually improving in financial markets, in several respects. But we are now seeing the fallout in the rest of the economy from that financial turmoil. The weakened ability of the financial institutions to provide credit to industry is one of the factors at work, but in my judgment a bigger one is the decline in confidence, and the sudden and widespread aversion to risk, among firms and households all over the world. It seems that everyone, everywhere, having seen the instability in financial systems in September and October 2008, and consequently feeling poorer and fearing bad times ahead, simultaneously decided to pull back their own spending, curtail their expansion plans and reduce their debt. It was, of course, entirely rational, at the individual level, for firms and households to behave in a more precautionary way. But the collective sum of those decisions created, over the ensuing six months, an international slump in demand for consumer durables and investment goods that was sharper, and more synchronised, than any seen for decades. The result is that the world's gross product is now thought likely to decline in 2009, the first time that has happened for many decades. Australians shared in this more cautious behaviour, particularly in the business world. A range of business surveys indicate that a trend moderation in business confidence that had been occurring for some months turned abruptly much weaker in October, and remained household confidence surveys has not been as weak, as I shall come to later.) While official data are yet to show it, it is likely that business investment spending is in the process of declining sharply. Hiring intentions have been scaled back quickly. Residential investment and exports have fallen. The net result is that the economy has been contracting, though on the best information we have, not at the pace seen in a number of other countries, where quarterly declines in real GDP of 3, 4 or even 5 per cent have been observed in the last quarter of 2008 and are likely to have occurred in the first quarter of 2009. A key dimension through which Australia experiences the global business cycle is the terms of trade, a gauge of the income gains or losses that international relative price changes impart to Australia. Over the five years to 2008, a period of exceptional strength in the global economy, the terms of trade rose by about 60 per cent, equivalent to about 2 per cent of a year's GDP - about $40 billion - in additional annual income. It was the biggest such gain in half a century. Now, the terms of trade are falling, reversing part, though so far only part, of that earlier gain. I would like to make two points, however, about those terms of trade swings. The first is that, in earlier episodes such as in the early 950s, and the mid and late 970s, very large terms of trade movements seriously destabilised the economy. On this occasion, there have been plenty of adjustment challenges - generally coming under the heading of the so-called 'twospeed economy', where the resource-intensive regions and industries grew quickly and others slowed. But for all that, a floating exchange rate, a much more flexible labour market and better macroeconomic policy frameworks have helped the economy adapt to the terms of trade swings without the degree of instability seen in the past. That is a testament to the arrangements that are now in place. The second point is that, at this stage, the fall in the terms of trade that is occurring does not seem to be reversing all of the previous rise. Even with the large falls in prospect for contract prices for bulk commodities, Australia's terms of trade look like they could, at the end of this year, still be about 40 per cent higher than the average for the period from 980 to 2000. Perhaps that will not persist. Alternatively, perhaps what commodities markets are telling us is that some factors beneficial to Australia - foremost the continued likely emergence of China - remain in place. It is probably not entirely coincidental that the clearest signs of a turning point in economic activity appear to be accumulating in China, though not exclusively there. That is a quick description of where we are, and some of the background of how we got here. I will not speak here of the broader background of the financial excesses that helped to create the situation, because that has been covered in detail before. Instead, I want to devote some attention to the question: how do we get on the road to recovery? History shows that recessions come, but also that they end. Can we speed that process? And to the extent that we have some capacity to shape the next expansion, how might we use it? Since this is essentially an international episode, and not really an Australia-specific one, much depends on what happens abroad. This neither means we are helpless to affect our own future, nor absolves us of the responsibility to pursue sensible policies to promote recovery here. I shall come to that, but first, a few words about the conditions for a durable global recovery. I take it as given that we all agree that a better financial regulatory architecture is needed and there is a lot of work under way on that. But that is about avoiding a repeat crisis. What about steps to get out of this one? There are several necessary elements. The first, as many have said, is to sort out the mess in the financial system, especially in the United States, the United Kingdom and Europe. It is not an easy problem to solve. But quite a lot is known from previous episodes, including in the United States itself, of the main principles that must be observed in this process. The first step is an honest accounting of the situation. Then, the 'legacy' assets have to be quarantined so that the potential for further erosion of their quality, and uncertainty over their value, does not lead to further loss of bank capital and associated confidence problems. The relevant institutions must then be recapitalised if need be, so that, freed of the problem loans, they can resume normal commercial activity - lending for sound proposals. It may be that, appropriately cleaned up, banks can attract new private capital. If not, then public funds have to be made available to recapitalise them where needed. Everyone understands these principles. The question is how to implement them. There are a few ways to go about it, all of which are on the table at present. One is to hive off the problem assets into a 'bad bank' or some other like vehicle, which is then managed and gradually wound down. The assets have to be transferred at some price, and the process of striking that price has to protect the interests of taxpayers, who should not over-pay for the bad assets and thereby give a windfall to shareholders. At the same time, there has to be pressure on the institutions concerned actually to get on with the clean-up, as opposed to just waiting for something to turn up. The plan being implemented in the United States is designed to induce private capital to take part in the asset management vehicles, which helps to sort out the pricing question. Another approach is to leave the assets on the banks' balance sheets, but have the government insure them, for a price, to limit further downside. This is the essence of the UK approach. Yet another approach is to nationalise the relevant institutions, which obviates any pricing issues for the assets per se and automatically provides enough capital, but introduces new questions in dealing with shareholders. This approach is the traditional one, though it has mostly been used in smaller countries or, where used in major countries, for smaller institutions. The economics of all these approaches is essentially the same: recognising losses that have occurred, reducing the riskiness of bank balance sheets and finding new capital to restart the credit process. Which technique to choose is a matter of judgment. The politics may be harder than the economics. Ordinary people resent, not surprisingly, taxpayer funds being used to fix problems that arose, in part at least, because of seriously misaligned incentives that rewarded financiers for taking too much risk. But it has to be done, otherwise economies will suffer for longer. The political leaderships of the United States, the United Kingdom and some other countries have the unenviable task of persuading their citizens to accept the need for these initiatives. A second near-term condition for recovery is macroeconomic support for aggregate demand, in an environment in which private spending has weakened sharply, owing to loss of confidence and strained credit markets. That is coming into place as a result of easier monetary policy, and easier fiscal policy also in many countries. Internationally, the role of fiscal policy is more prominent on this occasion than has been the case for many years, since the impaired credit system makes monetary policy less effective than it would normally be in many countries. The reason official interest rates are approaching zero in a growing list of countries is not because central banks think it is a good idea to make credit available for free. It is because the flowthrough from official rates to the rates that matter most in these economies - those paid by businesses and households - has not been working very well. Third, with these near-term policy requirements - repairing the financial system and macroeconomic stimulus - come associated medium-term requirements, which fall under the heading of 'exit strategies'. For those countries where governments end up owning part or all of banks, there will need to be a plan to divest that holding when conditions improve. The same can be said of the various guarantees under which banks globally are raising money at present. This was an important step to help the system through a period of severe dislocation, but it is surely not desirable as a permanent state of affairs. At some point, it will be prudent to start weaning banks, or more to the point investors, off those guarantees. Perhaps co-ordinating such a departure across countries would be a useful role for the Financial Stability Board. The other international exit strategy needed will be on macroeconomic policies. The size of the downturn, the extent of fiscal stimulus and the cost of the financial restructuring packages have placed a very large burden on government finances in a number of countries. I am not arguing against the measures. But they will need to be accompanied by a credible story about how governments will keep their own finances on a sustainable footing over time. Taxpayers, markets and creditors will lose, rather than gain, confidence if they cannot see that path back to sustainability. And, at this point, confidence is what it is all about. The same issues will arise for the exceptional monetary policy measures. The fourth condition for a durable new international expansion is to avoid perpetuating the so-called 'global imbalances'. The excess of saving over investment in the emerging world, especially Asia, was one part of the story of how the search for yield led to excessive risk-taking. This is not to blame Asia for the crisis, but simply to state the obvious: that for people to misuse abundant capital as they did, there has to be a fair bit of it around to begin with. As it has turned out, there was more of it than the United States and some other developed countries were able to use wisely. So to the extent that strong global growth relied on advanced country consumers lowering their saving rates, absorbing the export surpluses of the emerging world, and accepting higher debt burdens, the model is broken. Of course, the most important matter in the immediate term is for the US economy to resume growth. But even when it does, the reality is that for some time ahead, advanced country households will be looking to lower their debt burdens and save more of their income. They will not be the same spur to consumption growth as they were. This will mean that global growth will be, for a while at least, lower on average than we saw for most of the past decade. How much lower will depend in part on the extent to which the economies in the emerging world are able to foster more demand at home. For them to feel safe in doing that, and perhaps to return to their traditional position as capital importers, there will be other conditions - not least confidence on their part that the rules of international engagement are not just skewed to the advantage of the advanced countries. In the end, though, durable growth will have to be more balanced than the growth we had over the past decade. To the above, I should add that maintaining openness to trade and capital flows is critical - lest the mistakes of the 930s be repeated. This should hardly need saying, yet times of serious recession are often times when protectionist sentiments grow stronger. That is all I have to say today on the global conditions for recovery. Turning closer to home, Australians cannot do a great deal to make these improved international conditions come to pass. But we can maximise our chances of benefiting from a new international expansion. The first thing is to maintain some confidence in ourselves and the prospects for our country over time. We cannot achieve effortless prosperity either on the back of ever-escalating mineral prices or simply by bidding up the prices of our houses. It is as well to realise that. But as I have said on previous occasions, Australia's genuine long-term economic prospects remain good, and there remain good grounds to think that we will continue to weather the storm better than most. It is noteworthy that in measures of confidence taken from surveys, household confidence has fallen in Australia relative to the ebullient levels of a year ago, but it remains much more resilient to date than comparable results in major countries (Graph 2). While households expect unemployment to be much higher in a year's time, their stated expectations about economic conditions five years from now have barely diminished at all from what we have seen consistently over a number of years (Graph 3). So notwithstanding their evident caution at present, people remain essentially optimistic about the long term. Consumer demand in Australia, while weak compared with recent years, is actually at the stronger end of international comparisons among advanced countries. This presumably owes something to the stimulatory effects of fiscal measures and lower interest rates for borrowers (though savers are feeling the pinch). But perhaps it also shows the inherently optimistic view Australians take in the future. Optimism, combined with an awareness of risk, is a fundamental strength. It is to be hoped that this will be matched by a recovery in business confidence over the months ahead. That remains to be seen, though there have been some encouraging signs recently. What can policy-makers do to help? Unfortunately, there is no lever marked 'confidence' that policy-makers can take hold of. Our task is very much one of seeking to behave, across the board, in ways that will foster, rather than erode, confidence. Over the past six months, that has, of course, involved the rapid deployment of both fiscal and monetary measures, to support demand. The effects of those measures will still be coming through for some time yet. Measures to sustain confidence in the financial sector and to keep key markets functioning were also important. Perhaps there is also some value in articulating a view of where we want to get to when the cyclical downturn ends, as it will, and recovery takes hold. What sort of country does Australia want to be, economically, during the next expansion? How do we want to be positioned in the global marketplace for capital, in an environment in which markets will have absorbed a lot of government debt and will be evaluating opportunities for other uses of capital? I suggest that Australia has a very good chance of offering an economic setting in which the following conditions hold. First, political stability remains assured - something becoming a bit less common. Second, the Government does not own, and has not had to give direct financial support to, the banking system. Australia will be free of the difficult governance and exit strategy issues that such support is raising in a number of countries. Third, public finances remain in very sound shape, with modest debt levels and a medium- term path for the budget back towards balance. Without the massive obligations arising from bank rescues that will inevitably narrow the options available to governments in other countries, Australia should be able to articulate such a path more effectively than most. Fourth, sensible policy frameworks - both macroeconomic and microeconomic - remain in place; the financial regulatory system is strong and tested. Fifth, we remain open for trade and investment, and have a capacity to deploy both our own and other people's capital carefully and profitably. Finally, there is an exposure to, and an engagement with, an Asian region that still has the most dynamic growth potential in the world, where hundreds of millions of people will for decades to come be seeking rising living standards. There are rather few countries that have the potential to offer so attractive a proposition to international capital, and to their own citizens, over the years ahead. It is a proposition that, if pursued sensibly and consistently, offers the most secure basis for confidence in Australia's future. It is such confidence that, more than anything else, will help to drive us along the road to recovery.

r090519a_BOA

australia

NO_INFO

stevens

Thank you for the invitation to be here. As a one-time temporary resident of Canada and graduate of a Canadian university, it is pleasing for me to see the Canadian Australian Chamber of Commerce contributing to economic interaction between the two countries. It is surprising that Australians and Canadians do not spend more time comparing notes, given the things we have in common. Apart from a shared heritage as members of the British Commonwealth (though Canada, of course, has the French-speaking heritage as well), we are both federal states and constitutional monarchies. Both nations have relatively small populations that occupy physically large continents. We are both commodities producers. Our economies are open, and free flows of trade and capital are very important to us. There are some interesting similarities, and the occasional informative difference, in experiences, and examining these is helpful for Australians to understand better the way the past six or seven years have evolved. I propose to look at some of those today. Looking to the future, both our countries have reason to believe that we will come through this episode in reasonable shape. We also have important shared interests in the way the international economic and financial system evolves over the years ahead. In canvassing some of these issues, I am mindful that David Dodge, the former Governor of the Bank of Canada, spoke to this group only a few years ago, concerning many of the same questions. I find myself agreeing with the sentiments he expressed then, and repeating many of them today. Australia and Canada have similar levels of GDP per capita (based on purchasing power parity, in 008). Since 1990, Australia's growth in real GDP per capita has been a little higher than Canada's. In terms of economic structure, the primary production sectors, combined, are of similar size in the two countries (Table 1). Australia has less manufacturing, but more mining than Canada. There are also some notable differences in the composition of our mining sectors. Both these turn out to have been of some importance over recent years, as I shall point out shortly. But, overall, the economic structures of the two countries at a very broad level are reasonably similar and, beyond the resource sector concentration, not all that different from the 'norm' among industrialised economies. Agriculture, forestry and fishing total of above Finance, property and business services Health, education and community services Wholesale and retail trade total of above Utilities and transport Government administration and defence Communication services Trade and financial flows between Australia and Canada are small - Canada accounted for around 1 per cent of Australia's merchandise exports and imports in 008, and around 1 per cent of foreign investment received by Australia. But trade overall is very important to Australia, and even more so to Canada. Exports of goods and services amounted to just under a quarter of Australian GDP in 008 and more than a third of Canadian GDP. Commodities make up a significant share of the value of merchandise exports in both countries, although they are rather more important to Australia, as Canada also has sizeable exports of machinery, equipment and cars (Table ). The composition of the two countries' commodity exports differs somewhat - Canada's exports include a larger share of crude oil, natural gas and forestry products, while Australia has a larger share of exports in coal, iron ore and many metals. Crude oil Natural gas Iron, iron ore and steel Precious metals subtotal Agricultural and fishing products subtotal Machinery and equipment subtotal total Commodity prices tend to vary quite a bit, of course, driven largely by the ebb and flow of the world business cycle. This means that fluctuations in the terms of trade have long been an important feature of both countries' economic experiences. For many years, the movements seemed to be quite similar - at least until the international downturn of 001 (Graph 1). the subsequent global upswing, while both countries saw their terms of trade increase, Australia's terms of trade began to pull ahead of Canada's. Between the beginning of 00 and the middle of last year, the Canadian terms of trade had risen by more than 0 per cent. But over the same period, the Australian terms of trade rose by over 60 per cent. is that the more rapid rise for Australia reflected the fact that our exports have a higher share of commodities, and within that, a higher weighting towards the commodities that had experienced the largest price increases (Table ). That said, since Canada's trade share of the economy is considerably larger than Australia's, the smaller size of the terms of trade rise in Canada still imparted a pretty significant boost to national income. Year average rBA index of Commodity prices Income gains driven by the terms of trade are generally expansionary. The boost would be expected, other things equal, to result in stronger growth in demand and output relative to capacity, more risk of inflation, higher interest rates and a rise in the exchange rate, relative to countries that did not share the shock. So it seemed to turn out. In the phase of the terms of trade upswing, both our countries saw growth above average, interest and exchange rates rising and some upward pressure on inflation. There were, nonetheless, some differences. The Australian dollar did not rise as much as the Canadian dollar, which is a bit surprising given Australia's greater rise in the terms of trade. Australia also saw somewhat higher growth in demand on average during the 00 to 008 period than Canada. Associated with those trends was a more pronounced rise in inflation at the end of the upswing, which saw us deviate further from our inflation target than Canada That said, Australia coped with the terms of trade upswing better this time than in some past episodes. An inflation peak at around 5 per cent in 008 compares to around 5 per cent in the commodities boom of the early 1950s and 18 per cent during the boom in the mid 1970s contributed to this improvement - including the floating exchange rate, more flexible labour market and stronger monetary policy framework. More recently, the impetus from the global economy has reversed direction for both countries as a result of the global recession. Canadians would have sensed the change first, reflecting Canada's very close ties with the United States - which absorbs around three-quarters of Canada's merchandise exports, equivalent to around a quarter of its GDP. The economic weakness in the United States began to take root as problems in its housing sector and financial system emerged in 007, reducing demand for Canadian exports and weighing on growth, even with the booming terms of trade. In Australia's case, exports are not as large a share of the economy, as noted, and the destinations are both more diverse and more oriented to Asia (China and Korea account for more than a fifth of the value of Australian merchandise exports, and Japan accounts for another relatively little affected by the problems in the major economies. It was really only in the second half of 008, as the financial turmoil led to a sharp drop in confidence among households and firms around the world, that a reassessment about Asia's prospects began. Even then, Australia's export volumes have not weakened to date as much as those of many other One reason is that the slump in global trade was initially concentrated heavily in manufactures, which is a smaller share of exports for Australia than others. Another is the stronger linkage of key commodity exports to China, which appears to have seen a pick-up in growth this year. Chinese industrial output fell for four months between July and November, but has since recovered all those losses. A similar pattern has been seen in Korea, where industrial output suffered a sharp decline around year-end but apparently made up about half of that over February and March. Looking ahead, with commodity prices at present levels, Canada's terms of trade look like they are still somewhat above the average for the preceding couple of decades. Australian resource producers have accepted lower prices for the year ahead, and this is likely to contribute to a decline in the terms of trade by the end of 009 of about 5 per cent from the peak, as shown in the chart. Yet even with that, at this stage Australia's terms of trade over the coming year look like they will still be around 40 per cent above the two-decade average up to 000. So in some important respects, not only did the economic upswing that ended during 008 provide a bit more impetus to Australia than Canada, but the ensuing global economic downturn has not, to date at least, hit Australia as hard as it has Canada. On a comparison of these two countries, the effects of export volume losses in slowing overall demand in the economy have been less important in Australia. As for inflation, it has moderated. The headline figures overstate the fall in inflation in both countries because of the decline in petrol prices, but measures of core or underlying inflation are trending lower. Of course in Australia, inflation has further to fall than in Canada, since it reached a higher peak. One important feature that our two countries share at present is the relative resilience of our banking sectors. Notwithstanding the global credit crisis, Canadian and Australian banks continue to be profitable and are well capitalised by private investors - something that many advanced countries cannot claim. For the 008 reporting period, the return on equity for the five largest Australian banks was 17 per cent, and it was 14 1/2 per cent for Canada's major banks. This was lower than in the preceding few years, which had been ones of exceptional profits for banks around the world - and years during which, in retrospect, risk was increasing - but still very solid. It is noteworthy that equity market valuations of the two banking systems display more confidence in asset quality and potential future earnings than for US, European or UK banks, as judged by the market premium over book value The solid performance of these banks reflects a number of factors. Firstly, holdings of the complex securities at the centre of the crisis were modest by international standards. Secondly, banks in Australia and Canada had more conservative lending practices in their home markets than their counterparts in the United States and the United Kingdom. While subprime mortgages accounted for around 1 per cent of the US mortgage market in mid 007, the closest equivalents in Australia and Canada accounted for around 1 per cent and less than 5 per cent of their mortgage markets, respectively. countries have had regional booms in housing markets in the past few years, associated with the run-up in commodity prices and the associated effects of the shift in productive resources to those industries and regions that were enjoying the boom. Hence, house prices in Alberta and in Western Australia had a large run-up compared with most other regions in the respective countries prices generally have tended to soften. In Australia's case, the ratio of the median dwelling price to average household income has declined quite noticeably since 00, without a very large absolute This is evidence for at least the possibility that these adjustments can take place over reasonably lengthy periods and without being terribly disruptive to the economy. Of course, with the economy contracting at present, banks in both countries are seeing some pickup in mortgage arrears. Overall, though, Australian and Canadian households appear tobe having much less trouble servicing their debt than is the case in the United States and the United Kingdom, as shown by their relatively low rates of non-performing housing loans lending decisions in earlier years. Of course, good domestic policies can do only so much to ameliorate the impacts of very adverse international developments. Both economies have slipped into recession as international forces have taken hold, albeit through differing chains of causation. But for the reasons articulated above, there are good grounds to think that both countries should be in a relatively good position and well placed to take part in a renewed international expansion. It is too soon to say this is beginning yet, though developments over recent months are certainly consistent with the view that a recovery will get under way towards the end of the year. That said, most observers think that the early part of any new global expansion will be characterised by pretty slow growth. Even with the uncertainty over the near-term global outlook, however, it makes sense to look forward. So in the final part of this address, I should like to talk about the common interests we have at stake in the way the international community responds to the crisis and shapes the next expansion. First among these is the openness of trade and capital flows. The extent to which trade flows slumped late last year perhaps gives a sense of what could happen were trade barriers to go up. Everyone would suffer, and badly. This is fully understood at an intellectual level around the world. Yet we know that in times of domestic economic difficulty, the pressures for protectionism increase. Countries like ours need to keep making the point that trade is not a zero-sum game; it is collectively a positive-sum process that stimulates innovation and productivity, increases global growth and raises living standards. Secondly, the continued development of many emerging economies will enrich the opportunities for firms and individuals in economies like ours over time. But it will be sensible for emerging countries to have strategies that rely less on the absorption of consumer products by the developed world, at least for some years. That will involve, roughly speaking, more consumption and investment at home, lower trade surpluses and a step back from very large outflows of capital to the developed world. This is actually a rational choice for emerging market countries. But a lesson many countries took from the Asian crisis was that a strategy such as that was dangerous, because the rules of international engagement did not provide adequate protection in times of difficulty. Their response was the build-up of reserve assets in the period since 1998 - a costly form of international self-insurance, involving sending hard-saved capital from developing economies to the rich world. It was very much a second-best option but was pursued because first-best seemed unachievable. So it is in the interests of many developing countries to alter their growth strategy, but to do so they need confidence in the international system - its rules, governance, safety nets and so on. At the same time, the countries that have dominated the governance arrangements hitherto, and which will have to accommodate the emerging countries, will want to have some confidence that we are all - emerging markets and developed countries alike - reading from the same page about the role and responsibilities of the international financial institutions and their member states. Australia and Canada have a shared interest in fostering progress on these fronts, which will involve encouraging both emerging countries and highly developed countries to move in ways that accommodate each other. I know my Canadian counterparts have worked assiduously on these issues for many years. We support those efforts. Thirdly, much work is being done on the lessons we can learn from this episode for financial regulation and structure. As countries whose financial and regulatory systems have performed pretty well in this episode, and which are largely free of serious problems, Australia and Canada are perhaps uniquely placed to contribute to the discussion. I think we could hope to bring a sense of emotional detachment, balance and perspective to the international discussions on regulatory reform, which can be quite heated at times. The 'great white north' and the 'great south land' have much in common, as well as some very informative differences. Sound policy frameworks and robust business sectors are being tested at present, but they can meet the test. We both certainly have, at this juncture, much at stake in the global economy recovering to a path of balanced growth, with open markets and sustainable policy settings. There is plenty we can do together to promote our common interests in the world, as well as our own interaction. Part of this sharing of ideas and co-operation will be spurred on by forums such as this one. I wish you every success.

r090604a_BOA

australia

NO_INFO

stevens

Thank you to James Cook University for organising this occasion and for the invitation to take part. Townsville and the surrounding region boast a significant set of industries. Townsville provides a port and refining capacity for important parts of the mining sector. It is an export point for the live cattle industry, sugar and a range of other rural industries. For the tourist industry, it is an access point to the Great Barrier Reef and home to research into the marine environment. It is the base for an important part of Australia's defence capability. Of course, the University is also a strong centre for higher education. A number of the University's graduates in economics have become prominent in the world of finance and business. So it is a pleasure to be here, to talk about how economic conditions are unfolding, including in countries and industries in which this region has more than a passing interest. About a month ago, the Reserve Bank released its May . I want to give an update on that material, though developments have not caused us greatly to change our views. I will start with the international economy. The current global recession is being widely referred to as the most significant of the post-War period. There is, by now, little debate about that description. It is not necessarily the case, however, that it will be the biggest recession for all individual economies. It will be for many, but quite a few have seen larger recessions at some point in the previous six decades than they appear to be experiencing now. For some countries in Asia and Latin America, other episodes, with other causes, were more damaging than what has been observed, at least so far, this time. I do not think it will be the biggest recession of the post-War period in Australia either, though of course we will not know for sure for a while yet. Rather, it is the exceptional synchronicity of the international downturn that has been so remarkable. It is well known, of course, that the financial crisis had its genesis in lax lending in some of the major economies, and cheap credit generally, earlier in this decade. This has been well covered before, so I will not go over it today. Rather, I would like to focus on the sharp deterioration in global demand for goods and services that occurred late in 2008 and early this year. There are some important features of this event that help us to understand both our own experiences in Australia and those of other countries. Historians will study this episode for years to come. They may find additional nuances, but one very clear trigger for the sharp collapse in demand was the heightening of stress in financial markets. A sequence of extraordinary events occurred in September and October last year. These the US Government taking over the two largest housing finance entities; the bankruptcy of one of the four remaining large US investment banks, which people had presumed was 'too big to fail'; the US Government taking over one of the world's largest insurance companies; and in short order, pressure on systemically important institutions across the United States and Europe. Combined, this previously almost-unthinkable sequence resulted in a sharp increase in perceived systemic risk in financial markets and systems everywhere. Stock prices fell sharply around the world. Risk spreads on all sorts of debt instruments blew out, and capital markets for issuing (or rolling over) debt and equity essentially closed. It was the most turbulent period in international finance any current banker, economist, market trader or policy-maker has lived through or, we hope, ever will. Unlike most previous financial crises, moreover, the news about this set of events reached people all over the world very quickly. They did not learn about it the way they once might have: sequentially, with varying lags, via delayed print media, word of mouth, high-brow publications and so on. Instead, they learned about it simultaneously, via the 24-hour news cycle, in every country, more or less in real time. Not surprisingly, people everywhere suddenly became much more fearful of the future. In the face of this acute uncertainty, firms and households across the world did what you would expect. They acted in a precautionary way. They postponed discretionary purchases, shelved expansion plans and did what they could to consolidate their balance sheets. result was a highly synchronised slump in demand especially for consumer durables and investment goods. Production and consumption of more 'everyday' non-durable goods and services did fall, but by much less than for those products that could easily be purchased tomorrow rather than The nature of this slump helps us to understand both the relative performance of various national economies and the subsequent behaviour of production generally. It has become much clearer over the past month or two, for example, that the countries hardest hit have been those that are most involved in the production and export of these the major economies, Japan and Germany have seen the biggest falls in output. Among emerging market countries, some of the biggest contractions were among the Asian nations that are an integral part of the production chain for consumer durables. If the fall in global demand in late 2008 was rapid, the cut in production was even more aggressive as firms sought to reduce inventories. In many countries, these had tended to rise a little going into the crisis. As demand fell away, firms were faced with further increases in stocks of unsold items, at a time when the cost of funding them was moving up. Hence, they sought to get inventories down quickly as part of their strategy of surviving the downturn. To achieve a reduction in inventories, firms must cut production by more than demand, so that the level of production falls below the level of demand for a time. This is indeed what seems to have occurred in many cases. Once inventories are back under control, production will rise, back up to the level of demand. This is what we seem to be seeing now in some countries, particularly around Asia. Industrial production has risen quite sharply over the past few months, and in some cases has retraced a good deal of the earlier fall. The clearest signs of growth are in China, where our estimates are that industrial production had recovered all the losses by March. China does not publish quarterly GDP growth rates, but our best estimates are that the March quarter growth rate picked up relative to the weak outcome in the December quarter. The improvement in conditions in other emerging economies in Asia may be partly related to the pick-up in China. Quite a marked bounce in industrial output has occurred in Korea and Taiwan, and a similar pattern looks to be emerging in several other countries in the region. Even Japan's production now seems to be rising, though from extremely weak levels. Across the leading industrial economies, the best we can say at present is that while the contraction in overall output in the March quarter was broadly similar to that in the December quarter, recent data suggest that the rate of contraction in the June quarter will be significantly smaller. Now while the initial pick-up in output is coming from this inventory cycle running its course, that only lifts production to the level of demand, which remains lower than it was before. An ongoing rise in output will depend on demand starting to increase. Again, the clearest indication of stronger demand is in some of the emerging economies, particularly China. The improvement in China's growth does not seem to be coming from Chinese exports to the developed world, but from stronger demand at home. The reversal of earlier restrictive policies designed to slow the Chinese economy because of inflation concerns, together with a government spending package that by any standards has been very large, have both contributed. To date, the recovery has been led by increased spending on infrastructure. What is not yet clear is the extent to which Chinese private-sector demand is accelerating. A pick-up in China is relatively beneficial to Australia, as I will discuss in a moment. For the world economy, it will also be beneficial if the emerging world relies more on domestic demand for growth than it has in the past decade. A durable expansion will be one that is more balanced than the last one. That said, prospects for demand in the developed world obviously remain very important because of the still very large size of those economies. Most observers expect that demand in the United States and Europe (including the United Kingdom) will be quite subdued for a few years. One might, of course, ask whether the striking speed and simultaneity of the downturn could be seen again in the upswing. The reason people think such an outcome is unlikely is that the loss of wealth during 2008 and the need for private-sector balance sheets to be deleveraged are thought likely to constrain both household demand and the ability of the banking sector to expand credit, for some time. This is a reasonable reading of the history of most financial crises, and underpins the consensus forecast that global growth, when it resumes, will be pretty modest initially. Yet the speed and size of the responses to the downturn by policy-makers around the world is just as unprecedented as the speed and size of the downturn itself. If there were an upside surprise on global growth, it would most likely be because the collective effects of all those policy responses turned out to be bigger than expected, perhaps because those expectations were formed by looking at a history where such simultaneous responses rarely occurred. Having said that, the size of the build-up in government debt in some of the major economies will surely become much more of a constraint on their fiscal room for manoeuvre over the next decade. Let me be clear that i am not talking about australia here ; rather, I have in mind countries where public debt could approach 100 per cent of annual GDP over the next few years. It is not that these magnitudes are completely unmanageable, but they will constrain choices to an extent these countries have not been accustomed to for a long time. For example, their capacity to cushion the impact of another downturn, were one to occur in six or seven years' time, would be limited. The developments in the world economy over the past year have had a significant effect on our economy. One key channel has been the impact on commodity markets, where prices fell sharply in the second half of last year. It has been apparent for some time from developments in markets for coal and iron ore that there would be large downward adjustments to the contract prices for those commodities when they were renegotiated this year. Those falls have now largely been realised, broadly in line with what was expected. Compared with last year, there will be a lot less revenue coming in. But it is important to remember that commodity prices remain high by historical standards. Even with falls of 45-60 per cent for coal and around 35 per cent for iron ore, the 2009/10 prices are the second highest on record in US dollar terms. Five or six years ago, these sorts of prices would have seemed extraordinary. As the outlook for resources demand becomes clearer, and the uncertainty in financial markets continues to lift, it would not be surprising if plans for new mining projects that are being deferred at present were re-activated at some point, though this, even if it occurred, would presumably take some time to flow through into actual spending. The volume of Australian exports, moreover, has so far held up remarkably well, especially compared with those of some other countries (Table 1). Even people who were relatively optimistic, as I was, have been a bit surprised by this strength. december quarter 2008 march quarter 2009 Six months to march quarter - - - - australia - Excluding rural exports Part of the relative strength may reflect supply-side factors: a larger wheat crop in 2008 and the commencement of operation of an additional LNG compression train have both added to supply. There are, however, some particularly interesting developments in the pattern of demand for coal and iron ore. A large proportion of Australian iron ore goes to China and very little goes to Europe. Chinese demand has actually increased as infrastructure spending has picked up, whereas in Europe demand has fallen sharply. In the coal market, Australia's exports have traditionally gone to Japan, Korea and Taiwan, where demand has softened. But increased demand in China (which traditionally imported very little coal) has partly offset the falls elsewhere. Indeed, in the past year, China's share of Australia's merchandise exports has risen sharply, and is approaching increased demand from China can be explained by the constructionintensive activity taking place there, and part by reduced Chinese production of iron ore and coal, as the fall in prices has seen some of the high-cost mines in China being closed. For both iron ore and coal, Australian companies are among the lowest-cost producers and so gain when higher-cost firms exit the scene. Factors such as this have kept Australian exports doing relatively well so far, and would seem to offer significant long-term opportunities, including for this region. The Australian economy has, nonetheless, been affected by the global recession, with real GDP, on the latest estimates, posting a small net decline over the past couple of quarters. The major driver of the slowdown has been weaker private domestic demand, most prominently a sharp decline in business investment spending, with a fall-off in housing construction. The fall in investment is best seen as the same understandable precautionary behaviour by Australian businesses as displayed by their counterparts around the world. A decline in business investment spending of about 8 to 10 per cent in the December quarter seems to have been a pretty standard result around the world. Macroeconomic policies have not been able to prevent an economic downturn. They rarely can, especially in the face of a global recession of this magnitude. Indeed, attempts to do so have as often as not run into trouble by stoking up bigger problems a few years down the track. But it is reasonable to think that policies can have the effect of making the downturn shallower than would otherwise have been the case, and that they can help to establish conditions conducive to recovery. The scope to implement such policy changes has to be earned during the expansion phase of the cycle. But Australia did earn that scope, and has been prepared to use it during the last six months. The Bank made a number of changes to its operations in financial markets to help keep them functioning through the worst of the crisis. Measures the Government took in this sphere were also important for confidence and access to funding. The Board also moved quickly to ease monetary policy after the events of mid September, with interest rates being reduced significantly. At 3 per cent, the overnight rate is at the lowest level seen since the early 1960s. This has fed through into significant declines in the rates paid by borrowers, especially, but not only, households. The debt-servicing costs of households have fallen faster and further than in previous cyclical episodes. The Board has not felt the need to cut our policy rate to the very low levels - effectively zero - seen in some other countries. There are two reasons. The first is that the situation we face is not as dire. The second is that the reduction in interest rates we have implemented has had a more direct effect on borrowers than in many other countries. The combined impact of the easing of fiscal and monetary policy is likely to be substantial. Quantification of the effects is very much a matter of informed judgment. The fact that Australia is experiencing, so far, a smaller downturn than most countries reflects in part the relatively smaller extent of the sort of financial excesses that have been the problem in some other countries, as well as the good fortune of our position in relation to China. But significant macroeconomic policy responses will have also played a role. Fiscal initiatives were not only sizeable by global standards, but implemented quickly. The impact of monetary policy easing in terms of reducing debt-servicing burdens for borrowers has been greater than in the major northern hemisphere countries. The relevant question now is: what are the prospects for a durable expansion? It is likely that activity has remained subdued in the June quarter. The rapid decline in business investment is almost certainly continuing. While consumer spending has held up quite well so far, it may be weaker over the next few months, as the one-off government payments pass and rising unemployment starts to weigh on incomes and willingness to spend. On the other hand, we are likely to see significant growth in public spending over the year ahead, reflecting fiscal policy decisions. Moreover, while it will be a while yet before the effects of lower interest rates and the boost to grants to first-home buyers are seen in data on construction work done, the pick-up in borrowing for housing that we have been seeing for about six months is what would be expected if an upturn in residential investment spending is to begin later in the year. Overall, then, our expectation remains that the economy will be well placed for expansion towards the end of this year. Initially it will be fairly gradual, in part because of the global factors to which I referred earlier. If so, the degree of spare capacity in the economy will tend to be increasing for a while, and inflation will most likely continue to decline for some time. That in turn means, as the statement following this week's Board meeting indicated, that some scope remains to ease monetary policy further, if that were to be helpful to securing a durable upswing. The emphasis on 'durable' is important. It is the intention of current monetary policy settings to lower debt-servicing costs, assist efforts to reduce leverage and support demand. It would be counterproductive, though, if further reductions in interest rates induced a large number of marginal borrowers into debts they could service only at unusually low interest rates. This is a reason for care, both by the Reserve Bank and private lenders, and I note that lenders are being a bit more conservative on non-price loan conditions for households. Picking cyclical turning points is notoriously hard - even in hindsight, let alone ahead of time. But I think Australia is as well positioned as any country, and better than most, to enjoy a new expansion. Longer term, there also is plenty to be positive about. There are good grounds to think that we can emerge from the current global recession with our economy largely free of the problems in the financial sector, the stresses on public finances and the general disillusionment facing a number of other economies. Keeping to prudent policy frameworks and settings, maintaining flexibility, focusing on productivity and pursuing the opportunities arising from the growing engagement with the Asian region will all be part of a prosperous future. This part of Australia is as well placed as any to play its part in that future.

r090728a_BOA

australia

NO_INFO

stevens

Thank you all for coming today, and thank you to Macquarie Bank for their financial support, and the Australian Business Economists for their logistical support for today's function. Those of you who were here at last year's Anika Foundation lunch may have noticed that I have selected the same title today. The challenges have changed in nature, but there are no fewer of them. The first part of my remarks will be about the general set of issues confronting policy-makers in key economies. They are not about australia, unless specifically noted . I will devote time to Australia-specific issues in the second part. A year ago, the international financial crisis was unfolding, but had not, at that point, spun out of control. The global economy had reached the peak of a long, strong upswing, which had stretched capacity and seen a wide range of raw materials and energy prices reach very high levels. Strange as it may now seem in light of subsequent events, a wave of concern about inflation swept financial markets in the middle of last year. Many countries were grappling with the lift in oil prices, which were reaching their peak last July. That was starting to reduce growth but also push up the general level of consumer prices in the advanced countries. In many emerging economies, strong growth had pushed up inflation significantly, even apart from food and energy prices. Australia was experiencing high inflation too, a result of the expansionary impact of a once-in-fifty-years terms-of-trade rise in an economy already close to full employment. We were also being affected by the dampening forces of the financial events, though by less than countries whose banks were closely involved in the problem lending areas. Since then, inflation rates have trended down in most countries. One thing that helped this was that the rapid final lift in oil prices during the first half of 008 was reversed by the end of the year. Much of the cumulative increase that had occurred over the preceding five years, however, remains in place. Broadly parallel trends can be seen in other resource prices. All of that suggests a significant structural rise in demand for energy and resources has occurred, as a result of the cumulative growth of the emerging world. This seems more likely to be a feature of the international economy for some time than to go away. If so, it has to be accommodated by the advanced industrial countries that, hitherto, have had access to those resources on favourable terms. Such an accommodation can be made, over time, via responses to higher prices in terms of efficiency gains, structural change in economies and so on. But it is as well to recognise that an adjustment has to be made. This could well remain something of a medium-term challenge for economic policies in the relevant countries. At a cyclical frequency, the global economic downturn has taken the pressure off prices for goods and services for the time being. Most likely, inflation rates in the developed world will continue to be low for a while. Some observers worry about deflation. For the past nine months or so, the key imperative has been to stabilise financial systems, and to support demand during a process of deleveraging, so as to halt an incipient downward spiral of falling asset prices, contracting credit, slumping spending, further deflationary pressure on prices, and so on. Probably in some of the most important countries, this support will need to remain in place for a while yet. Once demand is on a self-sustaining path of expansion, the support can be removed. At a longer frequency, on the other hand, the aggressive, and in places unconventional, policy responses to the contraction in demand are seen by some observers as increasing the risk of inflation. The essential reasons for such concerns boil down to some fairly basic fiscal and monetary notions. Fiscal deficits are very large in some countries now, and look like remaining so for some years. Public debt is rising quickly in many countries. For the G7 countries, gross public debt will probably exceed 00 per cent of GDP within the next year. Some major central banks have expanded their balance sheets dramatically, purchasing government debt and/or private securities in order to give additional impetus to efforts to support financial systems and aggregate demand. It is not that the fiscal burdens are unprecedented: there are periods in history in which deficits and debts were this large, or even much larger. They were mostly, however, war-time precedents, and wars have tended to be inflationary for the combatants. Likewise, large-scale expansions of central bank balance sheets have usually been seen as a fairly sure way of debasing the value of a currency. So at present, we have the unusual situation where some, who look at the prospective deficits and debt burdens, combined with 'unconventional' monetary policy measures, worry about high inflation down the road, even as others worry about the possibility of deflation over a shorter time horizon, as a result of large-scale overcapacity. Logically, subject to one or two important assumptions, there must exist a path that avoids both these unpalatable alternatives - deflation and inflation. Finding that path is the challenge for policy-makers around the world over the next several years. Faced with a large downturn like this, it was the right thing to do to allow budgets to go into deficit. Over time, though, there will obviously need to be fiscal consolidation. This will be easiest where the fiscal measures taken were temporary: it would be a matter mainly of not repeating the measures. Where more permanent measures were enacted, it will be more of a hard grind to get onto the path of sustainability. In some countries, moreover, the legacy of the excesses of the earlier part of this decade, and of the steps needed to cope with their subsequent unwinding, is likely to be quite persistent. Some major country governments have assumed, one way or another, a significant part of the obligations associated with earlier poor decisions by lenders and investors. Moreover, the level of potential output in some economies may have taken a step down, which will make the path back to fiscal sustainability more difficult to reach. In the countries concerned, there was no alternative to these actions; inaction would have been more costly. Nonetheless, all of this suggests that, in those countries, constraints on economic policy are likely to last for some time. The higher debt burdens will limit the extent to which worthwhile structural spending levels can be maintained for other things - like in health, education, urban infrastructure and so on. Moreover, the capacity to respond with fiscal policy to another economic downturn, should there be one, would be much more limited. Over time, these constraints will tend to become more apparent. Of course they might be disguised for a while under conditions of higher inflation. Indeed, the potential attraction of the 'inflation tax' as a fiscal device is precisely why some worry about inflation, given the size of budget deficits in some countries. The main safeguard that stands between debt holders and that outcome is the agreed framework for monetary policy, which is, with some differences in detail, in place pretty much everywhere. Its key components are a strong focus on medium-term price stability and sufficient operational independence for central banks to pursue that goal. This framework will require central banks to remove the exceptional accommodation being supplied at present, in due course. Getting the timing of that right will not be easy. In the major countries, the calibration of even conventional policies has probably been dislodged by the sequence of events, not to mention the almost total lack of comparable history against which to calibrate the unconventional measures. But while achieving a successful 'exit' will be quite a challenge, the chances will be maximised under the sorts of policy frameworks currently in place in most countries. For a key assumption behind the notion that the ideal path between deflation and inflation can even be found is that inflation expectations remain anchored. Were they to start to drift upwards, policy-makers could be presented with an unenviable situation of gathering inflation and ongoing weakness in real economic activity. Their choices would be very bleak indeed in that world. So, expectations remain key. It would, therefore, be a mistake to weaken commitments to clearly understood goals for inflation, of either the explicit or implicit type. Assuming the present set of monetary frameworks remains in place, then, the real constraints will have to be faced squarely. This only reinforces the importance of maximising productivity growth. The households of the Western world are currently feeling that they can no longer consume as they did, in part because the earlier spending is now seen to have been based on an unrealistic set of assumptions about long-run income and wealth. To that extent, there is no real way around a period of adjustment involving lower consumption for a while. But the adjustment could nonetheless be eased if a better foundation for optimism about future income could reasonably be established. Productivity is the key to that. In fact it is the only real basis for it. Of course, finding more productivity is easier said than done. But one key element will be to maintain open and competitive markets for goods and services, since they are most likely to spur the innovation that raises productivity. It is a bit disturbing, in this context, that the World Trade Organization reports a pick-up in trade-restricting decisions by governments in recent times. The challenge for governments is to resist these tendencies. That, of course, is not a new challenge, but it is as important as ever. Part of the way ahead will, at some point, involve winding back the extensive government guarantees (and in some cases extensive public ownership) of financial institutions around the world. These measures were necessary last October in the extreme uncertainty of the time, and played a critical role in stabilising confidence in the core of the financial system, and re-opening key capital markets. But they are undesirable as a permanent feature of the landscape. Countries that issued very generous or even unlimited guarantees of deposits will want to make sure such steps truly were emergency measures, by scaling them back to a more sustainable set of deposit insurance arrangements. Likewise, it would be desirable that guarantees for wholesale raisings in capital markets lapse into disuse as conditions improve. To date, in excess of US$800 billion of government-guaranteed debt has been issued in public markets by banks around the world. An unknown additional sum has been placed into private hands directly. Taking account of the additional debt governments are issuing for regular fiscal purposes, plus the funding for bank rescue packages, the shape of global capital markets is changing significantly. Government and government-guaranteed debt of one form or another is rapidly increasing globally. This has been accommodated so far because it has, by and large, matched investors' shifting risk preferences. Certainly people will worry, longer term, about increases in long-term interest rates potentially 'crowding out' private borrowers. To date, though, long-term rates remain historically pretty low for public borrowers, despite the prospect of very large debt issuance. They have increased somewhat, but this is best understood as an unwinding of the extreme risk aversion of 008 and early 009. But the longer-term question is whether, even without adverse effects on borrowing costs, we would really want to keep moving in the direction of a world where the bulk of debt is government-issued or government-guaranteed. It seems to me that that could easily be a world in which investors end up being no more discerning about risk and return than the buyers of CDOs a few years ago, and in which banks themselves ultimately rely on the guarantees to an inappropriate or even dangerous extent. More generally, while some countries do need significant regulatory reforms in the financial sector, do we want to throw away the genuine advances of risk management and globalisation of the past generation? Surely the better world for the decades ahead is one where a global financial system, having been stabilised at a time of crisis by public intervention (at major cost to shareholders and incumbent managers as well as taxpayers), plays its proper role of capital allocation and risk management. To be sure, it failed to perform as promised in the recent past. But it would be preferable, in my judgment, to work at making the system more effective in doing that job, than to retreat into the financial repression of an earlier state of the world. Finding a way to combine efficiency and stability in the way we need is a major challenge. The regulatory arbitrages and skewed incentives of the past need to be corrected. The likely pro-cyclicality of the regulatory standards needs moderation. Work is well under way on those fronts. Most importantly, the global policy-making community will have to grapple more effectively with the problem of entities that are 'too big to fail', but potentially 'too big to save', especially where their activities cross national borders. This is probably the most taxing financial regulatory problem of our time. For their part, banks will need to reduce their reliance on the extended guarantees and stand on their own feet before too much longer. The banks of the United States and Europe are starting down this path on their wholesale issuance, having recognised that it is in their own interests to do so. It would make sense for Australian banks, which have accounted for 0 per cent of global issuance of government-guaranteed bank debt over the past nine months, to step up their efforts to do likewise. Since I have now mentioned the Australian situation, I will go on to talk about challenges for economic policies at home. The flexibility to use macroeconomic policies, and other measures such as guarantees for deposit-taking institutions, has been used to support demand and maintain confidence, through the period of maximum global economic contraction. To date, because of those actions, earlier sensible management (public and private) and a degree of good fortune, the Australian economy and our financial system have been travelling rather better than those of most of our peers through the crisis and the initial economic aftermath. Six months ago, my own view was that the biggest risk to the Australian economy was an unwarranted loss of confidence in our medium-term prospects. Late last year, survey after survey pointed to a major battening down of the hatches by businesses across the country. This was quite understandable, and in some respects eminently logical at the level of the individual enterprise. But the risk was that these actions, in bringing on the very weakness that everyone feared, could set off a cycle of further weakening in demand and output. Now, however, it looks like confidence has recovered some ground. Economic conditions remain very difficult in some sectors. But surveys now suggest that many businesses have found that the worst has not occurred, and are perhaps thinking about their medium-term strategies for the next expansion. They are tending to try to hang on to employees who were recruited and trained at some expense and who will be needed in the future under conditions of stronger demand. Many listed companies are taking the opportunity to raise new equity, strengthening balance sheets. The fact that they can tap the markets for those funds, by the way, says something about the underlying resilience of the system. Consumer confidence has also recovered a lot of ground. In fact in recent readings it has been at or above long-term averages. This should not be entirely surprising. Households have seen significant gains from the various fiscal packages as well as declining petrol prices. For indebted households, there has been a very large reduction in debt-servicing costs as a result of easier monetary policy. Against that, unemployment has been rising, and a great deal of prominence has been given in public discussion to forecasts that it will rise further, with associated predictions that this will weaken confidence and demand and so on. To date, however, the rise in unemployment has been a little slower than earlier feared, and the effect of the more positive factors for households has, so far, outweighed fears of unemployment. In addition, the decline in interest rates, together with the additional grants for first-home buyers, has seen a significant pick-up in demand for housing finance. The value of loan approvals has risen by about a third since the low point in the middle of 008. In contrast to developments in so many other countries, house prices are tending, if anything, to rise, and arrears rates on the bulk of mortgages remain very low by historical and international standards. In fact, across some portfolios arrears rates have declined in recent months. We cannot claim that Australia has avoided any downturn at all. It appears at this stage, however, that the downturn we are having may turn out not to be one of the more serious ones of the post-War era, in contrast to the experiences of so many other countries. It is becoming more common for Australians to see the glass as half full than as half empty. Put another way, we can much more easily imagine upside risks to the outlook, to balance out the downside ones, than was the case six months ago. So far, so good. But what challenges lie ahead? And how should we respond to them? Just as it would have been a mistake nine months ago to write off our long-term economic prospects at the height of the financial turmoil, it would be a mistake now to lapse into the comfortable assumption that easy prosperity will come our way. The pace of global growth, and the easy availability of credit, seen in the period up to 007 was not the norm. It is unlikely to be seen again any time soon. The path to economic health for the major countries of the world will still be a difficult one, because the legacy of the crisis will cast a shadow for some time. Major international banks will remain diminished in stature and balance sheet capability, and will be required to devote more capital to their strategies in the future. If global regulators have their way, the world will be characterised by less leverage, and scarcer and more expensive credit, than in the earlier period. We here in Australia have to accept that fact and accommodate it in our thinking. One thing this presumably means is that the prominence of household demand in driving the expansion from the mid 990s to the mid 000s should not be expected to recur in the next upswing. The rise in household leverage, the much lower rate of saving out of current income, and the rise in asset values we saw since the mid 990s, are far more likely to have been features of a one-time adjustment, albeit a fairly drawn-out one, than of a permanent trend. Moreover the risks associated with those trends going too far are apparent from events in other countries. These risks have been reasonably contained so far in Australia - but it would be prudent not to push our luck here. A very real challenge in the near term is the following: how to ensure that the ready availability and low cost of housing finance is translated into more dwellings, not just higher prices. Given the circumstances - the economy moving to a position of less than full employment, with labour shortages lessening and reduced pressure on prices for raw material inputs - this ought to be the time when we can add to the dwelling stock without a major run-up in prices. If we fail to do that - if all we end up with is higher prices and not many more dwellings - then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supplyside impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track. Over the medium term, the emergence of China (and other countries such as India) will continue, and will offer opportunities for Australia. Plenty of observers, the RBA among them, have been saying this for years. But China's emergence also presents challenges. If commodity prices do stay at their current relatively high levels on the back of strong emerging world demand, the mineral extraction sector and all those parts of the Australian economy that service it and feel its flow-on effects, will expand. Other sectors will, relatively, contract over time. That is to say, the structural adjustment issues that faced us a year and a half ago, and which have received less attention since then, would resume. These sorts of adjustment in the economy have industrial, geographical and social dimensions. Moreover, if we are more integrated into China's expansion, we will be similarly more exposed to the consequences of whatever might go wrong in that country. So our understanding of how the Chinese economy works, and of what risks may be accumulating there, will need continual work. To conclude, challenges abound for policy-makers, for private firms and for individuals. The fact that we have managed to get through the past nine months in reasonable shape ought to give us some quiet confidence in our capacity to meet the current set of 'crisis'-related issues. But many years of careful work is the price of being able to ride out crises and benefit from the ensuing period of growth. We will need to re-invest in all that over the years ahead. Thank you once again for coming today, and for your support of The Anika Foundation.

r090814a_BOA

australia

NO_INFO

stevens

Thank you for the opportunity to meet once again with the House Economics Committee. When we last met with you in February, international financial markets were stabilising after the extreme turmoil of September and October 2008. But the fallout of the financial events for demand, production and trade flows in the global economy was only then starting to become apparent in hard data. Household and business confidence around the world had been severely damaged. Households had sharply pulled back their discretionary spending, were tending to try to save more and were looking to pay down debts. Businesses had responded very quickly to a fall in demand by cutting production and costs, as well as shelving their plans for expansion. It was already fairly clear by February that the resulting contraction in economic activity in the December quarter was severe in many countries, and that global growth had suffered its biggest setback in decades. Global trade was falling rapidly. Central banks had eased monetary policy aggressively, including taking short-term interest rates to near zero in several cases, and some were considering or implementing 'unconventional' measures to deliver additional stimulus. Governments were putting in place fiscal stimulus packages. But these measures would take time to have their effect. In the short term, we worried that the March quarter outcomes for the global economy would be just as bad as occurred in the December quarter. For some months, the news from abroad indeed continued to be very poor and global demand contracted further in the March quarter. Given the speed of the global deterioration, we believed that it would not be possible to avoid a period of weakness in the Australian economy. We thought that Australia had several advantages - a sound financial system, an absence of the worst of the problems afflicting some other countries, exposure to an emerging China, and scope to use macroeconomic policies to cushion the downturn. The exchange rate had declined, which would also assist in adapting to weak global conditions and lower commodity prices. So we could reasonably have expected to have a smaller downturn than others. But it is very rare for Australia to escape an international downturn altogether, and it seemed quite unlikely that we could avoid one of this size completely, despite the advantages we had. For confidence here too had suffered a serious setback. This was clear in equity prices, in numerous surveys of sentiment and in the feedback we were receiving directly from firms. Australia was being affected through our trade, financial and business linkages with the rest of the world. was doing better than most countries, as had been anticipated. But for a few months it was not clear how much comfort we should take from that, because the economic news from abroad seemed to be so dire. As one metric, the IMF's forecasts for global output in 2009 as at last February were for growth of 1/2 per cent. That was already a marked reduction from a few months earlier. Subsequently they were cut further, and when released in late April showed an expected contraction of over 1 per cent, which would be the weakest outcome for at least six decades. Forecasts for Australia were inevitably marked down as well. The time of our May was when the outlook for the local economy seemed weakest. In this environment, the possibility that we would need to ease monetary policy further was obviously canvassed. Financial markets expected as much, at one point pricing in a decline in the cash rate to less than 2 per cent. Yet the Board had already aggressively eased monetary policy, delivering the largest reduction in debt-servicing costs to households in modern times. Interest rates were low, or in some cases very low, by historical standards. Substantial fiscal stimulus was also in train. These could be expected to provide significant support for demand. So even as activity abroad continued to contract, the Board had to be mindful of how much action had already been taken in anticipation of serious economic weakness. Those measures would take time to have their full effect. But that lag could not be shortened by increasing the dosage. Accordingly, while keeping open the option of further easing, the Board kept a fairly steady setting through this period. There was one further small decline in the cash rate in April. Apart from that, official interest rates have been unchanged since we last met, in contrast to the very sharp falls from September through to February. Where then do we stand at present? Things abroad hardly look rosy, but they look distinctly better than they did a few months ago. Conditions in international financial markets have continued to improve. There have been occasional reversals, but each time the improving trend has resumed. Extreme risk aversion has abated; spreads have narrowed; capital markets have continued to thaw, though in some overseas cases this has relied heavily on central bank financing activities. Financial institutions in the United States and Europe have recorded better earnings. Global equity markets have risen to be nearly 50 per cent above the lows in early March this year. There has been substantial new issuance of debt and equity. Spot commodity prices have picked up. In addition, it appears that the really large contractions in major countries' GDP are now behind us and that global output is levelling out. International trade and global industrial production have even recorded small gains over recent months. Of course there is a long way to go and there are notable differences in economic activity across regions. While the United States and Europe only now seem to be at or near a turning point, there has already been a marked improvement in economic activity in much of east Asia and India. This reflects significant stimulus put in place by governments in Asia, the dynamics of the inventory cycle, the healthier state of their financial systems and, in all likelihood, the inherently better secular growth prospects for these sorts of economies. The improvement has been most pronounced in China, but it is not confined to China. Korea, an important trading partner for Australia, recorded a significant bounce in GDP in the June quarter. There are also some signs that the Japanese economy has begun to grow. The IMF has recently raised its outlook for world growth in 2010. These forecasts are actually still for pretty lacklustre growth overall. But it is the first time we have seen upward revisions for quite a while. The Australian economy has been resilient, with economic activity looking stronger than expected a few months ago. Both foreign and local factors have been at work. Exports have been remarkably strong. For Australia, they grew over the six months to March, whereas for most countries exports fell sharply over that period. Further growth appears to have occurred in the June quarter. This reflects the strength of Chinese resource demand, as well as some other factors. The strength in demand from China has also been associated with the continuation of attractive prices for many commodities. Australia's terms of trade are likely to be around 20 per cent lower than their peak last year. But they are about 45 per cent higher than the average for the two decades up to 2000. Domestic demand has likewise held up pretty well, with retail sales posting a solid increase in the first half of the year. Demand for housing credit is up, as are house prices, and purchases of some investment goods by firms rose mid year. Some of this strength is likely to be temporary, the result of fiscal measures that have a finite life. We are assuming, for example, that consumer demand, and first-home buyer demand for finance, will be softer in the second half of the year. Nonetheless, the retreat from the extreme risk aversion of nine months ago, the partial recovery of household net worth and the impact of low interest rates will offer support to private demand over the period ahead. Survey measures of business confidence have lifted from the very low levels seen at the beginning of the year to be close to their long-run average. Capacity utilisation has stopped its sharp decline. Business credit has been falling, but this has been more than offset by increases in non-intermediated sources of funding, such as equity raisings and corporate bond issuance. Overall business external funding has remained positive, at rates similar to those seen in the 2001 slowdown. For their part, financial institutions remain profitable, even though they are absorbing higher loan impairments. Business investment has been an area of expected weakness in forecasts for the Australian economy. This is still likely to be true, though recent liaison suggests that some firms may be re-thinking the size of their planned cuts to investment spending. Differences across sectors remain. The commercial property sector, for example, is part way through a difficult period of adjustment to valuation and leverage, even as parts of the mining sector are back to producing at full tilt to supply Chinese demand for resources. The labour market has seen considerably softer conditions, but there has been little decline in overall employment, and the rise in unemployment, to date, looks smaller than had been feared a few months ago. As several commentators have pointed out, there has been a significant fall in hours worked, as there usually is in downturns. This may be a more reliable gauge of the extent of labour market weakening than employment or unemployment. Compared with some earlier cycles, the reduction in hours has occurred via a reduction in working hours across more people, rather than being concentrated among a group of unemployed. At this point, the fall in hours worked looks larger than what occurred in 2001, but not as large as in 1991. In fact, that is probably a reasonable characterisation of this downturn in general. On the basis of the information to hand at present, this may well turn out to be one of the shallower recessions Australia has experienced. Inflation, meanwhile, has been easing. CPI inflation has recorded its lowest outcome in a decade, of 1 1/2 per cent over the year to June. This compares with a peak of 5 per cent in September last year. The size of this decline overstates the real extent of the slowing in prices, just as the peak figure overstated the real extent of inflation. Measures of underlying inflation remain a good deal higher, at around 3 3/4 per cent over the year, but they too are gradually declining. We believe that decline has further to go, though in the medium term inflation on either a CPI or underlying basis does not look like it will fall as far as we thought a few months ago. Looking ahead, some of the recent strength in private demand might, as I noted earlier, prove to be temporary. But at the same time, the contribution of public spending to growth in demand is likely to increase over the year ahead. More generally, there has been enough genuine strength in the run of recent indicators, sufficient further improvement in financial conditions and enough recovery in sentiment such that forecasters are starting to lift their numbers for overall growth in both 2009 and 2010. As always, there are risks. The global economy could suffer another setback of some kind. The likelihood of that has declined in our view, but the possibility remains. Perhaps the growth in China's demand will falter. Certainly the pace of China's growth seen in the June quarter, which was extraordinary, cannot continue for long, and may be moderating now. We need to keep an eye out for potential imbalances in China. That said, though, sceptics about the growth of China thus far may have underestimated the determination of the Chinese policy-makers to grow their economy over the medium term. I doubt that determination has lessened. Some of the pick-up in global industrial output is clearly due to the cessation of inventory run-down, and prospects for final demand will be important in determining the pace of ongoing growth. On that score, the process of balance sheet consolidation for both the private and public sectors in some major countries will probably weigh on growth in demand there for some time. On the other hand, performances of both Australia and some of our key trading partners have exceeded expectations in the recent past; that could continue, particularly if rising confidence were to feed further demand, thus increasing income, and so on. That, after all, is the way most recoveries proceed, in cases where there is no strong headwind from financial restructuring. Moreover, just as the severity and simultaneity of the global downturn was unprecedented, so was the speed and strength of the policy response. Six months ago the possibility of concerted global policy action delivering a surprise on the upside for global growth was noted by some, but it seemed perhaps rather theoretical at that point. It is a bit easier to imagine now. The forecasts outlined in the recent give our best assessment of the most likely outcomes for Australia, contingent on these and other factors. Considerable uncertainty inevitably surrounds these numbers. Nonetheless, if things continue to look like they will turn out in that fashion, there will come a time when the exceptional monetary stimulus in place at present will no longer be needed. It will then be appropriate for the Board to do what it has done on past such occasions, namely to start adjusting interest rates back towards normal levels. The timing and pace of those adjustments, if and when they come, will be a matter of careful consideration, taking into account all the relevant factors, including what might be happening with market interest rates. Mr Chairman, last time we met, I said that there were reasonable grounds to think that the Australian economy would come through this very difficult episode as well placed as any to benefit from renewed expansion. That remains my view. The economy appears to be weathering a very large storm pretty well, and the community's confidence about the future has improved commensurately. No doubt the future will pose its own challenges, but we are well placed to meet them. My colleagues and I now look forward to your questions.

r090928a_BOA

australia

NO_INFO

stevens

Thank you Mr Chairman. I have just a few opening remarks. Economic conditions in Australia were generally quite subdued in the second half of 2008 and the first part of 2009. Output was sluggish, hours worked in the economy declined, unemployment rose and inflation started to abate. By the standards of past recessions, however, this was a mild downturn. Although the evidence is as yet incomplete, this episode has been much less serious than those in the mid 1970s, the early 1980s and the early 1990s. It also has been very mild indeed in comparison with recent outcomes in many other countries, where deep recessions have been experienced. For the G7 group of advanced countries, for example, a cumulative contraction in real GDP of nearly 5 per cent was experienced over the four quarters to June this year. The Australian economy recorded a small net expansion in GDP over the same interval. So I think it is reasonable to conclude, against the benchmarks of historical and international experience, that Australia has done quite well on this occasion. Why was that so? The key factors have been articulated before, but it may help to frame our discussion here today if I recount them. First, our financial system was in better shape to begin with, being relatively free of the serious problems the Americans, British and Europeans have encountered. Lenders have some problem loans, as always occurs during a downturn, but these are manageable. The banking system has continued to earn a positive return on its capital, unlike those in some key countries. The system has been affected by the spillovers from the global crisis, through tighter borrowing conditions in international markets, higher spreads and so on. But these too have been manageable and various policy responses have helped the system to cope. The Reserve Bank was prepared to expand its balance sheet to assist in maintaining liquidity and the government guarantees were important in shoring up confidence and maintaining access to wholesale funding. Second, some key trading partners for Australia have proven to be relatively resilient through this episode. The Chinese economy did slow sharply in the latter part of 2008, but quickly resumed very strong growth. China will easily achieve her 8 per cent growth target this year, led by domestic demand. Many of our other Asian trading partners have also returned to growth recently. Ongoing strength in demand for resources has kept Australian exports expanding. Australia's terms of trade, even though well off their peak, remain high by historical standards. Confidence about the future for the resources sector is building quite strongly. Finally, Australia had ample scope for macroeconomic policy action to support demand as global economic conditions rapidly deteriorated, and that scope was used. The Australian Government budget was in surplus and there was no debt, which meant expansionary fiscal policy measures could be afforded. In addition, monetary policy could be eased significantly, without taking interest rates to zero or engaging in the highly unconventional policies that have been necessary in some other countries. I have maintained throughout that Australia's medium-term prospects remained good and that we should not lose confidence. More people seem to be taking that same view. Measures of business and household confidence have shown a very substantial pick-up from the low points reached earlier this year. Share prices have risen by almost half. House prices have risen rather than fallen, though commercial property prices have fallen. People are realising that, though things have been tough, the worst has not occurred and the future is looking brighter. Earlier plans for drastic cuts to capital spending look like they are being reconsidered. Economic growth forecasts are being revised up. A straightforward reading of the economic outcomes would suggest that the various policy measures have been effective in supporting demand. In due course, both fiscal and monetary support will need to be unwound as private demand increases. In the case of the fiscal measures, this was built into their design. The peak effect of these measures on the rate of growth of demand has probably already passed. The extent of support will tend to tail off further over the next year. In the case of monetary policy, the Bank has already signalled that interest rates can be expected, at some point, to move off their current unusually low levels, as recovery proceeds. These adjustments back towards more normal settings for both types of macroeconomic policy are what should be expected during the recovery phase of a business cycle. Our most recently released set of forecasts assumes they occur. Such an outcome would mean that fiscal and monetary policy would be acting broadly consistently, as they did when they were moved in the expansionary direction when the economy was slowing. In both cases a degree of policy discipline will be needed. Policy frameworks will be valuable in enforcing that discipline. On the fiscal side, the forward estimates provide an indication of the restraint needed to move the budget back towards balance and eventual surplus over time, as required by the Government's medium-term fiscal commitment. On the monetary side, the inflation-targeting framework the Reserve Bank has been following for a decade and a half will guide adjustments to interest rates. These will be timely and ahead of a build-up of imbalances that would occur if interest rates were kept low for too long. These frameworks will, in other words, prompt the needed adjustments. It was the preparedness to make those adjustments in the past, guided by these very frameworks, that contained the build-up of imbalances in the upswing and which in turn earned us the scope to take bold measures to support demand when a recession loomed. A continuation of that approach into the future will serve us well.

r091015a_BOA

australia

NO_INFO

stevens

With economic prospects improving, people's thoughts naturally turn to the question 'what next for monetary policy?' Financial markets were the first to ask this question. Virtually as soon as the cash rate stopped falling, the pundits started to speculate about the timing of the first increase. Initially, this change in market tone seemed a little premature. But it is now a year since the dramatic financial events of September and October 2008 dictated a sharp change of course for monetary policy. The question of how monetary policy will be conducted during the next phase is therefore a reasonable one. It is understandable if it is also a rather prominent one, following last week's decision by the Board to lift the cash rate by one quarter of 1 per cent. The Bank has already conveyed a good deal of its general thinking, through its regular statements after each Board meeting, the subsequent minutes, other written material and remarks I have offered previously. Nonetheless, this is an appropriate juncture at which to try to bring all this together. So this morning, I intend to elaborate a little about the sorts of issues that have been important for the conduct of policy in the past year and those that look like they will be relevant in the period ahead. First, however, it is worth recounting the framework for policy, the process that we go through each month in reaching the decision, and the way that decision is implemented. The centrepiece of the framework for monetary policy is a medium-term target for inflation. This framework combines two important principles that both theory and practical experience about monetary matters have taught us. The first is that, in the long run, monetary policy is about the value of money - that is, prices. Over long horizons, the size of the economy and its average rate of growth will be driven by developments on the supply side - such as the availability of land and labour, the extent of accumulation of real capital, technology, and the efficiency with which we use all those factors. Monetary policy can't make those factors grow faster. The second is that, in the short term, monetary policy changes do affect the real economy, because they affect aggregate demand. If trend inflation has risen, for example, getting it down again usually requires a period of slower growth in demand. But we don't want that period of slower growth to be any longer or more pronounced than necessary. By the same token, if as a result of some shock demand falls below potential supply capacity, the resulting downward pressure on inflation may provide scope for monetary policy to be easier for a time, which will help to limit the cyclical weakness in economic activity. Our objective of keeping consumer price inflation to 2-3 per cent, on average over time, strikes a good balance between these short-term and long-term considerations. The 'on average' specification allows deviations from the target in the short term, which are often unavoidable anyway, but still embodies a commitment that those deviations will be reversed in a reasonable period of time. It allows the economy's growth potential, determined by productivity, labour force growth and so on, to be realised. At the same time, the explicit numerical goal for inflation helps to anchor expectations of inflation and works to preserve the value of money. As such, it is in our view fully consistent with, and gives practical expression to, the objectives given to the Bank in legislation: the stability of the currency (that is, its purchasing power); full employment; and the economic prosperity and welfare of the people of Australia. It has bi-partisan support in the Parliament. It has also been, in practice, over the 15 years we have been using it, the most effective framework for monetary policy Australia has had so far. The target is expressed in terms of the consumer price index (CPI). This is, of course, only one of a number of price indexes. But the CPI was chosen because: it is the best known and accepted published price index; it is pretty reliable; and it presents fewer analytical problems for this purpose than other measures of prices. I now turn to the decision process. The Bank is continually examining a vast amount of statistical and survey information. There are thousands of individual data series monitored by the staff in the Bank's Economic Group, covering Australia and a number of other countries. An array of financial information from all the major markets around the world as well as in Australia, is monitored on a daily basis. This work is complemented by an extensive program of business liaison. A lengthy list of contacts is maintained; about 100 organisations are spoken with in any given month. The Financial Markets Group also maintains close contact with financial market participants in Australia and elsewhere, and the Reserve Bank gains valuable intelligence as a participant in both local and offshore markets. In the lead-up to the Board's meeting, all this material is carefully evaluated. At a meeting of the most senior officers in the week preceding the Board meeting, discussion occurs about what should be recommended to the Board. Papers for the Board containing the factual information available, the staff's judgments about issues of interpretation in the data, the outlook and any topics of special interest are prepared. A four- to five-page paper, containing a high-level summation of the issues for policy and the recommendation, is completed on the Thursday afternoon ahead of the meeting. Board members receive the papers on the Friday. At the Board meeting, the most senior staff present the key messages from the papers. There is extensive discussion, and plenty of questions from the members about the material. The Board, I can assure you, is no rubber stamp and its members are no group of shrinking violets. They come from a diverse set of backgrounds. They bring their own experiences and their own independently gleaned pieces of information about what is going on. The analysis and arguments put by the staff and management of the Bank are well and truly tested. Any weaknesses will quickly become pretty clear. This discussion usually takes about three hours. It is, I would think, the most intense regular discussion of the state of the economy that occurs anywhere in the country, as of course it should be. At the end of the discussion, the Governor, as Chairman of the Board, will sum up and introduce the policy question. Each member has an opportunity to give their view and their reasoning on the decision at hand. Typically, a consensus emerges, and the decision is then taken. It then remains to issue a statement. The Board meeting is not a drafting session - the members are usually content to leave the precise wording to the Chairman, on the understanding that the statement will be consistent with the discussion at the meeting. The statement is then released at 2.30 pm and the community is thereby informed very quickly what the decision is and why we have taken it. Subsequently, the draft minutes of the meeting are prepared. These are finalised after members have the opportunity to comment on the draft during the following week, and are released publicly on the Tuesday two weeks after the meeting. A few days after this, the whole sequence begins over again. In addition to all the above, every three months the Bank publishes an extensive analysis of the economy, financial markets and the issues for monetary policy. This document, the , typically runs to about 70 pages. All of this is already known. The point of recounting it is to reassure people that there is a very careful, detailed and extensive process involved both in making the monetary policy decision and in explaining it. A lot of effort goes into the policy decision, as I have just described. But that only establishes one interest rate in the economy - and a very specialised one at that. (For today's purposes only, I am leaving aside the other channels through which monetary policy affects the economy, such as the exchange rate, inflation expectations, the supply of credit and so on. These remain important, but today it is the interest rate channel on which I want to focus.) The 'cash rate' is the rate for borrowing large parcels of cash, or settlement funds that are held in banks' accounts at the RBA, overnight. This is a very active market, but only a very small proportion of borrowing in the economy is actually conducted in this market. To have its broader effect, monetary policy relies on changes in the cash rate affecting other interest rates. Both today's cash rate and its expected value over the next 6 months to 12 months form the anchor for the spectrum of interest rates in the economy. But there are other factors at work as well. Term premia - the additional return that must be paid when money is tied up for longer periods - and compensation for risk also can affect the official yield curve and the structure of private interest rates. For some years, these other factors were reasonably stable. Compensation for risk actually tended to decline gradually, as a result of a very strong 'search for yield' by investors and heightened competition among intermediaries to lend. Hence in net terms loan rates slowly fell, relative to the cash rate. On the whole, though, changes in the cash rate came to be seen as driving most of the important rate changes in the economy quite precisely. This was, historically speaking, somewhat unusual. In the past 18 months or so, in contrast, a sharp reappraisal by investors around the world has seen compensation demanded for accepting risk increase. As a result, the various market interest rates that intermediaries have to pay to raise funds have, on occasion, moved independently of the cash rate. The Bank has published an analysis of funding costs, which provides a useful framework for thinking about these issues, so I won't go into them in detail. I will simply make a couple of observations. First, during the easing phase, interest rates for most borrowers still came down quite significantly, because the cash rate changes were so large. For mortgages, floating rates in the past year reached their lowest level since 1964. At the margin, the cash rate cuts were larger than otherwise because the Board could see that spreads between intermediaries' rates and the cash rate were tending to widen. Likewise in future decisions, the Board will take careful note of any tendency for spreads to change. Second, in Australia, housing loan rates came down much more than has been the case in many countries. This was partly because of the prevalence of floating-rate housing debt here, but also because spreads on housing loans (relative to the policy rate) widened by less in Australia than other countries. That is to say, monetary policy still works pretty effectively in Australia. Going into the crisis, the global economy had been growing strongly. Global GDP expanded by 5 per cent in 2007, which capped off several years of well above average performance. The US economy had been slowing for a while as concerns mounted over the financial problems, but even into the first quarter of 2008 global GDP was still expanding at 4 per cent. Prices for most commodities were still rising; oil prices would not reach their peak until July that year. Our economy was operating at full stretch, with our terms of trade showing their largest rise in 50 years and delivering a very large income gain to the community. Confidence was high; firms routinely complained of labour shortages; inflation was tending to rise, worryingly so in the second half of 2007; and demand for credit was strong. In this environment, the Board was running tight monetary policy to contain inflation. We now know (but could not know for sure at the time) that CPI inflation was on its way to 5 per cent. Measures of underlying inflation, which seek to look through temporary factors, reached over 4 1/2 per cent. These outcomes were well above our target, and it could not be credibly claimed that they were just due to temporary or imported factors. In fact, in late 2009, we are still to see whether inflation will be consistently back to target over a period of time. We think it will be, but, as yet, that remains a forecast. The big rise in energy prices in the first half of 2008 crimped growth in advanced and emerging countries alike, and most showed a significant softening in the June quarter of that year. By then it was starting to emerge that demand in Australia was in the process of moderating - though it is worth noting that domestic final spending still rose by 1 per cent in the June quarter of 2008 and 5 per cent over the year to June, both very robust outcomes. The Board was then in a position to start thinking about when it might be time to begin to ease monetary policy, in anticipation of inflation starting to decline - even though at that stage it had yet to reach its peak. The easing phase began in early September. About two weeks later, the simmering financial tensions in the northern hemisphere erupted into the most dramatic sequence of financial events we are ever likely to see. The failure of Lehman Brothers is usually taken to be the signal event. That is a reasonable assessment, even though the US Government takeover of Fannie Mae and Freddie Mac actually preceded the Lehman collapse. The ensuing sequence of crashing share markets, the huge financial strains, the need for governments to support struggling banks, and so on, had a massive effect on confidence around the world. As a result demand for goods slumped everywhere. Most economies went into recession; in a number of cases these were severe ones. This required a change in monetary policy thinking in Australia. Instead of the gradual easing of policy that we had been expecting would occur, as inflation gently subsided, the Board concluded last October that it needed to be more aggressive in lowering rates. Australian households and businesses, understandably, began to react to events abroad. This meant that there was likely to be a much weaker outcome for demand and output - and hence a greater prospect of falling inflation - than had been expected up to that time. This change to the outlook was reflected in revisions to the central forecasts prepared in the Bank. But the Board responded to more than just those forecast changes. It responded also to the risk that, in an environment of acute global financial strain and deleveraging, there could easily be a much weaker outcome for economic activity even than the one embodied in the reduced forecast. Accordingly, the cash rate was reduced by a total of 300 basis points in the four months leading up to the end of 2008. It was lowered further in the early part of 2009. This 'risk management' approach, in which policy responds quickly to a situation where there is an increased risk of a very adverse outcome, is fully consistent with the flexible inflationtargeting framework. Admittedly, a more conventional approach might have seen the Board ease policy more slowly, waiting for more evidence of economic weakness and moderation of inflation. Such an approach would have been defensible, particularly given how high inflation became during 2008. But the loss in economic activity would probably have been greater, and the risk of an even larger contraction would have been unaddressed. Inflation might well have fallen not only faster, but ultimately further, than we needed it to. The Board's view was that we should move to limit the downside risks to economic activity, to the extent it was feasible to do so while remaining consistent with the inflation target. The Board had some earlier analysis available to it that proved to be helpful in coming to that decision. A year earlier, for the September 2007 meeting, the staff had prepared some scenarios for discussion. One of those was a sketch of what might occur if the financial crisis escalated badly and the global downturn turned out to be much more severe than then expected. The message from that work was that such an event, if it occurred, would probably require a very rapid response from monetary policy, in the direction of lower interest rates. That event did not occur for another year, but when it ultimately did, we were a bit better prepared than otherwise might have been the case. Along with the fiscal measures taken by the Government, the recovery in China, and assisted by Australia's better starting point across several dimensions, this approach has had some success in heading off the worst effects of a very serious international recession. Australia has had an experience that, even if labelled a recession, was a pretty mild one. That is, clearly, a good outcome in the circumstances. Now that the risks of really serious economic weakness have abated, however, the question arises as to how to configure monetary policy for the recovery. We have said that, over time, interest rates will need to be adjusted towards a more normal setting as the economy recovers. A step in that direction was taken last week. Of course, there are still important matters of judgment in the timing and pace of how that is done. The global outlook remains uncertain and the Board is very conscious of that. The Board is also conscious, though, that a risk-management approach requires policy to be recalibrated as circumstances change. If we were prepared to cut rates rapidly, to a very low level, in response to a threat but then were too timid to lessen that stimulus in a timely way when the threat had passed, we would have a bias in our monetary policy framework. Experience here and elsewhere counsels against that approach. None of this is to say that the economy is, at this moment, 'too strong'. It isn't. The point is, rather, that the very low interest rate settings were designed for a weaker economy than we are in fact facing. Plainly, the downside risks to which the Board was responding earlier have not materialised. This is not a problem. In fact, it is a very desirable situation. It is a welcome contrast to the experience of a number of other countries. It is simply something we need to recognise in setting monetary policy - which means not holding interest rates at very low levels when that is no longer needed. The period of greatest weakness in the Australian economy has probably passed. Barring another serious international setback, the economy is likely to continue on a path of gradual expansion during 2010. That being so, those of us involved in monetary policy must turn our thoughts to encouraging the sustainability of that expansion. This is particularly the case for monetary policy given the lags in its impact. In conducting monetary policy during this expansion, our objectives will be the same as they were in the previous one: to keep inflation low; to react in a measured but prompt fashion to changes in the risks facing the economy; and, in so doing, to play our part in fostering a long, sustainable period of growth. Australia faces many challenges in the future, but we can have confidence that these can be met. A sound monetary framework is one of the foundations for doing so.

r091105a_BOA

australia

NO_INFO

stevens

When I spoke in April about 'The Road to Recovery', the issue was how to get onto that road. It was clear then that the global financial system had been stabilised by the extraordinary interventions of policy-makers during the December quarter last year. The system was, very gradually, mending. But it was also clear that the major countries had experienced a very sharp contraction in demand in the December and March quarters. It wasn't yet clear, at that time, whether that slump had been arrested - though we now know that it was bottoming out. Reputable observers were talking about the worst global recession since the 930s. For some of the individual major countries at least, there seemed to be a good deal of evidence for such a view (and there still does). It was widely anticipated that the Australian economy would be affected by these developments. Even if one was optimistic about the Australian economy in a relative sense, it seemed pretty unlikely that we could escape a significant impact from such an international downturn. To say that we would outperform other countries, while accurate, didn't necessarily reassure people a great deal, because things in a number of those countries seemed to be so bad. As it turns out, in April we were pretty much at the nadir of sentiment about the Australian economy. Six or seven months later, even most of the optimists are a little surprised, I suspect, at the economy's performance. So the title of this conference is particularly apt. But the issue before us now is not, in fact, how to get onto the road to recovery: we are already on it. The question, rather, is how to make sure that the road to recovery will connect to the road to prosperity. To make that connection, I suggest that we need to do two things. First, we need to draw the right lessons from our experience of the past couple of years. There are no doubt many lessons that might be mentioned. I will list just a few that I think are important. Second, we need to apply those lessons in the right way to the challenges that are likely to confront us over the years ahead. I will offer a few observations about some of those. The first lesson is that the business cycle still exists and that financial behaviour matters, sometimes a lot, to how that cycle unfolds. We need to have a broad definition of the term 'business cycle' in mind. There is more than just the cycle in the 'real' economy of GDP, employment, consumer price inflation and so on. These remain important, but it is just as important to recognise the cycles in risk-taking behaviour and finance. Failing to do that is precisely what has got some countries into trouble this time. For some years we heard talk of the 'great moderation', a reference to a period of unusually low macroeconomic volatility for the major industrial countries from the mid 980s until the mid 2000s. During this period, the United States had a couple of recessions - in 990 and 200 - but they were shallow ones compared with those in the mid 970s or early 980s. Inflation in most countries was low and pretty stable. So were interest rates. Australia shared in this experience from about the mid 990s onwards, with an unusually long expansion. Compared with the instability of the 970s and early 980s, this was a remarkably good period for macroeconomic performance. It was also very positive, for quite some time, for investment returns. But the problem with this apparently benign environment was that it made things seem just a little too easy. As the period of stability grew longer, so compensation for risk tended to diminish as investors continued their 'search for yield'. In the end that search explored some fairly remote territory, including complex structured products, exotic derivatives and so on. Key sectors of important economies accumulated a considerable degree of leverage along the way - in households, or financial institutions or both. In other words, as the macroeconomic environment seemed less risky, people changed their behaviour. The macroeconomic stability provided scope, it seems, for some financial trends to run further than they might otherwise have done, and further than they really should have done. Ultimately, this re-introduced risk through another channel: the financial structure of economies changed in a way that was more likely to amplify certain types of shock once they occurred. The great moderation has ended for many of the world's most advanced economies. They have become re-acquainted with the business cycle, in its most unstable and unpredictable form, where financial shocks and real economic activity become highly, or even dangerously, connected, through balance sheets. It's an old lesson, but worth re-stating. No country has managed to eliminate the business cycle. No country ever will, because the cycle is driven by human psychology, which finds expression in financial behaviour as well as 'real' behaviour. We are seemingly just made - 'hardwired', as some would put it - in a way that makes us prone to bouts of optimism and pessimism. Occasionally, we are prone to periods of myopic disregard for risk followed, in short order, by an almost complete unwillingness to accept risk. We could search for perfect policies that will eliminate, or completely offset, these tendencies, but that search would most likely be frustrating, and ultimately, I fear, fruitless. Realistically, what we need are policy frameworks that recognise the cycle - in its inevitability, yet unforecastability - and help us cope with it. They will do that, in large part, by limiting the build-up of excesses in the good times. Australia's policy frameworks have withstood the test pretty well during this period. Nonetheless, they will need ongoing investment if they are to continue to work well in the future. And even the best policy frameworks will not make the cycle go away. We need a parallel development in the general public discussion of economic and financial cycles. We might start with a more balanced discourse about recessions. We are still debating whether or not the events of late last year and early this year should be labelled a recession. The fact that we are still debating says something about the episode's severity. Perhaps we should just let the students of business cycles decide what label to apply and focus on the broader issue. If it was a recession, it was the eighth one since World War II. It certainly will not be the last one. Recessions are cyclical events that occur periodically, but not with sufficient regularity to be forecastable as to timing. They will occur in the future. If one's business or personal or policy strategy depends heavily on there not being a cyclical downturn, it is a risky one. The road to prosperity is not a road without cyclical ups and downs. But the second lesson we ought to draw from recent experience is that while downturns will inevitably occur, we are not helpless to do anything about their severity. We can make a difference. When a downturn came this time to Australia, there were certainly casualties. Risky business strategies (in most cases related to financial structure) were exposed, and those involved sustained losses of income, wealth and reputation. Other firms and individuals suffered much more difficult circumstances too. But on the best reading of all the available information, this appears to have been one of the mildest downturns we have had. Furthermore, it is likely that recovery is already under way. That's the next lesson: when downturns come, we can recover. Now the relative resilience of the Australian economy in this cycle warrants some discussion. Unless we are prepared to accept it has all been an incredible coincidence, we have to ask why things turned out that way. It wasn't just that China returned quickly to growth. That certainly was important in sustaining export volumes, and in re-establishing confidence in the outlook for the resources sector, which did wobble for a few months. But China's importance may be greater for future outcomes than recent past ones. Equally important recently were other factors, including the relative strength of the financial sector, the economy's flexibility and the willingness and scope to change macroeconomic policy. Those things were not accidents. Financial resilience resulted from sensible management by financial institutions themselves, and careful regulation on the part of the prudential supervisor. For the most part, the non-financial corporate sector was also fairly conservatively managed in respect of balance sheets - largely because enough corporate managers and directors today remember a time when that was not so. Moreover, businesses took a far-sighted view about employment decisions. Given the preceding difficulties in securing labour, they found ways of keeping people on payrolls, even if on reduced hours. They clearly had not only the good sense, but also the requisite degree of institutional flexibility, to do that, which must say something about the progress that has been made in labour market arrangements over the past couple of decades. And finally, long-term investments in prudent fiscal and monetary frameworks paid off. A whole generation of policy-makers painstakingly worked to build credibility by taking decisions with a long-run perspective. The return was in the form of a capacity to respond credibly to the downturn before it gathered much pace. The lesson here, then, is that all those investments were worthwhile. So I think this episode offers us an opportunity to re-visit our national script about recessions and recoveries, financial behaviour and policy frameworks. Recessions will occur, as they always have. Financial behaviour matters greatly and can, if we are not careful, contribute to instability. In our thinking about the future, we all need to remember that. But if we do, and act with due prudence during the upswings, recessions need not be bad ones and, when they come, we can recover. Signposts to that effect ought to be erected along the road to prosperity. The task before us now is to manage a new expansion. Of course, we are still in that period when we cannot be absolutely certain that the expansion will gain full momentum. Every upswing starts with that uncertainty. The conduct of macroeconomic policies in the near term must grapple with that uncertainty, as it always must do. Even so, it is not too early to think about issues of a medium-term nature. The key question is: having had a fairly shallow downturn, how do we make the upswing long and stable, and relatively free of serious imbalances? At least part of the answer is that we will need to re-invest in the same policy discipline, and the same careful private-sector management, that paid dividends in the recent episode. That means keeping tested frameworks in place, amended as necessary in the light of experience. It means unwinding temporary measures as appropriate. It means keeping a focus on flexibility. And perhaps most of all, it means resisting the temptation to assume prosperity is easily achieved, or easily managed. In that spirit, let me offer three observations. First, we start this upswing with less spare capacity than some previous ones. After a big recession, it usually takes some years for well-above-trend growth in demand to use up the spare capacity created by the recession. This time that process will not take as long. Most measures of capacity utilisation, unemployment and underemployment are much more like what we saw after the slowdown in 200, than what we saw after the recession in the early 990s. This is not a problem. In fact, it is good. It is a goal of macroeconomic policy to try to keep the economy not too far from full employment. And some spare capacity does exist, and will do so for a little while, which is why we think underlying inflation will probably come down a little more in the period ahead. But it does underline the importance of adding to supply, not just to demand, over the medium term, and of maximising the productivity of the factors of production that we have, if we are to have the sort of growth that genuinely brings prosperity. Second, and following on the theme of potential supply, others have noted that the rate of population growth at present is the highest since the 960s. On one hand, this may help alleviate capacity constraints, insofar as certain types of labour are concerned. On the other hand, immigrants need to house themselves and need access to various goods and services as well. That is, they add to demand as well as to supply. It follows that the demand for additional dwellings, among other things, is likely to remain strong. Corresponding effects will flow on to urban infrastructure requirements and so on. So the question of whether enough is being done to make the supply side of the housing sector more responsive to these demands will remain on the agenda. Adequate financial resources will of course also be needed. In that regard, the current issue is not the cost of borrowing for end buyers, which remains low, but the availability and terms of credit for developers. Perceptions by lenders of the riskiness of development in some cases are probably overdone just at the moment, given the strength of the underlying fundamentals on the demand side for accommodation. That will probably not be a permanent problem though; the more persistent difficulties look like they may be in the areas of land supply, zoning and approval. Third, the likely build-up in resources sector investment over the years ahead carries significant implications for the medium-term performance and structure of the economy. Even if a number of the proposed projects do not go ahead, the ratio of mining investment to GDP for Australia, which is already very high, will probably go higher still over the next several years. A sizeable share of the physical input will be sourced from abroad (through imported equipment) but the domestic spend will still be significant. So, other things equal, the investments will be expansionary for the economy. The financial capital to fund this build-up will mostly come from abroad. That is to say, absent some offsetting changes elsewhere, Australia's current account deficit could be considerably larger for some years than the 4 to 5 per cent of GDP we have seen on average for the past generation, which itself was a good deal bigger than seen in the generation before that. Now of course the current account position we have had turns out, contrary to what most would have expected 25 years ago, to have been manageable and sustainable. A temporarily larger one would probably be so as well, provided it involved a relatively modest amount of currency mismatch, and a rise in investment as opposed to a reduction in saving - and that seems to be the likely shape of things. In fact a temporarily sizeable current account deficit, if characterised by equity-type capital inflow, may well be optimal, because it would mean that a good deal of the risk of the projects was being shared with foreign investors, and that makes sense. Why would Australians alone take on all the risk of these massive projects? It is probably more sensible to share the risks with global capital markets and global companies. But these trends will take some explaining, not least to foreign and international organisations, many of which have a more traditional view of current account positions. Our explanation to our own citizens will also be important, and not just about capital flows. Over time, if the resources sector is to grow as a share of the economy, as seems likely, other areas will by definition shrink. This does not necessarily mean that they will shrink in absolute terms, particularly given the population is growing quickly, but certainly their growth prospects would be weaker than in an alternative state of the world in which the resources sector was to remain at its historical size. It follows that adjustment challenges will arise, with industrial and geographical implications. The 'two-speed economy' debate of a few years ago was really only a preview of what we could see if the resources sector build-up goes ahead. A further implication is that the economy's trade patterns could end up becoming less diversified than they have been in recent years. Such concentration would not be unprecedented and may well be worth accepting if the returns from doing so were high enough, as it appears they might be. But we might also think about how to manage the risks associated with any concentration. The emergence of China and India is a benefit to Australia, but we stand to have a heightened exposure to anything going seriously wrong in those countries. How then to manage an income flow that is higher on average, over a long period, but potentially more volatile? The answer to that question is beyond my brief today but presumably involves thinking about the extent and form of saving by the community. As we look forward to a new expansion, Australia has many advantages. The financial sector remains in pretty good shape. The Government does not own, and has not had to give direct support to, any financial institution. Australia, therefore, will be relatively free of the difficult governance and exit strategy challenges that such support is raising in some countries. Public finances remain in good shape, with a medium-term path for the budget back towards balance, and without the large debt burdens that will inevitably narrow the options available to governments in other countries. Sensible policy frameworks - both macroeconomic and microeconomic - remain in place, and they have worked. The financial regulatory system is strong and tested. We remain open for trade and investment, with an exposure to Asia, which still has the most dynamic growth potential in the world over the next several decades. These advantages are already paying dividends. Properly exploited, they will pay many more. But there is no such thing as effortless, or riskless, prosperity. There is still a business cycle, and we do well to remember that even if we have been spared the worst of the recent downturn. We will need to continue investing in all the things that helped us get through the recent episode. And we will need to accept and manage various changes that will probably confront us over the years ahead. The road to prosperity will have some bumps, twists and turns. But it is the road to the right destination.

r091208a_BOA

australia

NO_INFO

stevens

The financial crisis that engulfed global capital markets and brought a number of important international banks close to the brink last year has been followed by a good deal of soul searching among the regulatory community. In several countries, though not in Australia, regulatory structures and/or practices have been seen as inadequate. Work is proceeding to try to establish better arrangements so as to prevent the next crisis, or, more realistically, at least make it less costly - all the while seeking to avoid doing things that make it harder to recover from this one. I propose to offer today some information and some observations about these developments and the associated issues. I won't go into the causes of the crisis per se ; these have been covered at length before. The material offered is set in a global context, rather than an Australia-specific one. Just to be clear, if in the following paragraphs I am saying something about Australia, I will make that explicit . What conclusions have governments and regulators around the world drawn from this There are many. But the most important ones can be organised under five relevant headings. First, capital: there was not enough. In the case of global banks' trading books, a lot of risk accumulated and was not well measured. Capital held against complex structured products in particular was seriously insufficient. A good deal of risk was also supposed to be 'off balance sheet', but returned very quickly to major institutions once liquidity dried up. Moreover, some instruments were considered to be 'capital' but could not really absorb losses, at least while a bank remained operating. Second, liquidity: not enough attention had been paid to the risk that, in the event of some market shock, funding liquidity could become much more difficult. Comfortable assumptions that markets for some instruments would remain liquid proved to be unfounded. Third, the so-called 'shadow banking system': there were systemically important activities going on outside the 'regulatory perimeter'. This included the activities of investment banks, hedge funds, finance companies, money market mutual funds and institutions that often had close ties to banks, such as special purpose vehicles, structured investment vehicles (SIVs) and conduits. These entities were typically less closely supervised or unregulated, but in some cases their risk-taking behaviour and subsequent travails had systemically significant impacts on the core financial system. Fourth, cross-border arrangements: globally active banks and other entities operated apparently seamlessly across national borders and legal jurisdictions. But the structures to allow that were actually quite complex, and legal, supervisory and crisis-management arrangements remained nationally based. So when it came time to manage the process of deleveraging and winding up of some institutions, the degree of complexity was increased by the cross-border nature of the issues. Finally, pro-cyclicality: the episode demonstrated - again - that the financial system imparts its own dynamic that reinforces the natural cyclical tendency in an economy. In good times, lenders and investors tend to be confident and act with less caution. Standards decline and banks come under pressure either to use 'surplus' capital or return it to shareholders. Backwardlooking risk metrics present risk as low just when it is reaching dangerous levels and very high when everyone has already become much more risk averse. This all serves to fuel the boom and bust. Many commentators have argued that accounting standards contributed to pro-cyclicality. Fair-value accounting and buoyant markets make for strong valuations that can boost recorded profit, but problems emerge when banks have to mark-to-market securities whose markets have effectively ceased to function. The incurred-loss basis for provisions - where an event has to occur before a provision can be made - promotes transparency in one sense. But it arguably inhibits the build-up of buffers in the good times to cushion against future losses, and prompts more provisioning during the turmoil, further harming profitability and confidence. Other incentives have also been seen as adding to cyclical behaviour. Remuneration packages for some financial institutions' executives and employees appear to have been structured in a way that may have encouraged traders and managers to take excessive risks in activities that appeared profitable in the short term but led to large losses later on. People have also pointed to the role of earlier regulatory changes, credit ratings, the complexity of instruments and weaknesses in market infrastructure, not to mention the long period of low global interest rates, the 'global imbalances' and so on as all playing a role. I don't want to underplay those factors, but the five above are the big themes on which I want to focus today. Much has already been done, or is under way, to respond to these weaknesses by the various standard-setters, the Financial Stability Board and within the G-20 process. Many of the responses can be organised under the same five headings. First among them is capital regulation. Now it is worth pointing out, before going on, that it is something of a stretch to suggest, as some commentators have, that the so-called Basel II framework was to blame for the crisis. In fact the build-up to the crisis occurred under the old Basel I capital rules: most global banks did not even implement Basel II until after the crisis had begun. US banks are still not using it. Basel II is not perfect but it addresses some of the shortcomings of Basel I that were identified by the financial crisis. It allows, for example, greater differentiation between different types of risk, introduces capital charges for off-balance sheet exposures to SIVs and conduits, and creates more neutral incentives between holding assets on balance sheet and securitising them. Had Basel II been in place, it might not have prevented the crisis but it would probably have helped matters. Nonetheless, Basel II can be improved in the light of experience during the crisis. The Basel Committee on Bank Supervision is in the process of implementing numerous changes, which essentially require more capital and higher-quality capital. It has already finalised changes to risk weights on certain exposures related to securitisation, and issued new supervisory guidance on compensation, governance, risk management and concentrations of risk. It has changed rules around disclosure and valuation practices, which will come into effect at the end of next year. The Committee is currently rethinking the amount of high-quality capital banks should hold, specifying what instruments should be included in that definition, and developing a non-riskweighted simple leverage ratio as a supplement to the risk-weighted capital adequacy measures. The Committee intends to finalise this latter set of new capital rules by the end of this year and calibrate them in 2010 with a detailed 'quantitative impact assessment' to gauge their effects. Second, efforts to bolster liquidity management are under way, with the Basel Committee planning to introduce a new global standard for funding liquidity soon. This is likely to require financial institutions to focus on adequate funding liquidity over longer time horizons, as well as resilience to more demanding stress scenarios. In line with this, APRA has recently released for consultation proposals to enhance liquidity risk management by authorised deposit-taking institutions in Australia. Third, the regulatory perimeter is being extended. Some of the relatively less supervised institutions that were problematic prior to the crisis no longer exist - for example, US investment banks failed, or were converted into, or assumed by, regulated banks. But other institutions whose actions could on occasion be of systemic importance, such as hedge funds, are being subjected to more oversight. Fourth, attempts are being made to help the cross-border issues with the creation of supervisory 'colleges' for large institutions. These are designed to promote better sharing of information across countries. Agencies on the Financial Stability Board are also working on protocols for cross-border crisis management. Regarding pro-cyclicality, proposals are being developed for the use of capital regulations that would require banks to increase capital in the good times that can then be run down during a crisis. The proposals involve introducing target counter-cyclical capital buffers, above the redesigned minimum capital requirements. The Basel Committee is also working to promote the use of more forward-looking provisioning policies based on expected losses, rather than current arrangements that base provisions on losses already incurred. Accounting standard-setters are continuing their work on international convergence and clarity in regulation. They have issued guidance emphasising the need for judgment in valuing mark-to-market assets when markets for those assets are inactive, are working to simplify the valuation rules for financial instruments, and are seeking to close loopholes that generated incentives for off-balance sheet activities. All of this is worthwhile work. It forms part of a comprehensive set of responses to the conclusions drawn from the crisis. Implementing it presents a very demanding schedule for regulators. I want to offer a few observations about what we might realistically expect over time. These are not criticisms, but rather nuances that are, in my view, worth noting. The first is that the right balance needs to be struck between more regulation and more effective enforcement of existing regulation. There is no doubt that regulation can be improved after an event like this. Yet some jurisdictions ended up with very serious problems, while others did not, even though they were all, more or less, operating on the same internationally agreed framework for bank supervision. Why that was so remains a question of interest. Secondly, on the assumption that most of these regulatory changes go ahead, one effect will presumably be to make the process of financial intermediation more costly. The intention, after all, is that lenders will operate with more capital against the risks they are taking. But capital is not free; shareholders have to be induced to supply it, and it will have to be paid for. High-quality liquid assets typically carry lower yields too, so mandating higher liquidity will have some (modest) cost as well. Admittedly it can be argued that shareholders of financial institutions will have a less risky investment and so should be prepared to accept lower returns. But customers of financial institutions - depositors and borrowers - will also pay via higher spreads between what lenders pay for funds and what they charge for loans. That is, they will pay more ex ante to use a safer financial system, as opposed to taxpayers having to pay large costs ex post to re-capitalise a riskier system that runs into trouble. Now of course protecting the interests of taxpayers is very important, and there is no doubt that certain types of behaviour need to be backed with much more capital, if not severely curtailed or even stopped altogether. It is appropriate that pricing play a role in achieving that. We should try to ensure, however, that the cost is no more than necessary. The most egregious behaviour was mainly that of 30 to 40 large, globally active banks. They have imposed very large costs on their own banking systems, economies and taxpayers, and on the global economy. But there are thousands of other banks in the world whose risk appetite did not get out of control, that have remained solvent, and that have not needed public capital injections. So it will be sensible to ensure, as far as we can, that the proposed measures act effectively to constrain the worst excesses of the former without unnecessarily shackling the latter. I am personally not persuaded of the intellectual basis of the simple overall leverage ratio. It goes against the whole thrust of the idea that capital should be allocated against economic risk - after all, the Basel risk weights are a sophisticated leverage ratio already. I have not seen persuasive evidence that the banks of countries that had a leverage ratio in place have systematically outperformed those that did not. Nonetheless, it had already been agreed, before Australian officials joined the Basel Committee, that such a device would be introduced as a 'back-stop' to prevent extreme leverage in instances where the Basel rules, for some reason, may not. Provided that it is suitably calibrated, the leverage ratio will probably not do any great harm. That is, however, a very important provision. Were it to be calibrated in a way that unnecessarily constrains the common or garden variety commercial bank, it could be unduly costly. So the calibration is important and in this regard it is critical that adequate time be allowed for the completion of the technical work in assessing the quantitative impact of this measure. That will take at least another year. As far as the proposed counter-cyclical capital buffers are concerned, this is an appealing idea, based on the notion that it is precisely at the moment when capital appears to be abundant, profits high and the economy booming that true risk is approaching its peak. Requiring more capital to be put aside at that time, which can then support balance sheets after the cycle turns, sounds very desirable. But we should not think it will be easy to achieve. The proposals appear to involve balancing a degree of mechanical linkage to particular variables - such as credit - with an appropriate degree of short-term flexibility. Those familiar with the old debates about rules versus discretion in monetary policy might notice an echo here. Based on experience in monetary policy, I am sceptical about the durability of hard rules, but all too familiar with how difficult it can be to deliver genuinely counter-cyclical policy. There is no reason to think it will really be easier when using prudential tools for 'macro-prudential' purposes. That is not to say that we can't devise a framework combining certain rule-like behaviour with a sensible degree of discretion, but it might take a while. In the case of monetary policy, it took a couple of decades or more. If one is inclined to place a good deal of importance on quality supervisory judgment - as I think we have to - as much may be achieved by adjustments to accounting arrangements for provisions as by a complex set of variable capital ratios. What is needed is to allow banks more easily to make more forward-looking provisions when either they or the supervisor thinks they should. This is an important area of work for regulators. One should also be realistic that while using balance sheet regulation as a macro-prudential tool may have attractions, it is no panacea. Of course there may be occasions when the setting of monetary policy is about right for most of the economy but there is a desire to calm down some over-exuberant borrowing behaviour in a particular sector. In such cases, some kind of temporary regulatory measure may well be useful. But as those with any recollection of Australian experience of the 1960s and 1970s will know, if the fundamental problem is actually that financial conditions are just too easy - that is, interest rates are too low - balance sheet regulation won't ultimately constrain credit growth. Over time, private markets will find a way of doing the business outside of the regulated sector. Then the authorities face the question of whether or not to expand the scope of regulation to more sectors - just as we did in the 1970s. A possible outcome is that, the harder we regulate a set of institutions as a result of the last crisis, the more likely it becomes that the next crisis occurs in the hitherto unregulated part, perhaps even among institutions that do not yet exist. If the conditions are such that people want to take risk and gear up, they will find a way. Of course, that is acceptable provided the relevant private parties can be allowed to fail without bringing down the core part of the system. Caveat emptor can apply outside of the regulated net if there are few spillovers. But if risk-taking activity goes on long enough, then sufficient leverage may well accumulate somewhere to make the ensuing deleveraging generally disruptive, placing policy-makers once again in a very awkward situation. And that brings us to the most difficult of all the issues, namely that of the too-big-to-fail institution. Here the term 'big' might mean a large balance sheet, or refer to interconnectedness or complexity. Or all three of the above. In some countries, the debate on this issue is now quite active. One potential response is a tax on size: much higher capital requirements for 'systemic' institutions so as to lower greatly the probability of a failure of a really large firm, either by making large firms much less risky, or giving them an incentive to no longer be large. Another approach would simply be much more intensive - and intrusive - supervision of such entities. Either of these measures could be complemented by the requirement that a large firm compile a 'living will', in which it writes its own break-up/wind-down plan ahead of time - in the process, hopefully, highlighting those bits of complexity that ought to be removed while it is still alive. Before regulators even got to any of those possibilities, they would have to grapple with the practical difficulties of setting the threshold as to what constitutes 'systemic'. Expect furious lobbying by the finance sector on that. Nor is this issue just domestic in nature. It goes to the heart of what it means to have a globalised financial system. In the absence of clearly articulated rules about burden sharing, a potential failure of one of these institutions is further complicated because the frameworks for global governance and crisis resolution have not kept up with the process of globalisation itself. It is very hard for them to do so. Even in a region such as Europe where there has been six decades of continuous effort in building collective structures, the resolution of problems at entities like Fortis has, by all accounts, been very difficult. One response to that would be to unwind the globalisation of the financial institutions and go back to having local banks just doing local business. That seems absurdly costly, though - in general, capital flows have been a tremendous force for higher living standards over the long run. It would surely be a retrograde step to shut them off. A less radical response would be subsidiarisation - where foreign banks have a presence in the form of locally capitalised and governed structures, in which local authorities could intervene in the event of a shock in another country affecting the viability of the parent. That still entails some costs in terms of efficiency, albeit ones that countries might now be prepared to tolerate. To succeed in this approach, a country would need to have the capability and resources to ensure the viability of a local subsidiary of a failed major global institution, taking control of it if necessary. This would be at a time of tremendous damage to the relevant global brand. For many small countries this might be a big ask. In the crisis itself, the too-big-to-fail issue presented simply as an imperative for a number of governments to prevent failures. But as the crisis recedes, and the global financial system is gradually nursed back to health, it is this issue that is going to leave the biggest lingering challenge. The Financial Stability Board will be directing particular attention to it over the coming year. It is not likely to be amenable to simple solutions, or easy ones. In the meantime, enormous moral hazard, perhaps greater than ever before, exists in the global financial system as a result of the actions - albeit essential ones in the circumstances - of 2008. A year ago, I wished this audience a much less interesting 2009. That wish was partly fulfilled in that 2009 was less 'interesting' than 2008, though still not quite boring enough in my view. As 2009 draws to a close, things in the global financial system look much less worrying than they did a year ago. With the sense of immediate crisis much reduced, regulators can devote more focus to the job of designing and implementing changes to regulatory frameworks - work that is better done outside a period of crisis anyway. Realistically, the task is to reconfigure regulatory frameworks to lower the probability, and the cost, of future crises while assisting recovery from the recent one. That is every bit as difficult a challenge as getting through the immediate crisis itself. It will require very careful judgment to strike the right balance between costs and benefits of revised regulatory structures and practices, and due regard to the possibility of unintended consequences. It will also take a great deal of determination on the part of regulators to enforce arrangements adequately in future booms. And there is little doubt such booms will occur because, ultimately, the cycle of greed and fear itself cannot be regulated away. To assume that unrealistic optimism will not again, at some point, overwhelm the more sober instincts of investors, bankers, commentators and others would be a triumph of hope over experience. But it can't be beyond us to achieve some worthwhile reforms in this area and 2010 is a year in which we can hope to make some progress. I wish all of you a Merry Christmas and a prosperous and stable new year.

r100208a_BOA

australia

NO_INFO

stevens

Treasurers, distinguished guests, ladies and gentlemen, colleagues and friends, welcome. former Deputy Governors; and current and past members of the Reserve Bank Board and the and other representatives of 30 central banks from the Asia-Pacific region and around the world; our colleagues from the Bank for International Settlements; and past and present friends and colleagues from the public and private sectors. It is a very great pleasure indeed to welcome you all to Sydney and to this occasion. Fifty years ago, the Reserve Bank of Australia commenced operations as Australia's central bank. That occasion, though, was the end of a long journey. The history of the RBA actually began much earlier. Not many people realise that the RBA is, by a different name, in fact the entity that opened its doors for business in Melbourne on 15 July 1912, as as a publicly owned commercial bank that would compete with the private banks, but act in a more stable fashion, the Commonwealth Bank quickly became a significant force in the banking landscape. The story of how central banking evolved in Australia in the 20 century is told in the monograph prepared specially for this occasion by University. The early part of the story is bound up with the history of the young Federation, itself dating only from 1901. At that time, Australia had no central bank. Notes issued by private banks circulated, and reserve balances were held in sterling accounts in London. The financial system serving the Australian colonies had been notoriously unstable during the 1890s. After a speculative property boom rivalling anything we have seen in recent times, the ensuing collapse saw more than half of the deposit-taking institutions close their doors. constitutional power over currency and banking included a pledge to establish a 'Commonwealth Bank' to be 'a bank of issue, deposit, exchange and reserve'. When the ALP won office in 1910, the Government duly brought forward a bill to establish opened the first savings account. Initially, the functions were limited to commercial ones. Over many years, the Commonwealth Bank slowly acquired central banking functions. As with many central banks, war financing brought the Bank to prominence in the 1914-18 conflict. The note issue, initially a function of the Treasury, was transferred to the Bank in the 1920s. In the 1920s and early 1930s, further legislative attempts were made to strengthen the Commonwealth's role as central bank. At least one pure 'central reserve bank'. But major progress was not made until an inquiry after the Great Depression outlined the intellectual foundations for the conduct of the modern central bank. The 1937 Royal Commission's findings led in due course to major legislative change, culminating in the Commonwealth Bank being given explicit macroeconomic policy goals in the 1945 Act. The charter given to the Commonwealth Bank in that Act obliged it to conduct policies as to best contribute to: (a) the stability of the currency of Australia; (b) the maintenance of full employment in Australia; and (c) the economic prosperity and welfare of the people of Australia. They are the same words that are set in stone in the foyer at 65 Martin Place today. The same legislation, I might add, abolished the Bank's Board, in favour of a system that effectively made the Governor the sole decision-maker. The Board was re-instituted in 1951 and today's Board in fact is the continuation of that Board, with the same mix of internal and external members. Yet the Commonwealth Bank was still also a commercial bank. Various arguments were made, including by the Governor of the day, as to why it was acceptable, even desirable, for the central bank both to regulate, and to compete with, the private banks. But by the late 1950s, the opposition of the private banks was intense, and our position as poacher and gamekeeper was no longer tenable. And so, at least 30 years after the discussion began about the merits of having a separate institution dedicated solely to central banking, the Reserve Bank of Australia was established to continue the central banking activities, while the commercial functions were placed in the Commonwealth in the 1930s the Labor Party was inclined to move ahead with developing central banking and the conservative parties had resisted it, in 1959 it was a conservative government that introduced legislation to create the Reserve Bank and the Labor opposition voted against it. So, both parties have been on both sides of this debate! And no-one could say that Australia rushed into the decision. The Reserve Bank opened for business on January 1960. It had the same policy charter as the Commonwealth Bank had had, and an almost identical Board, including the Governor, who had been appointed to the post in 1949, and was eventually to retire in 1968 after a tenure of almost 19 years - longer even than Alan Greenspan. I confidently predict that this record will never be equalled in Australia. While the early leaders of the RBA sought to make it a distinctive institution, they also stressed the continuity of the central banking functions that had carried over from the Commonwealth Bank. One legacy of that history is that we not only have some old silver teapots carrying the CBA inscription, we also hold many of the very valuable archives of the early Commonwealth Bank. Some items from those archives - which date back to the convict era - are being shown this year for the first time in a modest display in our Currency Museum at head office. Over 50 years, the RBA has been present at, and part of, some of the great ups and downs of the Australian economy and the financial system. It has engaged in many arguments about public policy within its sphere of responsibility and competence. It won some of those arguments, and lost others. It has had its share of critics, and still does. Through all that it sought to call things as it saw them, even if it tended to put its views a little obliquely at times. It has always had a Board a majority of whose members have been drawn from outside the organisation, from commerce, academia and the broader community. A part-time Board with the decision-making power over monetary policy is unusual among central banks - I can think of no other major country with that structure. Yet that broader representation has given the Bank a degree of legitimacy that we might otherwise have struggled to achieve in Australian society. And I can say that in the 140 or so meetings of the Board in which I have participated, the members have always carefully set aside sectional and personal interest to act in the national interest. There are still some with us - even some here tonight - who were present at the creation in 1960. They and others worked hard over the years to establish and nurture a culture and an institution. Many others here have had a connection with the Bank in some way - political leaders, professional colleagues in government, counterparts in the financial sector, or colleagues from abroad. All of you have played a part in creating an institution. Some of you won't have agreed with things we have said or done at one time or another! But you nonetheless sustained support for the Bank as an institution and for the arrangements under which we operate. Whatever success we may have had over the years owes a lot to the support and trust that the financial sector, the political leadership and our community - whom we serve - have been prepared to give us, even on occasions when they didn't agree with us. We have also benefited greatly from the support of our international colleagues. Thank you for that support. We shall continue to do our utmost to be worthy of it. Thank you all for coming to be part of this celebration. Please enjoy your evening.

r100219a_BOA

australia

NO_INFO

stevens

Since we last met the global economy has continued an expansion that started around the middle of 2009. It appears that world GDP grew at an annualised pace of about 4 per cent in the second half of last year. Many forecasters now expect a similar result in 2010. International financial markets have generally continued to thaw, with most capital markets functioning again and the use by banks of exceptional support from central banks and government guarantees being wound down. These are, needless to say, very welcome developments. Having said that, the situation is not without some challenges. I will mention just two. The first is the two-speed nature of the global recovery. Normally after a sharp downturn, the ensuing upswing is correspondingly strong. This has been the case among a number of Asia-Pacific economies, which take half of Australia's Taiwan and others have all seen a significant pick-up in production and trade. In several of these instances the term 'v-shaped recovery' would be apt. Around the region, secularly rising incomes, generally healthy banking systems and relatively low public debt levels allow considerable room for confidence of a sustained expansion in demand. In fact in some cases the issue of overheating is arising and the authorities in both China and India have begun to tighten their policy settings. In the large industrial countries, on the other hand, the rebound has been more tentative, and driven more by the turn in the inventory cycle and temporary policy measures than a strong pick-up in private demand. It is not unusual, at this point of the recovery, for the inventory dynamics to be playing a prominent role in pushing up output. Nonetheless, the question is the extent to which a durable upswing in private final demand in the various countries will become established. Most observers expect this to be a fairly gradual process, given the lingering effect of the strain on banking systems and ongoing de-leveraging, not to mention the need, at some point, to begin the process of fiscal consolidation. Growth in these cases is therefore expected to remain modest and, as a result, these economies are likely to be characterised by a lot of spare capacity and ongoing high unemployment. So the historic shift in the centre of economic gravity to the Asian region is continuing, and if anything it has been highlighted by the different performances during the crisis and initial recovery. The differences in speed of recovery between the emerging world and the advanced world, and the likely persistent differences in growth trajectories into the future, will increase the pressure on exchange rate arrangements in the region. The second challenge is the increasing focus on sovereign creditworthiness. We saw a brief period of turmoil regarding Dubai late last year, and more recently the public finances of Greece have been under the spotlight, with some other European countries just in the background. Going beyond just these instances, government balance sheets in numerous countries have taken on considerable burdens as a result of the crisis, and markets are beginning to focus on issues of sustainability. It will be a very delicate balancing act for those governments to strengthen their fiscal positions without undermining the upturn in their economies. Happily, in both these areas, Australia is relatively well-placed. We are located in the part of the world that is seeing the most growth. And in terms of fiscal sustainability, Australia's position is, by any measure, very strong indeed. Turning to Australia, we think on the basis of available data that real GDP grew by about 2 per cent through 2009. We expect that it will grow by a bit over 3 per cent for 2010 and about 3 1/2 per cent in 2011 and 2012. Notwithstanding reports of patchy retail sales through the Christmas period, we judge consumption to have held up reasonably well after the various fiscal boosts faded. But in the future consumption is unlikely to be a leading driver of growth to the extent it was a few years ago. Households seem to be adopting a more cautious position regarding saving and borrowing, which is appropriate. A turnaround in private housing construction is under way. The effect of the temporary first-home buyers' boost is fading, but underlying demand is solid as a result of population growth and there is something of an 'underhang' of earlier low construction to work off. Credit costs and availability are adequate for households. While for developers credit remains quite difficult to access, it looks like we have seen a turning point in approvals for multi-unit construction. Housing prices have been rising quite smartly over the past year. Government spending is having an impact on demand, holding both residential and non-residential construction at higher levels than would have resulted from private spending alone. This effect will gradually diminish over the next year. At the same time, a large build-up in energy and resource sector investment is under way, prompted by optimism about long-run prospects for resource demand. The terms of trade are rising after last year's sharp fall, as the strength of demand has pushed up key commodity prices. In 2010 they could once again reach a very high level, exceeded in modern times only by the extraordinary level reached in 2008. Inflation has been falling, in line with recent forecasts. It is important to remember that inflation reached 5 per cent in 2008, or just over 4 1/2 per cent in underlying terms. This was much too high. The earlier period of tight monetary policy, and the weakening in demand in late 2008 associated with the escalation of the financial crisis, has seen inflation come down. Over the past year, it was about 2 per cent on a CPI basis and about 3 1/4 per cent in underlying terms. Over the past six months, underlying inflation ran at an annualised pace of under 3 per cent. We think it will be about 2 1/2 per cent in 2010. It is normal, given the lags in these processes, for inflation to keep declining for a while after the economy begins to firm. With the economy having had only quite a mild downturn, however, we start the new upswing with less spare capacity than would typically be the case after a recession. One measure of this is that the rate of unemployment peaked at less than 6 per cent, much lower than we or most others forecast. Only a few years ago, unemployment rates like this would have been seen as a good outcome in strong times, let alone in times of economic weakness. The general flexibility in the labour market, including the ability of firms and employees to adjust hours of work, limited the rise in numbers unemployed. But the overall size of the downturn in economic activity also proved to be considerably smaller than thought likely a year ago. This is of course a very good outcome. But it also means that there is less scope for robust demand growth without inflation starting to rise again down the track. Monetary policy must therefore be careful not to overstay a very expansionary setting. This situation is quite different from those faced by the major countries. Whereas many of them had their worst recession since World War II, Australia probably had its smallest. As such, it should not be surprising that Australia was among the first countries to begin to raise interest rates, once it was clear that the danger of a really serious contraction in economic activity had passed. The Board lifted the cash rate in October, November and December. Most lenders raised borrowing rates by a little more than the cash rate. Allowing for these margin changes, borrowing rates are still below average but not by as much as the cash rate. We have taken careful note also of non-price credit conditions. For large firms, access to capital market funding, both debt and equity, has been good. For some other business borrowers, access to credit has remained difficult, though we have some suggestions in our liaison now that this may be starting to ease. Furthermore it appears that the rate at which lenders are having to make provisions for bad loans has slowed noticeably, which is not surprising given that economic conditions have been improving. Given that, it is reasonable to expect that lenders will become more willing to lend over the coming year. That said, it seems unlikely that we will return to the easy credit conditions of three years ago. The world has changed, for a while at least. Moreover, the likely course of international standards for regulation over the next few years will probably, at the margin, act to raise the cost of intermediation by requiring banks to hold additional capital and liquidity. If economic conditions evolve roughly as we expect, further adjustments to monetary policy will probably be needed over time to ensure that inflation remains consistent with the target over the medium term. This is a normal experience in an economic expansion: as economic activity normalises interest rates do the same - though of course it is the interest rates borrowers actually pay, and that savers receive, that are important rather than the cash rate per se . The Board sets the cash rate with that in mind. Mr Chairman, I have previously said that Australia would come through the global crisis well placed to benefit from renewed expansion. For a time, the challenge was to sustain confidence, and to support the economy and financial system through some exceptionally demanding circumstances. By and large those efforts were successful. Now we must turn our attention to the challenges of managing an economic expansion. Issues of capacity, productivity, flexibility, adaptation to structural change and so on will once again come to centre stage, as they should. For our community to tackle those challenges successfully, monetary and financial stability are important conditions. The Reserve Bank will do all that it can to secure them. I look forward to your questions.

r100326a_BOA

australia

NO_INFO

stevens

Welcome back to Sydney. The last time that this body met here was in 1992. At that time the Australian economy was in the early phase of a recovery from a deep recession. Pessimism about the future was deeply rooted. The financial system was under considerable strain. Unemployment was in double digits and still rising. Inflation had fallen significantly, but many people thought this was a temporary impact of the downturn. They thought that if we did get a recovery - and some despaired of that - we would return to our old bad habits of high inflation. People worried a lot about Australia's substantial current account deficit. There were relatively few optimists. You might notice some of that sort of thinking today, in some other countries. I imagine that among the participants of that 1992 meeting one could have gotten some pretty long odds against Australia having a long upswing, with inflation averaging 'two point something', surviving the financial crisis and ensuing global downturn with one of the mildest domestic downturns we have seen, and facing the future with a fair degree of confidence. This shows how hard it is to forecast, of course. But perhaps it also demonstrates that with time, effort, discipline, good policies and a bit of luck, economies can be returned to health and their citizens to prosperity. To that end, it is helpful that the global financial system is gradually recovering its poise, after a near-death experience 18 months ago. Perhaps like a patient that has suffered an acute cardiac event, there has been some lasting tissue damage, but quick intervention avoided something much worse. A period of emergency life-support has been followed by a period of recuperation, with some ongoing medication, during which the patient has been able gradually to resume normal activities. Certainly the functioning of money markets has improved substantially. Extreme counterparty risk aversion has abated and spreads of LIBOR rates to equivalent maturity OIS rates have come down to about the lowest levels since mid 2007. The dramatic expansion in the balance sheets of central banks in major economies has largely ended, though policy interest rates remain at 50-year lows. Australia's situation is more advanced in this regard. The expansion in the RBA's balance sheet was unwound nearly a year ago and the policy rate has been increased somewhat, reflecting the very different circumstances facing the Australian economy. But we are not the only country seeking to manage the 'return to normality'. An increasing number of countries outside those most directly affected by the crisis have begun this process - though the speed of adjustment naturally depends on national conditions. Capital markets have also improved, with spreads to sovereign bond yields for private borrowers across most of the risk spectrum back to 'pre-Lehman' levels, and for the best rated borrowers back almost to mid-2007 levels. They are not quite back to precrisis levels, but then, they probably should not have been at such low levels anyway. Similarly, spreads for emerging market sovereigns are well down from their peaks. In fact overall borrowing costs for quality corporates and emerging market sovereigns are similar to or slightly below what they were in 2006. This finer pricing is being accompanied by a gradual pick-up in debt issuance. Appetite for risk has increased significantly since the end of 2008, albeit with some occasional setbacks. Of course we should expect that it would have increased, since September and October 2008 were characterised by sheer panic - there is no other word - and a flight from virtually any risk at all. Once the global financial system did not actually go over the precipice, there was going to be some re-appraisal. Hence, even as evidence continued to emerge in the first half of 2009 of the dramatic fall in demand for goods and services, share prices and spot commodity prices began to recover. Share prices are now about 60 per cent higher than the 'priced for disaster' low point, while commodity price indexes have increased by a third. Some individual commodity prices have risen by much more. Similarly, we have seen a preparedness to take foreign currency risk, and flows into emerging markets involving both foreign currency and credit risk have increased. Again, risk appetite has not returned to the heady days of the mid 2000s, but nor should it. Even the flows we have seen have begun to raise concerns among policy-makers in some of the emerging countries about potential risks of asset market excesses and eventual capital flow reversal. For major financial institutions, the picture has also improved. The general decline in risk aversion has eased funding problems, and some countries have been able to terminate or scale back their government guarantee programs as banks are increasingly able to access term funding markets under their own names. Share prices for those financial institutions that are still privately owned have generally increased by more than the broader market. A number of large American and European banks that accepted public-sector capital injections during the crisis have moved to repay them. The challenges that remain ahead for the banking system in major countries nonetheless remain considerable. The outlook for some of the remaining government ownership stakes remains unclear. While losses coming from write-downs of securities slowed some time back, losses are still occurring in lending books as a result of the normal effects of big recessions, not least in the area of commercial property. This will continue for a while. In addition, banks, particularly large internationally active banks with big trading operations, will require additional capital over time under proposed changes to global prudential standards. There is a considerable contrast between that picture and the one for banks in most other countries. It is important to note that the majority of countries have not had a banking crisis as such. Everyone was affected by the seizing up of markets in late 2008, but most were not afflicted with the sorts of asset quality and capital issues that so bedevilled large US, UK and continental European banks. This in turn meant that once the panic had subsided, the banks in most countries were able to continue to carry out their functions - albeit under more difficult circumstances and facing much more subdued demand for credit, particularly from corporations. Australia is a good example of this, though not the only one. The lowest rate of return on equity earned among the major banks here over the past two years was about 10 per cent in underlying terms; among smaller banks the lowest was 3 per cent. When markets for securitisation closed the major banks stepped into the gap by increasing their rate of housing lending, albeit at higher prices. These banks were able to support some business customers - again at a price - that in previous cycles they might have chosen to cut. The rate of provisioning for bad loans has stopped rising for several banks, and nonperforming loans are likely to peak at a considerably lower share of loans than earlier expected. This general picture, even if not the exact numbers, would, I suspect, be replicated across much of Asia. These differences in experience are an important backdrop for the international work on regulatory reforms. There is no question that there must be some significant reform. To use the medical analogy again, the recovering patient is usually advised to consider some dietary and lifestyle changes, and perhaps to submit to some ongoing monitoring, in order to avoid further emergency procedures. These changes involve: removing the scope for taking on excessive leverage via regulatory arbitrage; making sure that adequate capital is held against risk that is being incurred; ensuring better management of funding liquidity; countering, to the extent possible, the inherent tendencies in both human nature and regulation to form assessments of risk in a procyclical way; and improving resolution processes to ensure orderly and rapid crisis management and to help manage the issue of 'too-big-to-fail' institutions. These are all very important goals. The Australian authorities support them. But as we have said before, the really serious problems were generated in a relatively small number of very large, internationally active banks. They did not stem from the thousands of other banks around the world which have not needed to be 'bailed out' and whose capital resources have, in most cases, proved adequate to cover normal losses in a cyclical downswing. Hence it is important not to shackle unnecessarily the latter group in our efforts to constrain the relatively small number which caused much of the problem. Turning from banks to markets more generally, a recent development has been the increasing focus on sovereign debt and creditworthiness. The initial manifestation of this was late last year when Dubai World requested a six-month standstill agreement on its debt repayments. More recently, the focus has been on Greece, after it was revealed that the Greek Government's current borrowing requirement was much larger than had been previously disclosed. Greece is a small country - accounting for only half of 1 per cent of the world's GDP. The significance of Greece is that it is a euro area country, which means two things. First, its adjustment to its predicament cannot involve currency depreciation (unless it were to leave the single currency). The only way it can grow out of the problem is by gaining competitiveness against other European economies via domestic deflation, which will be a difficult and lengthy process. A very large fiscal consolidation is an unavoidable part of this path. Second, the euro area has an interest in this effort succeeding, which is why there has been intense discussion about whether, and in what form, European assistance might be forthcoming. Any assistance would of course have to pass the test of credibility more generally in Europe, and would need to be applicable under similar terms to other euro area countries if needed. This is obviously a difficult problem, on which the policy-makers concerned are continuing to work. Perhaps the broader significance is that the difficulties facing Greece, while unusually stark, are a reminder of the challenges facing many governments in Europe, and for that matter the United States and Britain, over the long haul. Ratios of debt to GDP are rising quite significantly in all these cases. There are several reasons. The first is the size of the recessions being experienced, which obviously reduces revenues and adds to some categories of spending - the so-called 'automatic stabilisers'. This effect is relatively larger in some European countries but it occurs everywhere to some extent. The second factor is the discretionary budgetary decisions aimed at stimulating demand and injecting capital into banks. In the circumstances, the former was understandable; the latter was unavoidable. 'automatic stabilisers' will presumably 'automatically' move budget positions in the right direction as economies recover. The costs of stimulus and bank rescue measures, while one-off in nature, do leave debt permanently higher. But without such measures, economies might have suffered much deeper downturns and so the extent of budget deterioration could have been much greater, itself leaving an even bigger debt legacy. If that was the end of the story, we would not want to get too worked-up over debt ratios. Unfortunately, though, there is more to the story. For several important countries there was a trend increase in debt-to-GDP ratios going on before the crisis occurred. For the domestic audience, let me be clear that Australia has been a conspicuous exception. Particularly in mainland Europe, the pattern has tended to be for debt ratios to rise quickly in periods of recession, then to stabilise for some years, before rising again in the next recession. No doubt multiple factors are at work but the interaction of changing demographics and generous welfare, health and retirement systems is prominent. The same factors also work, other things equal, to lessen future potential economic growth. It is certainly not unprecedented for countries to have debt stocks much larger than their annual GDPs. This has usually been seen when they faced the requirements of fighting wars. Those ratios subsequently came down over time. But the situation now is different. The decline in debt ratios seen after the Second World War, for example, driven by rapid growth in output as population expanded and productivity surged, will not easily be repeated in many of the major countries. It is these more deep-seated trends, which were in place before the crisis, that are really the greater cause for concern; the crisis has brought them more sharply into focus. The demographic drivers will continue for the foreseeable future, while the unwillingness or inability to tackle the structural trends in earlier 'good times' has significantly reduced future flexibility. So a number of advanced industrial countries face some difficult fiscal decisions over the years ahead. At some point, significant discretionary tightening will be required. Of course policy-makers need to get recoveries well entrenched, which is why many observers warn against attempting an early fiscal consolidation. But unless a credible path to fiscal sustainability can also be set out, growth could easily be stunted by rising risk premia built into interest rates as markets worry about long-run solvency. This is not happening as yet; long-term rates in many of the major advanced countries remain quite low. That provides a window within which to plan the eventual consolidation. Since markets can be fickle and things can change, governments will surely want to use the window. In the meantime differences persist in the pace of economic recovery across regions. In the United States growth spurred by a swing in the inventory cycle is thought to have marked the turning point in the second half of 2009, but most observers still expect only moderate growth this year. In Europe, the momentum of the recovery has been less certain. In both cases the old forecasting cliche about uncertainty applies in spades. In contrast, it is apparent that the letter 'V' is a reasonable description of the trajectory, to date, of important emerging countries like China, India, Brazil and a number of smaller east Asian countries. We should expect to see some moderation in the pace of growth of production in some of these cases this year. This is usually the case in 'V-shaped' recoveries, since the initial pace of expansion is considerably higher than the long-run sustainable growth rate. The question of what happens to demand in these countries is of course distinct from that of what happens to production. Full employment in parts of the emerging world will probably be reached before full employment in North America or Europe. Productive capacity therefore would remain to meet further demand from the emerging world, via imports of goods and services from the 'old world'. That is, emerging Asia and some other parts of the world could see their living standards rise a bit faster than the increase in their own productivity, for a time, if they were prepared to meet some demand through imports. Facilitating this most efficiently would of course involve, among other things, allowing exchange rates to change. The alternative approach would be to seek to slow growth in demand in the emerging world as production there approaches full capacity, so as to maintain internal balance at a given set of exchange rates. But that would leave unused capacity in the industrial countries and emerging world living standards lower than they could be. These are polar cases - it would of course be open to policy-makers to steer some path in between. Among Asian policy-makers many factors go into thinking about exchange rates and trade and capital flows. They have a degree of suspicion of rapid capital flows and large movements in exchange rates, which is understandable after the experiences of the late 1990s. It is also understandable that the smaller economies, some of which are extremely open, with trade shares of more than 100 per cent of GDP, do not wish to see volatile exchange rates because it is disruptive for their economies. Moreover, the issue goes well beyond just exchange rates per se ; it involves saving and investment patterns, and national policy approaches to growth, the speed with which these can be adjusted and so on. The point, nonetheless, is that the current and prospective differences in economic circumstances between significant parts of the world are likely to put strains on the relative settings of macroeconomic policies and exchange rate arrangements. This will need careful management, by all concerned, over the next few years. The stabilisation of financial markets and banking systems over the past year or more is a welcome development for all of us. There are still difficulties to overcome for financial institutions in some key countries as a result of the depth of recessions, and these will be the subject of attention over the coming year. Looking ahead, the differences in the speed of economic recovery are starting to present challenges of their own, showing up as they do in capital flows, asset valuations and exchange rates. When we add to all that the looming long-term requirement for fiscal consolidation in a number of major countries, there is plenty for markets and policy-makers alike to think about. I'm sure your conference will take up these issues with great energy. I wish you every success in doing so.

r100423a_BOA

australia

NO_INFO

stevens

Thank you for the invitation to visit Toowoomba. In my remarks today I would like to provide an update on economic conditions and prospects. This will be from a national perspective, and set in an international context. In so doing, I am mindful that next week we will receive some important data on prices. We, and everyone else, will have an opportunity to update our thinking on the current and likely future course of inflation. So my remarks today will be subject to that caveat. The Bank will publish a detailed overall analysis of the economy early next month. The latter part of 2008 and the first few months of 2009 saw what has come to be regarded as the most serious international recession in decades. Global growth has since resumed, but with a rather uneven pattern: it is being led, in the first instance, by the emerging world. It's worth asking why that pattern exists. At least part of the answer lies in the nature of the downturn and in the policy responses to it. It is frequently claimed that the downturn was the worst since the 1930s. In the financial sectors of some major countries that seems clear, but for economic activity it is actually less clear than you might think. For several important countries individually, the increase in unemployment and loss of real output was certainly equal to those in the most severe post-War recessions, but not significantly greater. Some respected scholars of US business cycles have suggested recently that it may be a bit soon to judge whether the recent period qualifies for the term 'great recession', at least in the US case. In east Asia, in most cases, the latest episode has turned out to be far less financial crisis. was striking about the recent downturn was the simultaneity of the collapse in demand for durable goods around the world at the end of 2008. Suddenly, everyone, everywhere, felt much more risk averse - understandably so, as they watched governments have to save major financial institutions in a number of countries. This affected consumption and saving decisions, firms' investment plans, hiring intentions and so on. But equally remarkable was the simultaneity of the policy responses. There was a degree of formal co-ordination - for example, most G10 central banks reduced their interest rates by 50 basis points on 8 October 2008. Beyond that there was a fairly consistent set of responses stemming from a common assessment of the seriousness of the potential threat. So the global downturn could have been much worse than it eventually was, but policymakers everywhere supported financial systems where needed, eased monetary policy and eased fiscal policy, to support demand. The responses, by and large, were quite quick. In the countries at the centre of the crisis, these policy efforts have borne fruit. But they have been working against the powerful headwinds of private sector deleveraging. Hence in those cases the recovery thus far has been quite hesitant. Economic activity remains well below the peak level seen in 2007 or 2008, and in some of these economies it may not regain that level for another year or two. It is in this sense, actually, that the downturn in parts of the advanced world may well turn out to be the most costly in generations: the forecast slowness of the recovery implies a very large cumulative amount of lost income in some cases. In other episodes of serious recession, once conditions for recoveries were in place, they proceeded quite strongly. People are not confident of those sorts of outcomes this time (indeed many forecasters and financial markets will be seriously wrong-footed if a rapid recovery in the crisis-hit countries does occur). Observers in some countries even wonder whether their trend growth rate may have been impaired for a lengthy period by what has occurred. But most countries did not have a bank solvency crisis. They had an acute liquidity crisis for a couple of months in September and October 2008 when the global financial system went into cardiac arrest, but thereafter those problems began to ease - mainly due, it must be said, to actions of governments and central banks in the major countries. Since in most countries banking systems were generally sound, the headwinds have not been blowing as strongly in Asia or Latin America as in some other regions. Accordingly, the policy stimulus applied in these countries appears to have been pretty effective in supporting demand. Once money markets and trade finance began to thaw, recovery proceeded at a very strong clip. In east Asia outside Japan and China, industrial production is now a little above its previous peak. In China, it surpassed the 2008 peak in the middle of last year and kept rising, while in India it never really fell. Despite the slow growth of Asia's traditional export destinations - North America, Europe and Japan - trade in the region has bounced back remarkably strongly after a precipitous fall in late 2008. A large part of this rebound has been an increase in intra- region exports of final products, particularly to China. This suggests that demand within the region is playing a bigger role in this upswing, though Asian exports to the United States and Europe are recovering too. Corresponding differences show up in other areas. Inflation in the euro area and United States is still trending downwards, and spare capacity could be expected to dampen price changes for some time yet, though rising commodity prices will work the other way. For much of Asia, on the other hand, the period of disinflation caused by the downturn may be past. Asset values also have moved up most quickly in these countries. Perhaps this is not altogether surprising given that no countries in the region have had seriously impaired banking systems, but most have had very expansionary monetary policy. While several major countries have had one of their most, if not their most, serious recessions in the postWar period, Australia had arguably one of its mildest. We had a relatively sharp but very brief downturn in aggregate demand and economic activity late in 2008, and then returned to a path of expansion during the first half of 2009. As most recently estimated by the ABS, real GDP grew by 2 3/4 per cent through last year - a bit below average, but much higher than for most other high-income economies. This was supported by monetary and fiscal stimulus, the recovery in Asia, and a sound financial system. The sorts of things that typically accompany downturns - such as higher unemployment, increased loan losses for intermediaries, a fall in asset values - did happen to some extent. But because the downturn was brief, these deteriorations were rather mild, which meant that they did not then become part of a major feedback loop back to aggregate demand and output. That in turn meant that the economy was able to get onto the recovery path more quickly. And so on. As a result, the rate of unemployment, at about 5 1/4 per cent, is more than 2 percentage points lower than we forecast a year ago. The level of employment is 3 1/2 per cent, or some 350 000 jobs, higher than we expected a year ago. GDP growth of 2 3/4 per cent through 2009 compares with our forecast a year ago of -1 per cent. That is, the level of real GDP today is nearly 4 per cent higher than had been anticipated. For 2009 as a whole, we estimate that nominal GDP was about $45 billion higher than our forecast a year ago. Measures of business confidence and conditions in most of the surveys carried out by private organisations have for some time been at levels that are suggestive of something like average rates of economic growth. The Reserve Bank is of course aware that the picture is not uniform across every region or industry. Moreover, the upswing is likely to have particular features that mean that differences across sectors and regions may widen. Not everyone will feel its benefits in the same way or to the same extent, though this is true of all economic cycles. But it does not in any way diminish those concerns to say that there has been a good outcome for the national economy in a difficult international environment. Our task now is one of trying to ensure, so far as we can, that the new economic upswing turns out to be durable and stable. There are many factors about which we can do little. The speed and composition of global economic growth for example, or the behaviour of international financial markets as they grapple with uncertainty and risk - these and other factors may turn out to our benefit or detriment. We cannot change them; we can only try to be alert to them, and maintain some capacity to respond to them. For the time being, at least, the global economy is growing again. Forecasters expect an outcome something like trend global growth in 2010 and 2011, which is much better than 2009 but not as strong as 2006 or 2007. Those were exceptional years for growth and that pace could not have been sustained for long, even absent the crisis. In the region to which the Australian economy is closely linked, growth has been very strong over the past year. Almost certainly it will need to slow somewhat in the coming year. Demand for natural resources has returned and prices for those products are rising. We have all read of the recent developments in contract prices for iron ore. As a result of those and other developments, Australia's terms of trade will, it now appears, probably return during 2010 to something pretty close to the 50-year peak seen in 2008. As usual with these things, we cannot know to what extent this change is permanent, as opposed to being a temporary cyclical event. However, the fact that we will have reached that level twice in the space of three years suggests there is something more than just a temporary blip at work. Financial markets have made a pretty good recovery from their cardiac arrest 18 months ago. Despite large budget deficits in major countries, long-term rates of interest remain remarkably low. Since risk spreads for most borrowers have also declined this means that overall borrowing costs for rated borrowers, corporate and most governments, are low by the standards of the past few decades. This has to be advantageous for well-run companies and countries looking to invest. Of course, risks to this outlook do remain. In the middle of the crisis, the international focus was on private creditworthiness. Now it is more on sovereign creditworthiness. The euro area is working on a response to the problems of Greece, but we can expect that a focus on sovereign risk will be a feature for some time yet. Periodic surges in concern are likely to be a recurring theme, and not just about the sovereigns themselves but about banks that might have exposures to them. A credible path needs to be outlined for fiscal consolidation and debt stabilisation in the North Atlantic economies over the years ahead. In the meantime, banks in the countries with weak economies are absorbing the normal sorts of losses associated with recessions. A different challenge for countries in other regions is managing the flows of capital that result from, on the one hand, the very low interest rates in major economies and, on the other, the solid growth performance in Asia and parts of Latin America. Setting monetary policy and managing exchange rates will be no easy task. More countries in the Asian region are starting to change policy settings to be less expansionary: at last count central banks in India, Malaysia, Singapore and China had all begun this process. Having said all that, what sort of outcome might be expected for the Australian economy? If the outlook involves a combination of solid-tostrong growth overall among trading partners, a high level of the terms of trade pushing up national income, reasonably confident firms and households and strong population increase, we are not likely to see persistently weak economic growth. This big picture view is why we expect that, short of something serious going wrong in the global economy, Australian growth in 2010 will be a bit faster than in 2009 - at something close to trend. The reason I say 'a bit faster' is that while some factors are building up in an expansionary direction, and might be quite powerful, at the same time the impact of earlier expansionary policy measures is starting to unwind. So what happens to growth depends on the net effect of the two sets of forces. It is noteworthy that, although measures of consumer and business confidence suggest that people are essentially quite optimistic about the future, a degree of caution still characterises consumer spending decisions. Some areas of retail sales are quite soft. In the period ahead, moreover, we might expect to see households inclined to save a higher share of current income, and perhaps to be more cautious about the amount of debt they take on, than in the preceding upswing. On the whole, taking a longer-term perspective, this is probably not a bad thing. A similar caution is in evidence, at this stage, in some firms' investment intentions, though overall investment as a share of GDP remained fairly high through the downturn. But of course there is also a once-in-a-century build-up in resource sector investment, which could see that investment, already high, rise by another 1-2 percentage points of GDP over the next four or five years. There are also high levels of public sector infrastructure investment planned in coming quarters and the housing needs of a rapidly growing population are likely to see demand for new dwellings remain quite strong over time. So the outlook for demand seems likely to be driven more by investment, both private and public, and less by consumption than in some previous periods. Even before the downturn, the relative share of consumer spending in total demand was tending to diminish and that of investment spending to increase. There will presumably be corresponding shifts in the industry composition and geographical location of output and employment. Such effects could well be seen in and around Toowoomba itself, depending on the outcomes of proposed gas and coal projects in the region. The key will be, and not just in Toowoomba, to retain flexibility in the face of such changes. Let me now make some observations about inflation and monetary policy. Inflation has fallen from its peak of 5 per cent in 2008. Measured on a CPI basis it fell to about 2 per cent in 2009, but that figure flatters us a bit as it was partly a result of some temporary factors. Underlying inflation ran at around 3 1/4 per cent for the year, and at an annualised pace of about 2 3/4 per cent in the second half of the year. Our forecast a few months ago for 2010 was that inflation, measured either in headline or underlying terms, would be in line with our 2-3 per cent target. Next week's figure will provide an insight into how things are tracking relative to that forecast. A year ago, when we thought we might be going into a significant recession, there seemed to be the possibility that inflation could fall noticeably below the target. That doesn't seem very likely now, though, with a recovering economy, rising raw material prices, the labour market having stabilised and with some firms even beginning to worry again about skill shortages. Given all of the above, one would not expect the setting of interest rates to be unusually low. If the economy is growing close to trend, and inflation is close to target, one would expect interest rates to be pretty close to average. The Reserve Bank has moved early to raise the cash rate to levels that deliver interest rates for borrowers and depositors more like those that have been the average experience over the past 10 to 12 years. Those interest rates are now pretty close to that average. These increases have been fairly close together but then so were the preceding reductions. It is important to recall that the cash rate was reduced by 75 or 100 basis points at each meeting of the Board in late 2008 and early 2009, for a total of 375 basis points in five months after the Lehman failure in September. This was the biggest proportional decline in interest rates, delivering the biggest reduction in the debtservicing burden of the household sector, seen in Australia's modern history. It was an appropriate response to the situation. These changes were newsworthy, as interest rate changes always are. But as I have said before, while the changes in interest rates make the news, it is the level of interest rates that matters most for economic behaviour. Eighteen months ago, the Board moved quickly to establish a much lower level of interest rates in the face of a serious threat to economic activity. But interest rates couldn't stay at those 'emergency' lows if the threat did not materialise. The aggressive reduction in interest rates needed to be complemented by timely movement in the other direction, once the emergency had passed, to establish a general level of interest rates more in keeping with the better economic outlook. Hence the cash rate has risen by 125 basis points over seven months - which is still only about a third the pace of the earlier declines. The Board's reasoning for those decisions has been set out in the various statements, minutes and so on. The question of what happens from here, of course, remains an open one, as it always must. The Board's focus will be on doing our part to secure a durable expansion and on achieving the medium-term target for inflation of 2-3 per cent on average. Australia has survived what some have labelled 'the great recession' in the global economy. So, as it turns out, have a number of countries that are of importance to us in our region. The common ingredient seems to have been reasonably healthy financial systems accompanied by liberal doses of policy stimulus. Our task, and theirs, is now to manage a new economic upswing. This will be just as challenging, in its own way, as managing the downturn. But it's a challenge plenty of other countries would like to have.

r100609a_BOA

australia

NO_INFO

stevens

Thank you for the invitation to be here today in western Sydney, a region which accounts for about one in every 15 people employed in Australia. Of course events far from western Sydney can affect all of us here, through various channels. In view of the developments in recent weeks in Europe, it seems sensible to devote some time to what has occurred, and to what it may mean for Europe itself, for the global economy and of course for Australia. I should stress at the outset, though, that any assessment is very much preliminary at this stage. To begin, let me sketch some background on the global economy. We estimate that world GDP grew by around 1 per cent, or perhaps a little more, in the March quarter of this year. This was the third consecutive quarter of growth of about that pace after the contraction in the first half of 2009. Note that this occurred with very little contribution from the euro area, a region in which domestic demand contracted over the past two quarters. Many respectable forecasters have pencilled in a growth rate for 2010 as a whole of 4 per cent or a bit more - that is, they have expected that the sort of the growth already seen for the past nine months or so would continue for the rest of this year. This would be close to, or slightly above, the average pace of growth for the global economy over the ten years up to 2008. This is not just the Reserve Bank's forecast - though we broadly concur with it at this stage. The IMF, the OECD and various private forecasters have numbers like this. There are some who are more pessimistic, though there have also been others somewhat more optimistic. It is worth noting, by the way, that this outcome would be noticeably better than what was expected a year ago. For most of the intervening period the bulk of commentators seem to have been worried by 'downside risks' - that is the possibility that things could turn out worse than expected. But it was the 'upside risks' that, in fact, materialised over that period. One reason for that may be that all countries responded to the events of late 2008 by moving their macroeconomic policies in an expansionary direction. Just as the downturn in October 2008 was highly synchronised, so was the policy reaction. In countries that have not had an impaired banking system, those policy reactions have had a considerable effect. They were amplified by the spill-overs that occurred because the stimulus took place in all countries more or less at the same time. Yet the upswing is uneven. It has been very strong in Asia and Latin America, moderate so far in the US and weak overall in Europe (which itself has quite a mix of growth performances across countries). Of importance to Australia is that the strongest growth in demand has been nearby. Apart from Japan, most of the economies in the east Asian region have experienced a 'v-shaped recovery'. While some of this recovery reflects the process of re-stocking of durable goods around the world, it also reflects strong demand within the region. Commodity prices generally rose somewhat after the very large falls in late 2008. But of significance for Australia, prices for those resources which serve as the raw materials for steel production in particular have been exceptionally strong. Prices for iron ore and coal rebounded very sharply during 2009 and early 2010. Contract prices for iron ore in the current period are double those of a year ago; until recently spot prices were well above even that level though they have retreated somewhat of late. In short, global growth, while uneven, has been recovering in the places and in the form that was most likely to deliver a boost to Australia's terms of trade. It looks like our terms of trade this year will again reach the 50-year high seen two years ago. It could, of course, be that some of this recent increase in prices turns out not to be permanent. Some economies in Asia will probably, one way or another, experience a moderation in the pace of expansion over the coming year, because the pace of growth over the past year can't be sustained without problems arising. The Chinese authorities have been seeking for some months to take the steam out of certain sectors of their economy, particularly housing prices. They may be having some success. For this and other reasons, we and other forecasters are assuming that this peak in the terms of trade won't be sustained. But to reach that 50-year high twice in three years would appear to signal that something pretty important has been going on - something more than just temporary cyclical events. It is increasingly apparent that the Asian region is becoming large enough that it has a tangible independent impact on the global economy and on Australia in particular. China and non-Japan east Asia together accounted for around 9 per cent of the world economy in 1990. By 2000, their share was around 14 per cent. In 2010, it is likely to be about 20 per cent. China is already the world's largest steel producer and the second largest user of oil after the United States. China's share of global GDP could exceed that of the euro area within another five years. This confluence of events is likely to see an acceleration in the shift in perceptions about the shape of the global economy and financial system. The prominence of Asian views, and the weight accorded to them, are likely to grow accordingly. What Asian policymakers do and say increasingly matters. Turning then to the recent events in Europe, it is worth asking at the outset how these countries arrived at their current position. The story has many nuances by country but broadly, the public debt relative to GDP has long tended to be on the high side in Europe. It generally ratcheted up in successive economic downturns over the past three or four decades and efforts to get it down in the good times had only modest success. For some countries that joined the euro area the substantial fall in borrowing costs they enjoyed masked a degree of vulnerability, in that their fiscal sustainability depended partly on being able to continue borrowing cheaply. Demographic trends - pronounced in Europe, with some countries already experiencing declining populations - further highlight the problem. A high debt burden is much more easily managed in countries with higher potential growth prospects, one driver of which is population growth. This problem was slowly but steadily accumulating over many years. Then the financial crisis occurred. There was a deep recession from which recovery is not yet entrenched. Budget deficits rose sharply as a result - reaching 10 per cent of annual GDP or more in a number of instances. The prospect of adding that much to the debt stock each year for even just a few years can make a difference to assessments of sustainability even for strong countries. For the not-quite-so-strong cases, markets began to signal unease. Borrowing costs rose for those countries, which of course makes the fiscal situation worse. And so on. Initially the effect of these developments on financial markets was very much confined to Europe. Wider effects were observed in May as global investors became more cautious. Uncertainty over the nature of the policy response, and fears that it could be un-coordinated across countries, saw a marked increase in volatility in share prices and exchange rates. Our own markets have been affected along with everyone else's. Qualitatively, some of the market events had a little of the flavour of September and October 2008 about them. , however, they have, at this point, been nothing like as pronounced. Indicators of stress in markets have not, to date, signalled anything like the problems of late 2008 when interbank and capital markets seized up. But of course the episode is not yet over, and the issues will continue to need careful handling by all concerned and close monitoring by the rest of us. European authorities have responded by assembling a large support package, which covers Greece but, if needed, other countries too. It has several elements. It provides European-level financing for individual governments - so relieving them of the need to go to private capital markets - for a period of time, subject to conditions. The European Central Bank is undertaking some operations to stabilise dysfunctional bond markets and is ensuring abundant liquidity in money markets. The IMF has also committed to make funds available and will play a role in ensuring conditionality requirements are met. The final element is that governments are committing to reduce budget deficits and thus control the future rise of debt, though debt will keep increasing for a few years. Of course much detail remains to be set out as to how the mechanics of the package will work. At this stage any assessment about the impact of these events on the economies of Europe and on those further afield is very preliminary. One might expect some effect on business and household confidence, but it is too early to see much evidence of that yet. Looking ahead, we would have to expect that the planned fiscal contractions will dampen European demand as they occur, which in some cases will be over a number of years. Now some such effects should already have been embodied in existing projections since fiscal consolidation has been planned all along. But with some euro area countries now intending to do more consolidation in the near term than they had earlier planned, the dampening effects will occur sooner than earlier assumed (though this presumably improves growth prospects in a few years' time compared with the earlier forecast). The alternative path of less fiscal action would carry less risk of near-term weakness in demand. However in the current climate it could also have an attendant risk of loss of fiscal credibility. If the latter occurred, it could be followed in short order by a serious crisis that would push up borrowing costs sharply for both governments and private borrowers, so damaging growth. So a path involving a credible fiscal consolidation has to be found that steers between these two possible bad outcomes. That task has become more difficult. Over the horizon of a couple of years it is hard to see how euro area demand won't be weakened. All other things equal, that would lessen global growth in 2011 compared with earlier projections (although it must be said that those projections have not relied all that much on growth in the euro area). Of course, all other things won't be equal. Financial markets and, perhaps, policymakers will respond to these events. The decline in long-term interest rates in the core European countries and many other countries around the world that has occurred may work, if it is sustained, to lessen the adverse impact on growth in those countries. If policymakers in other regions responded to the potential euro area weakness by leaving policies easier than they would otherwise have been, this too would have some offsetting impact, though possibly at the cost of more unbalanced growth. As to the effects on Australia, the euro area takes only about 5 per cent of Australia's exports. Those exports have been declining over the past few years anyway because the euro area has been weak for a while. So that direct effect doesn't seem likely to be all that large. It is usually the case, however, that the most important impacts on Australia from these sorts of events are not the direct export effects but those that come through the broader global channels - the impact on world and Asian growth, on resource prices and on the cost and availability of global capital. How big those effects may turn out to be remains to be seen. But one thing we can say is that one of the most important advantages in coping with episodes such as this is a good starting point. There is an old joke about the best way to get somewhere involving 'not starting from here'. We are not starting from the same place as Europe. In particular, Australia's budgetary position is very different from those in Europe and, for that matter, most countries. Public debt is low and budget deficits are under control and already scheduled to decline. The banking system is in good shape with little exposure to the European sovereigns having the biggest problems, and asset quality is generally better than had been expected. The flexibility afforded by our floating currency, coupled with credible monetary and fiscal policies, are all advantages in periods of global uncertainty. This doesn't mean there will be no effects. But these factors put us in the best position to ride through this particular event, even if it does get worse. Stepping back from the immediate issues, a final question worth posing is: what lessons might we take away from watching the travails in Europe? One is that vulnerabilities can remain latent for a long time, then materialise very rapidly. Markets can happily tolerate something for an extended period without much reaction, then suddenly react very strongly as some trigger brings the issue into clearer focus. There were certainly significant revelations about the true financial position in Greece that occasioned additional concern, but more generally in Europe it can't really have been news that the state of public finances was an issue: it had been so for years. But governments didn't come under gradually increasing market pressure to fix the problem - the pressure was minimal for a long time, then it suddenly became intense after a trigger event, in this case an economic downturn. It follows that potential vulnerabilities need to be addressed in good times, even when markets are not signalling unease, because by the time markets take notice and start responding seriously - which will usually be in bad times - the problem may have become pretty big. How is this relevant to Australia? Australia does not have a problem with public debt, as I have already said. Nor do we have a problem with corporate debt. Some highly leveraged entities foundered over the past couple of years but most of the corporate sector had pretty strong balance sheets going into the downturn and they are even stronger now. The big rise in debt in the past couple of decades has been in the household sector. There have been many reasons for that and, overwhelmingly, households have serviced the higher debt levels very well. The arrears rates on mortgages, for example, remain very low by global standards. As a result the asset quality of financial institutions has remained very good. So, to be clear, my message is not that this has been a terrible thing. But that doesn't mean it would be wise for that build-up in household leverage to continue unabated over the years ahead. One would have to think that, however well households have coped with the events of recent years, further big increases in indebtedness could increase their vulnerability to shocks - such as a fall in income - to a greater extent than would be prudent. It may be that many households have sensed this. We see at present a certain caution in their behaviour: even though unemployment is low, and measures of confidence have been quite high, consumer spending has seen only modest growth. This may be partly attributable to the fact that the stimulus measures of late 2008 and early 2009 resulted in a bringing forward of spending on durables into that period from the current period (though purchases of motor vehicles by households - a different kind of durable - have increased strongly over recent months). But the long downward trend in the saving rate seems to have turned around and I think we are witnessing, at least just now, more caution in borrowing behaviour. Of course this will have been affected by the recent increase in interest rates but the level of rates is not actually high by the standards of the past decade or two. We can't rule out something more fundamental at work. We can't know whether this apparent change will turn out to be durable. But if it did persist, and if that meant that we avoided a further significant increase in household leverage in this business cycle, it might be no bad thing. Moreover if a period of modest growth in consumer spending helped to make room for the build-up in investment activity that seems likely, perhaps that would be no bad thing either. These sorts of trends would surely increase the medium-term resilience of household finances and accommodate the resource boom and the rise in other forms of investment with less pressure on labour markets and prices than otherwise. The world economy has to date staged a stronger recovery than most thought likely a year ago, albeit one that is uneven across regions. Looking ahead, it has to be expected that the unfolding situation in Europe, which is going to result in earlier fiscal tightening than had been assumed by forecasters until now, will weigh somewhat on global growth in 2011. But the overall outcome will depend on what else happens and judgements about all that at this stage can only be preliminary. It cannot be denied that the potential for further financial turmoil exists, but to date the stresses have not been of the order of magnitude we saw a year and a half ago. Much still hinges, however, on the way European policymakers craft their ongoing response to a complex problem. We in Australia must naturally keep a careful watch on all this. It will be just as important, though, to keep a close watch on developments in the Asian region. Asia will be affected by events in Europe, but also by domestic forces. The experience of the past few years is that those domestic factors - good or bad - can loom just as large as ones further afield when it comes to Asia's economic performance and, therefore, our own. In the final analysis, sensible and credible policies at home, the strength of our financial institutions and the resilience and adaptability of the businesses and employees that make up the Australian economy, will continue to be our greatest assets.

r100720a_BOA

australia

NO_INFO

stevens

Thank you for coming along today in support of the Anika Foundation's work supporting research into adolescent depression. This is the fifth such occasion and it is very gratifying indeed to see such a strong response from the financial community. I want also to record my thanks to the Australian Business Economists for their support and to Macquarie Bank for their sponsorship of today's event. My subject is the consequences of the financial crisis. We are all aware of the immediate and short-term impacts the crisis had on the international financial system and the world economy. I won't repeat them. The initial phase of the recovery has been underway for over a year now. Global GDP started rising in mid 2009. When all the figures are in we will probably find that it rose by close to 5 per cent over the year to June 2010, though the pace has been uneven between regions and with some of the leading Asian economies seeking to slow down to a more sustainable pace, and European nations tightening fiscal policy, there is a bit more uncertainty just now about prospects for 2011. The bulk of financial institutions most affected by the crisis have returned to profit, while estimates of the total losses to be absorbed from the whole episode have tended to decline somewhat lately (though they are still very large). Financial market dislocation has gradually eased, albeit with sporadic episodes of renewed doubts and instability. But what of the longer-run consequences of the crisis? I want to offer some remarks under three headings, though with no claim this is an exhaustive list. These remarks are about the general international situation, not Australia in particular, unless otherwise noted. The first lasting consequence is the fiscal burden taken on by countries at the centre of, or close to, the crisis. There are three components to this. First, some governments took on bank ownership in order to ensure the replenishment of capital that had been too thin to start with and that was depleted by the losses on securities and loans. Table 1 shows public capital injections to the financial sector for several key economies. The amounts in mainland Europe could quite possibly grow soon as a result of the forthcoming stress tests. Note that this is not necessarily a permanent burden since, if carried out successfully, the ownership stake can be sold again in due course. In fact about 70 per cent of the funds invested by the United States in banks have been repaid, and the US Government expects to make an overall profit from these capital injections. Nonetheless for a period of time governments are carrying a little more debt than otherwise as a result of the provision of support to the banking system. Capital injections to financial sector Discretionary fiscal stimulus Per cent of GDP Second, the depth of the downturn saw recourse to discretionary fiscal packages. As the table shows, while there was a lot of national variation, for some countries this spending was quite significant relative to the normal pace of annual growth in GDP. To the extent that the packages had measures that increased spending for a finite period but not permanently, the result is a rise in debt of a finite magnitude, but not an ever-escalating path of debt. But it is the third factor - namely the magnitude of the downturn itself and the initial slowness of recovery - that is having by far the biggest effect on debt ratios. According to the IMF, for the group of advanced economies in the G-20, the ratio of public debt to GDP will rise by almost 40 percentage points from its 2008 level by 2015. Fiscal stimulus and financial support packages will account for about 12 percentage points of this. Close to 20 percentage points are accounted for by the effects of the recessions and sluggish recoveries. Another 7 percentage points comes from the unfavourable dynamics of economic growth rates being so much lower than interest rates for a couple of years. Now it is somewhat inaccurate to attribute the economic downturn effects entirely to the financial crisis because there would probably have been some sort of slowdown even without a crisis. There will always be a business cycle, after all, and deficits and debt rise when downturns occur. As a comparison, the rise in the debt ratio of the G7 from 2000 to 2005 associated with the previous cyclical downturn - which was not an especially deep one - was around 12 percentage points. Nonetheless the recent downturn was a bad one in many countries, and that is because it was associated with a financial crisis. For this reason, together with the other factors I have already mentioned, the major countries generally are going to have significantly higher public debt relative to GDP after the crisis than before, and the debt ratios will continue to rise for several more years. This was largely unavoidable. To a considerable extent, the fiscal legacy can be seen as one manifestation of a broader legacy of lost output (and hence weaker budgetary positions through 'automatic stabilisers') over a period of several years. Generally speaking, the public balance sheet has played the role of a temporary shock absorber as private balance sheets contracted. But the servicing of the resulting debt is an ongoing cost to the citizens of the countries concerned. At present that additional cost is, in some countries, reduced compared with what it might have been due to the low level of interest rates on government debt that we see. Moreover, had the debt not been taken on it could well be that the economic outcomes would have been much worse, so increasing fiscal and other costs. Nonetheless this lasting debt servicing burden is a real cost. More importantly, the pace of the rise in public debt has increased focus on the question of fiscal sustainability. This is especially so in those countries where debt burdens were already considerable before the crisis. The difficulty is that 'sustainability' is so hard to assess. It is more complex than simply the ratio of debt to GDP. In any number of countries, including our own, public debt ratios have on some past occasions been much higher than 100 per cent. Many countries found themselves with such a situation in the aftermath of World War II. Those ratios thereafter came down steadily though it took until the 1960s in our case, or longer in some others, for them to reach levels like 50 or 60 per cent that today is often regarded as a sort of benchmark. reduction occurred for a combination of reasons. The big deficits of the war years really were temporary in most cases; economies recorded good average rates of output growth in the long post-war boom with strong growth in both population and productivity; in the same period, business cycle downturns were not especially deep or protracted; interest rates were low - so the comparison of the growth rate of GDP and the interest rate on the debt was favourable; and lastly, significant inflation raised the denominator of the ratio - in some cases in the late 1940s and early 1950s, and more widely in the 1970s. So high or even very high debt ratios per se have not necessarily been an insurmountable problem in the past. On the other hand, that earlier decline in debt ratios may not be easy to replicate in the future. In some countries demographics are working the wrong way, with population growing more slowly or even declining. Other things equal, future growth of nominal GDP will thus be lower than in the past. A period of rapid catch-up growth in income, which helped Europe and Japan in the couple of decades after 1950, is more likely in the future to occur in the emerging world than in the parts of the developed world where most of the debt is. In fact it might be argued that the fiscal position of a number of countries has been increasingly vulnerable for quite some years. Perhaps what the crisis has done is to act as a catalyst to bring forward a set of pressures for long-term budgetary reform that were bound to emerge anyway. This has placed some governments in a very difficult bind, since the heightened focus on sustainability has increased the pressure for fiscal consolidation at a time when aggregate demand remains weak. The 'least-damage path' through the various competing concerns has become harder to tread. The second long-run implication of the crisis is that government intervention in the financial sector has become much more pervasive. I have already mentioned governments taking major stakes in banks in key countries, which was virtually unthinkable, certainly for an American or British government, only three years ago. But the intervention was broader than just a temporary period of public ownership - as massive an event as that has been. Take guarantees. Once the Irish Government guaranteed its banks, governments all over the world felt bound to follow suit in some form or other - expanding or (as in our case) introducing deposit insurance, and guaranteeing wholesale obligations (for a fee). The feeling was probably most acute in countries whose citizens could shift funds to a bank guaranteed by a neighbouring country without much effort. In circumstances of incipient or actual panic, or potential complete market closure, measures along such lines had to be taken. The simple truth is that, given a big enough shock, the public backstop to the financial system has to be used. But the backstop having been used so forcefully on this occasion, it is desirable not to use it again soon. The real question is how, having set the precedent, governments avoid too easy recourse to such measures in the future. They will want to get to a position where in future periods of financial turmoil, they are standing well in the background, not in the foreground. Meanwhile there is a growing debate, at a very high level, about what the financial sector should do, and what it should not do. The number of inquiries, commissions, conferences, papers and ideas about the desirable shape of the system in the future is growing. This is a growth industry with, I should think, pretty good prospects over the next few years. Another characteristic of public intervention is the expansion of central bank balance sheets. During a panic, the central bank's job is to be prepared to liquefy quality assets, with a suitable combination of hair-cuts and penalty rates, to the extent necessary to meet the demand for cash. Once the panic is over, the additional liquidity shouldn't need to remain in place, and indeed some particular facilities established by central banks had design features which saw their usage automatically decline as conditions improved. But overall it has proven difficult, so far, for the major central banks to start the process of winding down the sizes of their balance sheets. In effect central banks have been replacing markets. They had to. If counterparties feel they cannot trust each other and flows between them are cut off, with everyone preferring to keep large liquid balances with the central bank, the central bank has to replace the market to ensure that everyone has the cash they need each day (against suitable collateral of course). Central bank purchases have also acted to reduce credit spreads and yields. I am not arguing that this policy is macro- economically wrong. But consider the implications of persisting with it over a long period. One doesn't have to believe that markets can solve all problems to accept that well-functioning markets have a value. A cost of the zero or near zero interest rate and a greatly expanded role for the central bank's balance sheet is that some markets tend to atrophy - as Japan has found over a decade. Moreover some central banks have had to accept a degree of risk on their own balance sheets that is considerably larger than historical norms. Of course since the governments are ultimately the owners of the central banks, that is where the risk really resides. From a purely financial point of view, the risk of a rise in yields on bonds held by central banks, but issued by their own governments, is actually no risk at all once the central bank is consolidated with the government. On the other hand, to the extent that central banks are really exposed, or are exposing their governments, to private credit risk or to the risk of other sovereigns, those are genuine risks. So some central banks, like their governments, have found themselves in very unusual terrain. It is terrain: in which the relationship between the central bank and the government is subtly changed; where the distinction between fiscal and monetary policy is less clear; from which it may be hard to exit in the near term; and a side effect of which may be wastage, over time, in some elements of market capability. Of course I have not yet mentioned the other significant public intervention in finance which is the major regulatory agenda being pursued by the international community. This is being pushed by the 'perimeter' of regulation is being extended to include hedge funds and rating agencies. Governments are demanding a say in the pay of bankers and talking of specific taxes on banks' activities. The climate is more difficult for bankers these days, it seems, especially in countries where the public purse had to be used to save banks. But the core work on regulatory reform is being done not sure who first began to talk of this as 'Basel III' but the label seems to be starting to stick. Basel II came in only about two years ago for many countries, Basel III looks like being a lot shorter. Warning: that pace of acceleration in devising new standards is You would all be well aware of the essence of the proposals. In a nutshell, what regulators are pushing toward is a global banking system characterised by more capital and lower leverage, bigger holdings of liquid assets and undertaking less maturity transformation. It is hoped that this system will display greater resilience to adverse developments than the one that grew up during the 1990s and What will be the implications of the various changes? Put simply, the customers of banks around the world, and especially of large internationally active banks, will generally be paying more for intermediation services, in the form of higher spreads between rates paid by banks and rates charged by them. The reason is that capital is not free and it typically costs more than debt. The spread between a bank's own cost of debt, both deposits and bonds etc, and the rate it charges its borrowers has to cover operating costs, expected credit and other losses and the required cost of equity capital. Assuming the costs of equity and debt do not change, the more capital intensive the financial structure is, the higher that spread has to be. A requirement to hold more high quality liquid assets and/or to lengthen the maturity of debt has a similar effect. Of course the costs of equity and debt may not be, and actually should not be, constant as banking leverage declines. The cost of wholesale debt should fall over time if the equity buffer, which protects unsecured creditors against losses, is larger. In time, the cost of equity may even fall with lower leverage if the required equity risk premium declines to reflect a less variable flow of returns to equity holders. All of that assumes of course that the perceived riskiness of the underlying assets is unchanged. Still, such effects would take some time to emerge. Most observers appear to agree that even allowing for some possible pricing changes over time, spreads between banks' borrowing and lending rates will be wider in the new equilibrium after the regulatory changes have been fully implemented. What will be the broader economic effects of these higher costs of intermediation? The conclusion most people are reaching is that economic activity will, to some extent and over some horizon, be lower than otherwise. The question is, by how much and for how long? There are various ways of approaching that question. Researchers are putting it to various macroeconomic models. The answers will vary, depending on the models and particularly according to the degree of detail in models' financial sectors. Overall, these techniques are likely to show moderate but nonetheless non-zero effects on economic activity of the regulatory changes over an adjustment period of several years. Some other analyses, often by banks themselves, find much larger adverse effects. This is usually because they find that credit to the private sector must be reduced in order to meet the various standards, particularly liquidity standards, because it is assumed there will be quantity limits on the availability of funding in the form necessary. It is further assumed that a mechanical relationship between credit and GDP exists, which in turn results in big adverse impacts on GDP. To a fair extent these differences come down to a discussion about what economists would call elasticities: for the non-bank private sector to respond to a desire for banks to be funded differently, how big a change in the price is required - a little, or a lot? Some of the industry estimates appear (to me anyway) to assume elasticity pessimism. Official sector estimates are likely to be based on less pessimism. In truth, it is impossible to know for sure exactly how big these effects will be. That is a reason to proceed carefully, and to allow time for the new rules to be phased in. Clearly, we wish the new rules to be constraining risk taking and leverage as the next boom approaches its peak, but that will probably be some years away, so we have time to implement strong standards and allow an appropriate period of transition. That said, there are three broad observations that I would like to offer. First, I think we ought to be wary of the assumption of a mechanical relationship between credit and GDP. Of course a sudden serious impairment in lenders' ability to extend credit almost certainly amounts to a negative shock for growth in the short term. But did the steady rise in leverage over many years actually help growth by all that much? Some would argue that its biggest effects were to help asset values rise, and to increase risk in the banking system, without doing all that much for growth and certainly not much for the sustainability of growth in major countries. gradual decline in the ratio of credit to GDP over a number of years, relative to some (unobservable) baseline, without large scale losses in output may be difficult to achieve but I don't think we should assume it is impossible. Secondly, even accepting that there will probably be some effect of the reforms in lowering growth over some period of time, relative to baseline, we have to remember that there is a potential benefit on offer too: a global financial system that is more stable and therefore less likely to be a source of adverse shocks to the global economy in the future. So we have a cost-benefit calculation to make. Quantifying all this is very difficult, but then that is often the case when deciding policies. Thirdly, however, the reforms do need to be carefully calibrated with an eye to potential unintended consequences. One such consequence, obviously, would be unnecessarily to crimp growth if the reforms are not well designed and/ or implementation not well handled. Another could be that very restrictive regulation on one part of the financial sector could easily result in some activities migrating to the unregulated or less regulated parts of the system. Financiers will be very inventive in working out how to do this. If the general market conditions are conducive to risk taking and rising leverage (which, sooner or later, they will be if the cost of short-term money remains at zero), people will ultimately find a way to do it. Of course while ever the unregulated or less-regulated entities could be allowed to fail without endangering the financial system or the economy, caveat emptor could apply and we could view this tendency simply as lessening any undue cost to the economy of stronger regulation of banks. But if such behaviour went on long enough, and the exposures in the unregulated sector grew large enough, policymakers could, at some point, once again face difficult choices. The financial turbulence we have lived through over recent years has had profound effects. The most dramatic ones in the short-term have been all too apparent. But big events echo for many years. My argument today has been that the full ramifications are still in train, insofar as impacts on governments' finances, governments' role in the financial sector and the trend in regulation are concerned. It will be important, as these reverberations continue, for there to be a balanced approach blending strong commitment to sensible long-run principles with pragmatism in implementation. In Australia we have been spared the worst impacts of serious economic recession in terms of lost jobs, much as we will be spared the prospect of higher taxes that face so many in the developed world. These are factors that support our native optimism, at least about economic conditions. Nonetheless depression still ranks as a serious, and underestimated, problem in our community including among our young people. That is why the work of the Anika Foundation, working alongside other bodies seeking to combat depression, is so important, and why I thank you all very much for coming along today.

r100817a_BOA

australia

NO_INFO

stevens

Thank you for the invitation to deliver the 2010 Shann Lecture. It is an honour. People are shaped by formative events, and Edward in 1884, his family moved to Melbourne a few years later. Growing up in the Depression of the 1890s - an episode that hit Melbourne particularly hard - Shann saw first-hand the effect that financial crises could have on peoples' lives. Those memories stayed with him and motivated much of his career's work. In his early adult life Shann exhibited some Fabian tendencies - and a flirtation with the Left would be a not uncommon response by a later generation of intellectuals as a result of the sense that capitalism had failed in the 1930s. But by the time he had become prominent as an economist, his views had shifted in a direction that we would probably today call Libertarian. One of his most noted works was a short pamphlet, published in 1927, that described the lead-up to and crash of the early 1890s. It was prescient in drawing parallels with the financial developments in the 1920s that preceded the 1930s depression. The 1880s were characterised by rapid population growth and increased urbanisation which fostered an investment boom dominated by construction. There was a spirit of optimism, which saw international capital flow in and asset prices - particularly land prices - increase. Leverage rose and lending standards fell. As Shann's monograph noted, financial regulation at the time abetted the excesses, including an 'untimely amendment' of the Victorian Banking Act in 1888, which allowed borrowing against a wider range of collateral. In the 1920s, when Shann was applying this experience to contemporary issues, the problem was not so much excessive private debt or poor regulation. This time the problem Shann saw was too much public borrowing. He viewed the extensive public works popular with State governments in the 1920s as not only increasing debt but also lowering productivity. So it would come as no surprise that, after Australia's terms of trade collapsed in the late 1920s and international capital markets made new borrowing much more difficult, Shann was among the group that argued that the standard of living that could feasibly be associated with full employment was noticeably below that to which people had become accustomed in the boom. The Premiers' Plan of 1931, which Shann had a hand in producing, sought to recognise this, and to spread the associated decline in incomes across the different sectors of society. These two episodes had some important differences, but in a deeper sense both stories were rather similar, and all too familiar. The sequence goes as follows. Some genuine improvement in economic conditions leads to more optimism. It may be a resource discovery (including the opening up of new productive land), or a technological change, or a rise in the terms of trade, or even just greater confidence in economic policy's capacity to solve problems. Human nature being what it is, people (or governments) are inclined to project into the future with undue confidence and insufficient assessment of risk. They often decide to invest more in ventures that are marginal, or even speculative, borrowing to do so. Because their assessment of permanent income is that it has increased, they also decide to consume more now (either privately or in the form of public services). Financial markets and institutions - which are populated by human beings after all - help them do both these by making capital available. Then, at some point, an event causes people suddenly to realise they have been too optimistic. Maybe the 'new paradigm' disappoints in some way or the terms of trade decline again. The cycle then goes into reverse, usually painfully. This pattern is fresh in our minds after the events of the past several years. But Shann was writing about it 75 years ago, and of course he wasn't the first. Narratives like these are peppered throughout history. The thought that 'This Time is Different' springs eternal in the human psyche, and is a fitting title to the recent work by Reinhart and Rogoff (2009) covering eight centuries of financial delusions. Moreover, financial instruments, markets and institutions are always central to the way these cycles play out. So it is fitting, given Shann's own work, to ask the question: what is the proper role of finance? In particular, I will take up four questions: 1. What are the desirable functions of the financial system, and how did they evolve? 2. What problems are inherent in finance, and what issues do they raise for policymakers? 3. What questions arise from the growth and change of the financial system over the past couple of decades? And finally, 4. What are the challenges as we look ahead? What is it that we need the financial system to do? I think we can outline five key functions. We want it to provide: i. a reliable way of making payments (that is, exchanging value); ii. a means for pricing and pooling certain types of risks; iii. a way of transferring resources from savers to borrowers; iv. a way of transferring the returns back again, which requires that the savers' money is not lost and which, in turn, requires monitoring of borrowers and managers; and v. liquidity. These are very valuable things for a community to have. The modern economy could not have developed without these capabilities arising in the financial system. We tend to think of financial activity and innovation as very recent, but in fact the history is a long one. There is not time to do justice to that history here, and there are some fascinating books on the subject which repay the reader generously for the investment of their time. But it is clear that borrowing and lending is almost as old as civilisation itself. Evidence of such transactions, some of them remarkably codified, go back at least to eighteenth century BC Babylonian records. Some scholars suggest that the records of the Greek and then Roman ages show considerable evidence of several activities we would associate with banking, including taking deposits, making loans and facilitating transactions. Developments seemed to accelerate during the Renaissance, particularly in Italy. Bills of exchange were by then in common use as a means to facilitate trade and also to circumvent usury laws. Traders were able to take a deposit in one city, make a loan to someone transporting goods to another city and then take repayment at the destination (possibly in a different currency) - with a suitable addition to the price in lieu of interest. This activity would appear to be a forerunner - by seven centuries - of an instrument that in our terminology would combine elements of a zero coupon or discount security, trade credit and a sort of foreign currency swap. The most noted bankers of that era were of course the Medici family of Florence, who went further than their predecessors and contemporaries in the pooling of credit risk, by having a branch network with partners who were remunerated with a profit share. The development of double-entry bookkeeping, in Genoa in the 1340s, also helped banking assume more modern features: the receipt of deposits, maintenance of current accounts, provision of loans and management of payments. This form of banking in Italy later became a model for Holland, Sweden and England, to which further innovations were added. In Amsterdam, the , which was the first exchange bank in Northern Europe, pioneered a system of cheques and direct debits circumventing problems with different currencies. in 1656 and the oldest institution recognised today as a central bank, is credited by some as having pioneered fractional reserve banking. Other key innovations were joint-stock ownership and limited liability. These allowed more capital to find its way into banking and further reduced the costs of intermediation. The Bank of England, established in 1694, was for many years the only bank in England allowed to operate on a joint-stock ownership basis. Walter Bagehot devotes a chapter in to the virtues of joint-stock ownership, noting that while these sorts of companies 'had a chequered history', in general the joint-stock banks of Britain were 'a most remarkable success'. The same innovations helped to develop equity markets more generally. Meanwhile bond markets had also developed. Again the earliest forms were in Renaissance Italy, where wealthy citizens were able to buy bonds and thereby invest their savings in one of the few activities that was seen as providing a significant return: war. Such instruments allowed governments (and later large corporations) to raise funds from a broader set of sources. In time, the formation of secondary markets for these securities meant that risk had a price set by a market. These innovations also spread to Northern Europe and, by the mid-eighteenth century, London had a well-developed bond market. It was trading in the bond market that made the Rothschild family wealthy and for most of the nineteenth century its bank was the largest in the world. So by the middle of the nineteenth century a quite sophisticated financial system had arisen in major western economies. It included banks and other financial intermediaries, stock and bond markets and insurance. It allowed transactions to be made, and mobilised pools of savings for investment in enterprise while offering a degree of liquidity to savers. It pooled certain risks, and served in a fashion to monitor borrowers. It allowed payments to be made and funds invested across national borders. In the process, it facilitated the industrial revolution, which resulted in the biggest transformation in living standards seen in the history of western civilisation. This system did just about all the things we would want a financial system to do today, albeit with less technological efficiency. Arguably the biggest change a financier from much earlier times would notice today would not be the new instruments - nor the crises! - but the effects of the silicon chip and fibre optics on the way finance is conducted. Incidentally, the difficulties that accompanied having only a rudimentary financial system were nowhere better illustrated than in the early Australian colonies, as one of Shann's other works, makes clear. The most commonly used means of exchange for many years was rum. Indeed, he reports that in Sydney 'George Street between Brickfield Hill and Bridge Street cost four hundred gallons' of rum to build. In today's prices for rum, this amounts to about $80 000. It is doubtful that a road of that length could be constructed for that sum today, such has been the increase in the price of labour in terms of rum (and indeed other commodities). The colonists began to issue 'notes' or 'cards', which were forms of IOUs and which circulated as currency, although this system soon became unworkable partly because the quality of such IOUs varied greatly and tended to decline over time. Governor Macquarie famously sought to end the shortage of metallic currency by punching holes in a consignment of Spanish dollar coins, giving the 'ring' and 'dump' different values, and also rendering them less useful elsewhere, thereby retaining this currency in the new colony. However, the need for credit facilities, for pastoral expansion and short-term financing for local and overseas trade, still required the development of a banking system. In 1817, Macquarie granted a charter to a group of leading traders and officials to form the Bank of New South Wales, with responsibility to issue a paper currency. As Shann points out, the stock holders were given limited liability in the operations of the Bank of New South Wales, which at the time in England was still an exclusive privilege of the Bank of England, and was not granted to other British banks until 1858. So despite a somewhat shaky start, Australia's own financial system was able to catch up rapidly on the other developed economies by adopting their technologies. As banking had developed, it had become more leveraged. No longer was it a case of a few wealthy individuals risking their own money in enterprises akin to venture capital funds - accepting the risk and illiquidity that went with it. In their more developed form, banks raised deposits from the public - redeemable at their face value, at notice or at call. Leverage changes the dynamics of any business. Expected returns are higher but management needs to be on its game - which is an oft-quoted argument for having some debt in a corporation. In the case of banks, it meant that the business of banking became even more focused on monitoring, information gathering and risk management. Of course the depositors had some protection in that the capital of the proprietors was at risk before deposits. But banks also undertook maturity transformation. They offered depositors liquidity, but held only a fraction of their own assets in liquid form - enough for normal day-to-day operations. The whole thing depended on confidence - if depositors wanted their funds back en masse, a bank could not provide them because its assets were not all in cash. If there was a loss of confidence for some reason, the bank would be under pressure: there could be a run. So banks themselves needed access to liquidity in situations of stress; that is, they needed to be able to liquify assets when a shock to confidence occurred. When such a shock was idiosyncratic, a bank might seek funding in the market. Other institutions, mindful of the possibility of contagion if a run got going, might support one of their competitors provided there was a reasonably held expectation of solvency. But if the confidence shock was more systemic in nature the question was how the whole system could be supported. This came to be seen as the proper role of a central bank and was ultimately encapsulated in Bagehot's famous (if widely misquoted) maxim that the central bank should be prepared to 'lend freely, against good collateral at a high rate of interest'. Of course central banking was at that time embryonic at best: the central banks in existence in Bagehot's day mainly had been established to help sovereigns raise war finance; their stability functions evolved later, over time. But while the provision of liquidity in crises left the system less vulnerable to runs, it was no real solution to simple bad lending. Even if all the good assets can be liquified to meet a run, if not all the assets are good, failure may still occur. Failures of individual institutions could be allowed provided they did not damage confidence in others, but it is always difficult to know just how small or large a failure might cross the threshold. Inevitably, since there could be spillovers from failures, and since banks and others would accept funds from the general public, there would end up being a degree of regulation. And so the history of banking and finance is not just a history of financial innovation, it is also a history of regulatory response. That regulatory response has had its own quite pronounced cycles. Moreover, regulation prompts further innovation, and so on. From the 1930s, regulation became much more intrusive. In the United States, fear of the 'money power' saw some large institutions (J.P. Morgan for example) broken up, much as occurred in some other industries at the time. Yet simultaneously, competition between banks was intentionally curtailed in some respects, for fear of irrational behaviour. Regulatory intervention extended to interest rates, requirements for reserves, prohibitions on certain types of business, and even lending guidelines and quotas. In the 1940s this all became part of the war-time apparatus that essentially sought to run economies via direct intervention rather than by relying on the price mechanism. However, it persisted in finance for many years after the war had ended, perhaps in part to keep low the costs of servicing large war debts. It was only really in the 1980s and 1990s that this regulatory approach had finally passed, allowing banks to compete vigorously for all lines of business and allowing pricing to be driven by market forces. We can trace many of these trends in Australia. The Royal Commission argued for greater control and regulation of the Australian monetary and banking systems, motivated by the perceived failings of the financial system through the depressions. Legislation on many of the recommendations from the Commission was enacted in 1945 and continued the tight controls placed on banks during the Second World War. The focus immediately after the war was on stability with little regard given to the efficiency of the financial system. This was consistent with extensive government intervention and regulations in other markets. As a result, in the early post-war period, the Australian banking system was highly constrained. There were tight controls on interest rates for bank lending and borrowing, on terms to maturity of different types of deposits and loans, and quantitative and qualitative controls on banks loans in aggregate and to particular types of borrowers. These were introduced to guard against excessive risk-taking by banks with depositors' savings and also were regarded as serving the needs of macroeconomic policy. Given the pervasive and restrictive nature of these controls, it is perhaps not surprising that the banking system was very stable. In the almost five decades from the early 1930s until the problems of the Bank of Adelaide in 1979 no Australian bank failed or even faced serious financial problems. This was in a very real sense a result of the terrible 1890s depression which had been so influential on the young Shann. As Selwyn Cornish points out, that episode had a significant effect on the nature and form of much of Australian economic policy throughout most of the twentieth century, including financial regulation and central banking. But the constrained banking system left a gap into which others stepped. As early as the 1960s, new, less regulated, financial institutions began to arise. The banks' share of financial intermediation in the Australian economy steadily declined from the mid 1960s, reaching a little over half at its lowest point in The increasing size and complexity of the system and the rise of non-bank financial institutions made the regulatory architecture increasingly less effective. By the late 1970s, the philosophical tide was turning against intervention as efficiency costs became more apparent - a trend not confined to finance. Eventually these inefficiencies led to calls for financial liberalisation and so, around 40 years after the foundations for the intellectual and practical shift towards liberalisation and the current system. In addition to freeing up banks, the floating of the currency and the opening up of capital markets, a range of technological advancements - as well as economic development and policy changes affecting other sectors in the economy - also were important drivers of change in the financial system. The past 20 years has seen a major increase in the size and breadth of activity of the financial sector in most economies, as well as an acceleration in the globalisation of finance. Statistics abound to demonstrate this: the turnover in various markets, the real value of assets, the amount of gross derivative positions outstanding; all have grown considerably faster than the size of overall economic activity. Again some of these same trends are seen in Australia. Total assets of financial institutions relative to the size of the economy have increased from the equivalent of around 100 per cent of annual GDP in the early 1980s to almost Noteworthy in some countries has also been a significant increase in the share of financial activity in the economy's value added and the proportion of people employed in the financial sector. It is widely assumed that financial deregulation played a major role in this increase, and the timing seems to fit. Now, in the aftermath of the crisis, there is a more questioning tone about whether all this growth was actually a good idea: maybe finance had become too big (and too risky). This question is certainly a live one in the United Kingdom, where the City of London was very prominent in the economic success of the country since the mid 1980s. There are at least two potential problems in a world where the finance sector becomes 'too big'. If it is accepted that finance has its own cycle - of risk appetite, leverage, crisis and then de-leveraging - then a bigger financial system compared with the economy, unless accompanied by much more capital (and it wasn't in the case of the big international banks - the reverse was true), risks de-stabilisation of the whole economy. Because crises can be costly, moreover, calls are inevitably placed on the public purse for support. These are very difficult to resist. In the current episode, the direct costs to the public purse of restoring financial stability in some of the North Atlantic countries are non-trivial. But the cost of lost revenue in the lengthy periods of economic weakness that seem invariably to follow financial crises is an order of magnitude larger. It is this factor really that has unleashed the recent round of concerns about public finances in the affected countries. Secondly, as well as making incomes and activity less stable, an overly large financial sector, if characterised by perverse incentives that can drive extraordinary remuneration for individuals, may draw in too many resources that could otherwise be employed at a higher social return. To put it in practical language, too many PhD physicists, mathematicians and engineers working on options pricing and designing structured products could lower, rather than increase, the productive capacity of the economy. For finance is not, for the community, an end in itself. It is a means to an end. Ultimately it is about mobilising and allocating resources and managing risk and so on - providing the five outputs I listed earlier. Yet people have become suspicious of the way much of the activity in the financial system amounts to the production of 'intermediate' financial services, delivered to others within the same sector: the 'slicing and dicing' of risk, re-allocating it around the system to those who are most willing and best able to bear it (or, sometimes perhaps, and much more troublingly, to those who least understand it). Some commentators - among them the chair of the UK Financial Services Authority - have openly questioned the social usefulness of much of this activity. In essence people are asking whether the rising size and pace of transactions of the finance sector is actually a sign of higher economic prosperity, or of something wrong. They are also questioning implicitly whether the thrust of financial liberalisation in the 1980s and 1990s was correct, or at least may have gone too far, if it helped to produce these outcomes. These questions are likely to be debated intensely over the next several years. This will be a growth sector of the conference and consulting industry. It is therefore premature to draw strong conclusions, but a few observations may be useful. First, a small point of measurement. In most modern economies, the share of GDP accounted for by services generally has long been growing as agriculture and manufacturing get (relatively) smaller. It would not be surprising for the finance sector to be part of that. So it might make more sense to measure the financial sector as a share of the services sector, rather than as a share of total GDP. On this basis it will still have shown a distinct rise, but not quite as much. In Australia's case, by the way, the finance sector's share of services sector employment peaked around 1990, thereafter declined somewhat and has changed little for a decade. Second, a fair bit of the growth in financial sector activity was surely bound to happen in view of changes in technology. These dramatically lowered costs, so that the provision of news and information became instantaneous and ubiquitous, as did the ability to respond to news. The capacity to monitor and manage a portfolio more actively is likely a 'superior good': people will want more of it as their affluence increases. The increasing development of financial management techniques and new instruments - another kind of technology, if you will - also led to a lot more gross activity. For example the conceptually simple process of keeping to a benchmark drives a good deal of transaction volume. So surely some of the growth in the finance sector has been genuinely useful, and the technological changes mean that much of it has been accommodated without much in the way of real resources being used. That is not to deny that there is a very important set of questions about the price the general public is paying for some of the services and about whether the capacity to respond to every piece of 'news' is resulting in an excessively short-term focus in management. The latter is, of course, a question that extends much more widely than just the finance sector. Third, the increasing integration of the global economy - itself assisted by financial development - brought the savings of literally hundreds of millions of Asians into the global capital market. This meant that differences between countries' policies and saving and investment appetites became more likely to affect financial trends and market prices. These factors were certainly one reason that interest rates, including long-term rates set in markets, not just the ones set by central banks, were so low in the middle of last decade. Surely this had a major bearing on the pace of growth of intermediation and, ultimately, the appetite for risk in the global system. Fourth, we need to be careful how much blame we ascribe to changes in regulation for everything that went wrong. Of course it cannot be denied that the regulations had shortcomings. But while all significant countries were operating on more or less the same minimum standards for bank supervision, some countries had serious financial crises, but many - in fact most - did not. Moreover, a significant part of the problems arose in the 'shadow banks' - more lightly regulated institutions which were not banks (though some of them became banks subsequently when there was a regulatory advantage to doing so). Many observers have concluded that in the major countries, allowing large regular commercial banks to engage in more 'shadow banking' type activity without more capital was a mistake. But all this says that supervisory practice is as important as the formal regulations. Moreover, if those freedoms were granted in response to the demand by the commercial banks to get in on the action happening elsewhere, that points to the general environment as a big part of the story. As we know from our own history, if there is an incentive for risk-taking activity to occur (like low interest rates, for example), it will eventually occur even if it has to migrate to markets and institutions where fewer regulatory impediments are in place. To put this point at its most extreme, it could be argued that that the overall environment dictates the appetite for risk-taking financial activity, and that the nature of regulation simply determines the location of the activity. That is, as I say, extreme, but there is some truth to it. Where then does this leave us? The regulatory cycle has come fully around. After two or three decades of liberalisation and allowing markets and private agents in the financial sector more sway, the international debate has of late been consumed with issues of financial regulation: how to re-design it, and generally increase it. This is understandable, and it is entirely appropriate that these questions be posed in the light of the events of the past decade. My point is simply that we have been here before. If we think far enough back in history, there are things to learn about regulation and its cycle, just as there would have been - had people been more inclined to look - about the nature of private finance and its cycle. The objective shouldn't be to suppress finance again to the extent it was for so long in the past. There would be a cost to the economy in attempting this, and in any event the financiers will be quicker to figure out the avoidance techniques than they used to be. The objective should, rather, be to foster arrangements that preserve the genuine benefits of an efficient and dynamic financial system, but restrain, or punish, the really reckless behaviour that sows the seeds of serious instability. Such arrangements surely have to include allowing badly run institutions to fail, which must in turn have implications for how large and complex they are allowed to become. There is a large reform effort under way at the international level. I have spoken about this before on several occasions and so I will not revisit the regulation issue here. I would only say that while no doubt regulations can always be improved - and who would say otherwise? - it is unlikely that regulation per se , becoming more and more complex and widespread as it is, will be the full answer. A big part of the answer must come from practice, not just black-letter law. The finance industry, certainly at the level of the very large internationally active institutions, needs to seek to be less exciting, less ambitious for growth, less complex, more conscious of risk and more responsible about where those risks end up, than we saw for the past decade or two. And, of course, it does have to be better capitalised. Equally, surely regulators and supervisors in some jurisdictions need to be more intrusive and assertive, to be prepared to go beyond minimum standards and to be a little less concerned about the competitive position of their own banks, than they have been in the past. It has been not uncommon, for example, for Australian bankers to complain about APRA's relatively strict rules on definition of capital for regulatory purposes, where other jurisdictions were more lenient. But the international supervisory community is at this moment in heated debate about what can and cannot be counted as capital, and it is moving, belatedly, in APRA's direction. But to be effective, supervisors need support from their legislatures and executive government - in having strong legislation, adequate funding, and a high degree of operational independence from the political process in the conduct of their duties. In several countries legislatures are working now, in the aftermath of the crisis, to strengthen supervisory arrangements. That is good, but the most important time to have this support is in the boom period - when a cashed up private sector, which would much prefer the party to keep heating up, can bid quality staff from regulatory agencies and is not averse to looking for other ways of tilting the playing field in the direction of short-term profits. It is precisely then that capable, well-resourced and well-supported regulators need to be able to say 'no'. Edward Shann died tragically in 1935. He did not live to see the full recovery from the Great Depression, nor the long post-war prosperity. He could not take part in the subsequent debate about financial regulation in its ebbs and flows. But were he to have been able to observe the past fifteen years in the global economy and financial system, I think he would have recognised many of the features. Finance matters. Its conduct can make a massive difference to economic development and to ordinary lives - for good or ill. Moreover, finance has its own cycle - of risk appetite, innovation and occasional crisis. That won't change. Shann understood that and so must we. The sort of financial system we should want is what was once described as 'the hand-maid of industry': reliably facilitating transactions, fostering trade, bringing savers and investors together, pooling risk and so on. We don't actually want too many of the financiers to be 'masters of the universe'. There will always be a risky fringe, but it should stay at the fringe, not be at the core. But the man we remember tonight would not want the financial system to be simply an arm of the state either, subject entirely to bureaucratic or political direction. We shouldn't be looking to go back to the So we have to find the right balance involving regulation, supervision and financial industry practice. That is the task that lies before us.

r100920a_BOA

australia

NO_INFO

stevens

Thank you for the invitation to come to Shepparton. No one knew, when the invitation was issued almost a year ago, that you would be battling floodwaters just a couple of weeks prior to today. It is good to see the recovery already well advanced. In the global economy, recovery from the effects of a different kind of deluge - a man-made one - has been under way for a while. Progress has been quite varied, however, and the outlook is uncertain just now. I will give an update on those matters today. It also seems a fitting occasion to talk about 'monetary policy and the regions', since a question we are often asked is how we take account of differing economic conditions across the country in the setting of monetary policy. I will offer some perspectives on the issues that arise when we have one policy instrument for a fairly diverse economy. The essential message here is that such diversity matters, but is often not as pronounced as people assume, because all the parts of the economy are ultimately connected. Things that affect one sector tend to have spillover effects elsewhere. Furthermore, economies have a certain capacity to adjust to differing conditions. In Australia this works reasonably well. The global economy continues to present a mixed picture. In the Asian region, most countries have well and truly recovered from a downturn that occurred in late 2008 and the first few months of 2009. The main exception is Japan. In the bulk of cases, economies are much closer to their potential output paths now than they were a year ago and policies are moving to less expansionary settings. As a result, over the year ahead the growth in the Asian region is unlikely to be as rapid as over the year to mid 2010, when the 'v-shaped' recovery was in full swing. Similar comments could probably be made In Europe, the German economy has been powering ahead this year, reaping the benefits of many years of attention to containing costs and building productivity. But other continental economies are not as strong, and some are in the grip of a very painful adjustment to a world of constricted private credit and limits to budgetary flexibility. In the United States an expansion has been under way for some time, but seems lately to have been losing a bit of steam and growth has recently not been robust enough to reduce high unemployment. In Australia, growth has been quite solid over the past year, unemployment is relatively low, and inflation has, for the moment, declined. In fact, growth trends have been favourable over several years now in comparison with many other economies. The charts below, comparing trends in Australia's real GDP per capita with that of several countries, are illustrative. Of course we cannot match the extent of growth in China - a country where living standards are rapidly increasing in a process of 'catch up' to the it is clear that compared with the US or Europe, or Japan, Australia's per capita output and income has done pretty well over the past several years (Graph 2). The task ahead, then, is to seek as far as possible to continue a solid trend like this, through various challenges which lie ahead. The future is of course unknowable, and economic forecasts unfortunately are not very reliable. But we have no option but to try to form a view of how things will probably unfold. We think the global economy will record reasonable growth over the coming year, though not as strong as the past year (a strength that, incidentally, surprised most observers). We think Australia's terms of trade, after reaching a 60-year high in the current quarter, will probably decline a bit, but remain high. We expect that this high level of relative export prices will add to incomes and spending, even as the stimulative effects of earlier low interest rates and budgetary measures continue to unwind. We expect, and indications from businesses are that they do as well, that resource sector investment will rise further - as we experience the largest minerals and energy boom since the late 19 century. Even with continued caution by households, that probably means that overall growth, which has been at about trend over the past year, will increase in 2011 to something above trend. We think that means that the fall in inflation over the past two years won't go much further. Of course that central forecast could turn out to be wrong. Something could turn up - internationally or at home - that produces some other outcome. We spend a fair bit of time thinking about what such things could be. Possible candidates might be a return to economic contraction in the United States, or a bigger than expected slowdown in China, or the resumption of financial turmoil that abruptly curtails access to capital markets for banks around the world and damages confidence generally. But if downside possibilities do not materialise, the task ahead is likely to be one of managing a fairly robust upswing. Part of that task will, clearly, fall to monetary policy. What then are the objectives of monetary policy? Put simply, our job is to preserve the value of money over time and to try, so far as possible, to keep the economy near its full employment potential. Over the long run, these are mutually reinforcing goals, not conflicting ones. For the past 17 years the way we have pursued these goals has been to operate a medium-term target for CPI inflation of 2-3 per cent, on average. The 'on average' specification allows us to accept short-term fluctuations in inflation - as long as they are only short-term - and so avoid the risk of attempting to over-control inflation and in the process de-stabilising the economy. But the specification still requires us to limit inflation in the medium term. Over the 17-year period, CPI inflation has averaged 2.5 per cent (excluding the onetime impact of the GST in 2000), and the economy generally has exhibited more stability, with real GDP mostly a little closer to trend than it had been in the preceding couple of decades. The Reserve Bank has very effective control over one interest rate - namely the rate that applies when one financial institution lends cash overnight to another (hence the label the 'cash rate'). This rate has a major impact - though not to the exclusion of other forces - on a range of short-term market rates. Since the bulk of financing activity in Australia is contracted on variable interest rates that are axiomatically affected by changes in short-term rates, the rates paid by borrowers are usually closely affected by cash rate decisions - though other factors can impinge as well from time to time. Through this device the Bank can affect the relative incentives for saving versus borrowing, and so have an impact on spending on goods and services and on financial and 'real' assets. Because the relative rates of return on Australian assets compared with foreign assets are altered when we change interest rates here, the exchange rate also moves in response to monetary policy changes (although most of the time it is moving in response to a host of other factors as well). Often, the expectation of what will happen to the cash rate in the future is just as important as, or even more important than, the level of the cash rate today. For this reason what the Bank says - or what people think we have said - can be very influential on markets and behaviour. It is for this reason that central bankers are usually so guarded in public comments. It is obvious even from the above highly condensed description that monetary policy will affect different groups in different ways. For a start, changing interest rates shifts the distribution of income between savers and borrowers. The larger the size of one's balance sheet - either assets or debt - the more likely one is to be affected by a change in rates of interest. Someone with no debt and no savings will probably feel little impact - if they feel anything at all - of a change in interest rates, at least directly. In addition, we only have one set of interest rates for the whole Australian economy; we do not have different interest rates for certain regions or industries. We set policy for the average Australian conditions. A given region or industry may not fully feel the strength or weakness in the overall economy to which the Bank is responding with monetary policy. In fact no region or industry may be having exactly the 'average' experience. It is this phenomenon that people presumably have in mind when they refer to monetary policy being a 'blunt instrument'. The issue is that it is not possible to have different monetary policies by region or by industry within the country, at least not while we are all using one currency and funds are free to flow around. Either each area that wanted its own interest rate would also have to have its own currency, or there would need to be a draconian set of regulations to prevent savings in one region flowing to another to be loaned out - a sort of local and regional equivalent to the pervasive capital controls which once existed on international capital movements. Quite possibly both of the above might be needed for a comprehensive tailoring of interest rates to each set of local conditions. Obviously that is unlikely to be practical. Moreover there would be costs for a region having its own currency. It would have to establish its own Reserve Bank for a start, and would have to accept additional transactions costs for crossborder transactions with other regions, which would probably inhibit trade and investment flows with other regions in its own country. Very small currency areas have also often got into trouble over the years. These are reasons why many very small countries often peg their currency to that of a larger neighbour or simply adopt that currency outright. Perceived gains from being part of a larger monetary union have continued to attract small European countries to the euro, even though the membership conditions are fairly demanding, as we have recently seen. There is a field of economics that thinks about this set of issues. Apart from the obvious criteria like language, culture and political unity, a suitable case for a single currency is thought to be stronger when: the forces ('shocks') that affect a group of regions or countries are fairly similar and the way in which the regional economies respond is similar; there is a lot of trade between the regions (as there usually is within a single country); factors of production (labour and capital) flow fairly easily between the regions in response to differences in conditions; and/or when other means for responding to differences in experience (particularly fiscal transfers) are available. That framework suggests several questions we might ask for Australia and its regions: How different are the shocks by region? How flexibly does the economy respond to such differences? What other policy mechanisms are at work to respond? And finally, how different, ultimately, are the experiences after these responses have occurred? It is worth observing that not all 'shocks' that hit the economy have markedly different effects by region or industry. Some of them are fairly widespread in their effect. Take the sudden intensification of financial turmoil in September 2008. Confidence slumped and people began to 'batten down the hatches' - in just about every industry and every region around the world - more or less simultaneously. Banks became more cautious in lending - most particularly to the property sector, but generally to almost all borrowers - in every country. Other shocks are more particular. The one most people would think likely to have a differential impact across regions would be the big rise in mining prices and associated build-up in investment that we saw a few years ago, and which has returned over the past year and a half. Since the mineral resources are not found in abundance in every region, some areas would be expected to receive more of a boost than others. For example in Western Australia, mining accounts for a quarter of production; it is only 2 per cent of production in Victoria. So it would seem obvious that the impact of an event that increases the demand for minerals is likely to see, in time, the output of WA given more of a boost than that of Victoria. But as usual, the picture gets more complicated when we think further. The headquarters of some major mining companies are in Melbourne. Those companies will be putting additional demand on various service providers around the nation - from air travel to consultants, from geologists to manufacturers, and so on. The effects of the engineering and construction build up for some of the minerals investment will be felt in other regions around the country (and indeed also by overseas suppliers). The higher incomes generated from the mineral boom will be felt by employees, shareholders (some of whom are overseas) and by governments (via various taxes). Depending on how these entities respond to these gains in income, there will be subsequent effects on economic activity around the country. It may well still be the case that the effects are most obvious and most pronounced in WA, but there will be substantial spillovers as the economy responds. Incidentally, most data suggest that until quite recently economic activity was growing faster in Victoria than in WA. So to the second question, how about the mobility of factors of production? A remarkable feature of some of the remote area mining operations is the way the labour operates on a 'fly-in, fly-out' basis. Any user of Perth airport can easily attest to this but the 'commutes' also occur from the eastern states. More generally, population shifts have long been occurring between the south-eastern states and the resource-rich states. While moving is costly, in most analyses I have seen the mobility of the Australian workforce is pretty good - people shift in response to opportunity. Capital is of course highly mobile, at least at the margin. As for other policy mechanisms at work, there are substantial fiscal transfers. The 'automatic stabilisers' will take more taxes from regions that are doing well, since incomes will be rising relatively quickly, and transfer it to areas doing less well in the form of welfare payments. Governments can also use discretionary spending or other policies as part of this. Moreover there are structures in place that are deliberately designed to lessen systematically the differences in outcomes which might otherwise occur. Opinions will differ about how effective these have been, and about how effective they should be - as recent political events have probably demonstrated. But the general point is that in a political federation such as Australia, there are various fiscal transfer mechanisms that act to diminish the divergences that might result from differences in initial conditions and exposure to economic events. This is likely to be less so in an area which is a monetary union but not a political federation. Indeed some economists have long pointed to this as a potential difficulty for the euro area in some sets of circumstances, like the ones that exist in Europe at present. That said, we are seeing, albeit on a somewhat ad hoc basis, more intraEuropean transfer mechanisms being developed. So for Australia, the effects of a 'shock', even if concentrated initially, will tend to be felt more generally across the economy over time. The way the economy works will naturally tend to help this occur, as will various other policy devices. That is what is supposed to happen in a well-functioning, integrated national economy. The next question, then, is how different outcomes turn out to be after all these mechanisms have responded to the various impacts. Of course differences will remain at the industry level - ultimately, it looks likely that the mining sector and the areas that supply it will grow, and some other industries will, relatively, get smaller. And at this point, much of the impact of the recent resource price changes is yet to be seen. Nonetheless it is still worth examining just how different key trends have been to date across regions. There are various indicators at a state level and even a regional level. These are of varying reliability - sample sizes get pretty small in some cases. Two of the more reliable data sets are likely to be the consumer price index and the unemployment rate. It is these, of course, that people are probably most interested in as well. The CPI is available only for capital cities. Consumer prices in the capital cities have tracked remarkably closely (Graph 3) - at least as much as in other single currency areas like the United States or the euro area In the case of unemployment rates, a fair bit of disaggregated data is available. Graph 6 below shows the national unemployment rate and the range across the statistical regions measured by the ABS for which there are reasonably reliable continuous time series. If we weight these unemployment rates by population, the shaded area is where 80 per cent of the weighted observations lie. Recent rates of unemployment have been between almost zero in the Hunter region (outside of Newcastle) of New South Wales and about 9 per cent in the far north of Queensland. Eighty per cent of the population face unemployment rates between 3 and 7 per cent. Also shown is the dispersion at a state level (Graph 7), which enables a comparison with the 50 states of the United States, and the 16 countries of the euro These comparisons are affected just now by the fact that the US and Europe have had deep recessions and are only in an early stage of recovery, whereas Australia had only a mild downturn and unemployment has been falling for about a year now. As the charts show, dispersion of unemployment rates does tend to have a cyclical dimension. Nonetheless I think it is reasonable, based on the history shown here, to conclude that, while some events can lead to a divergence in economic conditions across Australia, overall these differences have not been especially large in recent times compared with those seen in other entities with whom we might compare ourselves. That is not to say the differences are unimportant or immaterial to people's lives, nor that they could not get larger. Nonetheless some perspective as to how large they actually have been is useful. That having been said, it is important to add that the Reserve Bank makes considerable efforts to look below the level of national data in its pursuit of a full understanding of what is happening on the ground. Over the past decade or so we have put substantial resources into a comprehensive liaison program with firms, industry groups and state and regional government entities. Officers based in every mainland state capital spend much of their time talking to people about what is going on. Every month they talk to up to 100 organisations around the country. I know that some of our staff visited Shepparton last month and some of you may have met them. The purpose of this is to help us understand what is happening 'at the coal face' - the conditions that businesses are actually experiencing and the things that concern them. This helps give a richer and often more timely understanding of what is going on than the higher-level aggregate data alone might provide. Talking to businesses about their plans for the future helps inform our forecasts, and has been especially useful recently for building a profile of conditions in different sectors, such as expected investment in the mining sector over the coming years. This is important for our analysis of capacity in, for instance, the mining sector, which affects how we see commodity prices, the terms of trade, the exchange rate and exports. As a physically large country, with quite a diverse set of industries, and our largest population centres separated by long distances and even living in different climates, Australia is always likely to see some differences in economic experience by region. What is remarkable, in fact, is that the differences are not, in the end, larger. That they are not is testimony to the degree of flexibility within our national economy that has been built up over time, and to the design of national policies that aim to lessen the more stark differences that might otherwise occur. Those structures have grown up in the context of a system of a national money. Monetary policy is, by design, appropriately a national policy. In conducting it, the Reserve Bank devotes considerable attention to finding out and understanding what is happening at the regional and industry level. That helps us to maintain an overall set of financial conditions that are appropriate for the national economy. But we know that there will always be some differences in how changes to monetary policy are felt (though it is not always to be assumed that these impacts are necessarily greatest in country areas). Monetary policy can't make those differences disappear. In the end, however, if monetary policy can help to deliver reasonable macroeconomic stability, that will offer the best chance for any industry, any region, any business or any individual to succeed on their merits. The Reserve Bank, taking account of all the conditions across the various sectors, remains committed to that goal.

r101025a_BOA

australia

stevens

The topic the AIG had proposed for this session of course involve forecasting up to 10 years ahead. That's a rather risky proposition because forecasts are very hard to make. It might be safer, especially for a central banker, not to look forward at all! The way I want to start is by looking back 10 years. This may serve as something of an admonition to be circumspect in making forecasts. But identifying some big trends in the Australian economy over the intervening period - one or two of which were quite unexpected a decade ago - may contain some indications of issues for us to be aware of in the next decade. A couple of the trends that are readily observable also point to some current challenges in global economics and finance, and it is these to which I shall turn in the second part of these remarks. A decade ago, Sydney had just hosted the hosted a meeting of the World Economic Forum moments for Australians in the Games, though the Games are perhaps remembered for their logistical success as much as for the medal tally. The WEF meeting is perhaps most remembered for the protests, which turned ugly. But these events should also be remembered as occurring at the height of the dot-com mania and its obsession with the 'new economy'. Australians were told by more than one prominent visitor that year that we lived in an 'old economy', with the implication that we needed to shift towards the production of IT goods. Blue-sky valuations were being applied to companies that had not, at that point, earned a single dollar of profit (and many never would). The Australian dollar was slumping. magazine remarked that: Other examples could be given. As we now know, the dot-com bubble had actually started to deflate by the time those words were printed. The NASDAQ share index had already fallen by about 25 per cent from its early 2000 peak. By early in 2001 the US Federal Reserve would be cutting interest rates as the US economy went into recession. The new economy - the latest (but not the last) in a long line of new paradigms - still had a business cycle after all. The Australian dollar would fall further in 2001, reaching a low point of about US48 cents in early April. Some felt that it might fall as far as US30 cents. More than any other single economic indicator, this particular price was often taken as a summary statistic for economic health. In 2000, some people were making the point that, in the old versus new economy stakes, it was probably in the use of information technology, rather than in the production of IT goods, that the gains would be greatest. On that score Australia ranked highly. they made the point that Australia would probably do best, in its production structure, to stick to its comparative advantages in minerals or agriculture or various services. But it was hard going trying to make sensible points against the barrage of market and media commentary. Ten years on, though, it does not seem to have been to Australia's disadvantage not to have built a massive IT production sector. On the contrary, the terms of trade are at a 60-year high, the currency just about equals its American counterpart in value and we face an investment build-up in the resources sector that is already larger than that seen in the late 1960s and that will very likely get larger yet. In the area of information technology, meanwhile, the pace of change continues to be rapid: prices continue to fall, profits have proved very hard to come by and a number of prominent names from 2000 have disappeared. It is still better, it seems, to be a user than a producer of IT. The point of saying all this is not to poke fun at those whose prognostications a decade ago turned out to be wide of the mark. Anyone who has to forecast for a living has, from me, a degree of sympathy. The point is simply that forecasting is very hard and that the latest conventional wisdom often turns out to be just a passing fashion. We might add that market pricing, at some points in time, may not be much better than that, even though markets tend to get it roughly right on average. Having given that caution, it is worth recounting just a few of the trends we can observe over the past decade or longer. The increased borrowing of the household sector was one such notable trend. It had already been under way for nearly a decade by 2000, but kept going for the best part of another decade after then. I have said before that this probably won't be a feature of the next decade. We are seeing more caution in borrowing, and the rate of household saving from current income, while still low, has risen over recent years. It follows that some personal and business strategies that did well in the earlier period of households gearing up probably won't do as well in the future. Other trends have been a continuation of developments that had already been under way for a long time. For example, as a share of the economy, services have continued to rise, while manufacturing and agriculture have declined. Those sorts of trends, in broad terms, are pretty common to advanced economies. Mining's share of output had changed little since the mid 1980s, but has picked up noticeably over recent years. This seems likely to continue in the near term at least, so we are seeing a faster pace of change in the relative sizes of industries than we had seen for a number of years. Formal metrics of the extent of structural change in the industry composition of GDP have increased but do not, at this point, show it to be outside the range of previous experience. That could well change, though, given the size of the resources sector build-up that appears to be under way. Looking at the trade accounts, we can see that the share of resources in exports has risen very significantly over the past decade while those of the manufacturing, agricultural and services components have declined. This is not to say that the absolute values of exports for the latter sectors have fallen since 2000 - indeed services exports have grown quite strongly - but the rise in resource exports has well and truly outpaced everything else, as a result of both volume and price rises. It is in the destinations of exports, however, that we see perhaps the most striking changes over the space of a decade. As it happens, the weights in the Reserve Bank's trade-weighted measure of the value of the Australian dollar were updated just a few weeks ago. In the most recent year, the overall weight on the Chinese currency rose by 4 percentage points. That was quite a large movement in a single year but it is just the latest manifestation of a profound trend. Stepping back, it is apparent that there has been a striking further orientation in trade towards the Asian region since The table below tells the story. A decade ago, Japan was far and away the largest export destination for Australian goods. The United States was second, South Korea and Europe tied for third and China came sixth after New Zealand. Today, Australia's top goods export destinations are, in order, China, Japan, Korea and India - accounting for some 58 per cent - followed at some distance by the United States, New Zealand and the euro area, all closely bunched, accounting for a further 13 per cent or so between them. Euro area Given the ongoing shift in the world economy's centre of gravity towards Asia, the direction of this change is not at all surprising. Many countries would be seeing the weight of their trade shifting in the same direction as ours. One of the reasons for the strong performance of the German economy this year, for example, has been the strength of demand for high-end manufactured products in Asia. For Australia, though, it is a powerful phenomenon. Now this is just the exports side. When we consider both imports and exports - and indeed when we include trade in services - the United States and Europe remain important for Australia (though less so than China these days). The United States and Europe - along with New Zealand - also continue to account for a large proportion of Australian investment abroad and are the source of the vast bulk of foreign investment into Australia. In fact, the share of outward Australian investment going to Asia has actually fallen slightly since 2000. Moreover, financial developments in the major economies, and especially the United States, are still very important drivers of capital flows, and of shifts in financial and business sentiment. So there are still important links to the major economies. I am not arguing for 'de-coupling', if by that idea is meant that somehow the north Atlantic countries have ceased to have a significant impact on the global economy, or no longer matter to us. Everything is connected, and economic events in the north Atlantic countries still matter greatly. But trends in those countries are leavened to no small degree by developments in the Asia-Pacific region, which is progressively becoming both larger and more capable of exerting a degree of independent influence over its own economic performance. It used to be said that when the United States sneezed, Asia caught a cold. Recently it seems that the United States has contracted pneumonia, while Asia sneezed and caught a bad cold, but then recovered pretty quickly. Even in the financial field, the size of offshore investments by Asian official holders has become quite important, including for the Australian dollar. And while the stock of cross border investment between Asia and Australia remains small compared with that between Australia and the United States or Europe, that is surely in the process of changing. The point of all this is not to say that somehow Australia has been, or will be, 'saved' by China or Asia. The emergence of Asia is to our advantage, if we respond to it correctly. But there is no free ride from the global or regional economy and there never will be. Nor is it to deny that a country's own policies, for better or worse, and followed over a long period, also make a significant difference to its economic outcomes. There is no escaping responsibility to keep our own house in order. The point, rather, is that we ought to take more than a passing interest in events in our region, and in the conduct of economic policies in our region, and not just those in the countries that once completely dominated the global economy, but no longer do. This brings me to the issue foreshadowed in my title. At the risk of over-using a cliched term, the global recovery has been very much a two-speed one. some continental European economies saw deep downturns in output, and have to date experienced only weak recoveries that have left the level of output well below its previous trend and unemployment much higher than normal. In the United States in particular there is a very troubling increase in the duration of unemployment, which, with its likely atrophy of skills, does not bode well for future growth. economies have traced out the more classic 'V-shaped' path. In east Asia excluding Japan, the level of real GDP is well above its previous peak. It follows that most of these economies are likely to experience some moderation in the pace of growth, from something well above trend, to something more like trend. This is normal after a rapid recovery. This difference in performance between large parts of the emerging world and the core of what we could call the 'established' world of industrialised economies leaves the global economy poised at a critical juncture. In Asia, capacity utilisation has more or less recovered and growth will moderate. Many of the old industrial countries, in contrast, still have large volumes of idle capacity and are searching, with increasing urgency, for ways to increase their growth. But they are having trouble increasing their own demand. So we face a slowdown of some degree in global growth at a time when substantial spare capacity remains in the global economy. The 'global imbalances', so called, have persisted, and have a new dimension: there is an imbalance in the location of spare capacity in the world. What could be done to foster a better outcome for There has been an increasing focus on exchange rates of late, with talk of 'currency wars' and so on. My view is that more flexibility of exchange rates in key emerging countries in Asia - including China, but not only China - would be part of a more balanced outcome. But exchange rate flexibility alone isn't enough. Changes in exchange rates don't themselves create global growth, they only re-distribute it. Unless the exchange rate changes were accompanied by more expansion in demand globally, we would not have solved the problem of excess capacity, we would only have relocated it. The additional step needed is stronger domestic demand, compared with what would otherwise have occurred, in the countries whose currencies would appreciate in such circumstances. Of course there should be room for this given that the higher exchange rate would, other things equal, help to dampen inflation. In principle, at least, this looks like a potential 'win-win' outcome. The appreciating countries could enjoy faster growth in living standards than otherwise, while the weaker countries whose currencies were moving lower would get some stimulus to aid their recovery. There are, however, some complications. A number of Asian countries have been experiencing worrying increases in property prices. Low interest rates and easy financial conditions have contributed to this. Arguably domestic financial conditions in these cases need to be tighter, not looser. So it is not clear that monetary policy would be the best option to boost domestic demand. That said, allowing exchange rates to appreciate more quickly would probably help to dampen increases in asset prices. What about more expansionary fiscal policies as the way of increasing domestic demand? Many, though not all, Asian countries would have some scope for that, given the long record of fiscal prudence and low public debt levels. But these countries are very unlikely to do things that would seriously impair their fiscal position in the long run. Hence my suspicion is that fiscal action, if it came, would be only modest. Some argue that structural changes are needed to lower national saving rates in countries like China. Such changes could involve a shift in the distribution of national income away from state enterprises to households, who are thought more likely to spend it, a better developed social safety net, and so on. In all likelihood these sorts of changes will occur over time. But structural change is rarely a rapid process. So I think we should be realistic about how much difference exchange rate flexibility would make to the unbalanced nature of growth in the global economy, at least over a time horizon of just a few years. It is definitely part of the answer (and it is surely in the interests of the countries with closely managed rates to accept more flexibility), but it is no panacea. A full resolution of the imbalances will take time. It will involve more far-reaching changes to very deep-seated attitudes to saving, which remain very different across the regions of the world. As incomes in Asia continue to rise, saving rates will probably decline over time, but only gradually. Meanwhile, aggregate saving rates in America and Europe will have to rise over time, given the extent to which financial obligations have grown relative to likely future income, particularly on the public side. The key question is whether these two trends, in opposite directions, will occur at the same pace, or not. Good policies can certainly help the world get to a better solution than might otherwise occur. But even with good policies, it is likely to be a slow grind out of the current difficulties for some countries. We probably have to accept that global growth was unsustainably fast in the few years prior to the crisis, that too much capacity of certain types was built up in the wrong places, that spending in some countries ran too far ahead of permanent income and that a period of adjustment and structural change cannot be avoided, even under ideal policy settings. If that is so, then, in all countries, an emphasis on accepting the need for adjustment generally - not just in exchange rates but in economic policies and structures across the board - is key. Economies are not static machines. They are a complex and dynamic combination of actors, all continually seeking to adapt to changing conditions. That is one reason that economic outcomes are very hard to predict, and why I am circumspect about predicting 'Australia to 2020'. Looking to the long run, we probably can make a few very general observations, but not much more. Real income per head has generally been on an upward trend in industrial economies for the past 250 years, with occasional setbacks. Most likely that will continue (albeit that some major countries will take some time to recover their income levels of three years ago). As a broad observation, and definitely not as a precise forecast, we might expect that a decade from now Australia's per capita GDP will probably be roughly 15 per cent higher in real terms than it is now, give or take a few percentage points. The economic policy arguments, by the way, will all be about what policies might gain or lose those few percentage points. In 2020, there will probably be, at a rough guess, an extra couple of million people working, compared with today's 11.3 million. But exactly how all those people working will earn their living and go about their work is considerably less predictable. A good proportion of those 13 million-plus jobs will be in firms that don't yet exist. Some will be in industries or occupations that barely exist as yet. And no one can give you a blueprint for which areas will succeed and which will not, any more than the pundits a decade ago, at the height of the 'new economy' fad, could foresee the shape of Australia's economy today. Succeeding in the future won't ultimately be a result of forecasting. It will be a result of adapting to the way the world is changing and giving constant attention to the fundamentals of improving productivity. That adaptability is as important as ever, in the uncertain times that we face.

r101126a_BOA

australia

stevens

When we last met with the Committee in February this year, it was becoming clear that the recovery in the global economy was proceeding faster than many had expected. It was also clear that the strongest performance was in the emerging world, while recoveries in countries that had been at the centre of the financial events of 2007 and 2008 were relatively subdued. Global financial markets had continued to improve, but were paying close attention to the rise in sovereign debt in a number of countries. At that time, people were talking about an expansion in global GDP of something like 4 per cent in 2010. As it turns out, it looks like the outcome will be stronger than that: current estimates for the year are about 4 3/4 per cent, which is above trend. The pattern of growth is still rather uneven. The additional strength has been concentrated in the emerging countries, with growth in China and India running at a pace of around 10 per cent in 2010. In contrast, growth of about 2 1/2 per cent for the G7 group, after a contraction of around 3 1/2 per cent in 2009, will leave a considerable margin of spare capacity and particularly of unemployed labour. Financial markets and policymakers have maintained, and indeed increased, their focus on issues of sovereign debt sustainability. First Greece, and now Ireland have sought financial assistance from European partners and the IMF, after a change in economic circumstances and a large rise in market borrowing costs left authorities with little other option, even with deep cuts to spending. Across continental Europe and the United Kingdom, governments are embarking on a path of fiscal consolidation, in order to put public finances on a sounder footing in the face of increased obligations and reduced revenues. These programs will unavoidably have some short-term dampening effects on economic activity, which will likely become clearer during 2011. But the scope of alternative possibilities open to the governments concerned is really rather limited. In this environment it is no surprise that the major central banks are mostly maintaining very low interest rates and in some cases increasing the sizes of their already expanded balance sheets via asset purchases. These actions are designed to impart some further stimulus through reducing long-term interest rates even further or via effects on private-sector balance sheets. Yet at the same time many other countries have moved to tighten their monetary policies this year, in recognition of the robust recovery in output. In most cases in Asia - Japan being an exception - the rise in activity along the upward part of the 'V' has now been seen and the pace of growth has to moderate if overheating is to be avoided. The combination of very low interest rates in the world's developed financial centres, on the one hand, and strong growth and tightening monetary policies in Asia and Latin America, on the other, could be expected to place pressure on exchange rate regimes, and so it has proved. There have been substantial capital flows seeking the expected higher returns in emerging economies and a rise in asset values in many of the recipient countries. A number have responded with the imposition of capital controls and other measures to contain leverage, especially in housing markets. In this environment, where the policy imperatives differ so much across countries, the intensity of international discussion about exchange rates was bound to escalate, and it has done so, quite markedly. A year from now we will probably have observed some moderation in global growth, from this year's above-trend pace to something closer to trend. That is the assumption we are making. The emerging world clearly needed some moderation, while the major countries working through the aftermath of banking crises are still likely, if history is any guide, to find it hard going for a while yet. How much progress we will have made in resolving the 'imbalances' issue remains very unclear. But the strength of global growth thus far, and the particular pattern of growth in key emerging economies, with its very strong impact on demand for steel, has had a major effect on Australia's terms of trade. These have returned to, and in fact exceeded, the six-decade highs seen two years ago. It is our assumption that prices for key resource exports will not remain this high, but will instead decline over the next few years. Even so, developments in the period since February have led us to lift our estimates for the terms of trade in the 2010/11 year. In February I suggested that real GDP growth in the Australian economy would be a little over 3 per cent in 2010, and a little higher than that - about 3 1/2 per cent - in 2011 and 2012. It would take only pretty moderate growth in the second half of the year to achieve that forecast for 2010. Next year, growth could be stronger than we had expected nine months ago, though obviously there are still numerous areas of uncertainty. Measured in nominal terms, the rise in GDP is running at about 10 per cent per annum just now, because of the rise in the terms of trade. Consumer price inflation has returned to rates consistent with the medium-term target, running at about 2 1/2 per cent in underlying terms, and 2 3/4 per cent in CPI terms, over the past year. This is clearly a marked improvement from two years ago, when the CPI inflation rate reached 5 per cent. A significant decline in inflation was expected at the time the Board started to reduce interest rates in September 2008. Sometimes, the process of disinflation can be quite costly in terms of economic activity. That is often the case when higher inflation lasts long enough to become embedded in expectations. That did not occur this time and the result was that inflation came down with relatively little short-run cost to output, very much as was the case in 2001 and 1995. It is, of course, one of the intended effects of having an announced objective for inflation that inflation expectations be well anchored, which aids economic stability and efficiency. It is unlikely, though, that we will see inflation fall much further from here. We will probably see some ongoing dampening effect on inflation of the rise in the exchange rate, as this usually takes some time to flow through fully. Growth in labour costs, however, is no longer declining, but rising. The overall pace could not be described as alarming at this stage, but the turning point is behind us. Nor is the growth of the economy falling short of potential growth; if anything, over the past year aggregate demand has risen considerably faster than potential output (something that is possible only with either considerable spare capacity or a rise in absorption from the rest of the world). At this point, the gap between actual and potential output is probably not that large. Moreover, while the annual pace of growth of utilities prices - a prominent feature of the past couple of years - has probably peaked, it is likely to remain high. Over the coming year, we think that inflation will be pretty close to where it is now, consistent with the target. But looking further ahead, in an economy with reasonably modest amounts of spare capacity, the terms of trade near an all-time high and the likely need to accommodate the largest resource-sector investment expansion in a century, it is pretty clear that the medium-term risks on inflation lie in the direction of it being too high, rather than too low. Last time we met, I explained it was important that monetary policy not overstay a very expansionary setting once it was clear that the danger of a really serious downturn in economic activity had passed. At that stage the Board had lifted the cash rate three times in late 2009. Most lenders raised borrowing rates by more than the cash rate, given that their costs of funds had moved up relative to the cash rate. I noted the Board was taking account of these shifts in deciding the appropriate setting of the cash rate. Most rates remained below normal at that stage. I also said that, if economic conditions evolved as we expected, further adjustments to monetary policy would probably be needed over time to ensure inflation remained consistent with the target. In the first half of 2010 the Board did indeed make further adjustments, lifting the cash rate to 4.5 per cent. This was roughly 100 basis points lower than what we would once have described as 'normal'. In fact it was close to the point reached by the cash rate in the two preceding interest rate cycles. But it resulted in borrowing rates pretty close to the average of the past decade or more, and so was what could be considered as 'normal', allowing for the changes in margins. The Board judged this to be an appropriate point at which to rest for quite some months. This allowed some time to assess the effects of earlier decisions and also to gauge what was happening in the rest of the world. Most recently, as you know, the Board decided to lift the cash rate by 25 basis points. Many lenders raised their loan rates by more than this. These moves have left the overall setting of monetary policy a little tighter than average, as judged by interest rate criteria. Of course, we are aware as well that, particularly for business borrowers, non-price conditions remain tighter than they were for some years prior to 2008. Overall, and also taking account of the exchange rate, which has risen substantially this year, we judge this to be the appropriate setting for the period ahead. As the minutes from the Board meetings show, recent decisions were finely balanced. Quite reasonable arguments could have been made to wait a little longer before taking this step. Good arguments could also be offered as to why, when we looked ahead, it was prudent to take an early modest step in the tightening direction. On balance, the Board judged that to be the better course. This sequence of decisions was taken in the same framework that has guided our monetary policy for nearly two decades now: seeking to keep the growth of demand sustainable so as to achieve an average inflation rate of between 2 and 3 per cent. It is worth noting, incidentally, that the recently re-elected Government has once again committed, as have I, to this framework, which will continue to guide our decisions. My colleagues and I are here to respond to your questions.

r101129a_BOA

australia

stevens

Thank you for the invitation to play a part in marking the 50 anniversary of CEDA. It is particularly significant for me to be here because 2010 also marks 50 years since the commencement of central banking operations by the Reserve Bank of Australia. There were in fact a number of significant beginnings in 1960. It was a time of rising prosperity after a long period of difficulty. Between the depression of the 1890s and the end of World War II, real GDP per capita in Australia had risen by about 35 per cent - or around half a percentage point per year. But in the 15-year period from the end of the war to 1960, it expanded by about 25 per cent - or about 1 1/2 per cent a year. The long post-war boom would eventually see growing excesses from the late 1960s, which ended in the disastrous instability of the 1970s. But in 1960, the boom still had a long way to run. So 1960 was a time of optimism. There have been many ups and downs for the Australian economy since then. CEDA has played its role in informing discussion and debate along the way. Two years ago, when I last addressed this group, optimism was anything but the order of the day in serious disarray and the global economy was heading into recession. It was obvious Australia would be affected but I suggested that there were good reasons for quiet confidence then about the long-run future of Australia. There still are, two years later. But we have to turn that confidence into lasting prosperity. So I would like to offer a few observations about some of the things we need to be thinking about. I do not have definitive solutions, but offer these observations as a modest contribution to the discussion. In so doing, I am not trying to convey anything about recent or prospective monetary policy decisions. Tonight, at an event marking the 50 anniversary of a body devoted to Australia's economic development, it is more useful to lift our gaze beyond the next interest rate decision to look at a broader canvas. I have one picture to show. the really large economies like the United States, the euro area or Japan. So the terms of trade matter. When the terms of trade are high, the international purchasing power of our exports is high. To put it in very (over-) simplified terms, five years ago, a ship load of iron ore was worth about the same as about 2 200 flatscreen television sets. Today it is worth about 22 000 flat-screen TV sets - partly due to TV prices falling but more due to the price of iron ore rising by a factor of six. This is of course a trivialised example - we do not want to use the proceeds of exports entirely to purchase TV sets. But the general point is that high terms of trade, all other things equal, will raise living standards, while low terms of trade will reduce them. Returning to the chart, to my eye there are three key features. The first is the degree of variability in the terms of trade through the middle parts of the 20 century, from about World War I to the aftermath of the Korean War. This was, of course, a period of considerable instability in the global economy, with the attempt to return to the Gold Standard after the 'Great War', followed by the 1930s depression, the Second World War, the post-war expansion and then the Korean War. I might add that, in those days, with the attempt to maintain a fixed exchange rate, these swings were very disruptive to the economy. Typically, a rise in export incomes would result in a rise in money and credit, a boom in economic activity and a rise in inflation. Then the terms of trade would fall back and the whole process would go into a rather painful reverse. The advent of the flexible exchange rate in the early 1980s made a great difference in managing these episodes. The second feature is the downward trend in the terms of trade, particularly noticeable from the early 1950s to about the mid 1980s. This was the period of resource price pessimism, the 'PrebischSinger hypothesis' and so on, which held that This is a very long-run chart of Australia's terms of trade. You may have noticed the Reserve Bank saying a lot about the terms of trade in the past few years. Before I describe the chart, why is it important? Our terms of trade have a big bearing on national income. In economic commentary, there is typically a very strong focus on GDP - the value of production - as a summary of national material progress. There is also quite rightly an emphasis on lifting productivity - real GDP per hour worked - as the source of our growth of material living standards. For open economies, though, our standard of living is affected not just by the physical output we can obtain from our resources of labour and capital, but also by the purchasing power of that output over things we want to have from the rest of the world. This is what the terms of trade is measuring. It is the relative price of our export basket in terms of imports. At the extreme, if the economy were open to the extent that we exported all our production and imported all our consumption, then the price of exports relative to imports would determine our living standards entirely, for any given level of productivity per hour worked. As it is, Australia is not that open, and not as open as many smaller economies, but it is considerably more open than primary products would tend to decline in price relative to manufactured products (Prebisch 1950, Singer 1950). The latter part of this period was the one in which the realisation became widespread that the (apparently) easy gains in living standards of the post-war boom were gone, and in which pessimism about Australia's economic future was probably at its most intense. It was also the period when, under strong political leadership backed by a highly capable bureaucracy and an economically literate media, our determination to press on with various productivity-increasing reforms was greatest. That these two phenomena occurred together was probably not entirely a coincidence. The third feature is the current level of the terms of trade relative to everything but the all-time peaks over the past century. Measured on a five-year moving average basis, and assuming (as we do) some decline in the terms of trade over the next few years from this year's forecast peak, the terms of trade are as high as anything we have seen since Federation. To give some perspective on how important this is, let me offer one back-of-the-envelope calculation. The export sector is about one-fifth of the economy. The terms of trade are at present about 60 per cent higher than their average level for the 20 century, and about 80 per cent higher than the outcome would have been had they been on the 100-year trend line. This means that about 12-15 per cent of GDP in additional income is available to this country's producers and/or consumers, each year, compared with what would have occurred under the average or trend set of relative prices over the preceding 100 years (all other things equal). That will continue each year, while the terms of trade remain at this level. Of course, part of this income accrues to those foreign investors who own substantial stakes in the mineral sector. In this sense, the current boom is a little different from the early 1950s one where most of the income went first to Australian farmers. Nonetheless, a good proportion accrues to local shareholders and employees, and to governments via various taxes. A non-trivial part of it is available to consumers as higher purchasing power over imports, as a result of the high exchange rate. It does not take much imagination to see that an event of this magnitude is expansionary. Incomes are higher - in some cases a lot higher - and, absent some offsetting force, some of that will be spent. So it has always proved in the past. Moreover, if, as seems very likely, these prices prompt a build-up in investment to supply more of the commodities concerned, there are further expansionary effects. Even applying significant discounts to stated investment intentions, as the Reserve Bank staff have done in their forecasts, there is likely to be a further significant rise in business investment over the next few years, from a level that is already reasonably high as a share of GDP. On all the indications available, we are living through an event that occurs maybe once or twice in a century. So a very important question for us is: how do we handle all this? We obviously have to be wary of overheating. The Bank has given its views on this point before and I will say no more about that tonight. But in fact the issues are broader than that. They extend to how we use the additional income, and how soon, and to questions of structural adjustment. One difficulty is that it matters a great deal whether the rise in the terms of trade is likely to be permanent or only temporary. Unfortunately, we cannot really answer that question. It is obvious from my chart that past episodes tended not to be permanent, but they sometimes lasted several years and certainly long enough to be very disruptive. If the rise in income is only temporary, it would be desirable not to raise national consumption by very much. Instead, it would make sense to allow the income gain to flow into a higher stock of saving, which would then be available to fund future consumption (including through periods of temporarily weak terms of trade, which undoubtedly will occur in the future). Moreover, it would probably not make sense for there to be a big increase in investment in resource extraction if that investment could be profitable only at temporarily very high prices (and which could come at the cost of reduced investment in other areas). If the change is likely to be persistent, then income is likely to be seen as permanently higher. Households and most likely governments will probably see their way clear to lift their consumption permanently, both of traded and non-traded goods and services. Structural economic adjustment will also occur as the sectors whose output prices have risen, now being more profitable, will seek to expand, in the process attracting productive resources - labour and capital - away from other sectors whose output will decline as a share of GDP. Australia's floating exchange rate, which tends to rise in line with the increase in the terms of trade, helps the reallocation of labour and capital by giving price signals to the production sector. The higher exchange rate also speeds the spread of the income gains from the terms of trade rise to sectors other than the resources sector, by directly increasing their purchasing power over imports. The resulting rise in imports spills demand for tradable goods and services abroad, which helps to reduce domestic inflation. So the shift in the terms of trade will, unless clearly quite temporary, drive shifts in the structure of the economy. It is easy, of course, to speak in the abstract of 'reallocation of productive resources', but this means that some businesses and incomes become relatively smaller; jobs growth in some areas slows even as in others it picks up. Some regions struggle more than others. Some sources of government revenue are adversely affected even as other sources see an improvement. This process will be seen, not unreasonably, as costly by those adversely affected, even though the overall outcome is that the country as a whole is considerably better off. (It is also obvious that, if the terms of trade change really is only temporary, it may not be worth paying these adjustment costs from the perspective of the overall economy.) The policy challenge for governments will be whether to help these sectors resist change, or to help them adapt to it. We can carry out the thought experiment of imagining that, as a society, we wanted to resist these changes completely and seek to preserve the existing structure of the economy. Let me be clear I do not advocate this. But consider what would be involved. We would need, inter alia , to prevent the resources sector from responding to changed prices (preventing any increase in its size). That would probably involve taxing away completely any additional national income resulting from higher prices, and maybe also preventing any additional exploration or capacity expansion to take advantage of strong demand that could be met profitably even at after-tax prices. We would probably need to re-cycle any funds raised overseas, in the process holding down the exchange rate. It is important to note, by the way, that such funds could not be spent at home without adding to aggregate demand and hence risking the inflation we would still be seeking to avoid in this scenario. In the scenario where we want as much as possible to be unchanged, the additional income handed to us by the change in global relative prices all has to be used offshore, one way or another. If all the above could be achieved - a very big if, when one considers the logistics of what would be required - then the economy's structure could, perhaps, remain as it was. This course would mean forgoing the potential for higher export income by investing more in resource extraction; either those gains would go instead to other resource-supplying countries or, in commodities where Australia is a major producer, our lack of supply response would result in further upward pressure on prices. So we would avoid the disruption of structural change, but overall would be poorer than otherwise would have been the case, as would, perhaps, our trading partners. It is hard to believe such an outcome could be achieved and no less difficult to imagine it being thought desirable. Realistically, we won't be able to hold the economic structure static in that fashion if there is a major, persistent change in relative prices. Nor, I would argue, should we try. Had we had that approach through our history, we would still be trying to employ 25 per cent of our labour in agriculture and still be trying to ride 'on the sheep's back' in chase of a world economy that had moved on to place a much higher value on many things other than wool. We would not have the highly developed services sector that we have today, nor the standard of living we currently enjoy. So if the terms of trade do remain fairly high for a lengthy period, the task is going to be to facilitate structural adjustment so as to make it occur in as low cost a way as possible. But that ought to be feasible given that overall income is considerably higher. Of course we cannot know whether the terms of trade will be high for a long period. History certainly would counsel caution in this respect. We do know that supply of various resources is set to increase significantly over the years ahead and not just from Australian sources. It is for this reason that we assume some fall in commodity prices over the next several years. The assumption underlying the Bank's forecasts published a few weeks ago is that iron ore prices fall by up to about 30 per cent over the next several years. Even if they do, the terms of trade will remain quite high by the standards of the past 100 years in the near term, as the chart showed. Is that assumed fall realistic? There is no way of knowing. Larger falls have happened before. In fact they have been the norm. On the other hand, experienced people seem to be saying that something very important - unprecedented even - is occurring in the emergence of very large countries like China and India. If the steel intensity of China's GDP stays where it is already, and China's growth rate remains at 7 or 8 per cent for some years to come, which appears to be the intention of Chinese policy-makers, then the demand for iron ore and metallurgical coal will rise a long way over the next couple of decades. If India's steel intensity goes the same way as most other countries have, that will add further. Even with allowance for supply responses by other producers and considerably lower prices than we see today, that seems to point to a prominent role for the resources sector, broadly defined, over a longish horizon. So the most prudent assumption to make might be that the terms of trade will be persistently higher than they used to be, by enough that we will need to accommodate structural change in the economy, but not by so much that we shouldn't seek to save the bulk of the surge in national income occurring in the next year or two, at least until it becomes clearer what the long-run prospects for national income might be. As it happens, there does seem to be a good deal of saving going on, thus far, in the private sector. A little-noticed recent statistical release was the annual national income accounts for the year 2009/10. In that release, the Australian Statistician has made some major revisions to the estimates for household saving (which of course is a residual arising from other major aggregates). The revision lifted estimated household saving by $45 billion, or about 5 percentage points of income, from the previous estimates. The net saving rate is now seen at some 9-10 per cent of income over the past year or two, up from about -1 per cent five years ago. In all the circumstances, considering what has happened around the world in recent years, more cautious behaviour by households is not surprising. Nor, I would argue, is it unwelcome. With the stimulus from the terms of trade and the likely investment build-up, the economy can cope with more saving by households for a time. On the other hand, to expect it to absorb a major surge in consumption at the same time as an historic increase in investment is also occurring would be rather ambitious. In fact, we probably need private saving to remain on a higher trajectory, and we will also need public saving to rise, as scheduled. In the longer term, the economy's increased exposure to large emerging economies like China and India (these two now accounting for over a quarter of exports) - assuming that continues - may also pose important questions. If these and other emerging economies continue to grow strongly on average, but also, as with every other country, still have business cycles, the result may be the Australian export sector, and therefore the Australian economy, having a potential path of expansion characterised by faster average growth in income, but with more variability. That possibility has been noted by some observers. It is worth recording that such concentration would hardly be unprecedented - think about the dominance of Japan in Australia's trade in the 1970s and 1980s, or the dominance of the United Kingdom in an earlier era. Nonetheless, the degree of concentration could be higher than we have seen in the past decade or more, which was a time of considerable stability for the Australian economy overall. We can't know whether this scenario of higher but more variable income growth will come to pass. But if it did, how should we respond? We could simply accept higher variability, if that comes, as the price of higher average income growth. That would see higher variability in demand in the economy, which would have its own implications, not least that it could make it harder for macroeconomic policies to foster stability. Another approach would be to reflect the higher income variability in our saving and portfolio behaviour rather than our spending behaviour. We could seek to smooth our consumption - responding less to rises or falls in income with changes in spending and allowing the effects to be reflected in fluctuations in saving. In the most ambitious version of this approach, we could seek to hold those savings in assets that provided some sort of natural hedge against the variability of trading partners, or whose returns were at least were uncorrelated with them. Of course, such assets might be hard to find - the international choice of quality assets with reasonable returns these days is a good deal more limited than it used to be. It is possible that this behaviour might be managed through the decisions of private savers. There might also be a case for some of it occurring through the public finances. That would mean accepting considerably larger cyclical variation in the budget position, and especially considerably larger surpluses in the upswings of future cycles, than those to which we have been accustomed in the past. There would also be issues of governance and management of any net asset positions accumulated by the government as part of such an approach, including whether it should be, as some have suggested, in a stabilisation fund of some sort. These are pretty big questions and addressing them would not be straightforward, so I am not going to attempt that tonight. The point simply is that, in the face of what appears to be a very big event in our terms of trade, these issues are deserving of consideration - perhaps by CEDA, among others, as you enter your sixth decade. As I said at the outset, we have grounds for confidence in the future of our country, just as at CEDA's beginning 50 years ago. Recent performance, not to mention the economic opportunities in our time zone, has helped to strengthen our confidence. But it would be a mistake to rest on recent achievements, as significant as they have been, and to fail to press on in our efforts to do better. Past periods of apparently easy affluence, conferred by favourable international conditions, probably lessened the sharpness of our focus on the other element of raising living standards, namely productivity. It was subsequently a long and difficult grind when we realised that international conditions had become less favourable. So while I have not talked about productivity this evening, I do not wish my focus on the terms of trade to be interpreted as implying that lifting productivity is unimportant. On the contrary, while our terms of trade are handed to us, for better or worse, by international relative prices, the efficiency with which we work is a variable we can actually do something about. A prudent approach might be to use the current period of exceptionally favourable international prices to raise our saving, while maintaining a disciplined approach to ensuring there are no impediments to lifting productivity. Consumption deferred - private or public - can easily be enjoyed in the future; consumption we get used to today is harder to wind back in the future if circumstances change. These issues, and the associated structural adjustment issues, no doubt will pose a challenge. But that's the challenge of prosperity - and not a bad challenge to have. It is sometimes said that Australia manages adversity well but prosperity badly. There will never be a better opportunity than now to show otherwise.

r101213a_BOA

australia

stevens

The Reserve Bank has provided a submission to the Committee that details trends in lending, costs, margins, fees and other factual material the Committee may find of use. We of course will seek to answer any questions on that submission. Perhaps I should note a few general points. First, risk has been re-priced since early 2007. All of us are still adjusting to this change and its implications. It is widely held that risk was under-priced for some years before then. That is to say, investors demanded very little risk compensation in their expected returns - perhaps in some cases because they didn't understand the risks. So financial institutions of all types could get ample funding cheaply, and this could be passed on to their borrowers. Business models that took particular advantage of low-cost wholesale funding and/or securitisation were able to provide a very competitive edge to certain markets, particularly (though not only) to markets for mortgage lending. But investors around the world changed their attitude to risk in 2007 and 2008. The compensation they require for taking on risk has increased. Wholesale funding and securitisation are now more expensive. In the case of securitisation, costs have also risen in part because some investors have left the market altogether. The increase in costs has affected all financial institutions, but to varying degrees. As such, it has also affected the competitive landscape. Some business models that did well in the earlier state of the world find it harder going now. Part of the competitive advantage they had has been eroded by market developments. The current relationship between variable mortgage rates and market funding costs is making it more difficult than it used to be for the lenders relying on securitisation to compete with the major banks. This changed attitude to risk has affected the locus of competitive forces. Whereas four years ago the environment was one in which the competition among financial institutions to lend money was intense, more recently it has been the competition to money that has been intense. Various other things have happened that also have a bearing on the competitive landscape, but this is a very fundamental change in the state of the world. That said, the market remains a good deal more competitive than it was in the mid 1990s and borrowers have access to a much larger range of products. Moreover, the overall availability of finance to purchase housing in particular seems to be adequate. The second theme is that, the market price of risk having risen, various players want the public purse to take on some of this higher price through various forms of support or regulatory change. The various ideas should, of course, be assessed on their merits. But an important high-level point is that, in some instances at least, it would appear the taxpayer is being asked to shoulder more risk, one way or another, in order to facilitate the provision of private finance. Whether, and in which areas, that might be a good idea - and if so how much might be charged for such support - is of course for governments and legislatures to determine. Hopefully your inquiries will be able to assist this process.

r110211a_BOA

australia

stevens

Hansard transcripts of public hearings are made available on the inter- net when authorised by the committee. The internet address is: To search the parliamentary database, go to: --I declare open this hearing of the House of Representatives Standing Committee on Economics and welcome representatives of the Reserve Bank and members of the public and the media. I thank the governor for that short indulgence while we had a very quick meeting. Today the committee will scrutinise the RBA over its projections for the Australian economy. With the recent devastating floods in Queensland and Victoria and Cyclone Yasi, the committee will be interested to hear the bank's opinion on what effects these disasters may have on the Australian economy--in particular, considering that inflation is currently within the RBA's target band, whether there will be a need for further rises or, with the disasters, whether now is the time for caution. Since October 2009 the RBA has lifted the cash rate seven times, taking it from three per cent to 4.75 per cent. Current economic conditions and forecasts suggest that the Reserve Bank may well be considering further increases in the cash rate. Unemployment is at five per cent and the bank is forecasting underlying inflation to increase to three per cent by late 2012. Increases in the cash rate could affect our exchange rate. If our trading partners keep their interest rates low then we would conceivably see the Australian dollar go well past parity with the US dollar. This would further affect our exporters and importers. In the minutes of its board meeting last December, the bank noted that much of the growth in our real incomes has come from the favourable change in our terms of trade but that productivity growth in Australia has slowed significantly since the 1990s. This theme also occurred in a recent report from the Grattan Institute which suggested that Australian productivity decreased over the past five years. The committee is interested in any advice the bank can provide on this topical matter. 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 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 contempt of parliament. Welcome to today's hearing. Mr Stevens, would you make your opening statement before we proceed to questions? --Thank you, Mr Chairman. It is good to be back before your committee. You seem to have shifted to the right. I am not sure what significance I should attach to that. Anyhow, it is a short period since we last met. In that time, I would say, the global economy has continued to expand and if anything probably looks a little stronger than it did when we were last here. China and India have sustained a strong pace of expansion and the United States seems to be gathering a bit more momentum, though it still faces considerable problems. Conditions in Europe remain quite mixed and the ongoing interplay of sovereign and bank creditworthiness issues there continues to be a source of great uncertainty. Observers have been revising up both the estimates of global growth outcomes for 2010 and, at the margin, their forecast of growth in 2011. The IMF is now saying world GDP growth was probably about five per cent in 2010, which is well above the 30-year average. For 2011, the fund has lifted its forecast to 4.4 per cent, which is still noticeably above the average pace of growth. Global commodity prices have risen further in recent months. This has been quite widespread--metals, minerals, energy and foodstuffs. In a number of countries, measures of consumer price inflation have reflected this rise in commodity prices, particularly in the case of food. For China, India and in fact much of Asia and Latin America, these are all important issues and managing these pressures I think is shaping up as one of the major international economic policy challenges for 2011. The commodity prices most important for Australia are at very high levels. In the case of coal just now, this partly reflects the supply tightness resulting from the floods in Queensland, which we think have reduced national production by something like 15 per cent, and that has a material impact on the global supply of traded coal. But the supply of iron ore has not been much affected by the weather, and its price has risen above the highs of 2008, driven by strong demand. As a result, Australia's terms of trade are higher than we assumed three months ago and look like they will peak higher and later than previously expected. A large build-up of capacity in iron ore, natural gas and coal is planned, and over the summer there have been further announcements of projects that had been proposed being given the go-ahead, principally in the gas sector. In broad terms, therefore, the main medium-term story the bank has been pointing to for some time still seems to be in place. We are experiencing a terms of trade event of a very large size, of the type that happens only once or twice in a century. Our job, of course, as policy makers is to try to manage that as best we can to avoid as far as possible the instability that has accompanied most such episodes in the past. To date, something that is probably unusual in the face of these developments is the relatively cautious attitude of households towards their finances. This has been much remarked on recently but in fact, looking back, it seems that the rate of saving out of current income has been rising for several years now. A caveat, of course, is that the measurement of saving, being the residual between two very large aggregates, cannot be as accurate as some other measurements that are done. But, given that caveat, it looks like the propensity to save out of new income has been fairly high recently and that people are working to reduce their debt more quickly and are more demanding of value in their purchases than they were before. This is no doubt a difficult environment for retailers. From a macroeconomic point of view, perhaps on balance it is not entirely unwelcome in the current circumstances. The reason I say that is that, if consumption were to boom at the same time as we try to expand the resources sector, upgrade urban infrastructure and increase our pace of housing construction to house a growing population, it would be harder to avoid the economy overheating. The more cautious behaviour by households is also, I think, building some resilience into household balance sheets, and that will be a good thing to have in the future should developments at some point turn in an unfavourable direction. The ratio of household debt to income seems to have stopped rising, having been going up for about 20 years. That is happening in a number of countries. It is not just here, so the factors behind it are not just local ones. But we have in this country the good fortune to be seeing this desire to have consolidation in household finances happening at a time when our incomes are going up because of the terms of trade story. That is an advantage that many other countries do not have. Locally, attention has of course been focused on the devastation caused by extreme weather across several states, most particularly in Queensland. I imagine we will spend some time today talking about the economic costs of this. It is important to say, I think, that the human cost cannot be quantified in dollars or per cent of GDP or those sorts of things, and the people affected are still absorbing that cost and some of them are going to be doing so a long time after the economic costs are not being talked about any more. Those of us who have not been directly affected have admired the courage and resilience of those people as they faced these devastating events. The Reserve Bank, for its part, has an obligation to consider the impact on the national economy. To do that there are a number of questions we have to ask and seek to answer. I will outline three of them. How large are the effects on output and prices that we should expect to see? Are they due to demand disturbances or supply ones, because that matters? How long will they last--that is, do they change the medium-term outlook for the economy significantly? It is early days. We had a stab at setting out some estimates in the Statement on monetary policy released the other day. That was finalised after we had seen the flooding in Central Queensland in December and more coastal flooding in January but before Cyclone Yasi had made landfall, so we could not assess that. I should emphasise that all these estimates are preliminary and there is inevitably going to be a great deal of uncertainty around them. I think that will remain the case for some months. With those caveats, the estimates we put together suggest that real GDP will be noticeably lower than it would have been in the absence of these events in the December and, particularly, the March quarters. By the March quarter, we think it could be about a percentage point lower than the forecast we had when we were last here. As to the reasons for those effects, it is not primarily because demand for goods and services has suddenly slumped. It is mainly because the economy's capacity to supply goods and services, particularly certain commodities, has been seriously disrupted. It is likely that the bulk of those supply losses will be recovered in the June quarter as production, particularly in coal mining, which is a very big swing factor here, resumes. Nevertheless, for many businesses there has been a period of lost income and the reduction in the level of GDP on average for the year of about half a per cent--this is the number that the government quoted and we have roughly the same figure--is one metric of the fact that there has been a period of lost income for those firms that will not really come back. After the initial period of recovery and production over the months ahead, there is going to be a process of rebuilding damaged structures, houses and so on. That will be accommodated in part by the deferral of some other spending but we will see some modest increment to overall demand over the coming year or two compared with what we expected some months ago. Since we put those estimates together, Cyclone Yasi has done major damage to some crops, particularly bananas, as we know. We have some very early intelligence that suggests that the extent of damage may not be quite as great as occurred with Cyclone Larry five years ago and that the recovery of some of the crops might be a little quicker than during that episode. Nonetheless, there has been a very substantial impact, and a large rise in the prices of some fruits like bananas is already occurring. That is on top of price increases that will be occurring for foodstuffs as a result of earlier flood events. The result of that is likely to be a temporary rise in CPI inflation to probably around three per cent, we think, for the June quarter. That is a higher figure than was in the statement we released the other day because we have now factored in an effect from the cyclone that was not in that forecast. The combined contributions to that three per cent number of all the summer flood events and the cyclone is probably half a percentage point or maybe even slightly more. These effects should begin to reverse in the second half of the year and should be largely gone by the end of the year, we think. We do not think that the impacts on economic activity that I have talked about will derail the expansion, nor should the price effects pose a serious threat to the achievement of the inflation target over the medium term, provided that the community can understand their temporary nature, and we all have a job to do there in helping people understand the temporary nature of it so that expectations of ongoing inflation can remain well anchored. I think we will be able to do that. Accordingly, the board's view at the recent meeting was that, while there will be substantial impacts on the short-term path of economic activity and prices, monetary policy should not respond to those--either the price impacts or the activity ones. Likewise, while the recovery efforts will probably add a little bit to aggregate demand in the latter part of this year and next year, we think those effects are manageable in an economy of this size. We did not have an assessment of the cyclone at the meeting but our assessment of the medium-term outlook today would not be very different to the one we had at the board meeting. So that is the assessment we made on the way monetary policy should look at these things. In brief, as everybody is saying, we are going to look through these various impacts and keep the focus on the medium term. Coming to inflation, the outcomes in the latter part of last year were moderate and probably a little lower than we had thought they would be. As always, assessing to what extent that is a signal of a lower medium-term trend, as opposed to noise, is difficult. There would appear to be some association between the consumer caution that I talked about and reports of widespread discounting in the retail sector, and of course this is facilitated by the exchange rate being very high. If that connection is in operation then one uncertainty about the outlook, of course, is how long this cautious behaviour will last. That is one of the things that we flag in the risks section of the Statement on monetary policy . It is not the only uncertainty but it certainly is one of them. Stepping back, though, to take the broader picture, underlying inflation has fallen substantially from its peak in 2008. It needed to, but it has. And I think it is worth recording that, on the latest numbers we have, we have an unemployment rate of five per cent and an inflation rate clearly in the twos, which is where we want it to be. That combination, when you go back and look at recent decades, actually is a pretty favourable one compared to many that we have had. Turning finally and in conclusion to monetary policy itself, as a result of the adjustment to the cash rate in November and the changes that lenders made, which were a bit greater than that, interest rates being paid by borrowers are a bit above average compared to the past 15 years. Household credit growth is positive but moderate, business credit is still declining as many firms are still seeking to lower gearing and consolidate balance sheets, and in the case of larger companies they are able to access capital markets directly. Reports do suggest that there is some easing of lending conditions starting in some areas, though my sense generally is that lenders remain fairly cautious. The exchange rate is very high. It is at a peak level for the floating era, since 1983. That is not altogether surprising, given how high the terms of trade are, but it is exerting a dampening pressure on the traded sector of the economy outside the resource sector. Overall, I would say conditions are on the firm side. In view of the outlook for the medium term that we have, I think that is appropriate. Having reached that position, though, in a fairly timely fashion the board has judged it recently sensible to sit and leave the cash rate steady. That is what I wanted to say, Mr Chairman. I look forward to your questions. --Thank you for that, Governor. I will kick off the questions. You have said in your statement that retail sales were relatively low, particularly in December, inflation is within the band and slightly better than when we last met for the medium-term projections. You have also made comments on the cautious approach by householders in relation to savings and you concluded by talking about interest rates being a bit above average. Does that mean that interest rates are now on hold for the foreseeable future? --How long is the foreseeable future; how long is a piece of string? Last time we met I think I said at that point of time that, with respect to the pricing in financial markets, which we take as a technical assumption for putting the forecast together, there was no anticipation of any change in the cash rate for some time. There has not been since then and they still have that expectation. As I said then, that is probably a reasonable expectation to have. It was reasonable based on what we knew then, and I think it is reasonable based on what we now know for them to hold that view. So I would not be seeking to dissuade people from that view. Whether it turns out that rates do not change for an extended period--of course, it may--no-one will be happier than me. But things happen. We cannot know for sure, but that is what people currently expect. Based on the current outlook that we have, that is probably reasonable. --Is there an argument for an easing of rates over the period of time, given your prognosis of inflation and given your statement about interest rates being a bit above average, compared to the past? --I think it is about right for them to be where they are, given that we have a once-in-a-century terms of trade event that is very expansionary and all the things that flow from that. It would be surprising if you did not have to have policy a bit on the tight side of normal in that event, taking account of the fact that the exchange rate is doing a fair bit of work for us. I think there would only be an argument for an easing if that strength looked like it was significantly dissipating or if we had some other very important piece of news that was quite view changing. At the moment, the medium-term inflation outlook is not really very different. Where we think it will be in two years from now is pretty similar to where we previously thought it would be. The near-term trajectory is a little lower because of working in the history of the low figure we got. The CPI basis is actually a bit higher because of the flood effects and so on, which we are saying will pass. But the medium term at this point does not look very different. Terms of trade actually look stronger, but we are saying that the medium-term inflation outlook is pretty similar to last time. So I think that says that policy is about right. --What are your expectations in relation to our foreign exchange rate with the US dollar and if that significantly changes or improves, as has been suggested by the market over the next 12 months, does that have an effect in terms of-- --A material change in the exchange rate can often have a significant bearing. It depends why it occurs, though. Also, some people in the market are saying that; some are saying it will go down. The fact is that nobody knows and it is a variable which the economics profession is particularly poor at forecasting, which is why we tend to assume no change because that actually is as good a forecast as any other. But the broader point is that if it rises because the terms of trade outlook and the economic outlook is actually even stronger, that will be one signal. If it were rising because some other factor was pushing it up and the real economic outlook was not stronger then that would be very a different message for monetary policy. So it depends what the thing is that drives it up. When we think about the exchange rate, we always have to ask that question before we can come to an answer as to what that means for monetary policy. In truth, no-one really knows what it is going to do. Someone who does know can make a lot of money, and not many people systematically do make money in that market. --If they did, they probably would not be sitting here, I suggest, Governor. I want to turn to the November increase and review it with hindsight, which clearly the board did not have the opportunity of doing. Given what has happened in Queensland and given the longer term forecasts that you have made, is there an argument that the rates did not need to move in November, particularly given the events in Queensland, and that there would be no significant difference in relation to the economy? --One rate rise or 1 1/2 even, as that one was--they usually do not make a major difference anyway. It is whether you have got the level roughly right that really matters for the medium-term path of the economy. I think the level is roughly right. I think it was the right call. I think if we had not done it in November we would have been sitting there in December with the same outlook, feeling, 'We really are going to have to soon.' If we had not done it then we would be coming into February and then the picture would have been much more complicated, as you say. But I feel that the current level is about right for the medium-term outlook that we have. As I say, we are going to have a lot of disruption from the flooding, both on output and prices, and some impacts of the rebuilding. But through all that, in two years time--unless we have got this wrong--the economy is going to be looking pretty similar to what we thought it was going to look like when we made that decision. So I think it was the right call, even in hindsight. --Many of us were critical of the banks supersizing that last increase and many households have obviously been hurting because of that supersize. I notice that the CEO of the Commonwealth Bank made some recent comments suggesting that, in all likelihood, that would not be a path they would go down in the future. Do you want to give some commentary in relation to that particular statement that was made and how that may affect your decisions in the --Do you mean his statement yesterday? --We need to be careful we do not get into price signalling here, I suppose. Generally speaking, the relationship between changes in the cash rate and changes in the whole structure of deposit and loan rates is a function of what happens in the marketplace. Since November I do not think market funding costs have really done anything very much relative to the cash rate. It is very gradual. As they roll over the five-year debt up here compared to down there, that is coming and it is a basis point a month worth, maybe. I think the CBA said that. So that is still happening and it will keep happening until we get to about five years after the widening in spreads first occurred, which was back in 2007 or 2008. Apart from that though I do not think there has been any material change in the structure of the other things that drive funding costs, since November, have there, Ric? --No. As Glenn said, the cost of long-term debt continues to rise. It is probably adding about five basis points a year to banks' cost of funds. The Commonwealth Bank was the bank with the lowest margins through last year and, because of the mix of its funding and its lending, it had quite low margins. Those measures it took sort of restored the margins. My guess is that Mr Norris's comments yesterday suggested that he is feeling more comfortable now with the current level of margins. --I am partly asking the question because in the past you have made the point that, when the reserve makes its decision, it takes into account what is happening independently with the banks. Given that statement yesterday, is the expectation that banks will not be moving beyond rises in the cash rate? --We are not contemplating a rise now but, if we were, I think it is not very likely that there would be material changes right at the moment. It is an analytical point, but since we are not contemplating a rise right now we do not have to worry too much. --Turning now to Queensland, you did provide us with your views in relation to that in your opening statement, but I want to go a little bit to your views on the effect of the capacity constraints with the rebuilding after the Queensland floods in the medium term. On a number of occasions you have made comments about the difficulties with capacity constraints here and the pressures they create. What additional pressures do you think have come from these natural --We have made the point for some years that capacity is an issue for the economy generally and I think we have seen evidence of that in a whole range of areas. I suppose there are two general points I would make about rebuilding and I will ask Philip to add any detail he wants to. My two general points are that the rebuilding is to some extent being accommodated by slowing down other areas of spending, so that helps with the capacity issue. In terms of constructing dwellings and things like that, if there were one region where you would think there is more capacity available than elsewhere, it is probably South-East Queensland, because in the lead-up to this episode it had among the weaker performances of house building and so on, for various reasons. That at least at the margin says that the capacity to construct some thousands of dwellings extra over the next couple of years, starting from where they started, is probably better there than it would be if it were happening in Melbourne, say, where things are much stronger. We probably should not overstate the capacity issues in this particular episode. Phil, is there anything that should be added there? --In the analysis that we put in the Statement of monetary policy last week, we said we thought that over the next two years there could be up to $8 billion of additional spending in repairing and rebuilding the infrastructure. You have to put that in the context of a $1.4 trillion economy. So $8 billion is a significant number but it is not, in the context of a $1.4 trillion economy, unmanageable. Think of the recent coal seam methane projects announced in Queensland. There are two of those projects. They are $15 billion each of additional spending over a three or four year period. So it is large but it is manageable. In the construction of dwellings, I think there is probably a couple of billion dollars there. A few thousand houses will have to be completely replaced and 20,000 or 30,000 will have to have significant rebuilding or repairs done to them. But, as the governor was saying, there is some spare capacity in the Queensland construction sector at the moment. So it is significant but I think it is manageable. --In relation to the natural disasters in Queensland, you spoke about a short-term spike in prices, but the role that we all play in managing those expectations of inflation. Would you like to go into a little bit more detail about what you meant by that and how short-term you see that spike being? --The peak for CPI inflation is going to be three per cent in the first half of the year. It is then going to go down a bit. The forecast is that underlying actually starts to edge up by the end of the year, so you have got two things working there. But the point about inflation expectations is important, because generally when we have a sharp spike, either up or down, in inflation and we are saying, 'It wouldn't be sensible to tighten monetary policy because inflation is temporarily rising because of a supply shock,' we look through it, we look to the other side and we say, 'It's going to come down, so we shouldn't raise rates in response to that.' That is the right analysis. The assumption we are making in being able to have that analysis is that people's expectations of the permanent inflation rate do not go up. I do not think they will actually. We have seen these sorts of things before. People understand that. People correctly sense that prices of fruit and vegetables and so on are going to go higher for a while. The damaging thing would be if they took that to mean that inflation everywhere is going to stay high permanently. Then we have got a problem, because it is not so easy then to say that monetary policy should not respond to that. It would have to if that turned out to be the problem. So that is why it is important for us to help people understand the temporary nature of things, and that is why we have set this out in some detail in the document. We can appeal, of course, to the Cyclone Larry experience, where banana prices went through the roof but a year or so later they were back to normal. That is what we need people to understand. So our job--those of us who comment on inflation--is to help people understand this point. I think we have got a pretty good chance of doing that, because, in the past episode, people expected inflation to be higher for a while but they did not expect it to stay higher permanently. That worked out well. I would be pretty confident we can achieve that again. We just have the job to do to explain. --Thank you. --Governor and members, welcome back. I would like to explore this issue of inflation a little further, to get a better understanding about the way in which the various stimulus measures are impacting upon the economy, following on from the chairman's line of questioning. I understand that private sector capex is forecast to be around $780 billion flowing through, the largest capital expenditure that we have seen in our economy for some time. Dr Lowe, I think you made the comment about there being approximately $8 billion of additional spending as a consequence of some of the challenges that we have faced over the summer. In addition to that we have seen some very significant state government stimulus measures and spending. I would be interested in your comments about the impact of state, public and private sector spending on inflation. --The $780 billion that you quote for private capex would be over a number of years. --It is a big figure. There is no doubt that private capex, as far as we can see, is going to be very high as a response to the resource prices and so on. What we do with the forecast for inflation is we take all the sources of demand and supply and put them in there and come up with an estimate for how inflation is going to track, as best we can. So the various spending and the various reductions in spending that have been announced recently in order to accommodate the gross impact of the recovery from floods and so on--so far as the public sector is concerned anyway--are all factored in as well. The outcome we come up with is an inflation rate that is in the twos for the near term and probably drifts up a bit the further out we go. With that forecast, of course, there is a while yet to see whether it comes true, but that is the outcome we have. That is the combination of the build-up of all the demands that we anticipate in the economy relative to what we think its potential capacity to supply is. --Could you put some context around the size of that private sector capex from a historical point of view? --The way we would think about it is as a share of GDP. Is there a chart on that in --I think so, it is particularly around mining investment. --Mining investment is going up several percentage points of GDP. It has already done so and probably will go up another one or two. That is very high. It is one of the highest that you would find if you went back through the history. Certainly the average since the early 1960s is that mining investment may be running at a bit under two per cent or around two and it is going to be on its way to 5 1/2 so that is a big change. Some other parts of investment will be a little lower because we are having structural change in the economy, but it is a big story. There is no question about that. That is the story we have been telling. --So it would be perhaps not inappropriate to say it is almost unprecedented in terms of this level of capex? --Mining sector investment certainly in the modern economic era of Australia-- the second half of the 20th century--yes. --More than double the average? --Yes, Ric did a long speech on this some months back. It is a very big event if it all gets done. --I am just mindful that we also see state government levels of net debt; New at levels that suggest a highly expansionary nature in terms of state government stimulus. Would it be fair to characterise it as such? --Are you referring to stocks outstanding of net debt or the issuance of net debt over a particular period? As a stock outstanding that would be very small. You must be referring to issuance. We have never really said that the size of public debt on issue per se in this country has been in itself a problem any time for quite a long time now. The issue really is not whether governments can fund borrowing if they need to, they can. The question really is the availability of the real productive resources to do the work. That is the question, not whether you can raise the debt funding. As we have said, we think that given the various deferrals or reductions in other spending and so on the extent of extra demand associated with the recovery is manageable in an economy of 1450 billion annual GDP. --I am interested to explore this issue of manageability. We know for example that Access Economics in their business outlook from December last year said: I think I actually raised a similar modelling with you at our previous hearing. The manageability aspect is at the core of this insofar as, with this largely unprecedented level of private sector expenditure, with an expansionary outlook by federal and state governments, the way you manage it is by putting up interest rates, isn't it? That is how we keep the economy in check: through the Reserve Bank increasing the cash rate. --The announced plans for federal fiscal policy are that the stimuluses that were put in place as a result of the decisions back in late 2008 and early 2009 have come through and are now tailing off, so, strictly speaking, I think the fiscal impacts as conventionally measured would be going negative in the current fiscal year or, if not, very soon. In the states I think there is a similar story of a large build-up in spending that then tails off. So I am not sure that, strictly speaking, a characterisation of that as strongly expansionary on the growth rate of the economy would be quite right. I do not think that is so. It has been, but these programs, particularly the federal ones, were designed to then start tailing off. That has to be delivered, of course. It is always quite a challenge for governments to deliver the restraint that they promise, but that is what is supposed to be in prospect. So I am not sure it is quite right to say that it is strongly expansionary out into the future. It has been expansionary on growth, but those things are going back the other way in the future if things are delivered as promised. --The seven interest rate increases that we have seen, which in real terms, coupled with an increase in bank margin, if not tied back to the expansionary nature of all of these-- --What they are tied to is that we had a very expansionary setting of monetary policy, the lowest cash rate in 50 years, to meet what was at that time perceived--and I think rightly--as a huge threat given the global situation, and then the worst did not come to pass. We had a modest downturn. We were into recovery quite quickly. And we said, 'Well, monetary policy should go back to normal once the economy is clearly on its way back to normal,' which it was, so we normalised. And now, of course, we are a little bit on the tight side of normal, looking forward to the forces that we think are already building up. Demand turned out to be, in the private sector, stronger than we had feared it would. We feared it would be weaker. --Which is a good story. --It is an incredibly good story, actually. --Isn't it fair to say, though, about the fiscal policy settings--and the way in which monetary policy settings were adjusted to take that into account--that the size of the fiscal policy stimulus coupled with the private sector stimulus did not take that into account in the same way that monetary policy did? --Fiscal stimulus did what it did. We observed that and we factored that into our forecasts and did what we did, and as it turns out the private sector recovered confidence pretty quickly and demand recovered faster than we had feared it would, so we responded to that. That is our job. Your question really is: would rates have been lower if the fiscal policy had been --We have been through this many times--most times in these hearings--and the answer is: that is right. The second question is: is that a better outcome? Not necessarily. It could be; maybe not. --I think you gave me that answer last time too. --Well, the presumption that interest rates always being lower is always better--I do not think that is so myself. I think that is often presumed and I do not think it should be presumed, but that is a separate debate. --With respect to some of the pressures that we see building in the economy, I am interested in how Australia sits with respect to household debt and interest payments against disposable income. I understand that we currently sit at about 160 per cent of disposable income against household debt outstanding. I understand that, for example, Canada is 136 per cent; the United States, 128 per cent; and Germany, 98 per cent. I would be interested in your thoughts around those numbers. --The debt to income ratio here 20 years ago was low by the standards of developed countries; now it is certainly up there with the high ones. Most countries are seeing households saying, 'Gee, maybe we'll get this debt down a bit. We can't keep gearing up like this.' I think we have joined that group. It is a fair bit less disruptive to try to tame the debt buildup here than elsewhere. But, for the orders of magnitude you quoted, we are up there with the Americans, Canadians and British--or higher than some. I think that is right. To go back to my earlier comment, this is why we should not always assume that really low rates are good, because that is one of the things that can prompt people to build up much more debt than maybe they really should. That is how, some people would argue, American households got into trouble--a long period of cheap money. --Our servicing costs are quite high by global standards, aren't they? --Our interest rates are relatively normal, whereas in a number of other countries their cash rates are certainly extremely low. Their actual borrowing rates are not as low because the long rates drive the borrowing rates. We have rates of servicing costs that have gone up materially in a trend sense over time, reflecting the amount of debt people have taken on. --I am also interested in your comments on the spread between the RBA cash rate and the variable mortgage rate. The 10-year average, I understand, was around 180; now I understand it is about 300. Do you have comments on that? --We are talking about a rise of a hundred points or a little more, give or take, depending on which exact product you are talking about over the three years since about the middle of 2007. That reflects the fact that the market funding costs across a range of sources have moved up materially compared to the overnight cash rate, which is why the overnight cash rate is considerably lower today than it would normally have been in these sorts of circumstances. It is to take account of that difference. I think we have said that pretty clearly many times. --Certainly a sentiment that is expressed to me on a regular basis is that, at a time when there appears--I am guessing at the Reserve Bank's attitude towards banking competition--there is a much lower tempo of competition in the banking sector and we have banks posting record profits and we have seen nearly a doubling of the spread between the cash rate and the standard home loan variable rate, there might be a little bit of fat in there that could be trimmed. --If we look at banks' overall interest margins, the long-run story is that they were 500 points in the early nineties. They are now between 2 1/4 and 2 1/2 per cent. It recovered a little bit of that very recent fall in the past year or so. The long-run big story is that those margins are actually much skinnier today than they were historically. --That is probably a consequence of cross-subsidisation. --The fall was a consequence of more transparent pricing and a lot of cost reductions in banks, which had to be done because there was competition there. So that is a story. It is true, as you say, that the competition to lend money in the mortgage space today is not as intense as it was two or three years ago. As I have said many times before, there is a lot of competition in the banking space. It is in the area of raising money in deposits and so on. That is where the competition is among the institutions. When funding was cheap and easy and freely flowing three years ago, nobody worried about how we were going to fund the lending. They said, 'Let's get out there and lend,' and there was intense competition which was tending to squeeze the margins down. But now, because of what has happened in the global economy, the really intense competition is from banks saying, 'How are we going to fund it? I have got to match that guy's deposit rate or do better and get deposits in.' That change in the location of where the intensity of competition is has basically been handed to Australia's financial system along with every other country in the world. Ric, do you want to add anything? --I think that is right. The key point is that it is not really relevant to look at the spread between the cash rate and the lending rate because there are all sorts of other factors affecting banks' cost of funds. The key point is that the net interest margins of banks have not really changed in five or six years. They got down to about 2 1/2 per cent in about 2005 and they really have not changed since then. They have been down as low as 2 1/4 and they have been up to 2 1/2 , but they are really still in that range. Subject to measurement error, you would have to say that is pretty steady. Despite all of the debate that is going on, the picture is that the banks are really moving their lending rates overall in line with their cost of funds. It has not changed in five or six years. --I guess the difficulty I have is that in an environment of lower commercial activity banks are making record profits and I am being told that their margins are constant or lower than they were. It does not seem to add up to me, but we will have to agree to disagree. --In dollar terms, there is no doubt that profits have continued to rise. Everything in the economy is continuing to rise. The return on equity of banks is actually lower than it was a few years back. That is the key point. You cannot look at things in terms of dollars because everything is rising in dollar terms. --I have one further line of inquiry with respect to wage price pressures. Your Statement on monetary policy includes this passage: I note that, with respect to wage growth by industry, we have got the public sector at the top, the mining sector is second from the top and, interestingly, the worst performing sector of our economy, the manufacturing sector, is now year-on-year breaking north of three per cent. Do you have any thoughts as to the reasons why we are seeing such strong wages growth? I think you have already explained the mining sector, but there is still the public sector and the manufacturing sector, which is our worst performing sector. --The public sector does not tend to have a great deal of cyclical variation. In the chart there the private numbers at the peak before they went down were at four or 4 1/2 as well. The private sector is more cyclically responsive. I think that has long been true. Three and a half per se across the economy on average in the private sector is not inflation breakout territory. So if it stays there I do not think we have got a problem with overall price pressures. We have got five per cent unemployment as of the January figures that came out yesterday. If our forecasts are right, that will edge down over the next couple of years and we would expect to see overall private wage growth go up some more from where it has been. That is part of the gradual increase in underlying inflation we are talking about. I do not have any particular comments on manufacturing per se. Another observation I would offer is simply that, when we think back through the last several years, we had a considerable degree of variation in relative wages and that is the economy's adjustment mechanism working as it is supposed to. One would hope that those capacities to adjust relative prices and so on remain in place as we go into this next period. --Thank you. Mr Ciobo pursued a line of questioning which was about the tightening in monetary policy post-GFC. For a bit of context around that, how do our current interest rate settings compare with the emergency levels during the GFC and with preGFC interest rates? --The cash rate has risen 175 basis points since the emergency. The current level is 475 and you would have to say that historically that is actually low. --But compared to pre-GFC it is at a low level? --Yes. The rates paid by borrowers, which went well below average--there is a chart, I think, in the document--are now back to a little bit above their average for 15 years. So they are a bit above normal, having previously been cut to well below normal very rapidly, as you know, at the turn of the year--from late 2008 to early 2009. So I would describe the current level of rates that most borrowers are paying, in absolute total terms after all the margins and so on are there, as slightly higher than the 15-year average. By 'slightly' I am talking 50 points maybe, give or take a bit. This is what the chart on page 49 shows. So the cash rate is below average because of the spread widening that Mr Ciobo has been talking about, and the lending rates are a little bit above average. --The second line of inquiry deals with the cost of living. I would be interested in your thoughts on what I perceive to be a disparity between the measured rate of cost of living--inflation et cetera--and the very persistent feedback that we get from our electorates and that we read about in the media--that is, the felt rate, or the felt cost of living increases. I would be very interested in your comment on that. --I will get Phil to talk to you a little bit about cost of living indexes other than the CPI, because there are some. Let me offer perhaps one observation, though. Different groups will be facing, even within the CPI basket, slightly different outcomes. People do, though, tend to overlook prices that fall a little bit and 30 per cent of the CPI items actually had a negative price change in the latest quarter. There are certain things that people do not buy quite as often as the weekly groceries and it is human nature that we tend to forget that those prices go down in many instances. So I think that is a factor and it is understandable. But, in the end, the consumer price index samples 100,000 prices every quarter. There is a far better sampling there than any of us could do by keeping a casual tab on our grocery bill--which we all do. Certain things are quite prominent, of course--petrol and things like that. But I think the CPI is probably amongst the most reliable statistics that the Bureau of Statistics puts out because, as I say, they do a very large sample. But there are differences in experience, because the CPI is calibrated for the average household living in a metropolitan area and none of us are actually quite average, are we? Any given person, probably quite rightly, will find that, if they could measure their own basket exactly right, it would not be quite the average experience. --The ABS also publishes cost-of-living indices for different categories of people. The latest data we have there is only up to the September quarter, whereas the CPI is up to the December quarter. In the year to September the cost-of-living index for age pensioners was up 3.1 per cent; the CPI over that period was 2.8 per cent--a small difference. For other government transfer recipients it was up by a bit over four per cent. These measures are on a different analytical basis and they take account of the fact that the consumption bundles of different people are different. One of the reasons the felt CPI is higher than the actual CPI for many people-- --For those people on welfare benefits, what they are feeling is actually true by the sound of it. --Yes. The prices of many goods at the moment are declining. If you go through the CPI over the past year, you see that the price index for clothing is down six per cent, the price index for major household appliances is down four per cent, the price index for audiovisual equipment is down 18 per cent, the price index for furniture is down two per cent and the price index for linen, manchester, is down around two per cent. Almost all the goods in the CPI are down quite significantly. I think many people, because they do not buy these goods on a regular basis and have in their mind a clear concept of what the actual price is for a shirt or some Manchester, do not feel price declines but they are real and they are happening. What people are noticing is the higher price of utilities in particular. The price index there is up roughly 10 per cent over the year and people really notice that when they get their electricity bill. That is affecting many people's perceptions of what the true cost of living is doing. --There was an exchange between me and the Governor at the last hearing on utilities. I think, Governor, without wanting to put words in your mouth, you made the observation that some of the price increases we are experiencing at the moment in relation to utilities are due to a decade or more of under investment. You will correct me if I am wrong. --I think that is right. I think utilities prices were flattering us for some years and we are now paying that back, in a sense. We have to help pay for the capacity expansions that we need. --I am interested in the opinions of any of the representatives on what you think is going to rectify that underinvestment, what risks there are to future investment, particularly in the electricity industry and what will stimulate and what will inhibit the necessary level of investment in that sector. --I would not claim to be highly expert in the economics of water and electricity. You can think of a few things that are relevant, one of which is that they need to be able to get a price for their product which covers their capital costs and returns. I imagine people will say that carbon pricing and all the things around that are going to be an issue. I cannot tell you what the right thing to do is though. It is an obvious thing which they will be thinking about in that industry--the cost of inputs, whether coal or gas are becoming expensive. All those things matter. In the end, we have to pay for the cost of the production and distribution of the power and water we use. I do not think we will get an efficient allocation or usage of those things if we do not price them right. --The major price increases that we are experiencing at the moment for electricity are not coming about because of higher generation costs. They are coming about because of the investment in the distribution network. One of the things that have happened over time is that not only demand for electricity has grown but the spikiness of electricity demand has grown as more and more people have got air conditioning. We have not built enough transmission infrastructure to deal with those spikes. So the electricity authorities are having to spend a huge amount of money building the transmission or rebuilding and repairing and expanding the transmission network. We have not seen, at least to date, large increases in utility prices come primarily from generation costs. In time I think we will, but at the moment it is really about the networking, the distribution expansion that is going on. --My final question goes to some of the observations in the SMP on inflation outlook for year end. You make the point that non-tradable items with particular contributions from rent, utility and other housing costs are feeding into your inflation expectations. My concern, which I would like your comment on, is that monetary policy is probably a pretty blunt and, if I dare say so, an ineffective instrument to deal with what are essentially supply-side shortages. In fact they could be counterproductive in dealing with those price increase expectations. --The argument about what causes particular price rises and whether it is supply and demand or demand-- --I think in relation to housing it can be beyond doubt that it is a supply-side issue. --It is an important point. But at some very broad level it is demand. Demand has been rising for electricity, and capacity to supply, until recently at least, has tended to struggle to keep up, for various reasons. It appears that to keep the supply growing at the rate we are demanding there needs to be higher prices to justify the various investments in networking and so on. You could argue that this is some supply problem and possibly it is temporary and therefore we should look through it, but I think you could also argue that really it is demand. Ultimately, at the current prices, demand has been growing very fast, and those prices are rising to reflect that in some very broad sense. --We will suspend this hearing for a short time. --In the latest Statement on monetary policy you discuss the increase to the household savings rate to around 10 per cent of household disposable income. The statement notes that this is a puzzle and seems to suggest that it is primarily due to a rise in risk aversion by Australian households. Given the magnitude of the increase, do you think that explanation is reasonable or could it be that monetary policy is overly tight? As a follow-up question, isn't there a risk that, if this new found conservatism of households grows, it could exacerbate the gap between the mining sector and the rest of the economy? --I do not think monetary policy is overly tight. Certainly I think savers are looking for a reasonable return on their saving. People are inclined to pay off their loans a bit faster. It could be that that is related to continual talk of interest rates going up, which we seem to have. We do not seek to contribute to that talk--we try to be fairly circumspect about what we say--but that could be a factor. My sense is that there is a change in attitude that goes beyond what the short-run path of monetary policy is doing, because we see this attempted change in saving attitudes and different attitudes to consumption and debt in a whole range of countries, even ones where interest rates are much lower than here. So, in seeking explanations, we should not look only at home. For reasons I am not sure I can articulate entirely satisfactorily, I think people have just changed their view about saving, borrowing and consuming. It is, as the statement says, one of the key areas that we are uncertain about--whether that will continue to the same extent. I think the statement says--doesn't it, Phil?--that you can imagine scenarios where this caution could abate and you can imagine ones where it could grow. That is a dimension of the outlook that we are uncertain about. If it continues in the way it presently is, I would have to say that I think that makes the task of managing the effects of the build-up in business investment that we think we are seeing easier for us--that is, interest rates are lower than they would have been had households been a lot less cautious. If they got really, really cautious then I suppose it is conceivable that you could imagine a scenario where interest rates might go down. I do not think that will happen, but you cannot say for sure that it will not. Likewise, it will turn out to be pretty unusual, I think, if we go through an event of this size the whole way and households do not pick up some spending at some point. That could happen. We are assuming a little bit of ongoing caution for a little while yet. But if there is no rise in household spending at all as result of the income boost that is coming, that will be a pretty unusual outcome historically. We have to give some weight to the things we can distil from history, obviously. --Turning to the labour market, it looks to me as though there has been an outward shift in the Beveridge curve. Is that your read of the data? If so, what do you think is the --Do you mean that the relationship between vacancies and unemployment is deteriorating or improving? --Deteriorating. For example, if you simply take the ratio of the vacancy rate to the unemployment rate historically you get a number of about 0.15. Now you get a number of about 0.4. Is that your read of the data? Is that a source of concern for you? --Is that more vacancies per unemployed person or fewer? --There appear to be more vacancies per unemployed person than has historically been the case, at least from my read of the data. --The vacancy rate as a share of the labour force is on the way up. It depends on which measure you use. The ABS measure is quite high and unemployment is low, so that is right. Is that a problem? Taken at face value, it signifies a certain degree of labour market tightness. One might say as a result of all that that we are pretty close to full employment. At one level that is good, isn't it? We are supposed to try to have full employment. We do not want to be over full, so we do not want to have serious pressure on wages and inflation. We do not want to have serious skill mismatch, which might be another issue to talk about. I must admit that I do not think about it in Beveridge curve terminology, but our assessment of the labour market is that it has been tightening. Probably the pace of employment growth is slowing down a little bit. That is our assessment. Nonetheless, unemployment has tended to trend down a little over the past year, and probably that will continue over the next couple of years, which is why we have to be alert to potential pressures. --So you are not concerned with issues of mismatch, be they geographic or skills --Dr Lowe can correct me if I am wrong, but I think what our liaison is telling us is that the resource guys and the people who are maybe doing some of the construction build-up associated with that and one or two other inputs are the people saying, 'We're starting to struggle getting the labour we want.' I think most other firms at this point are saying, 'Things have tightened up somewhat but we're not really finding serious problems just yet.' --I think one of the things happening is that there are a lot of job vacancies out there, as you say, but when we talk to firms we are not detecting that they are having to compete incredibly aggressively to get workers to fill those jobs. If you go back to 2007, when the vacancy rate was high as well, we were hearing a lot of stories when we were talking to businesses that it was very hard to get the workers and you had to offer very attractive terms to get them. The vacancy rate is again high, but we are not hearing the same aggressive bidding for labour that we were previously. Firms are happy to take a bit more time and they can find the workers they want at the moment. Things are tightening up and have tightened up a lot in some sectors, particularly, as the governor said, the resources sector, but overall, even though the vacancy rate is high, firms do not seem to be saying that it is particularly hard to find workers at the moment. --Turning now to one of the issues before us, can I ask you to compare market mechanisms for abating carbon pollution with non-market mechanisms. Given the same level of abatement, which of those approaches is likely to have a more adverse effect on growth and --You can ask me about carbon pricing; I am not sure I can give you a very wellinformed answer, though, because I am not an expert in it. I would be prepared to say that, if the problem is as large as the experts believe, I think we are going to find that you want to probably have a range of techniques working to deal with it, one of which would be to try to harness market forces. But I am not sure that I can say much more than that, because I just do not know enough about the science or economics of climate change. There is enough controversy with the things I do know about, so I will stick to them. --Moving on to foreign exchange, there is a chart on page 27 of the latest RBA chart pack that shows net purchases of foreign exchange and seems to suggest that, in general, the bank tends to lean slightly against the wind, purchasing foreign exchange as the Australian dollar strengthens. But that seems to have ceased in the last six months. Why is that? --We typically are not seeking to do intervention either way just at the moment. The history here in the broad is that, when the currency fell very sharply, there were moments of very disorderly conditions and we intervened to purchase Australian dollars and sell foreign exchange. Then at a certain point in time the exchange rate stabilised and began to recover. During that recovery period, what we normally look to do, once it is clearly going back towards average, is try to return the reserve position back to average as well. We are then repositioned for events either way that might come. Once that is done, the transactions to do it, of course, cease. I do not have before me the precise numbers on a month-to-month basis, but we are not seeking at this point in time to accumulate extra foreign reserves, so there are no measured intervention style transactions going on. We are content with the current reserve holdings. --What is the underlying philosophy of your foreign exchange transactions? --The philosophy is: in moments of exchange rate extremes relative to our best assessment of fundamentals, and if in addition to that we have very disorderly markets, we will be prepared to intervene. On those occasions we have been prepared a number of times over the years to intervene with great force, but we are not frequent interveners. Those episodes do not happen often. Once they are over, if we have used up a lot of reserves we will think that was the right thing to do, but then we seek to return the reserve balance to normal. There is not a lot of science around what is 'normal', but, Ric, I think that over the years we have felt that, if it was half the balance sheet, that is not a target, but-- --to have all our balance sheet in reserves--or almost none of it--is very unusual. We would think that was odd. We would seek to adjust back towards more normal holdings without wanting to actually move the price in the process of doing that, and there are ways of doing it that do not have much price impact. So that is the philosophy--we are not frequent interveners and we are not fine-tuners of the exchange rate, but if we think that there is a significant misalignment and disorderly markets we are prepared to act quite aggressively on those occasions, which are fairly few but have happened. --Governor, where can I go to find the performance of the Reserve Bank's foreign exchange transactions over time? --You mean the profitability or otherwise? --We have published some RDPs on that over time. They will be on the website, but we could make sure you get the links. The accounting profit and loss, of course, is in our annual accounts, and that is a very large accounting loss in the recent year because of the valuation effect of the exchange rate going up. As you know, we have to hold a large open position. That is our job because we hold the reserves, and that means we get big valuation swings. So all that is accounted under standard international financial reporting standards in the annual accounts. --This is my final question, Governor. Mr Battellino made some comments last year that other countries have taken up to 20 years to move through the development phase that China and India are going through. Do you foresee that China and India will continue to grow strongly for some time yet? Feel free to defer to the man himself. --I will leave it to you, Ric. --It is really based on a graph that Phil did, so I will pass it to him! Seriously, when you look at these phases of development that countries go through, it takes a reasonable amount of time for countries to work through those phases. It would be wrong to assume that there is going to be an uninterrupted trend in one direction. These countries continue to have cycles, but the point is that, as they go through those cycles and that development, the demand for resources is elevated relative to where it was in the previous period. China and India will continue to have economic cycles, and that is something that we have to take into account in managing our economy. But, on balance, history would suggest that their demand for resources on average is going to be relatively elevated for some time yet. --Governor, I am keen to follow up on the CPI discussion and comments that we had earlier. In particular, the Treasurer has given the RBA a consumer price inflation target of between two and three per cent on average over the cycle. As a result of that, it is widely believed that the RBA has a target range of around 2.5 per cent throughout the cycle. Many of the other countries have lower implied CPI targets of less than two per cent--countries such as Canada, Britain, New Zealand and the US and Europe. I am interested in your explanation as to why it is that Australia seems to have a higher inflation target than these other countries. --There is quite a lot of history here. As you know, the present Treasurer does endorse the target, and so did the previous Treasurer. Indeed, the bank really began articulating this notion as far back as about 1993. I think it is true that, as you say, a number of other countries have lower targets. Some have higher targets--many emerging or developing countries have higher figures than we do--but the typical number for those who have a formal target amongst advanced countries is probably a fraction lower. It is only a fraction, but it is nonetheless a little bit lower. Regarding the history of how we got to this set of numbers, in all honesty--and I was pretty involved in this--we got to two per cent in the early nineties as a result of a big fall in inflation that happened during the recession then. It did not look like we were going any lower. We had eight per cent inflation on average for 20 years. I certainly felt, and I think this was held in the bank generally, that, if we could hold somewhere near that, that was going to be a quantum jump in performance compared to the history. We should not over-promise and state exactly two, because that was reached in the depths of quite a deep recession. We should accept that there would probably be a little bit of upward movement as recovery proceeds, but keep the number under three on average. The other thing is, if you went back and looked at price-stability countries par excellence in the post-war period--Germany and Switzerland--they had a twopoint-something average, as I recall. My thinking was, 'That is pretty good. If we could do that, that would be a very good outcome.' That is basically where this two-to-three came from. So far, over 18 years, I think the average performance was not quite exactly 2.5 but it is very close, so we have achieved what we wanted to do. --I might very respectfully point to those figures, on average, over the last 11 years. Headline inflation on average since January 2000 in Australia has been 3.1 per cent per annum, which is well above the 2.5 per cent target. Core inflation has averaged at around three per cent during that period as well. It is a long period of time and it covers multiple cycles, obviously. My question is: why has the RBA failed to meet its inflation target over that period? And do you think that the average three per cent inflation rate over the last 11 years has affected the RBA's inflation fighting credibility? --I do not think it has affected credibility. I think most measures that I would look at there look okay, in terms of credibility. We had a big inflation episode in late 2007-08 and we had to respond to that quite forcefully. We did and inflation has come down again after that episode to about 2 1/4 most recently on the core and about 2 3/4 with the tax impact doing a little bit of that work on headline CPI. It would have been even better if we could have totally headed off that surge in inflation, but we could not. People can criticise us for having rates too low back in 2005, 2006 and 2007 if they want to, I suppose, but we responded to those developments and inflation is back under control. That is the job we promised to do. An inflation-targeting central bank has to say at any point in time that, as best we can tell in anticipation, things are going to be consistent with our target, and if they start to move in a way that looks like it is not consistent then we should respond to that. We have been responding to that. We have a fair degree of confidence that, with the right policies, we will achieve a two-point-something performance on average into the future. --I turn to a different topic: bank funding. Governor, can you please advise the committee on the RBA's current understanding of the funding composition of the banks--a split between retail deposits and wholesale funding sources? Of those wholesale funding sources, approximately how much would be sourced from overseas? --There are about 60 per cent deposits. --It is about 50. So, roughly speaking, for the major banks, about half their funding is coming from deposits, about a quarter is coming from long-term wholesale debt-- long-term bonds--and the rest is coming mainly from short-term debt, equity and securitisation. There has been a reasonable change in those compositions over the last few years, because banks, pressured by the supervisor, have been much keener to increase their use of deposits and long-term debt, and that is what has happened. The problem for the banks is that both those forms of funding that the supervisor is pushing towards are relatively expensive, and that has on average pushed up their cost of funds. --You can tell I am a student of history, and I do like to go back and look back. Did the introduction of compulsory superannuation in 1992 have a long-run impact on the source of funding for the Australian banking system? I am asking this because the IMF said in I am interested in your comment on that. --These things are difficult to prove one way or the other, but I think there probably is some evidence to suggest that there was a shift in the way households managed their savings. If you go back 40 years, most people held their savings as a deposit in a bank. With the growth of financial markets and financial deregulation--and I think the introduction of superannuation probably contributed to this, because people became more used to holding these sorts of investments--more and more of the money went into these sorts of funds rather than banks, and the banks in turn had to borrow that money back directly from the super funds as short-term wholesale debt. Or, they were to some extent countering the effect of the super funds from offshore. A typical super fund would have, say, 20 per cent of its money invested offshore. So the growth of the superannuation industry saw an increased leakage of household money into offshore markets through offshore equity investments, and the banks were in some ways bringing that money back home by borrowing money offshore. You can construct a picture that makes all these things consistent. But what is cause and effect, you can never really prove that. But I think on the surface I would probably agree to some extent with that comment. --Do you think it is a permanent, structural shift? --I think it is changing already. In the last six months or so we have seen a very big shift again in the way the Australian economy is being funded. The mining boom that is going on at the moment is really a boom in the big corporate part of the economy, and those corporations are funding themselves by bringing in money directly from offshore. Whereas in, say, the nineties or in the early part of this decade, a lot of the offshore capital coming into Australia was coming through the banking system, at the moment it is coming through corporations, particularly mining corporations. That is showing up domestically as bank deposits, and the banks in turn have therefore been able to scale back to some extent their use of offshore funding. In fact, in the last quarter or two, banks have been able to repay in net terms some of their offshore debt. --I do not want to put words in your mouth, obviously, but in terms of the comments that you have made, you would agree broadly speaking with some of the IMF's consistent warnings that the fact that the nation has got very, very significant superannuation savings of something like, I think, $1.3 trillion, has a direct impact on the Australian banking system in terms of its stability. Would you agree with that? --I think it was probably a factor. It changed the way banks funded themselves in that period. But these things keep evolving. As I say, already in the last year or so, things are changing again. --I know you say they are changing, but would you agree with that broad statement that significant superannuation savings has an impact on the stability of the Australian financial system? --Superannuation funds generally do not hold a lot of bank deposits, so the more household money goes into super funds, other things being equal--it is going to be harder for banks to fund themselves with deposits. --They are big providers of equity, though. --So, all things being equal, are there risks to the stability of the Australian financial system if, for instance, superannuation contributions are increased? --I am not sure I would extend the argument to that. The point too is the extent to which the banks were facing an increased risk by what they were doing. I myself have been always reasonably relaxed about the way the banks have funded themselves because, when you talk to the banks, they are very conservative. While they were borrowing money from offshore, every dollar of that was hedged both in the interest rates and in currencies. For them, it was really no different. Whether they were borrowing money from somebody in America or in Australia, the risk to them was exactly the same; it was hedged. So I think, yes, if you just looked at those raw numbers and equated offshore borrowing with risk, you would reach that conclusion, but if you look more deeply at the way it has all been managed I think those risks are probably overstated. --So what is your view? Is yours the IMF view? Do you agree or not agree? You have given two-- --No, I think I would agree with the IMF that the increase in superannuation and all the other things that happened in the wake of financial deregulation led to a change in the way in which banks fund themselves. Would I go the next step and say that that led to an increase in the riskiness of banks? No, I do not think so. I think all it did was change the way they fund themselves, and the banks continued to behave in a very prudent manner. --The stability of the system then, rather than the increased risk with the --On the stability of the system: we have just been through a very severe test of our stability and we came through with flying colours. --I have one final question. I am interested in turning to another matter entirely now, Governor--that is, the composition of the Reserve Bank board. Because I know time is limited, I will paraphrase my question here, because I know that the board is made up of a number of different independent directors of different backgrounds and different skills. In the past, it has been the practice of independent members of the board such as Professor Adrian Pagan to contribute to the economic policy debate in their own right, given the specific nature of their economic skill set. Do you have a problem with board members contributing to the economic policy debate in their own independent right? --I have never had a problem with people who are economists for a living going about the things that are involved in being an economist for a living, which will include commenting on matters of public policy. It is agreed amongst the Reserve Bank board members that, on monetary policy, the spokesman for the board is the governor. That has been the case for many years. I think that system is understood and all the members are content with that. But our board members, even the ones that are not economists--most of them are people with a commercial background, not an academic economics background--talk about all manner of things in their walks of life. How could it be otherwise? It should not be otherwise. Of course, when they say something, even if it is rather unrelated to anything to do with the Reserve Bank, the press always write it up as 'Reserve Bank board member Mr So-and-so or Ms So-and-so says this'. That is what the press do, but they are not talking on behalf of the bank about those issues; they are giving their own view. I have not had a problem with that. The arrangement we have is that when the bank has to say something about monetary policy I or the deputy governor will say it, and I think that has been pretty much respected by the members. --I am happy with that. --Governor, can I go back to talking about savings and the increased caution. You have said today and in your statement that what is going on is not something that probably anybody in the world really understands yet; is that correct? --My point was that I think there is something happening in a number of countries, and therefore when we are thinking about why, there are no doubt some local factors here but it could be that there is a common factor, across a number of countries, that we should not neglect. That was my point. I think that in most countries the simple story is probably that households have had a terrible fright. They have learnt that, guess what, housing prices can fall, that having a lot of debt can be dangerous and that not saving anything out of your current income on the assumption that asset value going up is going to take care of your saving for you is possibly not a sustainable strategy. So they are changing behaviour, seeking to get debt down and save more and so on. It might well be that one of the things that is at work in the households in our own country is that they have seen all of that in other countries. They have not suffered the same pain here, thank God, but many people will have said, 'I think I am going to be a bit more cautious in future.' This is an adjustment for the people who sell consumer goods. I understand that that is very tough, but I think in the long run we might be moving to a structure of household finances and saving that is a lot more robust to adverse shocks to income, which one day will hit us from somewhere. But I do not pretend to have a fully thought-out, fully articulated or provable set of hypotheses there. This is impressionistic, which is all it can be at this point. --So the bank is not doing research into changing spending and saving patterns? --We do a lot of liaison with the retail sector and we will I am sure be doing work on the sort of evolving structure of household finances but it is a fairly recent phenomenon. By recent I mean that it has been going on for some years but that is not a long time in economic data terms. So any research would be preliminary at this point. Is there any research you would like to refer to on this, Phil? --No. But I think we see lots of different parts of the economy telling us a similar story here. If you look at the use of credit cards, that has slowed down. The rate of payments on housing loans has sped up. You see it in the various consumer surveys where they ask people about their attitudes to spending and buying and there has clearly been a change there. You see it in the inflows into bank deposits, which have also increased. So there is enough circumstantial evidence here to say that there is something fundamental going on. The more difficult issue for us is just how long this is going to last. It is pretty clear something has changed; it is just how persistent it is going to be. Are we going to soon forget about the global experience of the last couple of years and go back to spending most of the increase in our incomes or are we going to continue as we have for the past five years spending a relatively modest amount of the income growth that we have had. That is the thing that is very difficult to answer. --Is there is a savings level or an attitude to spending that the Reserve Bank would consider to be a desirable level? Does it have a view? --I would be reluctant to give some figure that then becomes interpreted as a target to which we are trying to move, which would be the risk. But, let's put it this way: we had quite a long period where household saving, the flow saving rate out of income, went down--as measured by the ABS it actually went negative because they take account of depreciation as well. But it was very low. So we were collectively saving nothing out of the current income. We were gearing up balance sheets to own houses, basically, and spending all of our current income. Historically, that is very unusual. I am not one of the people who says that debt is always and everywhere a terrible thing. I have not said that. But people have picked up a fair bit of debt. A lot of that debt, a disproportionate chunk of it, is actually in the quite high income groups, not the really low income groups. Nonetheless, the community as a whole went, as we were talking earlier, from 60 per cent of income to 120 per cent, 130 per cent or some quite big number. They got to a point of saving nothing, at least as measured, out of the current flow of income. That could be perfectly rational for a time, maybe, but it does not sound like a position that you would be likely to be able to sustain for a long time without significant risk. You cannot keep gearing up indefinitely, and I think the gearing up is over now. The saving rate out of current income is now back at nine or 10 per cent. That is a lot more normal a figure historically. I am not saying it is necessarily optimal. We suspect it is closer, in some sense, to where we would expect it to be over the long run than zero, though. --In your consideration of interest rates, up and down, does the increased caution affect people's response to interest rate rises? --That is hard to say. I think the increased caution has a bearing on what level interest rates turn out to be. It already has had an effect, I think, and, if it continues, that will continue to be so. It is harder to say whether, when there is actually a move, the new-found caution somehow gives a stronger response to any particular move. It is possible that it could be so. It would be very hard to prove one way or the other so far, though, I think. --This is a curious question, really. Is there a comparison between the way Australia as a community responds to changes in interest rates compared to the rest of the world? --You would expect that, if you have two countries and one of them is carrying a pretty high level of debt and one is not, a 25 basis point move in rates, assuming it is fully passed through to the rates that people save at and borrow at, will have a bigger impact, yes. That is one of the reasons why the rate moves are a lot smaller today than they once were when debt levels were lower. --You said earlier today that it is not always better that interest rates are lower, and you have said that a couple of times. Perhaps it is because most people talk about interest rate rises and not the other way around. Would you like to expand a little bit on why that is the --I think that one of the things that has been learned as a result of the global events in recent years is that, if you have a very long period of very low rates, what will happen is that people gear up. Financial institutions, having lent all the money to the prudent, sound borrowers that they can, end up looking for other borrowers, because their job is to lend money. I think many people would conclude today that the very long period of unusually low rates in the global economy, at least in the decade or half-decade leading up to the events that we have seen in the past three years, from the point of view of financial stability, was unhelpful. There were a number of reasons that rates were low. One of them was that a number of major central banks kept their rates very low because they had unusually favourable combinations of growth and inflation and they felt that monetary policy should stay easy. But a whole lot of other rates which were not set by the central banks but set in the market were also quite low for various other reasons. So compensation for risk became very skinny and a lot of financial activity took place that turned out ex post--and it really should have been clearer ex ante--to be extremely risky. People were being given credit who really should not have got it, in the sense-- it is not a moral judgment on them--that their capacity to service and repay simply was not there. That is what happened with a very lengthy period of low rates. It seems to me that, when you look back, that is not a good outcome. That is why my feeling is that the presumption, which is often made in public discussion about interest rates in Australia, that with even lower--people used to ask us, 'Japan has interest rates at zero. Why can't we have that?' We would not want it because the reason Japan had it is not something we want to go through and it is not, in its own right, a very good place to be for a lengthy period of time. That is the background to my comment. --Putting it in the context of a person who maybe bought their home last year when interest rates and cash rates were in the threes and now they are in the fours: is there anything in it for them? --Well imagine we had had the cash rate go to nothing. Then a lot more people would have borrowed at very cheap rates, but interest rates have to normalise one day, do not they? So there would have been a bigger task of normalising, I think. That is why I am not sure that an even lower set of rates than the ones we had would have been especially desirable, at least not for long. If it had been the right thing to cut them, we would have, but I for one am not unhappy that we did not need to go lower than we did. I know the people who took out loans at the bottom have seen any significant rise in borrowing costs. I can only say that we always said that rates would normalise when the right moment came and lenders are supposed to and as far as I know do test of people's capacity to cope with a rise of a couple of hundred basis points. That should be done and as far as I know it is done. If it is not done, it should be. --We talked about the CPI briefly before and Dr Lowe referred to the analysis of CPI for various groups in the community, which was really interesting by the way. Different groups would have a different capacity to respond to CPI adjustment. Half a per cent is very powerful for some groups and less powerful for others. Do you do research on the capacity to respond to that and the impact of those changes? --Do you mean the capacity of people to recoup a particular CPI increase that they face? --To adjust their spending patterns. --I am not aware of research to that level of detail that we have done it. Someone may have done it somewhere, but I do not think we have, not as far as I know. --No. You can look at various household surveys of expenditure and get some guide there. I think the general point here is that at the moment the price of food is rising pretty strongly and the prices of utilities are rising strongly. So people who spend a disproportionate amount of their income on food and utilities are finding things tougher than people who buy the full range of goods and services on a regular basis. The ability to substitute away from use of utilities and the consumption of food is very limited obviously. So those people have less scope to respond than people who are in a different financial situation. As to the research on that, it is hard to put that into hard numbers from some research methodology. --So the research is done more so that you can understand the move in CPI? --I would say it is kind of analytical, thinking about what substitution possibilities there are for different types of income earners. I think we have a broad understanding of what those possibilities are. --You said before also, Governor--again, the perception thing is very interesting to me--that as long as people believed that the change in the price of fruit, for example, was temporary, that would not feed into longer term inflation. Again for people who do not really understand what that means, could you explain how a belief in a price change would feed into --The simplest way would be: suppose that wage earners felt that inflation is permanently higher, therefore they need a higher pace of wage growth. That then pushes up costs, which makes inflation permanently higher. That is what we want to avoid. The key insight here is that if you take bananas--it is not all about bananas, obviously, but take that as an example--there will be, let's say, a trebling or a very large increase in the price of bananas but, in two years from now, I would expect the price of bananas to be roughly the same in dollars as it was before the cyclone came because the crops will recover, the overall costs of production will probably not have changed that much and so the price level for bananas will go up and then down. The inflation rate on an annual basis of the price of bananas will go up, above normal, and then it will go below normal when the price fall comes and then back to normal. But, in the end, people do not need a higher wage for higher banana prices persistently because they will end up at the same place they started. That is the kind of idea we are trying to articulate and of course that holds for the whole range of fruit and vegetable and food prices in general. They should end up at approximately the same level as they were before and therefore we do not need the whole wage structure of the economy to inflate, because that would be a permanent impost in response to a temporary problem. --Given the extraordinary power an individual's response has, are you happy with the level of understanding in the community of economics and how the behaviour affects the broader circumstances in which people live? --I think most people would say that the general community here are rather more aware of and have an understanding of economic issues than many of their counterparts in other countries. Perhaps that is a reflection of the extent of economic coverage in our media or maybe the extent of the coverage is a reflection of the level of interest. Who knows? Or maybe the causality runs both ways. But my observation would be that, compared with communities elsewhere we get more focus on economic news. Certainly, the Reserve Bank gets more coverage than our counterparts, the central banks, do in the average media in their countries. That is very observable. I think we get too much coverage, really, to be honest--more than we should--but that is just my view. I think there is a lot of economic coverage in our media. There are certainly some very capable journalists writing about these things, so for the person who wants to understand--I am often frustrated by the way things are explained; maybe I would not have explained them quite that way--I have to say that, overall, there is a great deal of interest and a fairly good level of understanding of these issues in the community. We always have the job, though, of explaining clearly and simply some of these issues. That is a task before us but that can be managed. --I just want to have a quick chat about the multitiered economy and then about the flood crisis. It would be good if we could touch on some global commodity prices and inflationary issues and then finish off with equity in the banking sector. As I mentioned the last time we got to catch up, I have grave concerns about the tier of the economy that is subsequently doing it the toughest. We have a resources sector which is extremely strong, with unprecedented capital expenditure coming online, but interest rate movements will have very little dampening effects on the resources sector. What it will actually do is magnify and hurt the most disadvantaged. Are interest rates a blunt instrument right across the economy? --People always say that they are a blunt instrument and I think that is right in the sense that we cannot set a different interest rate for each person here according to their circumstances. It does not work that way; it is a market price that we move. That has always been true and always will be. There are actually not very many sharp instruments of macroeconomic policy, really, when you think about it. On the multispeed issue, I do not want in any way to diminish the differences that exist. They do exist. On many metrics the extent of differences in some broad levels recently has not been very large compared with history. If you look at, say, the rate of unemployment in the 70-odd statistical regions we have, there are very few of those where it is double digit. The majority of them are under six and a significant proportion are actually under five. That is only one metric, of course, I know. But I think it is probably to be expected that the differences will be bigger over the few years ahead if the scenario we are all talking about does pan out. That is the case. Monetary policy cannot do anything other than try to set the right rate for the average, and none of us are really average, so none of us are going to find it exactly to our liking. I know that. There is nothing we can do to change that. If we want to address regional differences or industry differences it has to be other policies that do that, and they are going to be in the preserve of governments in terms of spending measures, assistance measures and so on. It is going to be important though, I think, that those sorts of measures have a strong focus on helping people adjust rather than trying to prevent adjustment, because we are not going to be able to prevent at least some adjustment in the structure of the economy. I think we would not be well advised to try to do that, and I am not saying anyone is proposing that. It is those kinds of policies that have to try to cope with regional differences. By the standards of other countries which have a single monetary policy, or other regions, Australia has reasonable scope to do that if we want to use it. Those instruments of course are not in our hands--they are in the parliament's hands, really. --In Queensland we already have a king up there and we call him King Wally. Maybe we could have our own currency and our own Reserve Bank up there and import you up there and leave Ric here to run the show! --Well, this is an issue. I gave a speech on regional differences in Shepparton, where I went just after they had been flooded late last year. In principle, you can have your own currency. You have to have your own central bank. There are certain costs associated with doing that. I am not sure what would happen to Queensland's exchange rate, though, because I think you would find that if there is a very large build-up in gas and mining, the Queensland exchange rate is going to go up, because the capital is going to flow into your region, which means that South-East Queensland and the tourism guys are going to suffer. In fact, your exchange rate could even be higher than the one we have now--I do not know. So you actually would want a different currency for regional Queensland versus urban, and now you are getting down to pretty small areas. --I did not actually come in with that as a prepared question. --But the essence of the problem is that it is not just Queensland versus other bits of Australia. It is bits of Queensland versus other bits of Queensland, and ditto in Western --There is a huge disproportion between areas that rely on the resources sector and those that do not. The point I want to make sure that you guys absolutely have your head across-- --No, we understand it. --is that every time we shift that cash rate and interest rates move, my people up there bleed. --And I get emails telling me, believe me. Some of them are fairly frank. --Yes, good work. With reference to the flood crisis up there, we have already thrown around figures--say, the economy will take a $7 billion or $8 billion hit. In the global financial crisis, in particular in the December 2008 quarter, I think GDP fell by $3.2 billion and we had some substantial stimulus that reflected that. Can you explain the difference between the seemingly disproportionate responses to the two hits? --We had a negative in GDP growth in one quarter, which has since been revised. --It is still negative. --It is still negative, but I cannot recall the exact number--half to one per cent; something like that. What we had in that episode was a slump in demand because everywhere in the world people looked at all those events--the collapse of Lehman, the stock market fell 25 per cent in a matter of weeks and governments were rescuing banks. It was an incredibly dramatic period. I hope never to live through anything like that again. Everywhere in the world, including here, people who were watching all this on TV thought, 'Oh, gee, this is going to be terrible.' Everyone hunkered down and so there was a shock to confidence, plans went on hold and demand slowed right down. This one is a shocking event to the people involved, a supply event of capacity to supply coal, food and certain services as well. Many of those supply things will recover over the next six months or so. The overall demand track in the economy, I do not think, is going to be seriously affected. GDP is going to be a per cent lower than it would otherwise be. That is a big effect, but it is of a different nature to the one we had before. It is not a global financial crisis slump in demand and a total collapse in confidence everywhere. It is a different sort of-- --Can you expand on that for me why we will drop that one per cent in --A lot of it is through lost coal production. Coal was down already in December and will be further in the March quarter. We are saying there will be a 15 per cent decline, roughly, in national coal production as a result of the water in the pits and the rails being closed in the Queensland mines. In time, they will pump the water out. I think some of the railways are already well on the way to being ready to use. Ports are reopening and so that growth will come back. If we are right there, the June quarter GDP is going to get almost all of that one per cent back. That quarter will be a big plus. --In the midst of going into that phase, we are going to be shifting to a position of growth coming back on, we are going to have a tax and yet we are still going to have a stimulus. Isn't that a busy economy? --Do you mean the stimulus measures from the preceding program? --Yes, from the previous one. They are still in place. --They are gradually tailing down through this period. That is the point. --But they are still in place. --The rate of spending money went up, it plateaued and will come down over the next several quarters. So the federal programs--if the things go as they are scheduled to--those measures, are negatives on the growth rate over the next several quarters. They are a positive to the level of GDP but a negative in the quarterly change. The new spending is being accommodated at a federal level by slowing other spending, raising taxes. --On your opening comments about the global commodity prices--the rest of the globe is dealing with inflationary issues and commodity prices--how do we differentiate or disentangle those commodity prices and assess the impact that it has on our inflation, plus trying to disseminate the flood sector as well? --It does have an impact. The floods are temporary. The interesting question about the broader commodity price rises globally is why is that happening? There is a kind of cyclical element but there is a structural trend going on because of the rise in the quantity of protein in the diet in China, and in many other countries, and the effect of that on grain prices because you use a lot more grain to feed a cow to get protein than you use if you just eat bread as a human. Those things are deep structural forces going on and it is raising the relative price level of commodities. In principle that ought to be a level shift but it goes on for some years. --I have the gist of why the inflation is there but, when that hits our economy, how do we disentangle out what that proportion of inflation is in our statistics? --You cannot fully disentangle it, but you can look at the elements of prices where it has its most direct effect. The real question that you may be getting towards is: how does Australian monetary policy handle something that has a global origin? That is a good and very fair question. In principle, as a country that in the long run has an independent monetary policy with its own currency and a floating exchange rate, we are able to generally chart our long-run destiny ourselves but, of course, we have to let the exchange rate move to do that. Countries that import someone else's monetary policy by pegging their currency do not chart their own destiny. Their destiny is set for them by the anchor country, but we are not in that position. We have our own currency area, our own monetary policy and our own inflation target. It makes it harder to contain inflation when you are getting these global shocks--that is certainly true--but we do a lot better than we would otherwise by allowing our currency to go up if it wants to and keeping the focus on controlling inflation over the medium term. That is going to be the best thing to do. It is not perfect but it is the best model there is that I know of. --I just want to pick up on one of your comments earlier on with reference to the banks and equity. You said earlier that the return on equity in the banking sector has decreased over the last two years. But isn't it true that the banks have increased the amount of equity that they have and that their risk is reduced, given the various government guarantees that they have been the beneficiaries of? --I think what has happened is that the return on equity went down in 2008-09. It remained positive, which is good. It has recovered, probably, most of the fall but maybe not quite all. So it is back to good levels. Banks have taken on new shareholder equity, so they have raised capital--not so much recently, but way back in late 2008 and 2009 they were able to get quite substantial amounts of equity, which was good. The wholesale guarantee-- --Wouldn't that be a substantial reduction in their operating risk with the bank guarantee, and is that offset by their-- --Are they less risky now than they were? --Yes. And there would be a cost associated with that. --I think their perception of the riskiness of some of their portfolio went up and has not come down again--so, for most business loans, this is the repricing that people have felt. That is the banks' feeling: 'Gee, the portfolio we are holding is more risky than we thought and we have to reprice for that risk.' I think they would say that. I would say they are not hugely different on their risk perception on the housing portfolio. They will have to hold a bit more capital as a result of the forthcoming Basel rules, although they have a long time to accumulate it. In some general sense there is a big argument here internationally between the bankers and the regulators, because the regulators want the banks to hold more capital. The banks want to say, in essence, 'That means we have to have higher spreads because we have to pay for that capital,' to which many of the regulators would say, 'Actually you are less risky so your return on equity can be lower; therefore you do not have to have higher spreads.' Who is going to be right there? We are not going to know for a while. The real issue is going to be: are the shareholders going to be content to accept lower and hopefully more stable returns on equity, particularly in the really big global banks that were quite risky over time? That is an interesting question to which we do not yet know the answer. --I have one final question with reference to one of your other comments today. It was predominantly that you did not think that interest rates were going to move right now. Am I comfortable in assuming that that means 12 months? --I do not think I can give you a 12-month guarantee. What I said is that the market pricing at present has nothing much happening until quite late this year, which means they think nothing much is happening for some time. But nobody's expectations about the end of the year can really be all that strongly held, frankly, at this stage. I would not want to say that that is an unreasonable set of expectations given the facts as we now know them. That is not a guarantee that nothing will happen, but I am fairly content with where we are at the moment. I think we are in a good position. I think we are ahead of the game, which is where you want to be. That is the thing that affords you periods of sitting, waiting and watching. Sometimes they can be reasonably lengthy periods. --Governor, I would like to turn now to a different matter, the matter of Securency, in particular to clarify my understanding and to seek your comments on some aspects. As I understand it, Securency was 50 per cent owned by the Reserve Bank-- --And still is. --with plans to sell it, and 50 per cent by Innovia Films. Four of the board appointments are by the Reserve Bank and four of the appointments are by the other parent company. With respect to its operations, I understand that the Reserve Bank audit team undertook two audits--one in 2007 and one in 2008. Could you explain to me the first time that the Reserve Bank board became aware there might be an issue that required greater scrutiny? Can you give me a time line for that? --The time at which we became aware of the allegations that were made by the newspapers was when they were made. No-one in the Reserve Bank or on our board had ever had those allegations put to us before that time. They were very serious allegations, which is why the company took the steps it did at that time. --I think the first media reports were in 2007, and I understand that the RBA audit teams were requested to undertake the audits by the Securency-- --No. The allegations about Securency were made in 2009. --So why then would an audit team have gone in in 2007 if the first allegations came to light in 2009? --The audit team went there to do an audit of the policies and procedures concerning the use of agents. --At the request of the Securency board? --Was that an issue of discussion for the Reserve Bank board at that stage or was it more-- --After the issues with the Australian Wheat Board, I think every board in the country said, 'Gee, we better just make sure that we've got strong procedures around these sorts of matters,' and the Reserve Bank board did seek to do that. Securency were asked about their policies and procedures and the auditors went there to audit their procedures and compliance and so on. --Was it at your direction or at the request of Securency? --Securency asked the auditors to go, but the Reserve Bank board--I'm right, aren't I, Ric?--asked us, the management, 'What are the policies in Securency and Note Printing Australia?' They were provided with the relevant policies. I think that is correct. --That would have been in 2006 and 2007. --I understood it was 2007 and 2008. So you think it was 2006? --I am going on memory here. --Yes, that is right. --You may not be able to answer these questions, and I appreciate if you don't but I would be interested in your views subsequently though. With respect to my understanding of Securency's operations, the OECD has put out several warning papers to companies about the use of overseas agents--and overseas agents were used fairly extensively by Securency--and outlined that corruption warning signs--as highlighted by the OECD--include using as an agent a foreign official that is a foreign official's relative, friend or representative; using agents who do not provide any identifiable service; use of multiple agents for a single contract; use of corporate structures such as subsidiaries; use of beneficially held accounts, slush funds in offshore financial centres. Now it is my understanding that many of those practices were engaged in by Securency's agents. In particular I draw upon KPMG's findings to Securency. My own reading of the KPMG report into Securency as commissioned by Securency was that, whilst there were a number of written management processes and procedures in place, these were not effectively implemented by management and that, indeed, the board was largely unaware of some of the omissions with respect to the robustness of the enforcement of management policy. Have you got a view on that? --That is what the KPMG report found. It found that the use of agents is common, it is an acceptable practice and it has certain risks that need to be managed. It found that the company actually had on paper quite strong policies--and that is what the auditors, I think, also felt--but that the implementation of those had been weak, that there was not sufficient documentary evidence of compliance on the files and that the procedures needed to be strengthened in a whole bunch of ways. I think there were 12 recommendations, from memory, and my understanding is the company is in the process of implementing all of those at the moment. So that is what the report found. --And is that consistent with your view as the holding company? --I do not think I have got any basis on which to disagree with the KPMG findings there. I think they did a very thorough job and we in the bank accept the findings that they made. --Our staff that are on the board have those minutes, obviously. --But in their capacity as directors of Securency? --So I take it therefore the answer is no. --I do not know whether we have formally sought. Do you mean minutes of particular meetings? --Yes, for the period. --I do not know the answer, I am sorry. --Graeme Thompson, who was the chairman of Note Printing Australia--or may still be, I am not sure--and of Securency, stopped using agents following AWB's corruption scandal in 2007. Yet Securency continued to use agents in a similar structure to that used by Note Printing Australia. Has the RBA looked into this or asked the board as to why NPA stopped using agents and Securency did not stop using agents? --The thing is that the structure was not similar. That is the difference. --So what were the material differences, as you see them? --As a result of the AWB issues, there was some work done on the policies at NPA. The conclusion reached there was they were not adequate and, as part of some larger rethinking about the role of NPA anyway, the decision was taken that the use of agents would be ceased. That was on the basis that the company was going to focus in the future less on the international market and more fully on the existing customers. But also as for the procedures and policies in place there, when they were examined in the light of the knowledge of these issues that people came to after the AWB issues the conclusion was these policies were not good enough. So that was the reason for stopping the use of agents there. On paper the examination of the policies of Securency showed them to look pretty good. So they were not the same in policies, and that is the difference between the two experiences. --So you are satisfied that the Securency board used appropriate due diligence with respect to ensuring that the management controls, as outlined by process, were in effect being used? --As far as I can see, I think the board members that were appointed from our side have acted properly; I am yet to see evidence to the contrary. But, as we know, it emerges as a result of the KPMG forensic audit, which was an incredibly detailed exercise, that policies that looked very good on paper--looked very strong and had all the right checks and balances and due diligence, and so on--had not been implemented properly. That is a fact; there is no doubt about that. --Just to understand that: it would appear that the directors did exercise due diligence, then. --I have not seen evidence that they somehow failed in their duties. It is a bit early to say much more than that, because at this point a police investigation is underway; it is yet to be concluded whether or not illegal activities actually occurred. That is the claim, and it is a serious one that is being investigated, but the conclusion is not in yet. --I understand it is the largest investigation the AFP currently has going. --I do not know if that is true or not. --With respect to the commission payments: Securency policy said agents could only be paid one way, which was via a commission or a cut of the contract they helped Securency to win. I understand from KPMG's study that about $46.2 million was paid in commissions. In many instances these commissions went to multiple agents; in many instances they went to jurisdictions that were different to the one in which the agent was located; in their numerous instances, it is my understanding, again, from the KPMG report, that payments were made to multiple agents where it was unclear what work was undertaken. It is my understanding that, in many instances, although Securency was supposed to have a register of all payments made and the services for which those payments were being made, this was not, in fact, kept. All of these should be grounds for significant concern, shouldn't they--that potentially Securency was paying corrupt officials in foreign countries? --All the things you said go to show that, as KPMG concluded, the documentation was inadequate--they did not have, apparently, the clarity on whether the guy they were paying had done what he was supposed to do, and so on. That is what not having the documents is about. It is a matter of concern that proper records are not kept, in any event, even if there were no improper payments. The company should have had better procedures or the procedures should have been implemented much more strongly than that, there is no doubt. --We also have Securency using multiple agents to win contracts in Nigeria--for and Amanda Whatley--some of whom would appear to have been involved in previous criminal activity, including arms dealing. These should have been matters of concern to the board, if they had been brought to the board's attention or if the board had exercised due diligence, should they --I think in the most recent years and in the decade past the company had various due diligence procedures in place when agents were appointed. If it turns out that these people were engaged in illegal matters, either for us or elsewhere, and such procedures did not bring that to light, that obviously is a matter of concern. But I think, in fairness, the company's board at least tried to ensure that there were proper procedures in place to do the due diligence. I think they made serious attempts to do that. --What steps have been undertaken by the Reserve Bank subsequent to these allegations being raised, beyond simply the AFP undertaking an inquiry into anything that may be in contravention of Australian laws to ensure that there is now in place the required management controls? --A few things have happened that Securency has done. They called in the police, as you said, they commissioned the KPMG work and they have either already implemented or are in the process of completing the implementation of all those recommendations. From about September or October 2009, the agent arrangement was suspended anyway in all cases, I think, to review them and strengthen the procedures. That work is being done by the company. We support them in doing that. We would have insisted on nothing less had they not. So, for practical purposes, the agent arrangements are in suspension and are being worked through with a view to seeing which ones might be retained and which ones should not be. I do not know what the outcome of that process will be at this point. As far as the Reserve Bank is concerned, we have continued to insist that the company behaves in that fashion. We have lent any support to the AFP that they have asked for, as has Securency. We are examining ourselves. A question would be: is there any way that anyone in the RBA ever knew anything about anything? I am pretty sure the answer to that is no. Quite a bit of work is being done to go back through records. You would expect us to do that and we have done that. It is being taken very seriously, I can assure you. --I have a couple of follow-up questions about some areas that were raised earlier. Ms O'Dwyer raised the issues of superannuation and stability. Putting it really bluntly and simply: do we have a stable banking system in Australia? --Let's be clear: I do not think that the superannuation system or the proposed increases in superannuation contributions, which are supposed to occur in the future, make the banking system unstable. I would like to be clear about that. --Could I just clarify one point. My question did not go to whether it made it unstable but whether it increased risks for stability. --You asked that question and I asked my question. --It is sometimes assumed that, because you have more types of wholesale funding, that is a less stable source of funding. It can be, although that usually occurs because there is something fundamentally wrong in the bank. The truth is that, when wholesale markets think that something is wrong, there probably is something wrong. So the main game is making sure that there is not something wrong. I come back to something Ric said. We have had a tremendous test of the system, and certainly government measures were helpful, but I think they were appropriate in the broad, given the global disaster that was unfolding, and the system has come through very strongly. You would not expect to see a more serious test than that very often. --The other area that I wanted to briefly follow up on is in relation to some questions from Mr Ciobo about wages and employment. Regarding the areas where there have been wages breakouts, I think you were saying that the resource sector was the key area where that was happening. --There is pressure on wages there. You would expect that. In the textbook, what you expect to see is the really strong sector bidding productive resources away from the other sectors. The way it does that is with the relative price, and the attractiveness of working or investing your capital in the mineral sector goes up and capital shifts and workers shift. That is what you would think would happen. It is not surprising that there is pressure. I do not think it is especially worrying in itself. The macro question really is: does that engender pressure right across the economy in due course that is too great or not? At the moment, I think we are travelling okay. --With the changes in industrial relations regulation, you have not seen any evidence of a wage break-out due to those changes? --What we have seen in some sectors is that retailers and others would say that things are a bit tougher in terms of employing various types of labour. I do not think we see a wage explosion there. The test will come as the labour market tightens--if it does, as we think it might--over the next couple of years. The question will be: do we come through that reasonably well, as I think we mostly did on the wage front two or three years back--do we come through as well as that with the changes in the regulations having been made in the interim? The evidence is not really available to give an answer yet. We will find out, I imagine, over the next two or three years. --Governor, thank you for coming again and appearing in such a short period after the last appearance. We really do appreciate that and the time that you have given us today. Resolved (on motion by

r110223a_BOA

australia

stevens

The rise in prices for natural resources and the associated planned increase in Australian-based capacity to supply key commodities is one of the largest such economic events in our history. The Reserve Bank has had a good deal to say about it. I will touch again today on the main points we have made. I will not say much that is new. Nor will I be seeking to convey any messages about monetary policy. Those matters were covered in some depth with the House Economics Committee less than two weeks ago. I will structure my remarks around four questions. What do we know from previous booms? What do we know about this one? What don't we know? Finally, how should that knowledge, and the limits to it, guide our response to the boom? One thing we know, by observing this time series, is that large swings in prices for agricultural and resource commodities, resulting in big variations in Australia's terms of trade, have been a recurring feature of our economic experience ever since Australia became a significant producer of such commodities. There have been a number of big booms. They all ended. The really high peaks were quite temporary - just one or two observations in this annual time series, such as in the mid 1920s or the early 1950s. Periods of pretty high terms of trade lasted for some years in several instances - as shown by the five-year average - but so far they have all been followed by a return to trend, or even a fall well below trend. We also know that these swings were very important for the macroeconomy. My colleague Ric Battellino gave a very thoroughly researched speech on this question a year ago today. He looked at five major episodes, including the current one, over two centuries. Let me offer a reprise of his four main observations. First, global developments have always played a part in causing the booms. Changes to the availability of capital or the emergence of large, low-income countries with rapid growth prospects (Japan or China) have often affected the price of minerals and energy. Second, these booms were always expansionary for the Australian economy overall. Third and related, previous booms were usually associated with a rise in inflation. The exception was the one in the 1890s, which occurred when the economy was experiencing large-scale overcapacity. Fourth, the role of the exchange rate is crucial. The current episode stands apart from the previous ones because all those booms were experienced with a fixed or heavily managed exchange rate. This severely compromised the conduct of monetary policy, and also muddied many of the price signals that the economy needed to receive. In short, these episodes were major externally generated shocks that proved very disruptive, not least because the country's macroeconomic policy framework was not well equipped to handle them. The high levels the terms of trade reached on some occasions were not permanent, but they did persist long enough to have a big impact on economic outcomes. The main thing we know about the current episode is that it looks very large. It is being driven by a big increase in demand for key Australian export commodities. Global consumption of coal has increased by about 50 per cent over the past decade; consumption of iron ore has increased by 80 per cent since 2003. Back then, Australia shipped around half a million tonnes of iron ore each day; now it is over a million tonnes a day. Coal shipments have been running at a rate of around 300 million tonnes a year, at least until the recent floods. Australian capacity to export LNG is now around 20 million tonnes a year, up from around half that in 2004. This looks like it will increase to over 50 million tonnes within five years. The rise in demand has been driven in large part by the rapid growth of key emerging market economies such as China and India. Over the past decade: the average annual growth of GDP per capita has been around 5 1/2 per cent in India and almost 10 per cent in China; the number of people living in cities in those two countries, especially China, has risen by over 250 million, which implies having to expand or create cities (with the attendant buildings and infrastructure) to house the entire population of Australia more than 10 times over or, alternatively, to house the populations of France, Germany and Japan combined; and steel production has doubled in India and it has more than quintupled in China. Thus far, the demand for resources has stretched the global capacity of suppliers. Prices of key raw materials have consequently been driven upwards. As a result Australia's terms of trade have risen sharply, to be about 65 per cent above the century average level, and about 85 per cent above the level that would be expected had the downward trend observed over the 20 century continued. Even assuming the terms of trade soon peak and decline somewhat, they are nonetheless, over a five-year period, at their highest level since at least Federation - by a good margin. With the terms of trade at their current level, Australia's nominal GDP is about 13 per cent higher, all other things equal, than it would have been had the terms of trade been at their 100-year average level. Of course Australia has substantial foreign ownership in the resources sector so a good proportion of this income accrues to foreign investors. Nonetheless, probably about half of that additional 13 per cent of GDP accrues to Australians one way or another. We also know that a large expansion in the resources sector's capacity to supply commodities is being planned. Already, mining sector capital investment has risen from an average of around 2 per cent of GDP over the past 25 years to about 4 per cent, which exceeds the peak reached in the booms of the late 1960s and early 1980s. Given the scale of possible additional investment projects that have been mooted, resources sector investment could rise by a further 1-2 per cent of GDP over the next couple of years. If it occurs, this will be by far the largest such expenditure of a capital nature in the resources sector in Australia's modern history. Again, a significant proportion of the physical investment will be imported, but a large domestic spend is nonetheless likely. A further thing we know about the boom is that it is associated with a much higher level of the exchange rate than we have been accustomed to seeing for most of the time the currency has been market determined, a period of more than 25 years (though, over the long sweep of history, the nominal exchange rate was often considerably higher than it is now). On a trade-weighted basis, it is 25 per cent above its post-float average. The striking relationship between the effective exchange rate adjusted for price level differentials (the 'real' exchange rate) and the terms of trade that is observable over quite a long period in the data still seems broadly to be in place. We know that changes in the real exchange rate are part of the textbook adjustment mechanism to shocks like changes in the terms of trade. In past episodes, where movements in the nominal exchange rate were more limited (or did not occur at all), a range of other prices in the economy had to respond - arguably a more disruptive way of adjusting to the shock. On this occasion, the nominal exchange rate has responded strongly. This helps to offset the expansionary effect of the increase in investment, and also gives price signals to the production sector for labour and capital to shift to the areas of higher return. In other words, firms in the traded sector outside of resources are facing a period of adjustment. But in the face of such a shock they were always going to face that adjustment, one way or another. The main thing we don't know is how long the boom will last. This matters a great deal. If the rise in income is only temporary, then we should not respond to it with a big rise in national consumption. It would be better, in such a case, to allow the income gain to flow to savings that would then be available to fund future consumption (including through periods of temporarily weak terms of trade, which undoubtedly will occur in the future). Likewise it would not make sense for there to be a big increase in investment in the sorts of resource extraction activities that could be profitable only at temporarily very high prices. Moreover, the economic restructuring that would reduce the size of other sectors that would be quite viable at 'normal' relative prices and a 'normal' exchange rate - assuming there is such a thing - would be wasteful if significant costs are associated with that change only to find that further large costs are incurred to change back after the resources boom ends. If, on the other hand, the change is going to be quite long-lived, then national real income is going to be permanently higher, and we can look forward to enjoying significantly higher overall living standards into the distant future. In that world, a great deal of structural economic adjustment is bound to occur. In fact it almost certainly could not really be stopped. It would not be sensible to try to stop it. We know that the peaks of previous terms of trade booms were relatively short-lived. In the current episode, the very high level of the terms of trade already seems to be persisting for longer than in previous episodes. Is this telling us that we should expect the boom to disappear at any moment? Or is it telling us that this episode is different from the In favour of the latter view, if China and India maintain, on average, their recent rates of 'catch-up' to the productivity and living standards of the highincome countries, and if they follow roughly the same pattern of steel intensity of production as seen in the past in other economies, a strong pace of increase in demand for resources will likely persist for some time yet. On the other hand, resources companies in Australia and beyond are rushing to take advantage of the current increase in prices by bringing new capacity on line. Will this increase in supply be just sufficient to match demand? Will it be too little? Or too much? An additional complicating factor is that serious attempts at reducing CO emissions would probably change the story at some point. The lessons of history, moreover - that booms don't go on indefinitely - are also too great to ignore. At this stage, the Reserve Bank staff are assuming that the terms of trade will fall in the latter part of the forecast horizon. The associated assumptions about key resources prices are toward the conservative end of current market forecasts, which typically assume a smaller fall in prices. Even under the Bank's current assumptions, however, the terms of trade are still very high, by historical standards, at the end of the forecast period. But any forecast or assumption made in this area is subject to wide margins of uncertainty. We know that something very big is happening and has been for a while. We simply do not know whether it will continue like this, or not. How, then, should we respond to our knowledge, and to the limits of our knowledge? To recap, we know that: Previous commodity price and/or mining investment booms were big events that had major expansionary and inflationary effects. Those booms all ended, generally with more or less a total reversal of the earlier rise in the terms of trade, though this often took some time. On some occasions, this brought on a significant economic downturn. The current boom looks bigger than any other since Federation at least, in terms of the rise in the terms of trade over a period of several years. The previous episodes occurred without the benefit of a flexible exchange rate to help manage the pressures. On this occasion that particular price is adjusting, which should help to contain the pressures and help the economy to adjust more efficiently. We do not know what the terms of trade will do in future. It would be rather extreme to assume that the rise of China and India is a short-run flash-in-the- pan phenomenon. Likewise it would be imprudent not to allow for a fairly significant fall in prices, even if only to still pretty attractive levels, over several years. But the truth is that we will learn only gradually what the detailed shape of the new environment is. How should we handle this uncertainty? A few simple messages seem to me to be important. First, we should not assume that the recent pace of national income growth is a good estimate of the likely sustainable pace. We should allow a good deal of the income growth to flow into saving in the near term. We can always consume some of that income later if income stays high, but it is harder to cut back absorption that rises in anticipation of income gains that do not materialise. To date, that precautionary approach seems to be in place. Households are saving more than for some years and the much-discussed 'consumer caution' has been in evidence. Firms are consolidating balance sheets. Governments have reiterated commitments to stated medium-term fiscal goals. Second, there is going to be a nontrivial degree of structural change in the economy as a result of the large change in relative prices. This is already occurring, but if relative prices stay anywhere near their current configuration surely there will be a good deal more such change in the future. Because we can't confidently forecast where relative prices will settle, we cannot know how much such change is 'optimal'. Therefore we can't be sure that some of it will not need to be reversed at some point. But the optimal amount of change is unlikely to be none at all. So we should not look to prevent change; we should look to make it cost as little as possible. In general, that means preserving flexibility and supporting adaptation. Third, productivity is going to come back into focus, especially in sectors that are exposed to the rise in the exchange rate. Their prices will be squeezed, and their costs potentially pushed up by the demand of the resources sector and related industries for labour. Surely maintaining viability will involve achieving significantly bigger improvements to productivity than we have observed in recent years. Fourth, if we have to face structural adjustment, it is infinitely preferable to be doing it during a period in which overall income is rising strongly. If nothing else, in such an environment the gainers can compensate the losers more easily. Many other countries face major issues of economic adjustment in an environment of overall weakness. At the risk of sounding like a broken record, the rise in Australia's terms of trade over the past five years is the biggest such event in a very long time. It reflects powerful forces at work in the global economy to which our country is more favourably exposed than most. It presents opportunities and challenges. With a large boost to income, we need to think about the balance between saving and spending, because we do not know the permanent level of the terms of trade. I argue for erring on the side of saving for the time being, and I think this is by and large what is happening so far. With a large change in relative prices, we should also expect to see a good deal of structural change in the economy. A careful response to that prospect is also needed, and no doubt your conference will examine such issues over the day ahead. I wish you well in your deliberations.

r110310a_BOA

australia

stevens

Quite a lot has happened since I last had the opportunity to address a London audience in January 2008. Later that year, a sequence of financial events saw the global financial system teeter on the brink, followed very quickly by a very sharp global economic slowdown in the closing months of 2008 and the early part of 2009. For the global economy, a recovery in activity commenced shortly thereafter. It has turned out, contrary to widely held expectations two years ago, to be quite a robust one overall. Real GDP for the world is estimated by the IMF to have grown by 5 per cent in 2010, well above the medium-term trend of a touch under 4 per cent. As of the most recent published forecasts, the IMF expects the world economy to grow by almost 4 1/2 per cent this year - still above trend. But the pattern of the growth has been rather uneven. Here in this part of the world, recovery is proving to be difficult and protracted. Yet in the Asian region, the recovery has been quite rapid and concerns have been expressed about excesses. There is more than just cyclical dynamics at work in these trends. Important structural forces are in operation, and they have significant implications. These are worthy of careful consideration, even though we cannot do them full justice today. The group of countries that could be labelled as the United Kingdom and continental Europe) are in the early phase of recovery from a deep downturn. For several of them, the downturn was the worst for decades. In other cases the downturns were serious, though not more so than those of the mid 1970s or the early 1980s. But what has been unusual is less the depth of the downturn than the slowness of the recovery. For most major countries, in most cycles in the second half of the 20 century, the pace of a recovery tended to be related to the depth of the preceding recession: generally, the deeper the recession, the sharper the upturn that followed. This episode has been different, in that a serious recession has been followed by a fairly shallow upswing so far. In the case of the United States, the level of real GDP has reached its pre-crisis peak, but it took three years to do so. In the United Kingdom and the major continental economies, levels of real GDP remain well below their peaks of three or so years ago. In some other cases in Europe the declines are larger and, in fact, are continuing. In all these cases the level of output remains well below what policymakers would regard as their respective economies' 'potential' level. A corollary of that is the rate of unemployment in most cases remains unusually high after a year or more of recovery. real GDP unemployment rate Percentage change from pre-crisis peak Percentage point change from pre-crisis trough North atlantic Euro area - - This slowness of initial recovery is of course related to the nature of the downturn, which differed from most of the post-war business cycles in that it was characterised by serious and widespread financial distress. History shows that recoveries from downturns associated with banking crises and collapsed asset booms are, more often than not, drawn-out affairs. Really we need look no further than Japan's experience over the past two decades to see this, but in fact it is well established by a great deal of research. Moreover, while banking systems are in the process of regaining health, that process is not yet complete. Nor is it clear that households are yet finished the process of reducing their leverage. There are now some other factors that may impede the recovery. One of them is the delicate state of government budgets, which leaves many of these countries feeling they have little choice but to pursue policies of fiscal contraction. In a proximate sense, this problem is due to the financial crisis. The direct costs of assisting banking systems were the smaller part of the effect - the main impact on budgets has simply been the cumulative loss of revenue and the general impost on spending that comes with a protracted period of economic weakness. government budgets should move temporarily into a position of deficit when the private economy suffers an adverse shock. The budget should play the role of a 'shock absorber'. But that ideal assumes that the government's own accounts are in a strong enough position to play such a role without raising questions of the state's own solvency. The problem is that in a number of countries, large burdens of spending, significant debt burdens, underfunded pension systems and unfavourable demographics have been on a collision course for a long time. What the crisis has done is to bring on the adjustment sooner. In the euro area the intersection of banking and fiscal issues - including through the exposures of banks to sovereign debt - heightens the difficulty. Although the single monetary policy framework is highly developed, single frameworks for other areas of financial policy have been less highly developed. This is gradually being addressed, though of course it is a complex issue. At its heart, the debate is essentially over the incidence across the taxpayers of Europe of the various costs of fixing banking problems. The contrast between the story for the North Atlantic countries and that for Asia could, in all frankness, hardly be more pronounced. Most of the countries in the Asian region have had a 'v-shaped' recovery. Of course this has been led by China and India, where levels of GDP actually did not fall at all and where very robust growth rates have been maintained since the second quarter of 2009. Real GDP in both cases is now 20 per cent or more above pre-crisis levels. A range of other countries have also had a pretty strong rebound. Japan is an exception. The long aftermath of the 'bubble economy' period, together with a declining population and generally low rates of return on capital, have made Japan a much less significant source of dynamism for the region and the world than it was for the couple of decades up to 1990. In truth, though, the global economy has become used to this. How is it that the Asian story has been so different to The first important factor was that Asia did not have a banking crisis. In fact, most countries in the world didn't have one. The extraordinary events of September and October 2008 put immense pressure on markets, and banks everywhere inevitably felt the effect of that. But most banks in Asia and Latin America over the past few years have generally not seen unusually bad losses on loans, nor had they been very much involved in the holdings of securities that did such damage to some of the world's largest banks. Similarly, the majority of governments have not ended up needing to recapitalise banks in these regions. The second factor was that various countries in the Asian region had ample scope for fiscal stimulus, and were prepared to use it. The Chinese stimulus measures were just about the largest anywhere. The manner in which these were implemented may have led, in the view of some people, to other problems. But there is little doubt such measures were effective in boosting demand at the critical moment. The fact that there was scope to use fiscal policy this way reflects a long period of impressive fiscal discipline among most countries in the region. This is reinforced by Asian habits of thrift among the population and the generally better growth dynamics for these countries, which of course makes fiscal management inherently easier. There is another factor at work too, whose implications have been powerful but increasingly are being seen as not quite so benign. That is that monetary policy in Asia has been quite accommodative. Compared with the North Atlantic countries, this monetary accommodation has been much more effective as a stimulus, again because of the better state of banks through which much of its effect is transmitted. The issue more recently has been that accommodative conditions have started to look out of place given the robust growth in output, rising asset values and increasing goods and services price inflation. A number of countries, including key ones such as India and China, have been responding to this with tightening. Some of the Latin American countries have done likewise. The matter is complicated for those countries by the very low interest rates in the major countries - implemented, understandably, for their own domestic reasons - and concerns over the extent of capital inflow and potential exchange rate appreciation. This is one of the key issues for the year ahead. These are all important manifestations of the fact that different regions are at different points in their recoveries from the crisis. It isn't, however, only a cyclical matter. This contrast between the economic performances of the key emerging countries and those of the older industrial economies in the past few years is seeing a marked acceleration in the shift in the world economy's centre of gravity towards the accounted for about 70 per cent of the growth in global GDP (measured on a purchasing power parity basis). It has also accounted for about 70 per cent of the growth in global demand over that period. This compares with a figure of about 30 per cent over the It has often been said that more domestic demand is needed in Asia to help 'rebalance' the global economy. There may have been a structural sense in which Asian saving rates were 'too high' and saving in some other countries too low. But it is not at all clear that more demand growth in Asia is desirable at present. After all, global GDP growth has been strong, and prices for most commodities have been rising. Just at the moment, from a global perspective, what we need is not so much faster domestic demand growth in Asia, but a way of supplying more of Asia's demand for goods and services from the parts of the world where excess supply remains - mainly the North Atlantic countries. Of course exchange rates are relevant here. Moreover, there is a secular increase in living standards occurring in Asia and changes in consumption patterns are accompanying that. Energy intensity is rising quickly with income. The steel intensity of production is already high in China but, with China seeking strong overall growth for many years yet, steel consumption could well continue to increase at a rapid pace. In India, steel intensity has a long way to rise yet. In many developing countries, higher living standards are also prompting changes to diets. The already clear trend towards higher protein consumption in emerging countries such as China potentially has major implications for demand (and prices) for livestock and grain feed globally. So it is not really surprising that rapid economic growth in Asia is placing upward pressure on prices for foodstuffs, energy and minerals. There may be speculative demand adding to these pressures at the margin. But speculators can't hold up prices over the long run. These big changes, which appear to be rather long-running, surely are mainly a result of powerful, and rather durable, fundamental forces. What is new is that this pressure on prices is not coming from the advanced world (except perhaps in the case of demand for grain to be converted into ethanol). It is not the story that would have been told, until only a few years ago, of the industrial cycle of the OECD countries picking up and adding to demand for resources and energy. The action is, for the most part, occurring outside that group. Prices are under upward pressure because of rising demand, but it is the demand coming from a couple of billion people in Asia seeking, and in many cases rapidly converging on, the way of life that the advanced countries have enjoyed for decades. These price rises, not to mention those occurring most recently as a result of pressure on oil supplies, are quite unhelpful for the advanced countries, particularly those whose recoveries have been hesitant to date. They will also be unwelcome for very poor countries whose populations spend much of their meagre incomes on food. For practical purposes they amount to a supply shock for the advanced countries - someone else's demand has pushed up the price at which markets are prepared to supply energy, agricultural and resource commodities. That will make it harder to engender a strong recovery in the advanced countries. Moreover, were demand in the advanced countries to grow faster, as is presumably the intent of current economic policies in those countries, the price pressures will grow more intense, unless substantial new capacity comes on stream and/or growth in the emerging world moderates somewhat. As it happens, new capacity is being planned in many resource commodities. In Australia, where iron ore shipments are running a little over a million tonnes a day, projected capacity expansion will likely take that to about 2 million tonnes within four or five years. Significant capacity expansion is also planned in other areas. These and similar expansions in other countries will presumably help to contain pressure on prices for many resources over time. In the case of foodstuffs, much of the growth in supply over the medium term will need to come from productivity gains or greater farming intensity. The experts seem to think that such productivity gains are possible but not given. In fact the rates of productivity growth will need to be higher than those actually observed in recent years to generate sufficient output. One thing is for certain: the rise of Asia is changing the shape of the world economy and the set of relative prices that goes with it. It seems to be doing so more quickly than was generally assumed. Australia sits in an interesting position here. Like our Asian neighbours we were affected by the events of late 2008. But the downturn was fairly brief. We were in a position to apply a liberal dose of stimulus to the economy, which was done in a timely fashion. The banks remained in good shape. Hence recovery began in the first half of 2009. A strong Asian recovery has also helped Australia. As in other developed countries, our consumers feel the effects of higher commodity prices as a reduction in real income. But since Australia is also a producer, the big rise in demand for energy, resources and food is expansionary for the economy. In fact, with our terms of trade at by far their highest level, on a five-year average basis, in more than a century, these events are very expansionary indeed. A very large increase in investment in the resources sector is under way and has a good deal further to run yet. Just recently, we have been experiencing growth close to trend, relatively low unemployment - about 5 per cent - and moderate inflation, about 2 1/4 per cent in underlying terms. In comparison with the experience of the past generation, that is a pretty good combination. Looking ahead, our job is to try to manage the terms of trade and investment booms. Historically, Australia has often not managed periods of prosperity conferred on us by global trends terribly well. On this occasion, we have to do better. We have to take the opportunity to capitalise effectively on some very powerful trends in the global economy to which we are, almost uniquely, positively exposed. A few things are working in our favour. One is that the exchange rate is playing a role of helping the economy to adjust to the change in the terms of trade in a way that it was prevented from doing on numerous previous occasions. Another is that, at least so far, households are behaving with a degree of caution, insofar as spending and borrowing are concerned, that we have not seen for a long time. Having taken on quite a degree of debt over the preceding 15 years or so, households have thought better of taking on too much more. They are saving more than at any time for 20 years or more. So are households in many other countries, of course, but our good fortune is to be making that adjustment against a backdrop of rising income. We are now engaged in a national discussion about how to stretch the benefits of the resources boom over a long period, and how to manage the risks that it will bring. These are complex matters that involve a wide range of policy areas - macroeconomic, microeconomic, taxation, industrial and so on. But if that discussion can be conducted in a mature fashion, and followed up with sensible policies, then we have a good chance of leaving to the next generation a wealthier, more secure and more stable Australian economy.

r110414a_BOA

australia

stevens

Thank you for the invitation to speak in New York. New York City remains one of the world's dominant financial centres, on any metric. Its stock exchange is by far the largest in the world in terms of market capitalisation. The US corporate debt market similarly eclipses that of other countries and the city is home to some of the world's largest financial institutions. Likewise, the United States remains the world's largest national economy by a substantial margin. But the world is changing, and quite quickly. The rise of China (and, very likely, India) is a transformative event for the global economy. Unless something pretty major goes wrong, we are likely to see much more of this trend for quite a long time yet. As recently as 1990, the United States accounted for a quarter of the world economy. The European Union was just a little over a quarter. Japan, east Asia and India combined made up roughly another quarter; Japan on its own was about a tenth of global GDP. (Australia was then, and still is, just over 1 per cent of global GDP.) In 2010, the US share was about 20 per cent of world GDP, about the same as the European Union. By then, Asia was making up just under a third of the total. China alone had raised its share of global GDP from less than 4 per cent in 1990 to over 13 per cent - quite a change in the space of 20 years. India's share, which had been the same as China's in 1990, had been little changed until about 2004. It has started to increase more noticeably since then, though it remains well below China's at the moment. But given that the demographics for India are more favourable than those for China, we could expect that in another 20 years India's prominence will have grown a great deal - assuming that country continues the process of reform that has helped it to generate impressive growth over recent years. These figures are all based on the IMF's Purchasing Power Parity estimates for countries' respective GDPs. Some might find them a bit abstract - if you doubt that, try explaining purchasing power parity to your mother. But we can appeal to various other 'real' indicators to chart the rise of China in particular. The number of people in paid employment in China was 780 million as of 2009. The increase since 1990 was about 130 million, which is nearly the total number of employed workers in the United States (and 11 times the total number currently employed In that year of 1990, China produced just over 50 million tonnes of steel products. By 2010, China was producing more than that volume of steel products each month, and accounted for nearly half of global crude steel production. Virtually all of this steel is consumed within China, to build new cities and transport infrastructure. Currently, steel consumption in China is nine times higher than that of the United States. Electricity generation has tripled in China over the past decade, overtaking the European Union in 2008 to become the world's second biggest generator of electricity after the United States. Of course, per capita usage rates of electricity are still much lower in China but they will rise with incomes. In 1999, just over 23 000 Chinese postgraduate students were studying abroad. A decade later, there were 230 000. All of these metrics tell a similar story: the rise in the importance of the Chinese economy is extraordinary. Other countries in the Asian region have also shown solid rates of growth over this period, but the size and pace of change in the Chinese economy stands out. There are few countries that have noticed this more in their trading patterns than Australia. Our trade patterns have been strongly oriented towards Asia since the emergence of the Japanese trade relationship in the 1960s. But this has taken a further step up in recent years, with the share of merchandise exports going to the Asian region rising from a little over 50 per cent as recently as 2003 to over 70 per cent in 2010. A similar trend has occurred in imports. China alone has risen from 6 per cent of exports a decade ago to 25 per cent today. The rise in Australia's terms of trade - about which I will not give yet another sermon today - is part of this same picture. But it is of course not only Australia that has seen this shift in trade patterns. In fact, many countries are seeing a significant expansion in two-way trade with China and there are a number for which China is now the most important partner. Among that group is not only Australia, but also Japan and Korea. Clearly trade integration has been happening quickly in the These forces are also being felt further afield. The US economy has seen a much increased trade engagement with China. The share of US imports coming from China has increased from about 3 per cent in 1990 to 19 per cent today. That is a very large increase, though it appears to offset a decline in the shares coming from Japan and other east Asian countries: imports from Asia as a whole make up about the same share of US imports today - about a third - as they did 20 years ago. Probably what is happening here is that China has displaced other Asian countries to some extent as a source of finished products, including by becoming the final point of assembly for many manufactured items constructed from components sourced all over Asia. Even more interesting is the fact that the United States sells a higher share of its exports to China than to any other single nation apart from Canada Agreement partners. All these trends will surely continue, for the process of integrating China and India into the global economy has a good way to run yet. The Chinese Government is seeking growth of 7 per cent per annum over the coming five years. That would be a lower outcome than we have seen in the past five years, but is still very strong by the standards of the advanced countries. Growth at that sort of pace, on average, would see China's weight in global GDP exceed that of the euro area within five years and approach that of the United States within a decade. Of course, the future will not be that deterministic. The Chinese economy will have cycles; it will not trace out a path of steady, uninterrupted expansion. China could not expect to be immune from various other afflictions experienced by all countries that can occasionally impede economic growth. But by any reckoning, the emergence of China is a huge historical event. And then there is India. So the world of production and consumption is changing. But it must also follow that the world of finance is changing as well. As incomes rise so there is an accumulation of physical capital (which accommodates further increases in labour productivity and incomes) funded by saving out of current income. Moreover, the scale, scope and sophistication of financial activity increases, which typically sees the size of gross financial claims rise faster than income. The fact that Asian countries have traditionally seen quite high rates of private saving accentuates this trend. China's saving rate, at about 55 per cent of GDP, is one of the highest recorded and because China has become a large economy, the extent of that annual flow of saving is now globally very significant. In absolute terms, according to the available national income statistics, China is in fact now the world's largest saver. Its gross national saving, at an estimated US$3.2 trillion, exceeded that of both the United States and the euro area in 2010. Its gross investment is also the world's largest - at an these two figures - around US$300 billion - is of course China's current account position. That is the extent to which China, in net terms, exports capital to the rest of the world. As you might expect, to deal with this large volume of saving China has some large banks. As measured by total assets, 12 of the world's 100 largest banks are Chinese. This is a higher number than for any other single country, including the United States. Between 2005 and the start of this year, the Shanghai and Shenzhen stock exchanges grew by over 800 per cent. As measured by the market capitalisation of listed domestic companies, the Shanghai stock exchange is still far smaller than the New York stock exchange, but it is now more than two-thirds the size of the London and Tokyo stock exchanges. In terms of turnover, the annual value of share trading on the Shanghai stock exchange in 2009 surpassed that of each of the London and Tokyo exchanges. Asian bond markets, and particularly those in China, have also grown in size. Five years ago, total domestic debt securities outstanding in China were less than half of those outstanding in countries such as France, Germany and Italy; today these markets are roughly all comparable in size. So it is not just the centre of gravity of economic activity that is shifting to Asia - the weight of financial assets is also shifting. Now this is a slower process since the stock of wealth is a result of a long accretion over time and economies that rapidly become large in production terms may have a smaller stock of wealth than countries that have been similarly large for a long time - such as Europe and the United States. So at this point the advanced industrial countries still account for the lion's share of global wealth. Nonetheless, things are moving quickly. Within the remainder of the careers of many of us here today, we will very likely see a pretty substantial change in relative positions. It is interesting to contemplate how that world might differ from the one to which we have been accustomed. morning, financial market participants wake up to the closing moments of the New York trading day. The rest of the Asian region wakes up shortly thereafter. Despite the rapid increases in size of the Asian markets, most of the time it is changes in US or European markets that set the tone for the Asian trading day. Every so often, though, an event in Asia prompts global market responses. Surely this will happen more often in the future. As the Asian region becomes more integrated economically, with an ever larger Chinese and Indian economic mass at the core, and as the accretion of Asian financial wealth assumes increasing global significance, Asia is likely more often to be a source of 'shocks' for the global economy and financial system. I am not suggesting that Wall Street will dance exclusively to Shanghai's tune. The US economy and financial system will remain very large and internationally important for the foreseeable future. The point is that there will be several potential sources of music emanating from various centres around the world, to which markets everywhere will respond to some extent. The United States will certainly be one, and so will Europe (not always an enjoyable tune of late). We will all need to attune our ear to Asia's rhythms as well. Sometimes those differing tunes will clash - as they do at present. At the moment we see a US recovery that is gaining some traction after a lengthy period of weakness, a subdued experience in Europe overall with intraregional differences probably at their most extreme since the euro commenced, while China and India are seeking to slow their expansions in the face of clear evidence of rising inflation. US banks are well ahead of their European counterparts in cleaning up their problems, to the extent that the government capital injections of two years ago are being repaid, while markets are still waiting for more complete information about the state of balance sheets in Europe and worrying about the feedback to public sector finances. Asia's banks, meanwhile, did not have a solvency crisis and have been able to perform their task of supporting growth. If anything, their problems are more likely to be those of exuberance. More attention is being paid to the US fiscal position - and that will probably increase further. In Asia, public finances are generally strong except in Japan. These differences were bound to increase the focus on policy differences between regions, and exchange rate systems in particular. It is not surprising that we are returning to discussion of the 'global imbalances', since many of the underlying factors behind them have not gone away. Renewed efforts to find a framework for talking about these issues are now under way. As others have said, a prerequisite for a solution is a shared understanding of the problems within an agreed intellectual framework. But finding that combination is not proving easy. The dialogue needs to occur on multiple issues, to which countries bring different perspectives. Many of the countries of Asia come, for example, with a mindset in which the international monetary system is a device for stability, one of the foundations for strategies to grow economies and increase wealth. They see flows of capital, and fluctuations in exchange rates, as potentially disruptive to the real sectors of their economies. This is in many respects a traditional post-war perspective, when there was a US dollar standard, when the United States as an economic and financial power was unrivalled and all other economies and financial systems were truly small. But of course Asia is no longer small. Countries like the United States or Australia, on the other hand, have a different frame of reference. They tend to see the international monetary system as a device for accommodating shocks and reflecting differences in economic circumstances. They see price movements and capital flows, generally, as helping resource allocation. European countries share that perspective as far as flows and exchange rates between the major regions of the world are concerned, but share Asian perspectives on the need for stability within their own region. There are good reasons, in logic and history, for all these perspectives. We need to understand them, and find an accommodation. It does not help, in my judgment, that so much of the discussion takes place through a bilateral prism - particularly the US-China current account prism. Twenty years ago the prism was the US-Japan balance. The issues are multilateral, not bilateral. The US trade deficit was pretty widely spread for many years. It wasn't just with China. Over the past decade, the United States had a trade deficit with 13 of the 18 other countries in the G-20 (of the five surplus positions, the largest was with Australia). This bilateral focus can be quite troubling, and not only because it risks oversimplifying problems and therefore lessening the likelihood of solutions. It can be troubling for a host of small countries, which worry about the potential for more widespread effects of solutions that may be attempted. This is why it is so important that the problems be considered, and resolved, in a multilateral setting. Hence the importance of the international financial institutions, and of fora like the G-20, in providing the table around which these discussions should take place. That of course means that the legitimacy of those institutions, in the eyes of all their stakeholders, is key. Good progress has been made in improving the governance of bodies such as the IMF and no doubt more will be done in this area over the years ahead. The G-20, a body with a broader constituency than the G7, has taken a more prominent role. This is all good, but will need to be accompanied by ongoing efforts to reach a shared vision of the role of the institutions and the system they are supposed to watch over and protect. If we are all still not talking the same language about the role of the system or the institutions, then we will not collectively get very far. So much work needs to be done yet. America - still the world's dominant single economy and financial power, albeit not as dominant as it was - is critical to reaching the necessary framework. But so too is Asia - a fast-growing, high-saving region with increasing financial resources, a much increased part of the global economy and financial system, and with, therefore, commensurately increased responsibilities. Australia - a small but outwardlooking country with very substantial ties to both the United States and Asia - has more than a passing interest in the progress of this very difficult, but very important, discussion.

r110615a_BOA

australia

stevens

Thank you for the invitation to visit Brisbane today and to join with the Economic Society here in Queensland to talk about our economic situation. It is barely five months since the flooding that inundated parts of Brisbane and had such a tragic impact only a couple of hours west of here in Toowoomba and the Lockyer Valley. It is only four months since Cyclone Yasi wrought havoc on some northern coastal communities and flattened key crops. The people of Brisbane, and of Queensland, have shown their resilience and adaptability in the face of these disasters. The economic effects of those events, and of the Western Australian cyclones over the summer, have been seen at the national level. Falls in coal and iron ore production more than fully explained the decline in measured economic output in the March quarter, which occurred not because demand slumped but because the economy's capacity to supply output was temporarily curtailed. There was also a sharp rise in some prices, which tends to happen when supply is suddenly disrupted. Bananas are the most celebrated manifestation of this. With 75 per cent of the crop more or less destroyed, and few sources of alternative supply available, prices to the consumer have quadrupled. The effects of these natural disasters are now gradually abating. Information on coal mining suggests that it is gradually recovering, though more slowly than had been expected initially owing to the difficulties of getting water out of the pits. Iron ore production has fully recovered. The banana plants are regenerating. Most other crops are also getting back to normal supply levels. As this occurs, we should see the impact of these events on prices start to reverse. For Queensland, the scars from last summer's events remain - and always will. The destruction of capital stock is a loss of wealth, but capital can ultimately be rebuilt; lives lost cannot. But despite the tragedy, Queenslanders are getting on with things. The broader context in which these events have occurred is well known. The proverbial pet-shop galah can by now recite the facts on Australia's trade with China and our terms of trade, which are at a level not seen in over a century. It was already clear by about 2006 that something quite profound was happening in the continuing rapid growth of China, India and other emerging countries. upward trajectory continued, and even accelerated in some cases, in the subsequent period. Then the crisis occurred, and the Chinese economy slowed abruptly. But the authorities responded forcefully and China's economy returned to very strong growth quite quickly. And so the trends in place up to the middle of 2008 had resumed within a year. The rapid growth in Chinese, Indian and other emerging world demand has been stimulating demand in the global economy, despite the weakness in demand from the 'north Atlantic' group of countries. This gives a boost to a country like Australia: our economy's increased exposure to Asia - the part of the world where much of the growth is occurring - plus the high terms of trade make for an expansionary macroeconomic event. At present Australia's terms of trade are about 85 per cent above their 20th century average. The amount of additional income accruing to production in Australia from that is 15 per cent or more of annual GDP. Even allowing for the fact that a substantial fraction of this income accrues to foreign investors that own large stakes in many of Australia's resources companies, this represents a very large boost to national income. These expansionary forces are at work on an Australian economy that was widely regarded as very fully employed by early 2008, and that experienced only a fairly mild and short downturn thereafter. As of today, measures of capacity utilisation are not as high as at the end of 2007, and unemployment is not as low as it was then. Nonetheless, the degree of slack in the economy overall does not seem large in comparison with the apparent size of the expansion in resources sector income and investment now under way. With that general outlook, it follows that macroeconomic policies must be configured in the expectation that there will need to be some degree of restraint. Monetary policy has already been exerting some restraint for a while. Looking ahead, our most recent analysis (as published in early May) concluded that the underlying rate of inflation is more likely to rise than fall over the next couple of years. This central expectation - subject to all the usual uncertainties inherent in forecasting - suggests, as we said at the time, that 'further tightening of monetary policy is likely to be required at some point for inflation to remain consistent with the 2-3 per cent medium-term target'. It remains, though, a matter for judgement by the Board as to whether that point has been reached. At its most recent meeting, the Board's view was that it had not been. New information will, as always, be important in our monthly assessments of what monetary policy needs to do. As far as prices are concerned, we will get another comprehensive round of data in late July. Fiscal policy is also playing a significant role. The 'fiscal impact', calculated as the shift in the Federal budget position from one year to the next, is forecast to be minus 2 per cent of GDP in the 2011/12 fiscal year. A further, though slightly smaller, effect is forecast by the Treasury in the following year. There remain, of course, differences in economic performance around the country. Given movements in commodity prices over the past year and the stated investment intentions of major resources companies, these differences are more likely to increase than decrease over the coming period. More generally, while everyone understands that there is a 'mining boom', many people would say that they themselves cannot directly feel the effects. We have seen widespread re-emergence of talk of 'two-speed' or 'multi-speed' economies. Within the state of Queensland itself there were differences in performance, even before the floods, let alone after them. How then do we make sense of these phenomena? It is a complex story, and I do not wish to make light of any of the legitimate concerns that people have about the differing economic conditions - actual and potential - across regions or industries. But there are three observations worth making. The first is that the impact of the resources sector expansion does get spread around, in more ways than might immediately be apparent. Obviously mining employs only a small share of the workforce directly - less than 2 per cent. But to produce a dollar of revenue, companies spend about 40 cents on acquiring non-labour intermediate inputs, primarily from the domestic sector. Apart from the direct physical inputs, there are effects on utilities, transport, business services such as engineering, accounting, legal, exploration and other industries. It is noteworthy that a number of these areas are growing quickly at present. Once the costs of producing the output and other factors - such as taxes - are taken into account, the remaining revenue is distributed to shareholders or retained. While a significant proportion of the earnings distributed goes offshore, local shareholders also benefit. In fact, most of us are shareholders in the mining industry through our superannuation schemes. We don't get this income directly to spend now - it is in our superannuation. Nonetheless, it is genuine income and a genuine increase in wealth. A good proportion of the earnings retained by companies is used to fund a further build-up of physical investment, which imparts demand to construction and manufacturing. Based on the industry liaison the Bank has done, around half - give or take - of the demand generated by these projects is typically filled locally, though, of course, this amount varies with the nature and details of any specific project. So there are effects that spill over, even though it is not always easy to spot them. In the end the combination of the resources sector strength and all the other factors at work in the economy has, to date, produced a national rate of unemployment of around 5 per cent, and in Queensland only a bit over 5 per cent. There are regional variations in unemployment rates, but at this point these look comparable to what has been seen at most times in the past 10 years - a period that has seen both lower average unemployment rates and lower variation in unemployment rates than the preceding decade. Secondly, some of the undoubted differences in performance observable at present look like the inverse of earlier differences. Take housing prices and population growth, which are of course quite closely related. It surely is no coincidence that the two state capitals that have had the clearest evidence of declining house prices over the past couple of years - Brisbane and Perth - are the two that previously had the highest rate of population growth and that have since had the biggest decline in population growth. Moreover, it is hard to avoid the conclusion that changes in relative housing costs between states, while certainly not the only factor at work, have played an important role. Relative costs are affected by interstate population flows, but those costs then in turn have a feed-back effect on population flows. This is particularly so for Queensland. Historically, Queensland has had faster population growth than the southern states, as it has seen a slightly higher natural increase, a rate of net international migration on par with other states and a very substantial net positive flow of interstate migrants. Net interstate migration to Queensland peaked around 2003 - not long after Sydney dwelling prices had reached a new high relative to other cities. Interstate migration at that time was contributing a full percentage point a year to Queensland's population growth. By 2008 this flow had slowed a bit, but international migration had picked up and Queensland's population growth increased, peaking at nearly 3 per cent. Western Australia's population growth was even higher, peaking at almost 3 1/2 per cent. Meanwhile, at least up to 2007, people were confident and finance was readily available. Brisbane housing prices, which had been a bit over half of the average level of Sydney and Melbourne prices in 2002, had risen to be almost the same by 2008, which was unusually high. The rate of interstate migration to Queensland then slowed further, to be at its lowest in at least a decade. The effects of that on state population growth were compounded by a decline in international migration, something seen in all states. At the same time, finance became more difficult to obtain and lenders and borrowers alike became more risk averse. This happened everywhere, but its effects in Queensland seem to have been more pronounced. Since then, Brisbane housing prices have been declining relative to those in the southern capitals and the construction sector here has found it tough going. So a complex interaction of forces - the commodity price cycle, the financial cycle, population flows, endogenous responses of housing prices that then feed back to population flows and so on - has been occurring. The ebb and flow of these forces has made for differences in performance, first in one direction, then the other. Thirdly, the industry make-up of our economy is continually changing. While this is often a slow process - almost imperceptible in most years - these shifts have been significant over time. There is little doubt that trade-exposed manufacturing firms not linked to the resources sector are facing tough conditions at present. But many people might be surprised to learn that the peak in manufacturing's share of Australia's GDP was in the late 1950s - more than five decades ago. Its fastest rate of relative decline, so far, was probably in the second half of the 1970s. On the other hand 'business services' - including things such as accountancy, legal and numerous other services - have grown fairly steadily and now are credited with more than twice the share of GDP of manufacturing. Several of these sectors are being boosted by the flow-on effects of the resources boom at present. As for the mining sector itself, its share of GDP has tended to rise since the late 1960s, having been quite low in the mid 20th century. But in 2010, the mining sector's share of GDP was still only about the same as it was in 1910. It will surely increase noticeably over the next five years, though will remain much smaller than it was in the gold rush era. Again, none of this is to deny that there are differences in performance by industry and region. It is simply to give some perspective on what we see. The point about long-term shifts reminds us to look beyond the immediate conjuncture, and to think about the magnitude of the event through which we are living. For a good part of the change in our terms of trade is a manifestation of a large and persistent change in global relative prices . Let me be clear here: there is a cyclical dimension to the China story, and it is important that we remember that. But there is also a structural dimension. And the associated change in relative prices constitutes a force for significant structural change in the economy. I think we have all only begun to grasp its implications relatively recently. For a long time, the world price of foodstuffs and raw materials tended to decline relative to the prices of manufactures, services and assets. But for some years now the prices of things that are grown, dug up or otherwise extracted have been rising relative to those other prices. This is mainly due to trends in global demand. At any point in time for a particular product we can appeal to supply-side issues - a drought, a flood or a mine or well closure, or some geo-political event that is seen as pushing up prices. But stepping back, the main supply problem is really that there has simply been more demand than suppliers were prepared or able to meet at the old prices. We do not have to look far for the cause: hundreds of millions of people in the emerging world have seen growth in their incomes and associated changes in their living standards, and they want to live much more like we have been living for decades. This means they are moving towards a more energy- and steel-intensive way of life and a more protein-rich diet. That fact is fundamentally changing the shape of the world economy. Even if China's growth rate moderates this year, as it seems to be doing, these structural forces almost certainly will continue. It is worth noting in this connection that many commentators have for years been calling on policymakers in the emerging world to adopt growth strategies that rely more on domestic demand and less on exports to major countries. This is happening. It carries the implication though that, first, more of the marginal global spending dollar is going to products that are steel-, energy- and protein-intensive for the emerging world's consumers and less on other things like, say, luxury property in western countries. Secondly, more of the marginal production of the world economy has to be in those raw materialintensive products - and in the raw materials themselves - and less in the production of the other things. Ultimately there will be enough steel, energy, food and so on to meet demand - supply is responding. But considerable adjustment is needed to get there (and Australia is a very prominent part of that adjustment). The average consumer in an advanced economy is effectively experiencing a decline in purchasing power over food, energy, and raw material-intensive manufactures. Australian consumers face this to some extent as well. Were Australia not a producer of raw materials, we would be experiencing a good deal more of it. In such a world, there would be no resources sector build up. Our currency would be much lower. We would be paying much more for petrol at the pump, for our daily coffee and for a wide range of other consumer products. We would not be holidaying overseas in our current numbers. We would have more of some other forms of economic activity that we currently have less of - we would, perhaps, be less of a 'multi-speed' economy. But it's unlikely our economy overall would be stronger. As it is, the rate of unemployment has seldom, in the past few decades, been much lower than it has been recently. Moreover, in that alternative world the real income of Australians in aggregate would be a good deal smaller. is a resource producer, so we have the advantage of being able to take part in the additional supply of things that are in strong demand. This helps our incomes. Mining companies are doing their best to capitalise on the increase in demand, and the effects of this will flow through the economy, but other producers are also enjoying a boost to their income. Rises in the global prices of rural commodities over the past couple of years have been sufficient to deliver higher prices to most farmers despite the appreciation of the Australian dollar. As consumers, the rise in our currency means that we take some of that higher income in the form of greater command over tradeable goods and services. The foreign exchange market being what it is - namely an asset market - it has looked a long way forward into the resources boom and pushed up the currency quite quickly. This is having significant effects. While consumers do seem to be continuing their more cautious mindset overall, many seem over the past year to have had the confidence to leave the country to experience foreign travel at prices more attractive than any seen for a long time. Australia's tourism sector is feeling the resultant loss of business, particularly in Queensland where the floods also had a separate impact on confidence. That latter effect will pass - Queensland's set of natural endowments that attract tourists remains in place. But the need to adapt to the high exchange rate may continue. For as well as conveying a rise in purchasing power to consumers, the high exchange rate is exerting a powerful force for structural change. I think we are seeing this in the retail sector. The rapid growth of internet commerce - from a very small base - has been the topic of considerable discussion. This was bound to happen anyway with technology. But with the higher Australian dollar, the component of the retail 'product' that is added in Australia - the local distribution and retailing overheads that are required to provide the retail 'experience' - has become both much more visible, and much higher relative to the production cost of the good itself. So the incentive for the consumer to avoid those overhead costs has increased quite noticeably. The retail sector is therefore under pressure to reduce those costs. These are just some of the structural adjustment forces at work. Of course it is easy to talk about structural change in the abstract. It is another thing to cope with it in practice. There are no magicpill solutions, nor are there any real alternatives to adjustment. What solutions there are, though, are likely to involve a refocusing on productivity performance after a period in which, at least at a national level, our productivity growth has been disappointing. Yet, as I have said before, this is a much better problem to have than those we see in many advanced countries. The event to which we have to adjust is inherently income-increasing for Australia. Moreover, we do not carry the legacies of the past several years in our banks' or public-sector balance sheets that are such an impediment in other places. Queenslanders have shown their resilience and adaptability this year in the face of extraordinary events. People from elsewhere in Australia have nothing but admiration for you. and adaptability are among the characteristics we will all need in order to cope with a global environment that is growing more complex rather than less, and that presents both economic challenges and opportunities greater than those we have seen for many years. The task for the economics profession - all of us here today and in like gatherings and institutions around the country - is to do our part in trying to understand these challenges and opportunities, to explain them to our communities, and to articulate the responses that are most likely to see our country prosper.

r110726a_BOA

australia

stevens

Thank you for coming out once again in support of the Anika Foundation. I want also to thank in particular Macquarie Bank and the Australian Business Economists for their continuing support of this annual series. In last year's Anika Foundation address, I talked about the fiscal difficulties being faced by governments of some of the world's largest countries in the wake of the financial crisis. A theme of that talk was that a number of major advanced economies had been facing for a while the need to address long-term structural issues in their fiscal accounts. In large part these stemmed from the inevitable collision of long-run trends in demographics and entitlements. A deep recession and the prospect of a slow recovery have brought forward the pressure to face these issues. Over the past year, we have seen the focus on fiscal sustainability continue to increase. The problems have been most acute in Greece, though unfortunately not confined to it. Greece is a small country that has nonetheless assumed considerable significance. The citizens of Greece are now experiencing an austerity regime of historic proportions, which is a pre-condition for access to the foreign official funding that will allow them to meet their near-term obligations. But the longerterm solution surely will involve the taxpayers of Europe accepting part of the costs of restoring Greece to sustainability. The recent agreement appears to be a further step in that direction, with risk being shifted from the private sector onto the European public sector. I would view this as a step on the road to an eventual solution, though European policymakers continue to face a very delicate task in preserving the combination of fiscal sustainability and the single currency. Concerns about the US fiscal position have also increased, though this has not been reflected, at this point, in market prices for US debt. The immediate need is for the US authorities to lift the debt ceiling, then for them to work towards longer-term sustainability. In both the US and European cases, the process of allowing things to go right to the brink of a very disruptive event before an agreement is reached on the way forward has been a source of great uncertainty and anxiety around the world. That anxiety has extended to Australia, even though, as I am sure people are sick of hearing me say, Australia is in the midst of a once-in-a-century event in our terms of trade. I won't recite the facts yet again. Suffice to say that this is, at least potentially, the biggest gift the global economy has handed Australia since the gold rush of the 1850s. Yet it seems we are, at the moment, mostly unhappy. Measures of confidence are down and there is an evident sense of caution among households and firms. It seems to have intensified over the past few months. There are a number of potential factors to which we can appeal for an explanation of these recent trends. The natural disasters in the summer clearly had an effect on confidence, for example. Interest rates, or intense speculation about how they might change, are said to have had an impact on confidence - even after a period of more than a year in which the cash rate has changed only once, the most stable outcome for five years. Increasingly bitter political debates over various issues are said by some to have played a role as well. The global outlook does seem more clouded due to the events in Europe and the United States. We could note, on the other hand, that the Chinese slowdown we have all been anticipating seems to be relatively mild so far - that country has continued to expand at a pretty solid pace as measured by the most recent data. But these days, mention of the Chinese expansion reminds people that the emergence of China is changing the shape of the global economy and of the Australian economy. And structural change is something people rarely find comfortable in the short term, even though a capacity to adapt is a characteristic displayed by the most successful economies. So the description of consumers as 'cautious' has become commonplace. It is not one I disagree with. Indeed the RBA has made such references on numerous occasions over the past couple of years. Nor do I wish to dismiss any of the concerns that people have. People want to make sense of the disparate information that is coming at them. I want to suggest that to do that - to make sense of it all - it is worth trying to develop a longer-run perspective, particularly in the area of household income, spending, and saving. That is my task today. I have two charts that I think help us to understand the story. These figures are from the quarterly national of household disposable income, and household consumption spending. Income as shown here takes account of taxes, transfers and household interest payments. Both series are measured in real per capita terms, and shown on a log scale. In the lower panel is the gross household saving ratio, which is of course the difference between the other two lines expressed as a share of income. Also shown is a trend line for each of the income and consumption series, estimated using ordinary least squares, over the period 1995-2005. The trend is then extrapolated for the 21 quarters since the end of 2005. Notice that the trend growth for real per capita household income over the period 1995 to 2005 was 2.0 per cent per annum. That's a pretty respectable rate of growth for an advanced country. It was more than double the growth rate seen in the preceding two decades from 1975 to 1995. Growth at that pace means that the average real income doubles about every 35 years. Notice also that the trend line for consumption was steeper than that for income over the same period. These two lines were on their way to meeting. Real per capita consumption growth averaged 2.8 per cent per annum. This was a full percentage point higher than in the preceding 10-year period, and similar to the sorts of per capita growth rates for consumption seen in the late 1960s and early 1970s. For 10 years up to 2005, then, consumption growth outpaced income growth, which was itself pretty solid, by three-quarters of a percentage point, on average, every year. In fact this convergence of income and consumption was the continuation of a trend that had already been in place for about a decade. As the bottom panel shows, the flow of saving fell as a share of income. As you can see, things began to change after that. From about 2006, real per capita income began to grow faster. Over the five years to the end of 2010, it rose by 2.9 per cent per annum. It may not be entirely coincidental that that period is when the terms of trade really began to rise in earnest. Yet from about the end of 2007, even as income was speeding up, household consumption spending slowed down . In per capita terms, real consumption today is no higher than three years ago. It's no wonder that people are talking about consumer caution, and no wonder that retailers are finding things very tough indeed. Coming after a period in which real consumption had risen by 2.8 per cent a year for a decade, and had outpaced income growth for two decades, no net growth in consumption for three years is quite a big change. But these figures suggest that lack of income growth is not the reason for lack of consumption growth. It's not that the income is not there, it's that people are choosing, for whatever reason, not to spend it in the same way as they might have a few years ago. Why is that? To find an answer we need to look to the financial accounts of the household sector. It is now time to introduce the second chart (Graph 2). It shows gross household assets, also measured per capita, in real terms (i.e. deflated by the consumption deflator). The two components are financial assets (including superannuation assets) and non-financial assets, the bulk of which is dwellings. These data say that gross assets across Australian households presently average about $800 000 per household, or about $300 000 per capita. Between 1995 and 2005, assets rose at an average annual pace of 6.7 per cent in real, per capita terms. Completely comparable figures for earlier periods are hard to come by. But it's pretty clear that this increase stood out. Using the Treasury's series for private wealth, from 1960 to 1995 the annual average per capita rate of increase in total wealth, in real terms, was 2.6 per cent. That is, it was broadly similar to the per capita growth rate of real GDP, which is what one would expect. So the growth from 1995 to 2005 was at a pace well over double the average of the preceding three or four decades. A large part of the additional growth was in the value of dwellings. The extent of leverage against the dwelling stock also tended to increase, with the ratio of debt to total assets rising from 11 per cent at the start of 1995 to around 17 1/2 per cent by the end of 2005. It has tended to rise a little further since then. Had we really found a powerful, hitherto unknown route to genuine wealth? Or was this period unusual? Looking back, it appears the latter was the case. In 2008, the trend changed. Real assets per person declined for a period during the financial crisis. Given the nature of that event and the potential risks it presented, that is not surprising. Real asset prices have since risen again but, so far, have not resumed the earlier trend rate of increase, and at this stage they show no signs of doing so. They look very much like they are on a much flatter trend. This adjustment has been considerably less abrupt than those seen in some other places. Nonetheless, it is a very substantial change in trend. If people had been banking on a continuation of the earlier trend, they would be feeling rather disappointed now. Of course if that earlier trend in gross wealth owed something to a tendency to borrow to hold assets, then a continuation would have exposed households to increased risk over time. Casual observation suggests that this change of trend in the growth of assets, or 'wealth', roughly coincided with the slowing in consumption spending relative to its earlier very strong trend. It seems fairly clear that these financial trends and the real consumption and saving behaviour of households were closely connected. I would argue that the broad story was as follows. The period from the early 1990s to the mid 2000s was characterised by a drawn-out, but one-time, adjustment to a set of powerful forces. Households started the period with relatively little leverage, in large part a legacy of the effect of very high nominal interest rates in the long period of high inflation. But then, inflation and interest rates came down to generational lows. Financial liberalisation and innovation increased the availability of credit. And reasonably stable economic conditions - part of the so-called 'great moderation' internationally - made a certain higher degree of leverage seem safe. The result was a lengthy period of rising household leverage, rising housing prices, high levels of confidence, a strong sense of generally rising prosperity, declining saving from current income and strong growth in consumption. I was not one of those who felt that this was bound to end in tears. But it was bound to end. Even if one holds a benign view of higher levels of household debt, at a certain point, people will have increased their leverage to its new equilibrium level (or, if you are a pessimist, beyond that point). At that stage, debt growth will slow to be more in line with income, the rate of saving from current income will rise to be more like historical norms, and the financial source of upward pressure on housing values will abate. (There may be other non-financial forces at work of It is never possible to predict with confidence just when this change will begin to occur, or what events might potentially trigger it. But an international financial crisis that envelops several major countries, which has excessive borrowing by households at its heart, and which is coupled with a major change in the global availability of credit, is an event that would be likely to prompt, if nothing else did, a reassessment by Australian households of the earlier trends. It would also prompt a re-evaluation by financial institutions of lending criteria. This is precisely what has occurred over recent years. What are the implications of these changes? An important one is that, as I said at a previous Anika Foundation lunch two years ago, the role of the household sector in driving demand forward in the future won't be the same as in the preceding period. The current economic expansion is, as we all know, characterised by a very large build-up in investment in the resources sector and expansionary flow-on effects of that to some, but not all, other sectors of the economy. It is certainly not characterised by very strong growth in areas like household consumption that had featured prominently in the preceding period. That is partly because the change in the terms of trade, being a relative price shift, will itself occasion structural change in the economy: some sectors will grow and others will, relatively speaking, get smaller. That is particularly the case if the economy's starting point is one that is not characterised by large-scale spare capacity. But those pressures for structural change are also coinciding with changes in household behaviour that are associated with the longer-run financial cycles I have just talked about. Just as some sectors are having to cope with the effects of changes in relative prices - manifest to most of us in the form of a large rise in the exchange rate - some sectors are also seeing the impacts of a shift in household behaviour towards more conservatism after a long period of very confident behaviour. It would be perfectly reasonable to argue that it is very difficult for everyone to cope with both these sets of changes together - not to mention other challenges that are in focus at the same time. However, if we were to think about how things might have otherwise unfolded - if households had been undergoing these shifts in saving and spending decisions without the big rise in income that is occurring, to which the terms of trade have contributed - it is very likely that we would have had a considerably more difficult period of adjustment. What then about the future? Can we look forward to a time when these adjustments to household saving and balance sheets have been completed? We can. To return to the first of my two charts, the current divergent trends between income and consumption spending are no more sustainable than the previous trends ultimately were. At some point, the two lines are likely to stop moving apart. That is, the saving rate, debt burdens and wealth will at some stage reach levels at which people are more comfortable, and consumption (and probably debt) will grow in line with income, with a relatively steady saving rate. We could then reasonably expect to see consumption record more growth than it has in the past few years. After all, it is very unusual for real consumption per person not to grow. We cannot really know, of course, when that might happen. Doubtless it will depend on what else is occurring. We can note that the rise in the saving rate over the past five years has been much faster than its fall was in the preceding decade. In fact it is, at least as measured, the biggest adjustment of its kind we have had in the history of quarterly national accounts data. So the adjustment in behaviour to what should be a more sustainable relationship between spending and income has in fact proceeded pretty quickly (which is presumably why it has become such a prominent topic of discussion). That in turn means that the time when more 'normal' patterns of consumption growth recur is closer than it would have been with a more drawnout adjustment. Viewed in long-run perspective, it is not unreasonable for a nation to save a good deal of a sudden rise in national income conferred via a jump in the terms of trade, until it becomes clearer how persistent that new level of income is. As a better sense of the degree of persistence is gained, people will probably be more confident to spend than perhaps they are just now. It is entirely possible that, were some of the current raft of uncertainties to lessen, the mood could lift noticeably, so I don't think we need to be totally gloomy. But what is 'normal'? Will the 'good old days' for consumption growth of the 1995-2005 period be seen again? I don't think they can be, at least not if the growth depends on spending growth outpacing growth in income and leverage increasing over a lengthy period. A rapidly rising saving rate isn't normal, but nor is a continually falling one. While the rise in the saving rate has been unusually rapid, the level of the saving rate we have seen recently looks a lot more 'normal', in historical perspective, than the much lower one we saw in the middle of last decade. A return to those earlier sorts of growth rates for consumption would instead require, and could only really be sustainably based on, a continuation of the faster pace of income growth we have seen since about 2006. To the extent that that income growth has been a result of the increase in the terms of trade, however, it probably won't be sustained at the same pace. The level of income will probably stay quite high - above the level implied by the earlier trend - unless the terms of trade collapse. But the rise in the terms of trade has probably now come to an end. So the rate of growth of per capita income could be expected, all other things equal, to moderate from its recent unusually strong performance. If we want to sustain the rate of growth of incomes, and hence lay the basis for a return in due course to the sorts of growth of spending seen in the golden period of 1995-2005, we will have to look elsewhere. As everyone in this room would know, there is only one source of ongoing higher rates of growth of real per capita incomes, and that is higher rates of growth of productivity. Everyone here also knows that it is now just about impossible to avoid the conclusion that productivity growth performance has been quite poor since at least the mid 2000s. So everything comes back to productivity. It always does. It has been observed before that past periods of apparently easy affluence, conferred by favourable international conditions, probably lessened the sharpness of our focus on productivity. Conversely, the will to reform was probably most powerful when the terms of trade reached a longterm low in the mid 1980s. Those reforms ushered in a period of strong productivity growth. The thing that Australia has perhaps rarely done, but that would, if we could manage it, really capitalise on our recent good fortune, would be to lift productivity performance while the terms of trade are high. The income results of that would, over time, provide the most secure base for strong increases in living standards. That sort of an environment would be one in which the cautious consumer might feel inclined towards well-based optimism, and reopen the purse strings.

r110826a_BOA

australia

stevens

Terms of reference for the inquiry: To inquire into and report on: I declare open this hearing of the House of Representatives Standing Committee on Economics and welcome representatives of the Reserve Bank, members of the public, media and students from Eltham College of Education and Trinity Grammar School. Despite the current international uncertainty, the fundamentals of the Australian economy are strong. Public debt and unemployment are low, and we have a significant pipeline of business investment, particularly in the resources sector. Some sectors, however, are under pressure as a result of the patchwork nature of the economy--the level of the Australian dollar in particular, as well as the cautious consumer. On the international front, while Chinese growth is solid, European and US debt problems have created uncertainty. The committee will question the governor on these and other risks to the global and national economy. 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. The giving of false or misleading evidence is a serious matter and may be regarded as contempt of parliament. Mr Stevens, would you now make your opening statement before we proceed to questions. Thank you, Madam Chair. It is nice to be with the committee again here in Melbourne. Quite a bit has happened since we last met, in both the local and global economies, so I would like to talk about that. In February we had seen the Queensland floods, and Cyclone Yasi had just occurred at the time of our meeting. Tropical storms had also disrupted iron ore shipments out of Western Australia. There was understandably a focus on what the economic effects of these events would be. It was thought likely that economic activity as measured would be materially weaker in the March quarter than had earlier been expected but that there would be a recovery in the middle of the year. It was thought that the rebuilding efforts in Queensland would exert a mild expansionary impetus on demand in that state, beginning in the second half of the year. GDP was indeed weak in the March quarter, with a fall in coal and iron ore production more than offsetting a modest rise in output in the rest of the economy. Since then the rebound in production of iron ore has been more or less as expected, and the disruption to general economic activity in Queensland associated with the floods has abated. But in the case of coal, largely for environmental reasons, the process of dewatering pits is taking longer than initially expected, so the recovery in coal production in Queensland is probably about two-thirds complete at this time. It may be early next year before production has fully recovered. This has had a material effect on forecasts for GDP. It was also understood in February that there would be a large effect on the consumer price index because of the loss of key crops in the cyclones. These were expected to be temporary, and indeed prices for the relevant items are now starting to fall back as crops recover. The Reserve Bank has been clear that these fluctuations have had no implications for monetary policy. What we did not know in February was that a serious Japanese earthquake would have a significant effect on global manufacturing production and sales, including in Australia's motor vehicle sector. This explains part of the apparent slowing in global growth in the June quarter. Part of the slowing in growth in the major countries is also likely to have been caused by the increase in energy prices in the first half of the year, which now appears gradually to be reversing. Another factor at work, though, has been the concerns raised about public debt in major countries. These were apparent six months ago, but they have escalated markedly in the intervening period. Not only did yields on the obligations issued by so-called peripheral euro area countries reach new highs, but interest rates faced by large countries like Spain and Italy also rose to levels that would have made their financial position much more difficult. The euro area's response to these issues has had some positive effects but it remains a work in progress. Meanwhile, the United States is having a very difficult time finding a path that avoids having to have an immediate major fiscal contraction but still puts the US fiscal accounts onto a sustainable medium-term trajectory. As financial markets confronted all of this and also sought to digest a reappraisal of near-term global growth prospects, we have seen during August a period of intense turmoil, particularly in equity markets. The net result of this period is that equity prices in most markets around the world are anything from 15 to 25 per cent below their recent highs earlier in the year. Yields on long-term securities for the United States and the core European countries have fallen to historical lows as investors sought safety, despite the US sovereign rating downgrade by S&P. Measures of volatility have increased sharply. There has been a degree of renewed pressure on US dollar funding for European banks. The currencies of certain countries regarded as safe havens, like Switzerland, have soared and the price of gold has reached new highs. So markets remain on edge. All that said, the dislocation has not, on most common metrics, approached the extent that we saw three years ago. The main effect on Australia's financial markets has been lower equity prices, which have fallen along with those elsewhere. Other Australian markets for the most part have to date travelled fairly well in the circumstances. Funding costs if anything declined, which is being reflected in lower costs of fixed rate mortgages. Major Australian banks report being offered substantial US dollar funding in offshore markets on account of their relatively high credit standing, and that is quite a contrast to three years ago. In any event, their reliance on such wholesale funding is much reduced from three years ago, given the large increase in deposit funding at home and slower growth in balance sheets. There has been no abnormal demand for liquidity by financial institutions from the Reserve Bank in this period, and the quantity of settlement funds in the system has been completely normal over the past month. The exchange rate has come off its peaks of a few months back, but it remains quite high compared to most of the post-float experience. Some commodity prices have declined, but at least at this point they have not slumped in the way they did in late 2008 and early 2009. Prices for major Australian commodities generally remain quite high. People will understandably want to draw comparisons of this episode with the financial crisis in 2008. Of course, we cannot know what will transpire in the months ahead, but I think that what we have witnessed to date is best seen not so much as a new crisis but as part of the long aftermath of that earlier 2008 event. In the countries that were at the heart of that crisis, it was to be expected that after such serious problems in private balance sheets economic recovery would be a drawn out affair. That is usually the way with these things. This is having a predictable effect on the fiscal positions of the relevant countries--that is, revenues are weak and budget deficits have remained large. It is not surprising that coping with that is politically difficult and it remains a point of considerable uncertainty what the ultimate resolutions in the major countries concerned are going to look like. This may well be leading to some precautionary behaviour in itself, and as a result of all these things the global growth outlook does not look as strong as it did six months ago, even though it is not necessarily as weak as some of the pessimists fear. In our own region, indicators suggest some moderation in growth in the Chinese economy, but it still appears to be still pretty solid. Around Asia, inflation rates have generally tended to rise in the past six months. A key question for the countries in the region is whether enough has been done to contain the inflation pressure, which does look to have spread beyond initial rises in food and energy prices. Asia's management of these challenges will ultimately matter a good deal for Australia and for the world. In the meantime, Australia's terms of trade are very high and the investment expansion in the resources sector is proceeding. On all the indications available, it has quite some way to run yet. This is having positive spillovers to some parts of the economy. Our liaison suggests that, beyond the benefits being experienced by equipment hire, engineering, surveying and consulting firms, businesses as diverse as those supplying modular housing, lab services and training of semiskilled, trade and other workers are seeing effects of that minerals sector expansion. Meanwhile, other sectors are being squeezed by the high exchange rate and by the much-touted household caution. I think it is important not to overstate the degree of caution. Some areas of household spending--for example, overseas travel--are growing very strongly. But overall it is, in my judgement, increasingly clear that we have seen a significant change in household behaviour. There was a lengthy period in which households saved progressively less out of current income, increased their leverage and enjoyed a sense of rising prosperity from the increase in asset values. That was most likely a one-time, if rather drawn out, adjustment to a number of important factors. It is understandable that it occurred. It should be equally understandable that it was not going to continue like that indefinitely. The new normal, so-called, which is actually the old normal, is where households save a non-trivial fraction of current income and keep their debt levels or their growth in debt levels more in line with growth of income. One positive that I think is worth noting here is that the adjustment to this new or old normal has been quite fast, which may mean that a lot of it may already have been accomplished. Nonetheless, in view of the financial turmoil of recent weeks, it would not be surprising if a degree of caution persisted for a while yet. Three months ago, the Reserve Bank voiced concerns over the outlook for inflation in Australia, on the basis that measures of underlying inflation looked like they had ended a decline that had lasted for more than two years, were starting to turn up and were forecast to rise over the three-year forecast horizon. That outlook suggested that policy would need to be tightened 'at some point'. The Reserve Bank did not have a precommitted notion of when that point might be. Those sorts of indications are, in any event, always contingent on the ongoing assessment of the outlook. The policy decision must of course consider not only the central forecast but also the possibility that things turn out differently to that central view. In the intervening period, the international situation has become more clouded and evidence of caution at home has, if anything, intensified. Asset prices have declined, credit growth has moderated further and the exchange rate remains very high. All of these are affected by factors other than monetary policy, as well as by monetary policy, but together they suggest a fair degree of restraint is being exerted at the moment by financial conditions. Under those circumstances, the board judged that the most prudent course through this period was to sit still, in spite of inflation data that, on their face, continue to look concerning. Looking ahead, the year-ended CPI inflation rate will probably remain well above three per cent in the September quarter. It is then likely to come down as the impact of last summer's floods on food prices continues to unwind. We will see, we think, the effects of that around the end of the year and into the early part of next year. After that, the assumed impact of the carbon-pricing scheme, which we have now put into the forecasts, starts to affect the headline inflation figures. I am being very clear here that the Reserve Bank will abstract from those carbon price impacts in setting monetary policy, just as we did with the implementation of the GST a decade ago. It is the more persistent path of inflation on which the Reserve Bank must of course focus. In that regard, the question is whether recent events will have a bearing on that medium-term inflation outlook. It would be reasonable to anticipate that a decline in confidence, arising from the recent events internationally, may well dampen demand somewhat compared to the outlooks set out in our SMP forecasts earlier this month. That, together with the increased visibility of structural change in the economy, may also condition wage bargaining and price setting. If those forces persist, they may act to lessen the upward trend in inflation pressures that appeared to be in prospect. There are a number of maybes in those sentences. At the same time, significant rises in a range of administered prices are still set to occur over this period and unit costs have been rising quite quickly, given the fairly poor performance of multifactor productivity growth over recent years. So, as usual, there are varying forces operating in different directions about which the board will need to make careful judgments over the period ahead. In summary, there is a heightened degree of uncertainty at present. That is stating the obvious. There are major challenges to the global economy and there are significant forces at work in the Australian economy. But, at this point in time, our terms of trade are very high while our unemployment rate remains low. Inflation bears careful watching, but I think we can keep it under control. Our banks are strong, our currency is sound and our sovereign credit position is in the international top tier. Consumer caution, while certainly making life hard for retailers, is building resilience in household balance sheets. And corporate balance sheets remain in quite good shape. If we are entering another period of weaker international conditions, then I think that is a pretty good starting point from which to do so. Thank you, Madam Chair. We await your questions. Thank you. In the statement following the Reserve Bank board meeting of 2 August, with quite a level of foresight the board judged that it was prudent to maintain the current setting of monetary policy in the light of acute sense of uncertainty in global financial markets. I note that, in some of your statements since then, you have used the word 'anxiety' as well, which would have been in relation to the US debt crisis as that unfolded. Do you now see that level of uncertainty has pulled back or are we still at that heightened level? I do not think it has got worse. As I said, we have had a significant net fall in share prices and some other indications of some stresses, especially in Europe. Even this week we have still had some fairly significant volatility in equity markets internationally. Important as our proceedings are here to today, there is a speech by the US fed chairman tonight, our time, on which people are hanging. So I think there is still a bit of angst out there in international financial markets. That is partly because of the ongoing issues in Europe: how will they resolve these matters--and they are very, very difficult matters--and just what is the outlook for the US? Is the fed going to announce some further monetary stimulus? Around Asia I would continue to think that actually prospects are still pretty good and economies are moving along quite smartly, particularly in China. So the picture I think remains at this point more or less as I have outlined in the opening remarks. I do not think we could say right now that the anxiety has gone away. It is still there. There are going to be, I think, potential trigger points over the months ahead which might be to do with the US or with Greece or with the European stability mechanisms and so on, where markets will probably get anxious in the lead-up to those. I think the European story--periodic bouts of uncertainty and anxiety--is probably going to be with us for a few years, actually. As you said, there has been much talk about consumer caution and business confidence. Is the Australian experience fairly much reflective of what is happening internationally? I think in a number of countries where we have had the run-up in leverage, the rise in house values and so on there has been a tendency for consumers to start saving more. The adjustment has been rather more painful, I would say, in, say, the United States or the UK than it has here. That is at least in part because those countries have not been enjoying the terms-of-trade experience that we are. In a sense, we have had households become considerably more prudent. They have been able to lift the saving rate here by, I think, 10 or 12 percentage points over several years. That is probably a bigger increase in that measure of saving than we have seen in comparable countries, and it is bigger than we have seen in past periods of our own history. There has been quite a bit of income growth in the economy that has helped that happen. So, yes, it is reflected elsewhere. It is happening here in, I would say, a more benign way because we have had income growth that other countries have not enjoyed. You said quite recently--and you just alluded to it--that the rise in the rate of household savings is the biggest adjustment of its kind in the history of the quarterly national accounts. Is there a good side and a bad side to that from the Reserve Bank's perspective? The bad side is if you are a retailer coming off that 15-year period of gearing up, with falling savings and higher spending. That was a long and good period for those parts of the economy that serve the consumer. It was not really normal--it was unusual, historically--but it was a fairly lengthy period. So I think it was quite an adjustment to come off that and into an environment where consumption is growing, but much more slowly than it was. I have said publicly that I was not one of the people who felt that the rise in debt was all going to end terribly. I did not think that, but it did have to end at some point. At some point people reach a stage where they are feeling, 'I don't really want more debt; maybe I really ought to be thinking about some saving out of current income for the future.' There is a little bit more caution. Compared to going on as we were, that is going to leave household finances in a stronger position. That is good because someday, if there is a downturn, you do not want households to be excessively exposed in terms of their leverage when there is an adverse shock to income. So I think that is the good side of it. I suppose one could also say that we are having a very substantial investment pick-up in the economy in aggregate. As we have all been saying, it is not evenly spread; it is concentrated. But we have an investment boom; it is actually not a bad thing to have some saving to help fund that. We do not have to fund it all ourselves; we can use the savings of foreigners--that is perfectly sensible. But to have some saving at home is probably not a bad thing. To the extent there is uncertainty about just how high national income really will be in the future, and that is uncertain--where will the terms of trade settle, and so on--reacting to the initial surge in income with: 'Let's not spend it all,' probably makes sense to a certain extent. That is the good side of it. As with most things in economics there are always two elements. We do tend to focus on the downside sometimes. I have noticed that. I asked you once before, I think, whether the Reserve Bank had a view on what was a normal savings rate. At the time you said you did not really have one. You used the word 'normal' today, so I ask that question again. It is hard to be doctrinaire about the optimal rate being X in theory. We should also take care with building very strong hypotheses on the saving rate per se, because it is inevitably not a very well measured aggregate--it is the residual. Quite a bit of the rise in saving actually came in one set of national account revisions a year or so back. With that caveat in mind, I think what was not normal was for a saving rate to be zero in gross terms or negative in net terms. That is very unusual, historically. As to where it is now: I am not sure whether this is optimal, but it seems much more like the saving performance that we would have observed through much of the post-war period. So in that sense it is more normal than what we were seeing. Looking at one of your other comments, you remarked that our current terms of trade is probably the biggest gift that the global economy has given to Australia since the gold rush. If I am not in the mining sector, how is that a gift? National income is higher. I know that people say they do not feel the effects of the mining boom--not everybody feels it directly, that is quite clear--but these income flows do flow around the economy. It is very hard to be precise, but on the figuring that our staff have done, I think I can get Phil to speak to this in more detail, about half of that higher terms of trade revenue stays in Australia one way or another, be it through employment or profits that go into people's equity holdings, super funds, revenues to government and so on. I think that is about the figure. Yes. The work we have done internally says that, over the past decade, for every dollar of extra revenue we have got in the resources sector around 10c is spent on domestic labour; around 25c is spent on buying domestic services, inputs into the resources sector; somewhere between 15c and 20c goes back to the state through royalties or taxation and somewhere between 5c and 10c goes to the domestic holders of the shares of the mining company. When you add all that up, somewhere between 50c and 60c of every extra dollar of income that comes into the country stays in the country, either in the form of taxation, profits or domestic services and labour. And there is presumably flow-over from build-up in investment. Absolutely, those are significant effects. Given that the terms of trade has doubled compared to what it was in the 2000s, there is a lot of extra income flowing around in the economy. Can I talk briefly about the carbon price, which is estimated to have a one-off 0.7 per cent impact on inflation. The Reserve Bank has said that it will look through that, and you repeated that today. Could you explain why you would look through such an impact? It is a public policy intervention, so to speak, to achieve a particular outcome. We had a restructuring of the taxation system a decade ago, with the GST, which raised the price level. It actually raised it more in the short term than the medium term. The medium-term effect was in the 2.0 to 2.5 per cent range, from memory. Then there was compensation to households for that, as there is going to be in the case of the carbon price. So, we feel that that is an identifiable thing that is not 'normal inflation'. It would not be right to tighten monetary policy in response to that. The key thing will be to make sure that there are not ongoing significantly higher inflation rates resulting from that. There should not be if medium-term expectations of inflation remain anchored. If price and wage setters themselves look through the impact, seeing it for what it is, then so can we. I think the chances of that are pretty reasonable. I must admit that back at the time of the GST I personally worried that we might struggle there, but it actually worked out fine. The estimates that the Treasury came up with on the gross and net effects were, I think, pretty accurate. There was no lasting effect on inflation out of that and policy was able to look through it. It is to be hoped that that is the outcome here. You said a very similar thing about the price of bananas after the cyclone-- Bananas are going to reverse, of course. The carbon price or the GST is a one-time lift in the level that is there forever but does not have an ongoing rate-of-change effect. The bananas are a rise in the level and then there is a fall, so the rate of change goes up and then it goes down below normal and then comes back up. It is typically the case that central banks will allow temporary supply side shocks to pass in and out of the data and not respond to them, provided that we keep expectations about future inflation well anchored. That of course is where the inflation target is so important. I was referring to the perception side of the bananas and not the actual bananas--the much maligned banana, at the moment! The consumer caution side--the uncertainty, if you like, or the response of the Australian consumer to global conditions--seems to be very high. What would you say to Australians who look across Europe and the US and start worrying that Australia might be in a similar condition? Is the anxiety among Australian consumers overstated or stronger than it should be? Are there reasons why they should be? In so far as the recent global turmoil is concerned it is natural; people read the papers and see the news. Bad news is usually very prominent in the media. So it is understandable that people would ask the question: are we badly exposed here? To that I would say that the sharemarket has been affected but, as I mentioned earlier, the vast bulk of the functioning of other markets here is largely unaffected. We do not obviously have anything like the sovereign debt issues that are confronting in Europe or America. These are terribly difficult issues to deal with. We do not have that problem. We do not have the problem of weak banks. The exposures of our banks to the troubled European periphery countries is trivially small, so there is no linkage there. And of course we as a country are still continuing to benefit from the increasing links with Asia. It is not as though we have switched totally and the US never matters any more and only China matters. It is not that at all. But there is a progressive reorientation of our trade--and I think that over the years we will increasingly see it in finance as well--to the part of the world where hundreds of millions of people are becoming affluent quickly. That is transforming the global economy and it poses challenges for us, as we have been reading. But it is also an enormous opportunity. That is what I would say: by all means pay attention to these stories, but there are other much better stories that we must keep in mind. I will go to a story which has not been so good since the mid-2000s, productivity growth. You have referred in a couple of your speeches to the fact that it has not been looking as good as it should be since about the mid-2000s. I assume that was part of a trend. I assume it did not happen quickly. Is that a case of good times making you a little bit fat, if you like? It is not a conclusion I was that keen to draw myself for quite a while, but I think you cannot avoid concluding from all the figures we have that productivity growth has slowed. It has slowed in a number of countries, not just here. I think I would be right in saying that it probably seems more pronounced here. There is a story that says that some of this is the impact of the major build-up in capacity in mining--the productivity has fallen there but it will rise--and I think that is right. But the slowdown appears to exist in the bulk of the industry sectors, when you look at that data. It is hard to avoid it. Why did it happen? I think I have said once or twice before that when times are good we do tend a little bit to not press as hard on some of those reforms as we might. I do not think there is any doubt that the period of maximum focus on productivity-enhancing measures and reforms was really in the period when the banana republic issues were being debated. There was not any alternative; we felt we had to do it and we did do it. It perhaps proves harder to do that when affluence has been better for a period of time. As I said recently in a talk, the thing we have rarely done is to try to work on improving productivity materially when the terms of trade are high, but if we could do that it would be a fabulous way to take advantage of the opportunities we have. Really, it is up to us as a country to try to do that. I do not have here in my papers the magic bullet of exactly how; it is not an easy matter. It is grinding, difficult and time-consuming work over a number of fronts over years. That is what does it. Thank you, Chair--well done on your first job as chair of the committee. Governor, I just want to touch on a couple of things. With respect to some of the challenges that the Reserve Bank currently faces, obviously there is a lot of commentary about not mutually exclusive but certainly areas of friction between two opposing forces: domestic inflation, which appears to be moderating perhaps over the medium term, and the eurozone debt crisis, for lack of a better term. Of these two competing factors, is one ranking more highly than the other in terms of the RBA's focus? No. When I think about the 'international crisis' issues there are two dimensions. There are periods of tremendous turbulence when I think it is a very good thing for policy to just sit still, if it can, rather than add to that turbulence by starting to change our settings. You can only do that if you feel that you are in some sense ahead of the game on inflation, which I have felt. The other dimension, which is the thing to which I was alluding in the opening remarks, is what the impact of the turbulence will be, if any, on demand versus supply, and therefore prices. That is not going to happen immediately but over time. The issue we face is that the forecasts that were written down three months or a month ago have inflation not exploding but going up. Obviously we have to be concerned about that. Is it possible that what we have seen recently will amount to a diminution in demand pressures that will tend to cap that? That will be the question. It is too soon to know at the moment, but that is obviously a question we have to ask. So you can, I think, build these various elements into, in a sense, ultimately what it means for the outlook for the economy and inflation and craft your response from there, keeping in mind that at times of extreme turbulence it is often a good idea to sit still, as a kind of tactical thing. Fundamentally you have eased from, effectively, an overall monetary policy setting to one that is slightly restrictive--I think that is your word. There has been a change over the past two years from the RBA. The history, as you know, is that we eased very aggressively into the late 2008-early 2009 period because we felt that those events so fundamentally changed the world outlook, and I think that judgment was right. Then Australia came through better, really, than we had expected. As you know, we felt we should normalise, so to speak, our settings reasonably promptly thereafter. We are in a position of exerting a certain degree of restraint right now, mainly because, if you think about the biggest expansionary terms of trade shock for 150 years hitting the economy and inflation in core terms is okay but is not falling anymore, you would expect to be exerting a bit of restraint there. That is the logic of where we have been. I think that was right. Balancing the various forces and trying to work out what they mean for the outlook does not seem to be getting any easier right now, though. That is certainly true. Regarding the restoration of the federal government's budget position both domestically and abroad, we have seen massive deficits being the root cause of a lot of problems with respect to the Euro zone. In Australia we historically have not faced that situation. Can I ask for your view on the age-old question that we often discuss here: the trade-off between fiscal and monetary policy. How crucial is restoration of a surplus position in terms of the federal budget and its impact on monetary policy settings? The projected return along with the unwinding of the stimulus measures, which is occurring more or less as it was designed to, is all part of the picture for the outlook that we try to put together. If that changed course materially, obviously that affects the outlook in some way--it could be in either direction, and we try to take account of that. It is built into what we are trying to do. It is very hard to do all that, of course, but we have to make the best estimate we can and monitor developments. The government said, I believe, that they will allow automatic stabilisers generally to work if the economy is stronger than expected. I think that is appropriate; that is a stabilising mechanism that is kind of built into the system--that is a good thing. I suppose the question they will have to ask is: if the automatic stabilisers work the other way if the economy is weaker, do they want to then do some discretionary tightening to meet a balance by a particular day. That is ultimately a fiscal policy call on which their advisers will give them advice. Whatever they do there, we would seek to adjust our thinking about the outlook accordingly. You have effectively answered, though, in a very reactionary sense rather than a proactive sense. I am trying to explore what your advice would be in terms of the best fiscal policy settings going forward to ensure that we do not allow inflation to put undue upward pressure on what is happening in the Australian economy. It is hard to say. Yes, from an inflation point of view it is important that the unwind of the discretionary stimulus measures occurs, and it is occurring. They were designed that way, so that is appropriate. As to what the effects on inflation would be of a different fiscal-monetary mix, you have to factor in the exchange rate as well, so it is not a straightforward question to answer. But I think the key issues on the fiscal side are making sure we keep sound public finances over the medium term. You have to go back to balance and surplus, obviously, to do that. That has to be done. And--for the use of significant discretionary countercyclical measures--I guess I would counsel a reasonable amount of caution there, and I think that has been the approach in Australia over many years. There were discretionary measures at the height of the crisis. In a crisis of that nature that is fine. I think, though, that, absent crisis conditions, essentially devoting the fiscal side to issues of good structure of taxation, efficiency et cetera and sound public finances in the long run, which has been the approach historically, is a good approach in normal times. If I look at the differences between forecasts an actual outcomes--and you made references to this in your opening statement--I think the RBA predicted back in February for June of this year growth in GDP of 3 1/4 per cent. In May that was trimmed to 2 1/2 per cent and the actual was 1 1/4 . For June next year GDP growth is forecast, as of February, when the prediction was made, to be 3 3/4 per cent. In May that was revised upwards to 4 1/4 per cent and I think Treasury forecasts are 4 1/2 per cent. My question is this: given your focus is on mediumterm inflation outlooks, and obviously GDP growth will be a major feature of that, and given Treasury forecasts are so optimistic and would almost appear to be perhaps out of touch with the reality of where things currently stand, is it a concern to you that we could see an ongoing budget deficit situation, and therefore that is something that you need to take into account with monetary policy settings? Let us suppose you saw weaker than expected activity and the budget took longer to go to surplus. That would be the automatic stabilisers working. There is nothing particularly wrong with that, actually. Most countries and most economists I think would accept that the automatic stabilisers should be allowed to work. Are we going to go and jack up rates were that to occur? No, I do not think so. It is not obvious to me that we would. If the economic activity was weak enough, you could conceive of a scenario where you might reduce them--I am not saying that will happen. But I do not think there is quite so mechanical a link to whether the budget gets to balance on a given day or not. It depends why the difference is occurring. If that was occurring because of a new round of discretionary stimulus, that is a different story. So it matters why the assumed event has occurred. Can I ask about the labour market. In particular, you made comments earlier in response to the chairman's question that implied for me--and this may be an incorrect assumption--that a large part of the inflation pressures we see are demand driven. I would have thought that the bulk of what we are seeing is supply side impact. You have previously made comments to this committee about business concerns over a lack of flexibility or reduced flexibility in terms of an industrial relations framework. I am just interested in your comments and thoughts about the way in which this is having an impact on major price inflation and, in addition to that, your comments about the extent to which this is feeding into the slowdown in productivity. In terms of demand versus supply inflation if you take as your starting point that there has been a material slowdown in productivity--if that is so--that is really saying in a way that the economy's capacity to supply the demand that we want to have is not what it used to be. You can say that is supply-side inflation in a way, but I think you can also say, and I would say, that that has to condition how much demand growth you think you can have. What you are really saying is that the economy's capacity under that hypothesis to grow at a certain rate without inflation has been impaired. What businesspeople say to me--and I think this would be a theme I have heard from a number of quarters--is not so much that wages are excessive and indeed at this point in time the aggregate data on wage growth which is probably fourish, a touch under maybe, is on a par with what we have seen over the years. What people say to me, I cannot verify it obviously, from their individual businesses is that they find it harder to negotiate flexibility. That is something that is said. If that is true that I think is a matter for concern. In terms of the RBA's tolerance level for wage growth, historically it is a combination of productivity growth plus inflation. With a trimming of productivity growth does that mean that what is effectively I think what it means, if the hypothesis is that productivity growth is permanently lower, is that then the rate of nominal wage growth that everybody has been accustomed to will not be consistent with the inflation target any more unless some other factor is at work providing an offset. That factor could be a rise in currency but it would have to keep rising not just rise once. It is quite an important question. I would not pin this just on labour productivity, multifactor productivity generally has slowed down. It makes the Reserve Bank's job easier of course in controlling inflation but even apart from that it is in the interests of all of us for our future living standards to have the best productivity performance we can have because that is the source of growth in our living standards, there is not really any other source ultimately. I have a final question in terms of the effectiveness of monetary policy. This has been put to the committee by a number of commentators. If the source of inflation is predominantly coming from that 25 per cent of the economy experiencing a 15 or 16 per cent rate of growth--that is, the mining sector and associated industries--and 75 per cent of the Australian economy is growing at one per cent is monetary policy the best tool to curb inflation or are we better off looking at, for example, other alternatives like quantitative easing or perhaps reductions in government expenditure? What are your comments on those? Quantitative easing is an easing of policy--I would expect that to increase inflation. If we look at the 100,000 prices that are in the CPI, aggregated into 100-odd expenditure classes, it is not actually mining that is pushing up most of those things directly. Prices of goods in the latest quarter rose surprisingly strongly, we thought, given the reports we had had about discounting. There may be a seasonality issue in the data there. Utilities prices are rising strongly. I think that is testimony to not enough investment in the network capacity and so on over a very long period of time. That is a supply side constraint that has to be addressed with higher revenues for the producers, so the administered prices are rising. So I do not actually accept that all the inflation is in fact coming just out of mining. It is true that a lot of the growth and output comes from mining and all the parts of the economy that feed into it; it is not just mining itself. But what I think we do have, on our best estimates of abstracting from special factors and so on, is a bit more broad-based rise in prices. At least, it stopped falling and it looks as if it may be just starting to edge higher. I do not think that per se is directly just the mining stuff. Were it not for the high exchange rate, I think we would have more of this. Phil, do you want to add to that? Yes. I think the underlying inflation pressures in the economy are really coming from this combination of relatively weak productivity growth and around average wage growth. That means that unit cost growth since the mid-2000s has been quite high. That has not led to a rising trend in inflation but it has led to fairly high inflation. It has been offset to some extent by the decline in manufactured prices. If you look at the CPI at the moment, the prices of many manufactured goods are lower than they were 10 years ago. That is the benefit of the high exchange rate, but the range of domestic services have been rising pretty solidly, and not just directly because of the mining sector but because of the growth in unit costs. That pressure, at least at the moment, does not seem to have gone away. Governor, I want to start if I may on the issue of inequality. You have written a lot about the impact of the mining boom: that quadrupling of commodity prices on the broader economy. But I suspect it is also likely that the mining boom has increased the gap between rich and poor in Australia. It is a trend we have seen for the last couple of decades. For example, Jeff Borland's paper at your conference last week showed that wage growth for the top quintile of the distribution had been twice as fast as for the bottom quintile over the past decade. Obviously inequality means a larger share of Australian incomes are going to a smaller number of people, so I guess my question for a monetary policy maker is: do you aim with monetary policy to target the average dollar in Australia or the average person? We aim to contain the growth in the CPI at between two and three per cent. That is supposed to be a reasonably representative index of cost of living, although there are other indexes, as you would know, that are more tailored to particular groups. But that is what we are trying to do; we are trying to preserve the purchasing power of money, and not particularly the purchasing power of the money of the richest or the poorest but the total. But you also have other aspects to your mandates around growth and full employment. Wouldn't those suggest that you should be placing some weight on the impact on the average person rather than just the average dollar in the economy? Yes, we have in our statutory objectives full employment, stability of the currency and the general prosperity and welfare of the Australian people. Over the past year or so the unemployment rate has been five, plus or minus a tenth basically. I think, by the standards of the nearly 32 years that I have been working as a professional economist, that is a low number. Indeed, when I started at the Reserve Bank, the notion that you could have five-ish per cent unemployment and two-ish or three-ish per cent inflation was a dream in those days. My answer to the full employment question would be: I think the Reserve Bank has fulfilled that side of its mandate, recognising of course that a sustainable unemployment rate ultimately is a function of industrial relations matters, not monetary policy. Let me move to another issue. On the carbon price, inflationary expectations obviously matter. You have spoken here and in the recent statement on monetary policy about your expectations as to what the actual price effect of a carbon price will be on 1 July next year--0.7 per cent on the CPI and a quarter of a per cent on inflation for the 2012 year. But a number of pretty influential commentators--Peter Martin, Ross Gittins and Bill Evans--have suggested that the scare campaign that has been run around Australia in recent months has seen Australians' expectations about that price effect become completely out of whack with what Treasury and the RBA are predicting. For example, suggestions that towns will be wiped off the map and that petrol prices will rise are all presumably pretty unhelpful to the management of inflation expectations. What does the Reserve Bank do in instances where people are claiming that inflationary impacts will be different from what you believe they will What we do not do is get into political debates over particular policies. What we do is keep focused on articulating our expectations and also monitoring actual measures of inflation expectations, which I think at the moment have probably, just in the last month or two, come down a little bit. I think at this point we are probably okay there. Ultimately people will see what the effect is and then it will be clear. It is only another year or so. Are you concerned if inflationary expectations about a particular policy change are different from what you believe they will be? If it was a very big difference that was clearly having an effect on other price setting and wage setting, I think that would be a matter of concern. I have not seen evidence that is occurring at the present time. How would you react if you were to see that evidence? It is hypothetical, isn't it. We have to keep stating what the facts are or what the best estimates are. We have to keep behaving ourselves consistently with our stated objectives and try to convey to those of the community who read what we say a reasoned estimate of these matters. But that is all we can do. On the measurement of inflation, there has been an argument recently that the ABS's fairly infrequent rebasing of the CPI has led to an upward bias in the CPI, maybe in the order of half a percentage point. Are you concerned about that? Are you tending to use, say, the household implicit deflator rather than the CPI because of that? We are not doing the latter. Perhaps I will get Phil to talk to the technical aspects of the frequency of updating. At the moment, the ABS does a survey once every six years to work out exactly what we are spending, what goods and services we are buying. So the weights get changed once every six years. I think the analysis that various people have done suggests that the fact that they only do that weighting once every six years does lead to a slight upward bias in the CPI, particularly towards the end of that six-year period, because what happens over time is that we all substitute towards the goods that are slightly cheaper and away from the goods that are fairly expensive, so the true costs that we are actually paying for goods and services are not rising quite as quickly as the CPI. But the effect is fairly small. In most of the estimates I have seen, it is around 0.1 of one per cent. The ABS in its most recent review says it would like to move to four-yearly reweighting. Then they would have to do a survey every four years of the population about what we are actually buying. That requires extra money. I think they are still seeking budgetary approval to do that. I think if we could go back to once every four years that would be a good thing to do, because that would allow them to capture the substitution towards cheaper goods that we all do from year to year. None of that really undermines the credibility of the CPI, though. This effect is there, but it is fairly small in the overall scheme of things. Governor, there have been a number of statements that you and others have made about the importance of pay being strongly related to productivity outcomes in the economy. In a context in which there has been some public comment on the salaries of Reserve Bank officials, this might be a useful opportunity for you to comment on your views on some of that commentary, changes in Reserve Bank salaries and the relativities to other central banks. I am not sure I can help much there. I do not set my own pay. The board set it. They had quite a lengthy process of reviewing it after the system had been in place for many years. They took their decision, and I take what I am given, like anyone else in the country. I am not able to give you the whys and wherefores of whether that was an appropriate decision. I did not take it. I had no involvement in it. At our last meeting, you expressed some uncertainty as to what was driving the consumer caution in the economy at the moment. Do you have more views as to what is going on? Are there new things that have clarified your thinking around that issue? From my own views, the most complete treatment I could offer is the Anika Foundation speech of a few weeks back, which tried to set out a number of the things we have been talking about here today in a historical setting. Just to reiterate the remarks I made at the beginning, we had a long period in which growth of spending exceeded growth of income every year on average by about a percentage point. So, if you drew the two lines of income and spending, spending was catching up. Saving fell, leverage increased, housing prices rose, wealth rose. Why did that occur? I think the best explanation is that we had a number of factors--you had financial liberalisation; you had Australian banks coming out of the early nineties recession with a few bruises from lending to corporates, but there were the households, undergeared really, by international standards anyway. You had a big decline in nominal interest rates because inflation went from an average of eight percent to an average of two or three. Nominal interest rates came down in parallel. The average level of nominal interest rates has been roughly half what it was in the high-inflation period. So banks are looking for customers to lend to, there are customers who have not had much gearing, partly because the high-inflation, high-interest rate period suppresses it, and then that is removed. Then there is a period of international economic stability, the so-called great moderation. That is now gone of course, but from probably the mid-90s through to the mid-part of this decade, at least, that was by all estimates of volatility a remarkably benign period for economic activity. There was low inflation, positive supply-side surprises and so on. That is a perfect environment for people to think it is sensible to have more debt: 'I can afford it, the bank wants to give it to me and so on.' There is nothing especially wrong with that, but when income and consumption do this sooner or later they are going to go back to parallel, which is roughly what they have done--actually they have diverged a little. As I said in the Anika Foundation talk, a trend of diverging income and consumption is not any more sustainable than the preceding trend. At some point it will give way to something different, but I do not know when. I think we can appeal of course to proximate things at the moment, be they debates about carbon, international turmoil, whatever. No doubt those things have their impacts, but the point I was trying to make in that talk is that this long, low-frequency thing has occurred. It is sort of superimposed on the short-run stuff, and it is superimposed on the resource boom as well. Those things are combining, but they have kind of come from different sources. As it happens, they are both in play at the moment. That, I suppose, is the longwinded answer to your question. That is very helpful, thank you. Just to make you earn your coffee, some high-school students are going to ask some questions. I am from Eltham College. How do you prioritise the economic goals other than inflation when considering changes in monetary policy stance? This goes a little to the issues Mr Ciobo was raising earlier. We have a statutory goal of full employment, which is not defined in terms of numbers of unemployed, so there is an issue: we have to work out what that means numerically. There is also stable prices--we have to put a number on that too. Those two things can in a sense be in conflict over short periods, but in the long run they are not actually in conflict. I would say that one of the main insights of macroeconomics in the period I have been following it is that the sustainable unemployment rate is ultimately determined by the set of systems in the labour market. Monetary policy can make it go away from that for a while, but not permanently. In the medium term and the long run, inflation is largely a monetary thing so provided our definition of full employment is consistent with what the real economy is telling us there is no inherent conflict between the two goals. Where there can be temporary difficulties is where you get a so-called adverse supply shock that pushes inflation up and activity down, in some countries that is what is happening now, but that is difficult. We have to take a reasonable and balanced path between the two when that occurs. I think that is as good as I can do on that. Thank you for the question. I am from Trinity Grammar School. Mr Stephens, with a two-speed economy and the likelihood of a bout of Dutch disease, isn't monetary policy too blunt a tool to manage the Australian economy? So shouldn't the RBA just keep the rates neutral and let supply-side policy do the work? Well, there are multiple speeds in the economy. That is actually always true. It is probably a bit more true now than on average. In the end, though, it is the central bank's job to try to preserve the value of money and promote financial stability. Supply-side policies can certainly help that or hinder it, depending on how they are operated, but we have to take supply-side policies as given and do our job of containing inflation pressure while taking account of the impact on the real economy. As I said earlier, right now the unemployment rate is around five, where it has been for a while; the inflation rate is a bit troubling but not out of control. I think from that overall point of view we are travelling okay. The differences in regions and industries are actually not things that monetary policy can fix. If they have to be fixed, that will need to be done by other arms of policy. Thanks very much. Thank you very much. Governor, I thought the student from Trinity had a very good question before. So I am going to ask the obvious question. Do you believe that Australia is suffering from Dutch disease? What is Dutch disease? I think that is a phenomenon where a rise in natural resource prices leads to a larger rise in the exchange rate, squeezes other sectors, and that is all temporary, and then you reverse. I think that is generally the definition. So the real question is: is what we are seeing temporary or persistent? We do not know, of course, and I have spoken about this at length a number of times publicly. If we are seeing just a temporary huge surge in the terms of trade and it is all going to collapse back to the 20th century trend, which is a long way lower than here--we are about 80 per cent above that trend at the moment--but if you knew that was going to occur then you would not restructure the economy in response to the shift in relative prices, or at least not much because it is costly to restructure and then it would be costly to restructure back. If it is permanent, if relative prices stay permanently altered in a significant way from where they used to be then we will get restructuring. We cannot actually stop it, I do not think. What we have to do is facilitate it and adapt to it and ease the transition. Is it Dutch disease? I am not sure that it qualifies for that. Treasury had a very good piece on this in the budget papers. I am not sure if you saw that, but that is actually well worth a read. If we are suffering from Dutch disease, are the areas to focus on fiscal policy or monetary Monetary policy cannot stop a phenomenon of structural change occurring. I do not know that fiscal policy can either, actually. My point is that if this really is a very persistent change in global relative prices, global structure, then we will be adjusting one way or another and we need to find ways of doing that that ease the difficulties for those who are getting smaller, obviously, and that goes to a whole bunch of things which probably do cost some public money. But I do not think fiscal policy per se can somehow make this adjustment go away. Before in your testimony you mentioned the need for government to pursue reforms to drive productivity. Can you enlighten the committee again on your views on what we should focus on in terms of productivity? Have any areas become clearer to you since the last time you provided testimony here? The problem, of course, with me saying productivity is important is people then say, 'Well, right, what should we do?' That is obviously the question. The best thing I can say in response is there is a body who spends all its time thinking about productivity, namely, the Productivity Commission, and their list of things is quite long: competition; efficient pricing of utilities and infrastructure--roads, rail, ports, water, energy; reducing inefficient regulation of major resource projects; zoning and planning restrictions; harmonising consumer, industrial and building codes; reducing barriers to entry; improving competition in a range of industries, including various professions; harmonising licensing fees--and so on it goes. I cannot do any better than say that there is a body that the taxpayer pays to think about this stuff all the time. They are going to be much better equipped than me to point their finger at specific things that can be done. None of those things are easy to do, of course, and they take time. And a lot of them require state-federal cooperation. Focusing purely on financial system stability, are there policy matters which you believe Australia should have been addressing since the last financial crisis to better position for this one, or I think you described it more as a 'lag' today? Are there policy measures in the financial stability area? I think that perhaps I could try to answer that by talking about what is actually going on. In this sphere there is, as you would know, a lot of international work. The thrust of that is more capital--particularly for the large global banks that were very highly leveraged and undercapitalised--and better quality capital. So there is the whole Basel 3 thing, and Australia will implement Basel 3. We have one or two unique challenges in implementing it but they will be met. There is a range of work surrounding what I suppose you could describe as increasing the strength of financial infrastructure to do with clearing of derivatives and those kinds of things. Those also pose challenges for Australia and there is a work stream underway there under the auspices of the Council of Financial Regulators. That is actually quite a difficult issue for Australia because, without wanting to go into great detail, there is the issue of whether we ought to mandate central clearing of certain instruments onshore so that they do not drift offshore--or not. It is quite important, and there is a consultation paper out at the moment on that matter and the council has to form a judgment on that. So those things are all being done. Is there more that we should be doing? I think that the fundamentals ultimately matter most. We want good prudential supervision, and I think it is very important that the government fully and properly resource APRA to do that. We also want effective oversight of various markets, and ASIC comes in at that point. We want overall financial stability, which we feel is our obligation even though it is a bit hard to define what stability means other than by you know it when it is not there. But all those things mattered greatly in the crisis, and were there to be another crisis they would matter again. I would say that in a number of respects we are probably better placed now than we were three years ago. If we take the reliance of banks on offshore wholesale funding, they still have some but it is much reduced. In fact, they could probably cope with the closure of those markets for a period of time--that has not happened, but if it did. Banks are pretty well capitalised. The consumer balance sheets, as I said earlier, are coming into better shape too. There is a number of ways in which, while we do not want to say that nothing would bother us, I think that perhaps we have a stronger position than we had a few years back. That is an interesting perspective. You have talked about governance, so I might as well go to those questions now. I know that in previous testimony my colleague Steven Ciobo asked some questions regarding Securency and Note Printing Australia over the last two hearings. You have provided testimony to this committee that the first time that the RBA became aware of bribery allegations in relation to the agents of Securency was around May 2009. Is that a fair-- That is what I said and that is correct, yes. At the time that they were made public in the media--in the article in the that was related to it--I understand that was the point when you involved the police? I am just trying to understand; if there were allegations regarding Note Printing Australia, which was a sister subsidiary to Securency, and those allegations were made in May 2007, is it correct to say that there was a board paper presented to the board in relation to Note Printing Australia at that time? Do you recall, Ric? There was a board paper at the NPA board in early 2007 that reviewed, as I understand it, the implementation of stronger policies surrounding agents that they had adopted in the preceding year. The board had a process of quizzing the management, 'How are we going with this?' and giving them a bit of a hurry along, I think. Is that correct? Yes. The background here is that, after the Cole royal commission, like many organisations the Reserve Bank board said: 'Well, you've got these subsidiaries that are using agents. What do we know about the policies that govern that use of agents?' They asked questions of the NPA board on those policies. Remember that NPA is a separate organisation from the Reserve Bank and the responsibility for managing NPA rests purely with the NPA board. So they asked the NPA board and the NPA board in turn set in train a process of reviewing the policies and strengthening the policies. That process was completed in around July, I think, 2006. By that stage the company had a new set of policies and the question was implementing those policies. By early 2007, the board of NPA were becoming frustrated that management had not implemented the policies yet, so they were pushing management to do it. They asked management for a status report of where things were up to, and that was discussed at the NPA board meeting in May that year. So nothing was sent to the RBA board at that point? There was no information provided? No. The RBA board, having asked the questions about the policies, were given the policies in the middle of 2006, and basically they accepted those policies as being sound policies. The problem was the implementation. So, as a result of that meeting in May, the board of NPA said that there were issues about bad business practices in relation to the agents and things like that, so they took some fairly hard decisions. They said, 'Look, we want to stop the use of agents.' Didn't the NPA sack all of the agents at that point? Yes, they stopped the use of agents. At the same time they commissioned an audit of what had been going on with the use of agents. That audit started more or less immediately. The audit was completed around early June 2007. The audit made a number of recommendations, which basically said, 'Stop using agents,' and said that the NPA board should undertake an investigation to make sure that no Australian laws had been breached. Just so I am clear on this point: even though NPA--which is, as I understand it, a 100 per cent subsidiary of the RBA--had sacked all of its agents, that was not made known to the RBA board? Yes, it was. It was. At that point, did the board ask questions? Yes. The main problem with the agents was that there were very--I would say--not sound business practices around the way those agents were being controlled. This goes back. The board of NPA had been disappointed with the management of NPA in a number of respects in terms of business controls relating to security and a number of issues like that, so there had been a sort of ongoing disappointment there with the management. This all came to a head in the middle of 2007, where I think the board of NPA said, 'Look, we don't think it's worth continuing with this model,' and they stopped the use of agents. The business was refocused onto mainly supplying Australian banknotes and continuing to look after any existing overseas customers, because there are quite a number of customers now who use NPA to print their money. The whole business was restructured then. In terms of that investigation, the board had to commission Freehills to do that-- The NPA board. They commissioned Freehills. They had a look at it. The investigation concluded that there was no evidence of any Australian laws being broken, and the NPA board at that point drew a line under it. I have two follow-up questions in relation to what you have just mentioned. The first is: why, after sacking the agents--obviously there was serious concern to sack agents--were the police not contacted at that point? There was no basis to. This was an investigation that was started by the NPA board as part of an ongoing control around the way the business was being run. They pursued that to its logical conclusion. You would have to accept that it is a very serious matter for any organisation to call in the police to have its staff investigated. My guess is that most organisations would not do that without-- It is very serious to sack them as well, isn't it? To sack the agents? It is very serious, but that is something that companies do. They do terminate contracts. I think the board asked all the right questions, sought all the professional advice it could and acted on that advice. My final question on this is: if there was a restructure, obviously the business model there was flawed given that Securency operated under the same business model and shared the same chairman, so why was that not also restructured immediately? That is a good question. When we had the audit done of NPA, the question arose because we knew that Securency was also using agents. So an audit was done of Securency's use of agents as well. That showed a very different picture. That audit came back as a very sound audit with very few findings. In fact the conclusion--I forget the exact words--basically said the company had very sound business practices and policies. On that basis there was really no basis to discontinue the use of agents there. Remember that the RBA does not control Securency. For a decision to be taken to stop the use of agents, it would require the unanimous decision of the board, of which the RBA only had half. So there was really no basis for the board of Securency to stop the use of agents. At that stage, the agents that had been causing concern had been terminated at Securency as well. They were terminated at the same time from Note Printing Australia and Securency? Yes, within weeks. It was not simultaneous, but it was within weeks. I would like to continue with some questions about Securency and NPA and what the members of the Reserve Bank board knew at what stage. Was there a meeting of the board of NPA in May 2007? On the board of NPA were members of the Reserve Bank board at the time? No members of the Reserve Bank board. That is right. He was not on the Reserve Bank board at the time? No. Graeme Thompson at that point had nothing to do with the Reserve Bank. So there was no overlap between the boards of NPA, Securency and the RBA? Let me give you list of people on the board. The board of NPA at that time was: Thompson as The board of Securency was: Graeme Thompson, Les Austin and the managing director of NPA, which was Ogilvy. Who was on the board of the RBA at the time? None of those people were. So there was overlap between the boards of NPA and Securency? They also shared an agent at that time, Mr Abdul Kayum? Mr Kayum is currently on trial? The NPA, at its May meeting, received a report? That is right. It has been suggested in the newspaper, since the last meeting of this committee, that that report said that at least one agent had admitted to bribery, at least one agent had demanded 'under the table' secret commissions, at least one agent had demanded excessive payments and that payments were being made to thirdparty accounts. Is that an accurate summary of what was in that report? I cannot recall. A range of issues were raised in there. Allegations had been made by one of the staff members that the agents had said certain things. The agents denied those. One of the agents had sought to mislead one of the central banks overseas about the exact size of his agency fee. There were a number of issues like that. After receiving that report, did Note Printing Australia call the police? Were any members of the Reserve Bank board at the time made aware of either the details or the essence of that report? I go back to the situation I discussed in response to Ms O'Dwyer's comments. As I said, the NPA board had started its investigations. That investigation was about poor business practices. There were a number of allegations about various agents. But the basis of the decisions taken by the NPA board in May 2007, as I understand it, was really dissatisfaction about the whole way in which the model was being run. They just decided to change the model. newspaper summarises it and it puts it at a higher level and suggests that there might have been in that report, prima facie, evidence of illegal conduct by an agent of a subsidiary. If that were right, do you think they should have called the police? This is where the audit recommended that the situation be investigated by the NPA board. That is what the NPA did. They hired a very sound legal firm to carry out that investigation. That firm concluded, having investigated everything, that there was no evidence of any breach of Australian law. Was that reported back to the RBA board at any stage? When was it reported back? That would have been reported back to the RBA board, I think, in early July, at the July 2007 meeting. The board were briefed on the results of the audit and they were told that an investigation had commenced. At the next meeting they were briefed on the results of the investigation. When was the next meeting after the July meeting? So, by August, the RBA board had been given the Freehills's report and the RBA audit report? The RBA board were briefed on the outcomes of both those. As far as I am aware, they were not given copies of those reports. At some point while all this was happening Note Printing Australia sacked its agents? That is right. That included the agent who was common to both NPA and Securency? Given that, did the RBA board ask whether Securency had also sacked that agent? I cannot recall, but basically they would have been told that an audit was also being undertaken of Securency's use of agents. During 2007, did Securency take any actions to change its practices? No, because, as I say, the audit showed that Securency had very good policies. In fact, even when we had KPMG come in and do a very forensic audit of the company which lasted for six months--it was very intensive--after the allegations were raised in 2009, they reached a similar conclusion: that the policies of the company were very sound. Were KPMG given the RBA audit or the Freehills report? KPMG had all the information that was available. Including those two documents? That was 2009. Coming back to 2007, though, when the RBA board knew that there was at least one agent common to both of the subsidiaries and that one of the subsidiaries had sacked all its agents--but the RBA board presumably knew that the other one, as I understand it, had not made any changes--did you ask Securency or make inquiries of Securency during the course of 2007 or 2008 or before the allegations were made in the newspaper? Did you ask any questions about Securency's ongoing use of this agent? I do not think the RBA board knew that there were some agents in common. I do not think that would have been an issue that they would have been across. That was a matter for the companies. Wouldn't the audit have shown that? As I say, the audit reports did not go to the RBA board. Moving ahead to 2009, after the reports in the paper, you said the RBA board commissioned The Securency board commissioned KPMG, as they should. At what stage did Securency make any changes to its agency network following the revelations in the media in 2009? It was around late 2009. At that point the KPMG audit investigation was still continuing, but they brought to the attention of the Securency board some information which they felt showed that the management had not been honest with the board and had been withholding information from the board. At that point the board of Securency terminated or suspended the management and suspended the use of agents. Are those reports--the RBA audit and the Freehills report--public documents? Does the RBA have any intention of making those documents public? All that information has been given to the police. The police have had those for a long time. They have been through it. These are matters before the courts, and I think that is the proper thing to have done. When were those documents given to the police? When they asked for them. As soon as they asked. They were told of their existence as soon as the allegations about Securency were raised in early 2009, and as soon as the police asked for those documents they were given them. The police themselves have said on a number of occasions how the Reserve Bank and the two companies have cooperated fully with this investigation. There has never been any hint that the companies or the Reserve Bank have withheld any information from the police. Were any of the people who were board members of Securency or NPA at any time, either before or after, also board members of the RBA? Yes. Dick Warburton was a member of the RBA board. I do not have-- He retired from the Reserve Bank board long before these events. Could I just add to that that Graeme Thompson at one point, when he was Deputy Governor of the Reserve Bank, would have been a member of the RBA board, as well. Looking back on it now, knowing that there was such a high degree of overlap between Note Printing and Securency, including the use of a common agent and a common chair of both boards, and that the RBA fully owned one and half-owned the other, do you think it was appropriate that from 2007, whilst one company sacked its agents, the other one continued on with business as usual for a period of years? You have got to look at what information was available to the two boards. In one case you had the Freehills work, who said that there are serious problems with business practices here but no illegality, so that board fixed that problem. And, as Ric said, there were many issues in NPA at that time that had nothing to do with foreign agents but were to do with their conduct and their performance as a printer for us. This was in a context of a wide-ranging refocusing of that company. As you say, it is true that the other board had a common chairman. They also had the same group of auditors who had been to NPA go to Securency looking for the same issues and they came back with a completely different story. As Ric said, we know now certain information that should have been available to that audit and indeed to the Securency board was not available. Possibly that audit would have found a different conclusion had they had that, but they did not. So that audit came back with that finding. I think the two boards acted reasonably on the information they had and the advice they received. That is really the story of why the agents finished in 2007 in NPA but, in the other case, not until more information became available. I think there was only one common agent, wasn't there? Actually, that was contrary to NPA's policies. That was actually a problem and that was part of the background to him being removed. There is the sequence of processes that generated information, the response to that, the getting of advice--the advice had two bits in NPA: 'There is a problem here. There is not illegality here.' So they fixed this problem. Then, with Securency, of course the same auditors go and the Reserve Bank actually pressed for that to occur. Obviously, the answer was completely different. I do not think the board of Securency at that time had a logical basis on which to say, 'Right, we are going to sack all the agents.' Information changed later, of course. Thank you for your openness on that. Earlier you were asked about Dutch disease. I come from a region in the Illawarra that includes BlueScope, one of its largest employers. This week 1,000 workers from that plant were advised they no longer had a job. That adds to similar announcements by OneSteel and other manufacturers of job losses in the thousands. I do not really need to contemplate too much about whether regions like mine have the Dutch disease. We have seen the hollowing out of manufacturing at a pace we have not seen before. The question I have for each or any of you is: in its monetary policy setting, what consideration is the RBA giving on the impact of monetary policy on regional economies like mine and on industries such as manufacturing? I say that noting some of the comments from the August board meeting and the comments that you made today. I am not sure that you will find my answer terribly satisfying but I think these issues of structural adjustment--that is a mealy mouthed term isn't it--are difficult. Some parts of the economy will shrink while others grow. I wish I could say that we had a way of avoiding that. I do not think we do. I do not think monetary policy can stop that occurring. I think what we have to do is try to gauge the overall amount of spare capacity in the economy in total and that is very important in our assessment of the stance of policy and work from there. We are certainly conscious that the exchange rate in this episode is giving more of the tightening than it has done in some other episodes. I believe we have done our very best to account for those impacts on the overall economy. We do not have an instrument that can prevent these shifts in the structure of the economy from occurring. I am sorry but I think that is just the reality. The issue of the exchange rates has been a matter of some discussion over recent weeks. I invite you to comment on it. In the August statement on monetary policy you had usefully included at page 29 a table which charts the movements in the US dollar against selected currencies. In the table we see that over the last 12 months the Australian dollar has appreciated 15 per cent against the US dollar. That is not an adjustment, that is a shock, particularly for the manufacturing sector which often runs on very narrow margins. It is not just manufacturing, tourism and education services are affected as well. I note in the same table that the Chinese currency has only appreciated by five per cent over that period. That seems to be out of step with all known reality when you look at the growth rate of the Chinese economy and the capital flows. What should policymakers be doing here in Australia about what seems to be a lack of credibility in the setting of the Chinese currency and the impact that that is having for businesses here in Australia? That is a good question. It is a question being asked around the world. In my opinion on any objective gauge the Chinese currency should be higher today than it is. They are still doing quite a bit of intervention. It is coming up some. I think it would be beneficial to the global economy and indeed beneficial to the Chinese people for there to be more flexibility in that price. There is no shortage of people telling the Chinese authorities that and in private discussions that we have that issue gets raised. Unfortunately, it gets surrounded by the whole US China relationship issue. The megaphones come out, there is a bit of shouting to and fro and actually that is not all that productive. It is a significant distortion in the global system and it is actually giving rise to, I think, another significant imbalance which is that China--and, indeed, Asia generally--have very large quantities of official foreign assets and they are overweight in dollars. This is an imbalance that will be a problem for the global economy in the years ahead. What can we do about it? We can make the comments I have just made, and no doubt they will be publicly reported, but what would really make the difference is a long-run engagement with the Chinese side on why it is actually in their interests to be more flexible. That is a government decision. My assessment is that the central bank there would do more on this immediately if it were their call, but it is not: exchange rate regimes are a government decision. I think that is what we can do, but that of course promises no early solution to what is continuing to be a growing structural problem in the global economy. With all my colleagues around the world this is a very common topic of discussion, but to date it has proven difficult to make a lot of progress. These are not disassociated questions. If we are seeing a very rapid economic restructuring occurring here in Australia, at least in part because of an artificial advantage that one country gains through the suppression of its currency, it poses real questions for domestic policy makers about what we do in response to that. It is an issue of immediate concern, I must say, for me and for the electorate I represent. I can understand that. But what can we do about it? Arguably, interest rates can be a bit lower than otherwise and I would say they are. We have not done intervention in the currency in this recent period. I thought that at $1.10 it was getting a bit ahead of itself, but it has fallen back a bit since then. We have not done intervention because our assessment is that it would be fairly futile in the environment we are facing. There are very big forces at work globally. Changing track for a moment, in response to some questions you were asked earlier about productivity in general--the focus was on labour productivity. You made some anecdotal observations that seemed to me to be out of step with the limited evidence in this area about labour productivity and flexibility. I accept that they were anecdotal observations, but when it comes to flexibility we know that, at least in relation to hours of work, the Australian workforce has shown enormous flexibility over the last decade and that there is no credible evidence to suggest that industrial instruments over successive periods of industrial regulation have been an inhibition on flexibility around hours at work. We are working more hours in Australia and than just about any other country in the OECD at a time when industrial instruments largely regulate we work 38 hours per week. I was asked about what people had said to me. I think that was the question that came, and that is what a number of people have said to me. I would be the first to say that I do not have a rigorous study which can quantify whether that is material or not. I am relaying what a number of people have said. I still do make the point, and make it with the greatest respect, that when the Governor of the Reserve Bank repeats an observation that has been made to him it gains a little more currency and credibility than it might if a simple Labor Party backbencher made the same observation. This is a concern that a number of people have raised. It is not illegitimate of them to feel that they should raise it. They might be wrong in their assessment of the system, but I think there are people who feel that. If they are wrong, then it would be good to get the heads together and show how the system is actually very flexible, because I think there are people whose instinct is that it has gone back the other way. On the productivity question, I believe insufficient attention is given, perhaps even in relation to our monetary policy, to capital accumulation and investment in plant and equipment. You read through the Productivity Commission's list of obstacles to productivity growth in this country, and certainly in the sectors that I have cited, where I believe there are significant issues in manufacturing in particular, it is the rate of capital accumulation, investment in plant and equipment and technology, which is the biggest brake on productivity growth, not labour factors. And monetary policy does have a direct impact, a direct bearing, in that area. Actually, on the available figures, the country's capital stock--the stock of equipment, structures and so on--has been rising quite quickly over recent years. Indeed, when people compute the multifactor productivity they are taking into account the amount of capital as well as the hours of labour. I suppose the arithmetic is showing that apparently there has been a substantial rise in the capital stock, with--as yet, at least-- marginal output growth coming from that, not at the same pace that it once might have been. Perhaps that is a temporary thing, at least in some areas, but I do not actually think it is true that there has not been much investment. I think in fact there is quite a bit going on. That is what the figures show. Shifting again, I want to briefly ask for your observation in the area of housing. It is impressed upon me, certainly in some of the regional areas that I speak to and in capital cities, in the suburbs around Sydney, that there is a shortage of housing and a lack of new housing starts. I am wondering whether this is a matter that the RBA is taking into consideration in its monetary policy and whether you believe that the current lack of activity in the sector is going to lead to another unhealthy asset price bubble in three to four years time. I think that this question of--as best one can tell--not enough addition to the dwelling stock for population, even though population has slowed down, and why that is, is a very important question. I do not have a kind of easy answer to it, but I think there is still in the banks a certain tightness of availability of credit. I think that is tending to ease a little bit, but there is a long way to go there yet. The rental returns on the rental stock I suspect have actually been lower than really needed, because people were getting part of their return through capital gain, so the rental yield can be low, but I do not think we can keep having indefinite capital gain. To get the return, you actually need the rental yield to offer the investor a return, and that is coming up gradually. I am sure I have said this before; I am not an expert in these matters. How is it that a country of our size--we are not short of land--cannot add to the dwelling stock for the marginal new entrant more cheaply than we seem to be able to do? I cannot get past that basic question. But--without denying that interest rates have an effect on the housing market, obviously--it seems to me that this goes to a whole group of things on supply, zoning, transportation, infrastructure et cetera. I think Phil would probably say, without putting too many words in his mouth, that better transportation could in a sense increase the amount of well-located land--that is, land you can live on and from where you can get to and from your job quickly. I think these are very important questions. I do not consider myself an expert in them and I had better stop offering too much opinion here lest I say something wrong. But they are very important and they have a very important social dimension. There is a very big inequality between generations that is building up. I think that is a social problem as much as an economic one. A concern, Governor, is that decisions that are not being made now are going to have an impact in three to four years time, exactly as you have identified. I have an inflation question. Headline inflation is outside our range and underlying inflation is towards the top end of it. If I could just draw your comments back to something that you said during one of your answers about the limited impact of the mining sector on inflation and get you to expand on that. What inflationary pressures does the mining sector have on the economy at the moment? Let me see if I can articulate. The shock to the mining sector is expansionary for the economy. Incomes rise. They demand more inputs--goods and services and so on. That adds to it. The investment build-up also adds. So in general demand increases and the economy has to supply at least some of that demand. My point earlier was that I do not think you can pull apart the CPI and say, 'There are a couple of bits here that are just mining and that is all there is.' I do not think that is the case. One of the channels people do worry about is: will the tug of labour into the resource sector push up aggregate wages? I do not think it is doing that at this point. Our discussions with business do not point to widespread difficulty in attracting labour the way they did in 2008. At the moment I do not think that is proving to be a problem, but of course the mineral boom has a way to go yet. To come back to Phil's point from earlier, productivity data are difficult to measure and you have to be careful using them and so on, but as best one can see the unit costs have been rising pretty smartly over the past five years or so, much of the time. They dipped very deeply during the international crisis. Productivity has been weaker and costs are coming and they are fairly widespread. They are not directly mechanically attributable to the resource boom. The resource boom, all other things being equal, does add to income and demand in the economy compared with the alternative situation. Then you have got things that work against that. The exchange rate goes up, which leans into the expansionary impetus. These things automatically occur and the ultimate question is: what is ultimately the net effect? What about being more specific within the mining sector--the one in 100 year capital expenditure line item of the industry? It is very large. Typically, resource sector investment was running at between one and two per cent of GDP. It will be six per cent, we think, at the peak in another year or two. That is a very big change. Some other sectors have softened a bit, but overall investment in the economy in the business world is pretty solid. What impact does that have? There is a debate at the moment about how much of that gets supplied from onshore versus imported. Certainly there is a significant import component. When we import things that does not create inflation for us; that is alleviating inflation. But there will be a reasonable spin-off of these things around the rest of the economy, I think, and that is part of our general outlook. If what we have written down turns out to be right--and they are only forecasts, and forecasts are not very good; no-one's are--what they say is that growth will be at trend, not now but out into the future, and there will be a bit of pressure on overall inflation. That is the forecast we wrote down in early August. As I said earlier, one of the issues is the extent to which the events that have been occurring in recent weeks dampen demand pressures over time. We cannot know yet, but that is one of the things we have to keep an eye on. You say that you take the opportunity to look through certain situations--the cyclones. What do you determine? What are the points that help you determine whether or not you are going to look through a particular situation? It is whether it is a one-time identifiable thing which, in that case, will actually reverse within a matter of months. So it would be pointless, really-- Wouldn't the construction phase in the resources sector follow the same graphic or Not within a matter of months; it is going to run for years, and that is the point. I come from an electorate where, in the Grantham and Murphys Creek area, we will be cleaning up for years. Which actually adds to demand, in fact. Unemployment up in that region is pretty low, isn't it? Yes. Now that we are talking about my electorate--I do not know how we got there, but it never seems to elude this question time--my electorate does not have any linkages into the resource sector, so I am in that 75 per cent of Australians that are hitting that one per cent growth rate. What do you suggest I say to my businesses, particularly in the retail sector, that are telling me that this is the worst environment that they have had to trade in? Some of those businesses are generational. I cannot give you easy solutions to those questions. My point, I think, would be that we went through earlier what the spillovers around the community are from the resource story. They are there. People cannot see them directly. That is quite understandable, because some of them are quite opaque, but they are there. In the end, if the unemployment rate in the electorate is, as I think it is, three or four per cent, that is not so bad, is it? Ultimately the question is whether we have most people in a job at a sustainable inflation rate. That is what we are seeking to achieve. On the periphery of my electorate, on the Gold Coast, I have huge issues on retail, construction and tourism, and none of those rates that you mentioned earlier on fall anywhere within the national average. Absolutely. South-East Queensland has significant issues. They are partly exchange rate issues; that is absolutely so. They are also, I think, the outworking of the earlier period of property booms and busts; I think that is quite a big feature. I think that, in the story of some of the lower lending standards and so on, it is like western Sydney was a few years back; it is also like some areas of Perth are. That is a function of a period of very great optimism, rising property values and rising debt which then, as we know, usually gives way to things turning down for a while. I sympathise with that. I have a number of regular correspondents from the Gold Coast. Mr Ciobo is not one of them; he is rather more polite. So I am aware of that. As I say, I think some of these things are to do with these other forces in the financial cycle. The talk I gave in Brisbane some months back tried to grapple with that. What comfort can I give to my mums and dads? Your data shows that they have got increased household savings. However, when you quantify that and turn it into a material thing, they are probably a couple of payments ahead on their mortgage but that is little comfort to them when the reality of the market they live in means that they have probably torn up about 30 grand in the value of their property from the downward trajectory of real estate values. I do not know how prices in that particular area per se have moved. In South-East Queensland they have declined; across the country it is variable, though most prices remain a good deal higher than four or five years ago. Actually I would say that the majority of people in the country are ahead on their mortgage. That is a fairly standard fact and some of the major banks quote 60-odd per cent of people have made advance payments. So the stock of savings is rising as a result of that. You mentioned the mums and dads. Well, the grandmums and dads want us to preserve the value of their savings, don't they? I don't deal with them just yet! Well, they're there. I'm more to do with the mortgage punters. Exactly, and fair enough. But 35 per cent of people in the country have a mortgage; 65 per cent do not, of which slightly more than half have paid off, and the other half rent and they would like to have a mortgage if the prices of houses were a bit lower. There are varying groups here. With all compassion towards people with a mortgage, there are also people with savings and people who would like to have a mortgage. Can I change the topic to an old hobbyhorse of mine, and it is not Securency. It is the issue of three-party and four-party schemes and interchange rates. In your capacity as a regulator, can you outline for the committee, given that some time has now elapsed since regulatory changes were made, what has happened in terms of market share between the three- and the four-party schemes? I think in recent times the three-party schemes have gained some market share. A lot of that comes from linking up with some of the banks to issue cards. I think that is probably what is going on there. Some of the concerns that I and others raised at the outset of this was that we would see an erosion of competitiveness by the four-party schemes over the three-party schemes because of, I would suggest, the regulatory imbalance that arose as a consequence of the intervention. If that is the case, and as I understand this matter will be reviewed again next year, are you able to provide the committee with any insight on your thoughts on the matter? It would probably be a bit premature to do so. The Payments System Board certainly is conscious of the comparison and the four-party schemes continually make the point that the three-party ones are not subject to the same intensity of regulation, though I think those schemes have actually voluntarily complied with certain things that the board wanted. I think this ought to be part of a wholesale, ongoing discussion about not only interchange regulation but also surcharging, where, as you know, we have got a review going on at present. Most of the submissions on that have taken the positions that you would expect, given who wrote in. So we will have to come to a position on those matters. That actually does, I think, go to the three versus four party because of the practice of blended surcharging that the three-party schemes tend to try to promote with some of the merchants because it is to their advantage to do so. So those things are under review at the moment. Given we have seen a shift in market share between the three- and four-party schemes, with the benefit of hindsight do you think it was a mistake to have only regulated part of the market? I am not sure I would draw that conclusion. There are not interchange fees in the three-party scheme, so if you are regulating interchange fees there is not one to regulate there. The question, I suppose, ultimately in the end is-- It might not have that name but it is a similar mechanism. I am not sure I should concede it was a mistake. Phil probably knows a lot more about this than I from his previous role, but the board's attitude is that if unintended consequences occur that we can address then we will certainly seek to do so. I am very conscious that I do not want to see the Reserve Bank go down into the role of regulating more and more here. I think that is strategically not the right direction. I think a few simple things that we can hold to for long periods are probably best. Did you want add anything, Phil? Yes. It is a broader comment, really, but a lot of this reform was about the relative incentives for people to use credit cards and debit cards. We have seen very big changes there, partly due I think to the consumer caution that we have talked about--that people do not want to use credit as much as they did before and they are happy to use their debit cards. The relative price of using credit or debit cards has changed as well as a result of those reforms. We no longer get charged when we use a debit card. Some of us used to get charged. The points that we get from using credit cards have declined as well, so there has been a narrowing of the relative price differences. That may be right but the four-party schemes were not necessarily-- They have come down as well. The average charge that the three-party schemes are levying on the merchants has come down, partly because of the surcharging and partly because of the competitive pressures in the system. The rewards that we get from using credit cards have diminished and the cost we pay for using debit cards has gone away. So I think people have partly responded to that and as a result there is more use of debit cards and less of credit cards. That was not an objective of the reform; it was really to get the price signals together so that people would make choices based on underlying costs of providing these things rather than distortions coming out of the interchange system. I think that, broadly speaking, that has worked. I am mindful, Governor, of what you said, and I agree that more regulation is not necessarily the outcome to achieve, for lack of a better term, competitive neutrality. There is the other alternative, which is to take a step back. Are you willing to provide any insight into what your preferred method between those two options would be if competitive neutrality were a guiding factor? I have given a fair bit of thought in the time I have been in this role as to whether it is possible for us to take a step back on interchange and about the condition that we would need to see in order to do that-- and nothing would please me more, in a way, to be honest, because this is incredibly complex stuff and, as I said, I do not want to see us getting into finer and finer levels of regulation. What would we need to see if we were to do that? I think we would need to see some sense that competition within the system, generally speaking, has increased because the payment system board's mandate is efficiency but also competition. If we do not see any competition, that is really how we got into the regulation in the first place. If one could see clear evidence that we have competition between card schemes and between competing payment mechanisms or both, that is at least a precondition about which you could think 'maybe we need to do less intrusive regulation in the future'. Do we see that yet? I am not sure that we see quite enough. We have seen some encouraging things, one of which in my opinion is the development of EFTPOS--that becoming more of a network architecture with perhaps some reforms to their governance and so on. Maybe, just maybe, that can be a serious competitor to scheme debit. And, if we had competition between systems, that I think is certainly a necessary condition that we need to see for us to be thinking we can take our hands off other things. I think if we took our hands off the interchange now the interchange fees would just go back up and we would be back to the situation that Phil has been talking about that we were trying to move away from. They were at least the original intentions of the reforms. So it is a work in progress in that sense. As I say, I think a key issue is: can we see convincing evidence of competition in the system between providers and between mechanisms? I just have a couple of questions. You have already talked about influences on electricity prices here as a lack of investment over probably more than one decade, but in your opening statement in the fourth paragraph you also said that part of the slowing of growth in major countries is also likely to have been caused by the increase in energy prices. Is that a trend we have seen across the world? I meant oil prices. Oil prices went up quite steeply in the first half of the year, and that typically, in countries like America or Europe, and even in Australia, acts kind of like a tax on consumers, so their discretionary income for other things is reduced. That is one of the things to which people appeal for the growth slowing in the major countries in the June quarter--not the only one. If I were an ordinary person sitting in my lounge chair at the moment, I would be looking around the world and seeing what is happening in Europe and the US and I would remember the Japanese earthquake et cetera. I hear people sometimes say: if there were another major shock--not one of the shocks caused by strong things like growth of commodities et cetera but on the downside--would Australia be in a position to respond? I am well aware that there are many countries that would not be in a good position to respond, but how are we, relative to where we were before the last global financial crisis, in our capacity to respond? I assume you mean, by macroeconomic policy, stimulus-- You have already said that banking is in a very good position. Yes, banking is good. As I said earlier, I think we could even argue that we are in a better position there than before. In monetary policy-- But in the late 2008 period, of course, we had had high rates of interest combating inflation. There was a lot of room to cut when the outlook changed a lot. Similarly, the budget was very strong. People want to quibble with this measure or that, but there was no question that you could undertake significant fiscal easing without impairing the long-run public finances of the country. If we did see a very dramatic change for the worse in the global economy, certainly the policy ammunition--we have plenty of interest rates to play with if need be, and I would still, I think, say that the fiscal position maybe does not look quite as good as it did then but, when you compare with other countries, it is in pretty sound condition. The issue for us would be: would we have some comfort that the inflation track is going to look better? We certainly did believe in late 2008: this is really going to turn it down and we should respond quite quickly. I would hope that we could be in that position again were there to be a dramatic event, but I am not quite as certain now as I might have been then. But hopefully we would have some leeway. So I think, in terms of macroeconomic ammunition, there would be not that many countries who can say they had more than us in the event of a really big episode. I do not think that is what is occurring at the moment. But the thrust of your question is, 'If it did, would we have some ammunition in the cannons?' and I think we would. Thank you. It is probably worth adding that there is plenty of scope for the exchange rate to take some of the adjustment, as well. Given its very high level at the moment, there would be a lot of room for the adjustment to come via the exchange rate. And it would. That is absolutely right. One last question and then we will hear from the school kids again. We have heard a little bit about Dutch disease, but it sounds to me that, when I read some of your statements, you see the changes that are taking place now--growth in Asia, obviously, the exchange rate, commodity prices et cetera--as things that, if not permanent, are certainly quite substantially long-term. I think it is very likely that that part of the world economy will provide a lot of the growth impetus that is relevant to us. I think it is quite likely that the demand for natural resources will be strong for quite a while. I doubt, though, that the absolutely very high prices we presently see will persist. I think they will come down; indeed, we assume they will by a substantial margin. Whether we have got that exactly right I do not know. The terms of trade will not stay this high, but I suspect that the fundamental shift in the structure of the global economy is quite a long-running thing. It is profound for everyone, including Australia. I was interested in following up on the question of global inflation, on the point you made in your opening statement about the links between global inflation and monetary policy in Australia and also in combination with the exchange rate. Would you comment on the confluence of those three things? A few things are at work here. Global monetary policy is quite easy, really. In major countries it is very easy. It is tightening in the emerging world, which may or may not have a bit more to do--I am not sure. But that very easy policy, particularly in the United States to the extent that other countries like China, but not only China, at least condition what they do off exchange rate considerations. That has tended to give them quite an easy stance over recent years. That is part of the story of the strong growth and rising inflation in the region. That does not make our life easier. It would be easier for all of us if there were more exchange rate flexibility in some of those countries, and, in a sense, for them not to contract out quite so much of their monetary management to the Fed. That would be better. It is a world I hope we see at some point, but it will be a while coming. In the meantime, there is the strength of demand in Asia and South America. Those are factors which are pushing up global commodity prices, including oil and so on--the bulk of commodities that Australia sells. Our exchangerate shields the consumer from a fair bit of that. If we had a 70c dollar we would be paying a lot more for petrol and taking far fewer foreign trips as well. That is what the floating rate is supposed to do; it is supposed to help insulate you. In the textbook it insulates you fully, but in real life probably less than fully. I think it would be a better world if all the emerging countries had a flexible inflation target and a floating exchange rate, like us, and allowed their currencies to move as they should. We would then all be doing a better job collectively of controlling global inflation, and would have fewer imbalances in the world economy. That would be good. I am not exactly holding my breath. Governor, I want to come back to you very briefly on the issue of productivity and labour market deregulation and urge you to place evidence above anecdotes. I would make three points. Firstly, the turning point on productivity is around 2000. Productivity, if anything, declines more rapidly in the Work Choices period, 2006 to 2009. Your recent conference had papers on the labour market from Jeff Borland, who found that Work Choices had no impact on reducing unemployment, and on productivity from Saul Eastlake, who said, 'In particular, the workplace relations reforms, introduced by the Howard government under the term Work Choices in its last term of office, were not primarily productivity enhancing.' Should that not put the nail in the coffin of any claims that going back to Work Choices would boost productivity? What a ridiculous question. I am not advocating any particular system here. I was asked a question, referring back to something I said in an earlier hearing, about anecdotes. I am always happy to try to find evidence and if the story is that, collectively, over a long period we have lessened the reform intensity and if that happened under successive governments, then so be it. But the point is, as I think Saul Eslake made pretty clear in his paper, in his usual inimitable and frank style, it has slowed. While I do not have a silver bullet policy to fix the problem, I can do no other than say as a public official that we should be giving careful consideration to these matters but, by all means, on as rigorous evidence as we can find. I am very pleased that the Reserve Bank conference provided some. I forget exactly how you referred to the Productivity Commission before, but I think you said it is made up of 'people who think about this stuff all the time'. A couple of months ago, the chair of the Productivity Commission said, 'The key influence on Australia's recent productivity slump has been the massive injection of labour and capital, together with more costly production and resource depletion effects, directed at satisfying minerals demand.' The Australia Institute recently disaggregated mining productivity and non-mining productivity to suggest that, if you look at it that way, if you took 1995 as the base, in fact the non-mining sector has continued to grow, 40 per cent higher in 2010 than in 1995, but it is mining productivity that is in fact slumping.' Do you agree with that I think there is substance to the statement that there has been, as measured, a significant decline in mining productivity and that obviously must affect the aggregate. I can get Dr Lowe to elaborate but, on the work that we have seen--which is not our data; it is other official ABS data-- We looked at, I think, 16 different sectors where we can get the data. In 14 of those 16 sectors, productivity growth has declined since 2004. The declines in some of those industries are not very large, but it has declined across the board. Interestingly, in mining we have had to use a lot of extra inputs, a lot of extra labour and capital to get relatively little output. The value of that output is very high because of the high global commodity prices. Ultimately, what matters is the real value of the output. So I do not think the decline in productivity in the mining sector is a bad thing. It could also be the production labour. It could be the production labour but, if you look at the real value of extra production from the labour and capital, you will see that it is high because global commodity prices are high. I think productivity growth in mining will recover. It will recover in the utilities sector, because we have had to do a lot of investment to increase the reliability of the electricity distribution system. That ends up being reflected as lower productivity, but it is actually increasing reliability. I think that will turn around. As the governor said before, even in manufacturing and a number of other sectors, the fact that there is a lot of investment in plant and machinery going on because the global price of plant and machinery is low because of the high exchange rate gives some optimism that you could see a lift in productivity increases again, after a decade when--at least in our analysis, and the same with Saul Eslake--the productivity growth slowed across a very wide range of industries. Thank you. We will bring over the students again. I attend Eltham College. What impact are the inflationary pressures in China likely to have on monetary policy in Australia? Callum, that is quite a good question. I think the Chinese economy is experiencing some inflation pressure. Ric may want to add to this. For some years China exported deflation, in a sense, to the global economy--more cheap stuff. Maybe we are seeing a transition to a world where they are exporting inflation. If that is true, that actually makes the job of central banks elsewhere more difficult. Do you want to add anything, I only want to confirm that I think that is the case. We went through a period from the early part or the mid part of the 1990s through to about 2005 when China was adding to the supply of cheap manufactured goods around the world and really pushing down prices, so it was very favourable for everybody else. But now their living standard has risen to the next level, where they are demanding more and more goods and services themselves. They are now the biggest producers of motor vehicles in the world. They all want to drive. They all want to buy more petrol. This is now pushing up the cost of goods to everybody else in the world, so they have become a source of global inflation. I think that is right. I attend Trinity Grammar School. The current strength of the exchange rate is causing problems for some sectors of the economy, but would a fall in the exchange rate not cause greater problems for the general economy, as this would imply a high nominal interest rate is needed to meet the inflation target? That is another good question. What the change in the exchange rate means for monetary policy always depends on why the change happened. If you go back, for example, to late 2008 and early 2009 the exchange rate went down a long way because the fundamentals of the global economy, and therefore of ours, changed so dramatically that we actually lowered interest rates. But there could be other times when the exchange rate falls for some other reason, which might have us thinking that needs to be offset by higher rates. In economist-speak it hinges on what the shock was which drove the exchange rate change. That is what you need to know in order to determine what bearing on monetary policy it would have. But you are right that, if there was a big fall on the exchange rate, that might well be because there were big problems around the world. That is an important point. Thank you very much to the high school students who have attended today. Thank you, Governor, Resolved (on motion by

r110907a_BOA

australia

stevens

It is very good to be with you this morning. In the process of deciding a title for this address, I recalled that three years ago I was talking in public addresses about the times being interesting, perhaps a little too interesting. That still seems to be the case, hence the title. As you know, yesterday the Reserve Bank Board met here in Perth. The Board reviewed the international and local information to hand since its last meeting, and decided once again to leave the cash rate unchanged. The reasons for that decision were given in the statement released following the meeting. More information on the nature of the discussion and considerations the Board took into account will be published in the minutes of the meeting, two weeks from yesterday. I do not want to dampen any of your undoubted eager anticipation for what may be contained in those minutes. What I will do is say a little more about the sequence of decisions the Board has taken over recent months. To do that in appropriate context, it is worthwhile first recounting the framework for monetary policy that has been in operation since the early 1990s and that continues to guide the decisions of the Board. So I will say something about that. Then I will describe how the flow of recent events, viewed through that framework, has had a bearing on decisions. The framework for monetary policy is a mediumterm, flexible inflation target. It seeks to achieve a rate of increase in the Consumer Price Index of between 2 and 3 per cent, on average, over time. This arrangement has a fair bit of history now. The Reserve Bank began to articulate it in the early 1990s and it has been formally agreed between successive Treasurers and Governors, in published statements, beginning in 1996. The 'on average' specification allows the Bank to take account of the fact that it cannot finetune inflation over short periods, and of the obligation to promote, insofar as monetary policy can, full employment, which is another of the Bank's charter obligations. Having a numerical goal takes account of the importance of inflation expectations, and seeks to provide an anchoring point for them - which is a critical function of any monetary policy regime. It also provides a focal point and a measuring stick for monetary policy decisions, which recognises that, in the end, monetary policy is really about the value of money. We arrived at this framework after a long search - the 'search for stability' set out in detail by Ian Macfarlane The current framework is not necessarily the end of history. But it has worked well for a period not far short of two decades now, with no obviously superior framework on offer. Sometimes people ask whether a higher target for inflation might not be better, particularly when inflation is looking like it will rise and the Bank is running a setting of monetary policy designed to resist that. The answer ultimately hinges on how prepared we would be to accept the things that would go with higher inflation. Higher average interest rates would be among them - there is no reason that savers, any more than wage earners, would be prepared simply to accept an erosion of their financial position. That is why countries with higher inflation generally have higher nominal interest rates. whatever structural challenges the economy faces would still have to be faced at higher inflation rates. Higher inflation wouldn't make those issues go away, nor make them any easier to cope with (as we know from our own history when inflation was high and structural change still had to occur). We would simply waste more real resources as everyone sought to protect themselves from the higher inflation. In supporting the decision process that puts this framework into practice, the Bank carries out a great deal of detailed statistical work, tracking several thousand individual data series. It conducts extensive liaison with businesses and other organisations, usually speaking in detail to as many as 100 contacts each month. It produces voluminous published analysis of these data. The objective of these efforts is, at its heart, fairly simple. We are trying to form an assessment about the course of overall demand in the economy and how it is travelling in relation to the economy's supply potential. That assessment in turn informs a judgement as to whether inflation pressure in the economy is likely to increase, decrease or stay about the same, and how the likely outcomes compare with the announced objective. That judgement then informs a decision as to whether monetary policy needs to restrain demand, to support it or to be 'neutral'. Of course other factors that affect prices - like exchange rate changes, changes in the price of oil, and so on - have to be taken into account as well. Note that the economy's supply potential is a key element in the above framework. This is not a directly observable thing: there is no time series labelled 'potential supply'. Assumptions have to be made about the availability of productive factors - labour and capital - and about the productivity with which these factors can be used. This is why the current productivity discussion is so important. Incidentally, the desire for more productivity is not a call for working harder. Australians already work pretty long hours by international standards. Productivity per hour, which is what counts, is not improved by adding more hours, but by finding ways of making the hours that are already being contributed more effective. The Board's decision each month, and the reasoning behind it, are communicated to the public. These statements are among the most closely scrutinised documents in the country. I am often awed by the layers of hidden meaning that people are able to detect in them. But the main purpose of these statements, and of all the other communication we do, is simply to try to make the Bank's assessment of the outlook and its actions as understandable as possible to the many people who need to make long-term decisions, including households and businesses. Of course, events and new information often change the outlook, as we have seen recently. How has the Board evaluated recent developments within the above framework? Throughout the past year or so, the forecasts that the Bank's staff have provided to the Board have suggested that underlying inflation would probably stop falling and then gradually rise through the three-year forecast period. The backdrop to this view was that the rise in the terms of trade was expansionary for incomes and investment, which would likely see demand growth remain pretty strong even as fiscal stimulus spending unwound. The exchange rate was working to offset a good deal of this expansionary impact, by restraining some parts of the economy exposed to international trade but not exposed to mining. Nonetheless, given the size of the terms of trade rise, and the fact that the economy started from a position of reasonably low unemployment, it was thought that underlying inflation was more likely to start to go up than to keep falling. On the evidence we have so far, that's what seems to have been happening. Faced with that outlook, the Board judged that it was appropriate for monetary policy to exert a degree of restraint. As of the end of last year, the Board's view was that it had reached that position. We believed that we were therefore in a position of being able to maintain a steady setting for a while. The post-Board statements I issued each month at successive meetings said that the Board viewed the stance of monetary policy as remaining appropriate for the outlook. Of course, there are always uncertainties surrounding forecasts, and the Bank's publications have been careful to articulate possible risks that we could identify - including things such as the possibility of a serious worsening of the situation in international financial markets, driven by sovereign debt concerns. Most of these risks do not come to pass, and if they do eventuate they don't necessarily unfold as we had imagined they might. Still, the Bank makes considerable efforts to think about how things could turn out differently to the central forecast. By the time of the May Board meeting, there was evidence that the pace of underlying inflation had started to pick up. I myself felt that the Board was still well placed to sit still at that time. We had already put in place a response in advance of the expected pick-up in inflation and it is not necessarily always wise to respond to one high (or low) figure. Nonetheless, the updated forecasts carried a fairly clear message: policy would probably need to be tightened further, at some point, if things continued to evolve as expected. The Bank said that - indeed there was no other credible thing we could have said. In the ensuing months, little has changed about the outlook for resources sector investment. More large projects have been approved and the pipeline of future investment looks very large. On all the available information, resources sector investment will probably rise by another 2 percentage points or more of annual GDP over the next couple of years. Prices for important commodities remain high and the nation's terms of trade are at an all-time high in the current quarter. At the same time, it has become clearer that precautionary behaviour by households and some firms is exerting restraint on the pace of growth in demand, and that the higher exchange rate is diverting more demand abroad. This is putting pressure on trade-exposed sectors. Moreover, the sense that a higher exchange rate might not just be a temporary phenomenon may be leading to a pickup in the pace of structural change in the economy. In net terms, the outlook for the non-resources economy in the near term is weaker than it looked a few months ago, and the recovery of flood-affected mining in Queensland is taking longer than earlier thought. At the same time, looking at financial variables, credit growth has slowed a bit further and asset prices have tended to decline. These factors, along with ongoing evidence that underlying inflation had turned up, were incorporated in the Bank's outlook as published early last month. Meanwhile, the sense of unease about how Europe will manage its problems has increased over recent months. We also had the anxiety over the US debt ceiling issue, which became acute early in August. Measures of confidence in both economies declined significantly as all this occurred. Equity markets fell as investors shifted to the relative safety of bonds issued by the major countries - even though S&P had announced a downgrade of the US sovereign credit rating. It is too soon to see much evidence of a concrete impact of these events on the global economy. Any assessment we make at present is highly preliminary. Moreover, we have no way of knowing what events will transpire in financial markets over the months ahead. There are any number of hurdles in Europe or the United States that could serve as a catalyst for increased anxiety. This state of affairs is likely to persist for the foreseeable future. With those caveats, a few preliminary observations can be offered on this episode in comparison with what we saw in 2008. First, the focus is more on sovereign creditworthiness as opposed to the state of private bank balance sheets per se (though in Europe of course the two are intertwined). In a proximate sense, that is the direct result of the previous crisis and especially the ensuing period of weak growth that has had a severe impact on government revenues in the affected countries. But, taking a longer-term perspective, some countries, especially in Europe, have had fiscal positions that were quite vulnerable to a shock to confidence for some time now. High debt levels were sustainable while markets thought they were and hence were prepared to offer financing at low interest rates; if people suddenly doubt sustainability and charge high interest rates, that same position becomes much less sustainable. So to no small extent, it is actually a matter of confidence - confidence that there is a sustainable long-run fiscal path, that policymakers know how to get onto it, and that they have the will to do so. In crafting any policy response to near-term economic weakness, this is a key point. Second, there have been pressures in funding markets for some European banks recently, but at this point not to the same extent as in October 2008. Bank capital levels are improved from three years ago and leverage is reduced. We have not seen significant funding problems for US or UK banks recently; their problems at present seem to relate more to the possible size of legal costs arising from pre-crisis lending standards. Overall, we have not, to this point, seen the widespread withdrawal of willingness to deal with counterparties that we saw in late 2008. Third, a key feature of this episode is that confidence in the euro is a more prominent issue than was the case three years ago. Those countries at the so-called 'periphery' are paying a high price as they play their part in keeping the euro together. But the ultimate outcome is going to hinge on the willingness of 'core' euro countries to accept socialisation across the euro zone of some of the losses associated with countries in trouble. That is really the issue that is being debated in Europe now. If there were a major international downturn, an important question would be how policymakers in major countries would respond. The scope for fiscal policy easing in many major countries is hotly debated. Some commentators call for further stimulus, citing faltering recoveries, while others point to medium-term debt paths that look very troubling as a reason for fiscal consolidation. Both have a point. The question in major countries is whether a package combining short-term stimulus with a highly credible medium-term path back to sustainability could be crafted. It certainly does not look easy. As for possible monetary policy responses, most major countries would be quickly into the realm of 'quantitative methods', if they are not there already. It is hard to gauge the effects of those measures. In Asia and other parts of the emerging world, however, ample policy ammunition is available, both fiscal and monetary, should the authorities have a need to use it. To do so credibly would presumably require confidence that the upward trend in inflation seen over the past couple of years would be likely to turn down. Of course, a significant weakening of the global economy would result in lower commodity prices and generally lower underlying inflation pressures. So far, the decline in major commodity prices has been fairly modest, though enough to help rates of CPI inflation to moderate a little. In summary, the environment presents no shortage of challenges, though we should not assume that this is necessarily 2008 all over again. It is reasonable to conclude, at this point, that the outlook for global growth is not as strong as it looked three months ago. Forecasters are generally revising down global growth estimates for 2011 and 2012, mainly as a result of weaker outcomes for the major countries. Turning back to the implications for Australia, periods of sudden increases in anxiety within international financial markets are moments when, if at all possible, it is good to be in a position to be able to maintain steady settings. In the recent few meetings, the Board has judged it prudent to sit still, even though we saw data on prices that were, on their face, concerning. To be in that position of course requires timely decisions to have been made in earlier periods. Looking ahead, the task for the Board is to assess what bearing recent information, and recent international and local events, will have on the medium-term outlook for demand and inflation. They probably won't have much effect on the largescale investment plans in the resources sector, but households and firms watching what is happening may continue their precautionary behaviour for longer than otherwise. This would presumably dampen demand somewhat compared with the outlook set out in the published in early August; it may also condition wage bargaining and price setting. If so, that may act to curtail the upward trend in inflationary pressures that has, up to this point, appeared to be in prospect. At the same time, significant rises in a range of administered prices are still set to occur over the period ahead. Moreover, unit costs have been rising quite quickly given the fairly poor performance of multi-factor productivity growth over recent years. In fact the experience of the past year, as the Deputy Governor noted recently, is that while growth seems to be turning out weaker than expected at the end of last year, underlying inflation seems to be turning out higher. A key question is whether that is just the vagaries of statistical noise and lags, or whether it is telling us that the combinations of growth and inflation available to us in the short term are less attractive than they seemed a few years ago. If the latter, the spotlight will come back on to supplyside issues. More than at most times in my professional life, Australia's economy faces a very unusual, and powerful, set of complex forces. Major countries are still coming to terms with the excesses of earlier years and experiencing what many have learned before, which is that after a period of financial distress it is usually a long and difficult recovery. Economic growth has been uneven and patchy, and financial concerns keep recurring, with waves of positive and negative sentiment sweeping global markets. Australians feel the effects of those swings in sentiment. Meanwhile, the emerging world continues to expand, and it is not all due simply to exports to the rich world, even though the world could still do with some more rebalancing. There is an epochal change occurring, and Australians are also feeling that. It is overwhelmingly positive for us in net terms, even if our tendency to dwell on the downside is more prominently on display at present. The future is uncertain, but it always is. What we know is that, as we move into that future, whatever it holds, we do so: with our terms of trade at a record high; with more jobs in the economy than ever before, and with 95 out of every 100 people seeking work in a job; with our banks sound, our financial system stable and our sovereign credit respected globally; and with the capacity for macroeconomic policy to respond sensibly to events, appropriately guided by well-established frameworks. We have our problems, but with some good sense and careful judgement we ought to be able to navigate what lies ahead.

r111117a_BOA

australia

stevens

I am pleased to be with you this morning to open this Financial Services Forum focusing on the role of internal audit in financial services firms. The Reserve Bank's Audit Department has a long association with the IIA and we are strong supporters of the work of the Institute. The fact that you are holding this Forum is significant. As all of you know only too well, there have been many practices exposed in global financial institutions over the past few years that show poor risk management and failure of controls over lending and trading activities. The fact that these issues continue to surface is a clear indication that the subject matter of today's Forum remains relevant. From my own experience at the Reserve Bank over many years, I have gained an appreciation of the important role that internal audit can play in our financial institutions. The Reserve Bank is, of course, very much a bank. We have a substantial balance sheet that requires management, we provide a range of banking services to government clients, we operate key pieces of financial infrastructure, and we rely heavily on our IT systems to deliver these services. Over the years, we have worked to develop a detailed risk management framework to identify where the key risks lie, and set out how they are to be managed. Yet even though much work has gone into developing that framework, like any risk-management approach, it can only ever be a work in progress - and it remains under continual review. Complementing the risk framework, our internal audit program focuses its attention on the most important risks identified by management. Like many auditors today, our Audit Department takes a broad view of their responsibilities, reviewing not only the effectiveness of controls but also whether they are the most efficient way to achieve an end. I know that they are conscious that procedures they may have recommended some years ago may no longer be appropriate, given the changes in technology. And of course technology continues to challenge both our systems operators and our auditors, as the threats to the security of our data and communications increase. Audit Department's work is overseen by the Board's Audit Committee, which has among its members two of the Bank's independent directors, one of whom (Jillian Broadbent) is chair, and which also brings external expertise to bear on assessing the overall audit work of the Bank. This is a key part of the governance structure. Of course, these arrangements are not unique in any way. They are designed both to meet requirements for Commonwealth authorities and also to be in line with good practice at commercial entities. They do, however, give us at the Reserve Bank an insight into some of the practical challenges facing other financial organisations. Of particular importance to this audience, we also recognise the challenges involved with appointing, training and keeping an audit staff capable of assessing whether the controls are working as they should. Our audit team has continually to improve its understanding of the breadth and depth of our business and changes to it. To help us maintain best practice, our auditors need to ensure that their technical skills remain up to speed. The IIA's training and certification processes play an important role in assisting this process. Fostering improvements to the practice of identifying and managing risks, and to the audit processes that are an integral part of that, are central to development of policies aimed at fostering greater financial stability, both in Australia and internationally. The financial stresses of the past few years have placed much greater emphasis on this aspect of our policy work in the Reserve Bank. There are few signs that the additional focus is going to lessen any time soon. If anything, it will increase. Domestically, we have worked closely with the other members of the Council of Financial Regulators on a number of initiatives including the Financial Claims Scheme, the structure of financial market regulation and the role of central counterparties in the settlement of securities and derivatives transactions. Internationally, through our membership of the Financial Stability Board, the Basel Committee on Banking Supervision and the G-20, along with colleagues in APRA and the Treasury, we have been involved in efforts to strengthen the international financial architecture, the rules governing the risks to which financial institutions are exposed and the buffers they are obliged to maintain in case things go wrong. The implications of these initiatives on the way in which financial institutions are managed are potentially far reaching. They are also important for internal auditors, in two respects. First, they are designed to make the institutions you are working for more resilient in the face of a wide range of pressures. If the changes are made effectively, they should help you sleep a little better at night. But second, many of the changes are complex and challenging, requiring important shifts in the way institutions operate, with even more emphasis on controls focused on risk than in the past. There is clearly a need for internal auditors to keep well abreast of these developments in financial institutions so that you can play the role expected of you in contributing to good corporate governance and, thus, to improved prospects for financial stability. Australia's corporations and governments, not to mention savers and investors, rely heavily on your work and it is crucial that it is done well. Today's agenda suggests that you should finish the day even better equipped to meet this challenge. I wish you a successful day.

r111124a_BOA

australia

stevens

Thank you for the invitation to return to this platform. This being a forecasting conference, you will have spent much of your time contemplating the outlook for 2012. The Reserve Bank set out its views on the outlook only a few weeks ago, and I will not canvass any changes to them on this occasion. Instead, I propose to return to a theme I have covered on some previous occasions, namely, the nature and use of forecasts for policy purposes. A couple of important points that have been illustrated over the past two or three years are worth drawing out. To begin, I would like to draw some observations from another kind of forecast. I do a bit of aviation in my spare time. Hence I am a serious user of weather forecasts and there are very detailed forecasts prepared on a frequent basis for the aviation community, in order to make flying more predictable and safer. I want to give an example. A couple of months ago, a pilot I know had planned to fly in a light aircraft from Bankstown airport in Sydney's west to Armidale, about 90 minutes flight time to the north, pick up some people and return to Bankstown. excerpts from the forecasts for the two aerodromes were as follows: It was windy and wet in Sydney that day, one of those days when strong south easterly winds bring in moisture from the Tasman Sea and dump it on the Sydney basin. The Bankstown forecast indicated that for much of the day, there were expected to be periods of reduced visibility and heavy, low cloud. Conditions could thus be quite marginal for a landing on the return flight, and it was possible they would be below the legal minimum for a landing off an instrument approach during those periods of time. This meant a requirement to have extra fuel on board in case of the need to hold prior to landing, waiting for the weather to improve. The Armidale forecast showed some similar periods of weather, also requiring extra fuel. More significantly, the Armidale forecast indicated that there was a probability (assessed as 30 per cent) of thunderstorms in the area, which could persist for up to half an hour at a time. Thunderstorms at the airport amount to very dangerous conditions in which to attempt a landing because of the potential for very strong winds and windshear near the ground, not to mention heavy rain or hail. Even large aircraft avoid landing in such circumstances. Again, this meant a requirement to have additional fuel in case of the need to hold prior to landing, waiting for the storm to pass. Apart from that, the general conditions between the two airports were forecast to include isolated thunderstorms, rain and areas of low cloud, all produced by the south-easterly airstream operating across much of New South Wales. The route goes more or less along the Great Divide, which means that terrain effects on weather conditions are an issue to keep in mind. These conditions did not necessarily preclude the flight, which could have been legally commenced, provided the requisite additional fuel was carried. It is very likely that it could have been safely completed. For professional pilots, who fly every day in a multi person crew environment in high performance aircraft, dealing with these conditions would be seen as reasonably routine, if a bit tedious. The main question was whether it was prudent for an amateur single pilot flying a light aircraft to conduct the flight on this occasion. It was observable that at the intended time of departure from Bankstown, conditions there were at least as bad as forecast, while a phone call from Armidale indicated that there were in fact storms present at that time. It did not look like a day on which the forecasters had been too pessimistic. The pilot in question decided to stay on the ground. The point of this little diversion into aviation is to make a few observations about the nature and use of forecasts, which I think have some relevance in the economic sphere. The first is that the weather forecasters had understood what I would call the 'big forces'. In this case, there was a high pressure system over Tasmania, and a low pressure system off the north east coast of New South Wales. This combination fed very moist air over the south east of the continent, resulting in cloud and rain. In fact, meteorologists know a lot about how weather works. They have pretty long time series of observations and increasingly frequent realtime observations of conditions. They have highly developed models. The combination of real-time data, understanding of how the dynamics of weather occur and their experience, enabled the forecasters to get the big picture right, and give a very useful forecast for those planning on venturing into the skies that day. The second point of note is that some elements of the forecast were probabilistic in nature. This was explicit in the use of the term 'PROB30'. Weather forecasters know they are dealing with a very complex, non-linear system, and are careful to present their forecasts accordingly. They are able to observe the unstable atmospheric conditions that are conducive to storms - mainly heat and moisture, with a role played by terrain as well. They cannot say for sure that there will be storms over a particular location, but they know enough about likely conditions in an area to assess a probability. On the day in question, there would almost certainly have been some storms to avoid somewhere along the route. The third observation is that forecasts are used in particular ways. In aviation, lives can depend on the way a forecast is used. Professional pilots in large, well-equipped aircraft that fly above most of the weather still carefully study forecasts and make the requisite amendments to their plans. They carry additional fuel, have a plan B for an alternative airport and so on as needed, in response to the forecast conditions. Many of us have had the experience of fog-induced delays in Canberra in winter, for example, where the runway is not fully visible at the legal minimum on approach and so the aircraft cannot land and must go somewhere else. International flights into Sydney very occasionally end up in Brisbane or Melbourne because of fog, having been required by the forecast to carry the necessary additional fuel. They may have carried it all the way across the Pacific, at non-trivial cost. Despite the criticism aimed at weather forecasters, the forecasts I have seen in use for aviation are generally pretty good. And the saying that economic forecasters are there to make weather forecasters look good has something going for it. Of course one big difference in economics is that some decisions based on forecasts may alter the outcomes - as in the case of economic policy decisions, or spending decisions by businesses and households - whereas our response to a weather forecast will not actually alter the weather. That factor makes economic forecasting more difficult than weather forecasting. Still, some aspects of the process of weather forecasting are valuable in the economic sphere. One is that the most useful economic forecasts, like weather forecasts, are those that are based on a good sense of the 'big forces', as well as on an understanding of the dynamics of how economies typically behave. In addition, we should admit that economic forecasts have a margin of error - they are a point in a distribution of possible outcomes. On the latter point, often much is made about small changes to forecasts, or small differences in two forecasters' numbers. But when consideration is given to the real margin for error around central forecasts, such differences are often, for practical purposes, insignificant. For example, in the case of a year-ended forecast for growth of real GDP four quarters ahead, experience over the past couple of decades is that the probability of a point forecast being accurate to within half a percentage point is about one in five. For year average forecasts the accuracy is better, but still the margins for error are non trivial. So any point forecast will very likely not be right. The likelihood of some outcome other than the central forecast is actually quite high. When comparing forecasts, if we are not talking about differences of at least half a percentage point, the argument is not worth having. In any event, the question is not really whether the forecasts will turn out to be exactly right. The question is whether they form a reasonable basis for sensible analysis or decisions at the time. When the forecast turns out to be not exactly correct, as is very likely, that is actually not much of a basis on which to criticise the decision-makers who used the forecast (or, for that matter, the forecaster). For monetary policy operating a medium-term inflation target, we are naturally interested in our ability to forecast inflation. Experience over the inflation targeting era (since 1993) suggests that the probability of the CPI outcome being within half a percentage point of the central forecast is roughly two in five at either a one-year or a two-year horizon. For underlying inflation, the probability of the forecast being within half a percentage point is about two in three at one year and just over one in two at two years. The smaller forecasting errors for underlying inflation reflect the inherently more stable properties of the underlying measure, which of course is by design. Hence, if the central forecast for CPI inflation at a two year horizon was 2 1/2 per cent, the chances of the outcome being between 2 and 3 per cent, based on this historical experience, would be about two in cent would be three in five. I note in passing that, if this is a reasonable description of forecast accuracy, it suggests that the configuration of the inflation target is a pretty good one (though I hasten to add that, when it was first set out, we did not really have a great deal of confidence in the accuracy of inflation forecasts). It would, in my judgement, be vastly preferable for discussions of forecasts to be couched in more probabilistic language than tends to be the case in practice, and for there to be more explicit recognition that the particular numbers quoted are conditional on various assumptions. Careful observers will have noted that the latest forecasts published by the Bank actually have a range for growth and inflation at the horizon. Moreover, there is more extensive discussion these days of the ways in which things could turn out differently from the central forecast. This goes at least some way to recognising the inherent uncertainties in the forecasting process, and is also important in relating the forecast to the policy decision. Taking account of the accuracy statistics I have quoted above, we can characterise the RBA's latest published outlook as suggesting that, absent large shocks to oil prices or the Australian dollar, or further extreme weather events, or the world economy taking a serious turn for the worse (say, because of events in Europe), Australia's inflation rate in 2012 has a pretty good chance of being between 2 and 3 per cent. The chances of a similar outcome in 2013 are also reasonable, though with slightly greater probability that inflation would end up above 3 per cent in that year than seems the case for 2012. That is, the point forecast is a little higher in the second year. Even so, a margin of uncertainty is inevitable. A big change in any of the variables subject to assumptions would quite easily push outcomes away, and maybe a long way away, from the forecast. This degree of uncertainty can of course be quite disconcerting. It is only natural to desire certainty. Everyone wants to know what will happen. We all want to believe that someone, somewhere, does know and can tell us what to expect. But the truth is that the best we can do when talking about the future is to speak about likelihoods and possible alternative outcomes. This is not a counsel of despair. It is not as though we can say absolutely nothing about likely performance. We know something about average rates of growth through time, and we know something about the long-run forces that work to produce them (productivity and population growth). We know that there have been, and will be again, periods of recession and recovery, though our ability to forecast the timing of those episodes is limited. We know from experience some things about the nature of inflation, including its characteristic persistence, and the things that can push it up or down. We know some of the 'big forces' at work on the global and local outlooks - a once in a century terms of trade event, for example, and a once in a century deleveraging event in major countries. We know that our country is exposed to both forces - the expansionary effects of the rise in the terms of trade, and the dampening effects of a mild degree of deleveraging in our household sector (and indirect effects of the more intense deleveraging in some other countries). We also know that the terms of trade change is a large shift in relative prices, which will bring about changes to economic structure. So there is a good deal we can say about the things that are relevant to our future, and economists' understanding about these forces will be helpful in making sense of what occurs over time. We simply have to recognise the limits on our capacity to predict their net impact with any precision. This in turn has implications for the way policymakers use numerical forecasts. In the case of monetary policy, forming a forecast is unavoidably part of the process, simply because the evidence suggests that monetary policy changes take time to have their full effect. So we have to use forecasts - but not unquestioningly. We have to form a view about the big forces at work, but also operate with due recognition of the limitations of numerical forecasts. The extent to which policy should respond to forecasts will therefore always have some element of judgement. The conduct of policy over the past few years has exhibited these features. The Bank's assessment of the very broad major forces at work has been central. Policy was tight in a period in which the economy was very fully employed, confidence was high, the terms of trade were rising and inflation was picking up. The very large and rapid easing of monetary policy late in 2008 and early 2009 was a response to a major change in the outlook, which occurred because the 'big forces' changed direction very quickly, due to the financial events at that time. Among other things, this saw strong growth in Asia go into sharp retreat, appetite for risk and willingness to lend sharply curtailed and confidence slump. The changes to monetary policy beginning in the latter months of 2009, designed to restore 'normal settings', occurred when it had become clear that the risk of a major economic contraction in Australia had passed. In fact, the 'big forces' in the expansionary direction had reasserted themselves, after an unexpectedly short absence: resurgent Asian growth helped to push the terms of trade to new highs. In that world, leaving interest rates at 50-year lows would have been imprudent. Over the past 18 months or so, policy changes have been much less frequent, but the process of decision-making has nonetheless not been dull. A year ago, the then current data on inflation showed nothing particularly alarming. The analysis of the Bank's staff suggested, however, that the fall in inflation we had been seeing since 2008 would probably not continue, but instead inflation would probably begin to rise, albeit quite gradually. The Board took the view that, on the basis of that outlook and in the circumstances prevailing, it would be prudent for policy to exert some mild restraint, and so it decided late last year to raise the cash rate by 25 basis points. The inflation data for the first half of 2011 do indeed show some increase in underlying inflation (though after a sequence of revisions, this is not quite as large as it looked a few months ago). As of May this year, the central forecast was for inflation to pick up further over the ensuing couple of years, eventually rising to be clearly in excess of 3 per cent. This carried a simple message. As the Bank said in the central outlook sketched above suggests that further tightening of monetary policy is likely to be required at some point for inflation to remain consistent with the 2-3 per cent medium-term target. But there was still a matter of judging how to respond to that message. The Board did not tighten policy at that time, nor did it do so three months later when the forecasts for inflation still looked similar to those in May. It certainly considered whether that course of action would be appropriate, but elected to sit still, watching unfolding events. Eventually, last month, far from tightening, the Board actually eased policy slightly - though by then, of course, the forecasts had changed materially from those of six months earlier. This was not a repudiation of the forecasts, nor a sign that forecasts are not useful. The process of forming forecasts remains key to the forwardlooking conduct of policy. In electing to take time in considering their response to signs of an increase in inflation, and central forecasts of further increases, the policymakers were simply recognising the inherent uncertainties of the situation and the difficulties the forecasters face, and giving those factors due consideration. It is, in my view, entirely appropriate that there be this degree of limited discretion for the policymakers in their response to changes in numerical central estimates. It is not that forecasts should be ignored. But neither should the decision be rigidly and mechanically linked to forecasts. Were that to be so, the policymakers would in effect have delegated the policy decision to the forecasters, which is not what policymakers are supposed to do. So the relationship between the formal forecasts and the policy decision can sometimes be a subtle one. Ultimately, the policymakers have to make a judgement call, based partly on what the central forecast says but conditioned also by the degree of confidence they have in it. At the same time it must be emphasised that policymakers can be in a position to make the sorts of judgements I have just been describing only if they have generally acted in a timely, forward-looking way in earlier decisions. In my view, these judgements over the past year were the right calls. But in truth we will not know for a while - such are the lags in monetary policy. As always, more data will help the process of evaluation, though they might also provide evidence of new shocks (that is, things the forecasters could not predict). Such is the nature of the forecasting game. In conclusion, to those of you here who do not have to make forecasts, I hope you realise how fortunate you are! To those who do, I offer my sympathy - and best wishes for clear vision over the year ahead.

r111208a_BOA

australia

stevens

It is a very great pleasure, as a former student of Professor Warren Hogan, to give this lecture in his memory. Thank you to the Hogan family, many of whom are here this evening, and to the School of Economics at the University of Sydney for giving me this honour. recounting one or two personal reminiscences, it is appropriate to say something about his life. Many fascinating details of it are revealed in the interview with John Lodewijks, and the eulogy by Tony Aspromourgos, both fittingly published in the . Warren Pat Hogan was born in Papakura, just south his undergraduate and Master's education at Auckland University College, where he was taught by Colin Simkin, who later was also at the University of Sydney. He married Ialene, a fellow student in the same faculty, in 1952. Hence, it is not altogether surprising that Hogan's children seemed drawn to economics. Four of the five children, and several of the grandchildren, have degrees in economics. After gaining early work experience at the Reserve Bank of New Zealand, Hogan, with a young family in tow, came to Australia in the mid 1950s, where he in 1959, his research being on growth theory. His supervisor for that work was Trevor Swan, one of Australia's most renowned theoretical economists (and subsequently a member of the Reserve Bank Board). Ivor Pearce, with whom he would later collaborate in writing about international finance, was a close confidant and mentor. Among the early fruit of this work, as recounted in the Lodewijks interview, is that Hogan uncovered an error in a celebrated paper by Robert Solow. This led to an exchange between Hogan and the future Nobel Prize winner in the . Heady stuff indeed for a young graduate student from the antipodes. Hogan rose quickly through the ranks at Newcastle University College in the 1960s. But it was as Professor of Economics at the University of Sydney, for 30 years from 1968, that Hogan came to more prominence. Joined by Simkin, he sought to lift the technical standard of economics at the faculty, including by putting more emphasis on quantitative techniques. This met a good deal of resistance as part of the broader debates about how economics should be taught. By the time I was a student here from 1976 on, both sides seemed to have dug into the trenches and the dispute had been bitter. None of that stopped Warren Hogan from grappling with significant issues in economics or economic policy. In fact, Hogan's professional life shows an active mind always pursuing some important question. In a career that produced over 150 articles, books and chapters of books, and many shorter publications, he ranged broadly. As early as 1958 he was producing articles examining the rise of new financial intermediaries outside the regulated banking system - a theme about which we were still hearing in the 1980s, and one which should resonate today in light of the attention being given to 'shadow banks' and the expansion of the weight and width of the global regulatory footprint currently under way. Hogan retained an interest in both financial regulation and deregulation throughout his career, and married this with a nuanced understanding of the behaviour of financial players in their appetite for risk. Hogan also worked on issues of development in the emerging world, wages, immigration and transport. He served as economic adviser to one companies, most notably serving on Westpac's Board for 15 years, including through the period of deregulation and subsequent tumult. In his later years he conducted a major review of pricing in aged care. He also served in numerous capacities over the years in various university administrative positions and on other committees in the broader community. His was a full life indeed. It was in my third year at Sydney University that I think I first encountered Professor Hogan. This would have been in 1978. More than three decades after I sat in afternoon seminars conducted by him, the memories of his general style are clearer than the things he actually said. He was usually dressed in a suit - which would have been much more unusual for an academic in the late 1970s than it is now. The reason was perhaps that he had been in the city earlier in the day as he was active in dealing with practical policy issues and had links with the business world. On days when there might have been a nice business lunch, there was a certain relaxed expansiveness to his demeanour. He spoke often without notes on whatever economic topic we were covering, and as he spoke he would take the various coins from his pocket and arrange them into small piles on the table. We wondered what subconscious portfolio balance idea might have been behind that behaviour. Warren often had a somewhat elliptical way of saying things - you had to listen carefully to get what he may have really been saying, and sometimes you weren't sure you had understood correctly. As I reflect now on this characteristic, I wonder whether he missed a calling as a central banker! He certainly had built up contacts in the central banking world, as an occasional visitor to the BIS, where he was on very good terms with the late Palle Schelde Andersen, a renowned BIS economist and student of the international economy and financial system. I assume that their acquaintance was made in the late 1970s, when Andersen visited the University of Sydney for a period, funded by a grant from the Reserve Bank. One Hogan paper of that era that really struck a chord with me then - I have always recalled its title - was about the issue of revisions to economic These days the study of revisions to data is an art in itself (though the quality of national accounts data is better than it was in the 1970s). Central banks put huge effort into what has come to be called 'nowcasting' - that is, working out what the national accounts probably will, or should, say about the current quarter in three or four months' time when they are released. Some central banks actually 'backcast' the recent past, deciding their own version of GDP, not necessarily the same as the one published by the statisticians, in effect foreshadowing revisions to come. has not gone to that extent, though of course we have seen certain difficulties in assessing the current pace of underlying inflation in our own country over recent months, with reasonably significant revisions to some data series. So Hogan was on to something here - as far back as 1978. But the work on which I wish to focus for a brief period tonight is the book Hogan co-authored with Ivor Pearce entitled . Published first in 1982, with subsequent editions published in 1983 and 1984, this fascinating little book sought to explain the workings of the Eurodollar market and the institutions which operated in it. In the 1970s - the dataset on which Hogan and Pearce based their work - the Eurodollar markets were an exotic new development, spawned by a period of international financial turmoil and innovation, some of which was in response to regulation. The post-World War II compact known as the Bretton Woods system had held for about 20 to 25 years. This involved a US dollar standard, under which countries fixed, and occasionally adjusted, their exchange rates to the US dollar; the dollar was fixed to gold at US$35 per ounce; private capital flows were limited in scope; and official flows made major contributions, via the IMF, to international adjustment. But by the late 1960s and early 1970s, this arrangement had come under severe strain as private capital flows began to increase in size and US policymakers found they could not live with the constraints of the system. In a sequence of events, including the break of the link with gold and the decision by key countries to allow their currencies to float against the dollar, the system broke down. The result was a system in which exchange rates between the then major currencies have floated, with occasional efforts at management, ever since. The Eurodollar Market was in essence a pool of obligations issued by banks outside the US jurisdiction but denominated in dollars. It grew rapidly, apparently unconstrained by regulation conducted on a national basis (as all regulation was, and largely still is). It was part of a large increase in cross-border financing activity by internationally active banks. When Hogan and Pearce published their third edition in 1984, the stock of cross-border assets held by BIS reporting banks was about In the early 1980s, much of the talk about the Eurodollar Market was couched in terms of whether Eurodollar deposits should be added to measures of the money stock, which were the height of economic fashion at the time. As you will recall, this was the period in which the US Federal Reserve targeted monetary aggregates explicitly and in which weekly monetary aggregates data were scrutinised closely for signs about the likely direction of US interest rates. One can see this background quite clearly in Hogan and Pearce's little book, which has lots of discussion about whether Eurodollar deposits are 'money' (they thought not) or just 'debt' It was only a few years later that most countries gave up the effort to define 'money' and to conduct their policy discussion in terms of money aggregates, instead going back to the former model of setting a short-term interest rate. It is interesting, though, that in recent years the 'zero lower bound' for nominal interest rates, which as students we would have been taught about as 'the liquidity trap', is no longer a curiosity in the textbook from a bygone era, but has actually been binding in several major countries. One implication, among others, has been that calibrating monetary policy in terms of monetary quantities has come back into vogue in some places - this time with the relevant central banks consciously seeking to increase the size of their balance sheets. Whether the relationship between 'money' and nominal GDP or prices has become any more reliable than it was 25 years ago, when it was found too fluid to be useful for policy purposes, is not clear. But if the language in Hogan and Pearce's early 1980s work is, perhaps, a product of its times, some of the observations are astute, and there are some quite prescient insights. To begin with, Hogan and Pearce note that the activities of Eurocurrency markets - and we could generalise this to cross-border private financing generally - lessened the pressure on countries to adjust to current account imbalances, especially on the deficit side. This could be seen as good - allowing capital to flow more efficiently to the locations offering the highest risk-adjusted return. Or it could be worrying: the markets giving a nation more rope, so to speak, by allowing current account balances to become larger and more persistent than they would otherwise. Remember that at the time they wrote, current account positions had rarely been more than a few percentage points of GDP for any length of time, at least since 1945. The analysis of the mythical planet Htrae, with three countries Surplusia, Deficitia and Balancia, with respective currencies Surps, Defs and Bals, focuses on the operation of markets and, importantly, the role of financial institutions as intermediaries between savers in one country and borrowers in another. In the language of more recent times, financial institutions are key to the dynamics of so-called 'global imbalances'. Indeed, Hogan and Pearce state, rather bluntly: 'Financial intermediaries live upon imbalances'. At one level that is obvious - financial intermediaries or markets exist to transfer resources from savers to borrowers (and back again), which is to say that an imbalance between saving and investment at the level of an individual household or firm in the economy is matched against an equivalent imbalance of opposite sign in some other firm or household. The deeper sense in which this 'thriving' takes place in an international setting is that savers in one country lend their money to borrowers in another jurisdiction, about whom they know next to nothing, but feel safe in doing so because what they hold directly is an obligation of a large, well-known, globally active bank, assumed to be safe. But as Hogan and Pearce point out, a European entity raising dollars to fund a balance sheet does not have automatic access to a lender of dollars of last resort in the event that market conditions change. It is therefore exposed to serious funding risk in a way that does not occur in purely local currency operations. The average 'Eurobank' in the early 1980s had access to marks or francs - today euros - or pounds from its national central bank, but it could not be assumed that in times of stress these currencies could necessarily easily be swapped for dollars. In fact, this very phenomenon was at the heart of the crisis that began to unfold in 2007. It was in Europe, where banks had, and still have, a structural need for dollar borrowing to fund US dollar denominated assets, that the market strains first appeared in August 2007. As the crisis intensified, the need for access to central bank funding in dollars required a number of central banks to enter into swap arrangements with the US Federal Reserve so their domestic banks could borrow US dollars secured by local currency collateral. European banks were by far the largest users of these facilities - about US$400 billion was accessed via the ECB and other central banks in Europe at the peak in Of course, it is also in Europe that we have seen the epicentre of the most recent stage of the crisis. In some other respects, today's problems are a little different, and perhaps more complex, from those of three years ago. They arise from cross-border lending within a currency area that has a single money but very divergent experiences in terms of fiscal discipline and productivity, and that lacks a well-developed capacity for intra-area transfers - which is being built as we speak. Nonetheless, dollar funding for European banks has again tightened up and the swap lines among major central banks have setting potentially the most far-reaching is the set of proposals recently endorsed at the G-20 summit to mitigate the problems posed by institutions that are too big to fail at an international level, otherwise have been identified as fitting the criteria to be labelled G-SIFIs at present, though the list is not a fixed one: banks can enter and leave it over time. There will, in due course, be a framework for globally systemic insurance companies with parallel criteria. The intention of the policy is to make the failure of such entities less likely by requiring additional capital, and to make the consequences of failure less dramatic by developing better tools to resolve entities that have failed or are on the point of failure. The latter, in particular, is a very ambitious undertaking and contains some potentially far-reaching components - such as the ability to 'bail in' certain creditors to an institution on the point of failure, effectively turning them into shareholders, so as to lessen the likelihood that taxpayers will be called upon in such a situation. To make it work would require considerable co-operation across jurisdictions at moments where everyone's instinct is to protect creditors and counterparties in their own jurisdiction. I don't know what Hogan would have made of this. I suspect he would be wondering whether, if regulatory actions bind on one group of institutions, the behaviour in question would end up migrating to other, less-regulated places. This possibility is understood by the international regulatory community, which also has a regulatory agenda for 'shadow banking'. This is actually a critical point. I would offer the observation that, if we can get through the next year or so without a major crisis and successfully implement the various reforms - which might both be big 'ifs' - the next financial crisis may not occur in the same sorts of institutions as last time (or this time), but in different ones. It could well occur in institutions or markets that do not as yet exist. again been activated to assist. This is presumably designed to slow the speed of European bank deleveraging of dollar assets that would otherwise be forced to occur. Lots of people claim to have predicted the crisis, though I doubt that Warren Hogan, were he here, would claim that he and Ivor Pearce foresaw it in all its dimensions almost 30 years ago. I think they would perhaps claim that their saga of Htrae, where international cross-border financing ultimately produced a crisis, contained many relevant insights. I doubt that they fully appreciated the role that the financial institutions of the leading deficit country - the United States - would play in creating risk and transferring it elsewhere. In their story, the key institutions were those of the country of Balancia, where the international accounts initially were balanced. I think they would have expected the response of major central banks to the crisis to have resulted in more inflation than it has, so far. That may be a reflection of the inflationary times in which they were writing - when it seemed almost inconceivable that deflationary problems akin to the 1930s could re-emerge. The example of Japan, where there has been deflation for well over a decade, had not yet occurred in 1982. Of course, they might just have expected the inflation still to be coming. They would not be alone in that view. It is certain though that Hogan would have been watching all these developments with close interest. He would have been recognising certain things that he could have broadly predicted, and I suspect he would have said so with that very dry turn of phrase he had. He would also, surely, have been observing things that would have surprised him, and he would have been thinking about how his view of the world needed revision. He would have been pondering the future of the international financial system. In that vein, I shall use the remainder of the time this evening to make a few observations in that area. The first is that there is an extensive program of regulatory reform under way. In an international The key thing in avoiding disastrous crises in the future is less the specifics of regulation or resolution - as important as these are - than having a clear understanding of the nature and extent of risk-taking behaviour, in all its potential dimensions and locations. On my reading of Hogan's work, I believe he would have shared this view. Put in the simplest of terms, we might ask: where are financiers apparently making easy money? In what area of risktaking are the profits large or expected to be large? There is a good chance that it is there that, given enough time, the likelihood of excesses is greatest. In Hogan and Pearce's book, financial institutions and their behaviour were seen as central to the build-up of imbalances. But they are in one sense merely facilitating flows of capital that are reflective of other phenomena, resulting from the collective behaviour of the actors in surplus and deficit countries. So in contemplating the future of the international financial system, reforming the regulation of financial institutions, and understanding their behaviour, will be key, but it will be of equal importance to understand the underlying behaviour of the entities in the real economies. The role of official capital flows, in particular, is one element of the post-crisis world that seems to be becoming quite prominent. Indeed, perhaps one of the most striking features of the international financial system is the size of official reserve assets that have been accumulated by what Hogan and Pearce would have labelled 'Surplusia' - the countries that have run persistent current account surpluses. In the early 1970s, the accumulation of US dollars by surplus countries made for problems of monetary control in some large reserve holders finally broke down in 1973, total foreign reserves of all countries amounted to about 2 1/2 per cent of annual global GDP. West Germany's reserves were about 7 per cent of West German GDP. Today, total reserves in the world amount to the equivalent of about 15 per cent of global GDP, up from 10 per cent only five years ago. China's reserves are close to countries have equivalent ratios around 30 per cent or more; while, in Latin America, foreign exchange reserve holdings are typically in the 10-15 per cent range. There are numerous reasons behind this build up. The very high levels of energy prices in recent years have pushed up the reserves of oil producers, and this accumulation may have some logic as they seek to spread over a long period the income gains accruing from a finite resource. The reserves of many Asian countries have risen to much higher levels after the 1997 crisis, as a form of insurance against capital flow reversal. Indeed, the IMF advised this after the crisis, advice that has been taken to heart perhaps a little more than the Fund intended. One can understand the desire for self-insurance, and particularly as those Asian countries that had IMF programs in the late 1990s felt the conditions for mutual insurance - through the IMF - were very onerous. But the self-insurance provided by large holdings of reserves is costly, especially in the low interest rate environment we see in the major countries. Trillions of dollars and euros held on behalf of the citizens of countries across Asia (and elsewhere) are earning meagre returns and subject to increasing sovereign risk. This cost of self-insurance is therefore becoming increasingly apparent, a trend that will surely continue as, inevitably, Asian productivity levels continue to increase relative to the Western countries and their real exchange rates rise. Large centres of high saving with portfolios that are overweight in foreign assets whose return is low and whose value is highly likely to go down, measured in the currencies of the holders, amounts to something of a problem. Attempts by those holders to exit this position quickly would be, to say the least, highly disruptive. They know that and that is why they do not attempt it, though there is a degree of diversification under way. To paraphrase the old line, if I owe you a few billion, I may have a problem. If I owe you a trillion or two, you may have a problem every bit as big as mine. So there is a very long-term issue of portfolio rebalancing to be addressed here as well as one of structural realignment of national price levels (i.e. real exchange rates). At the same time though, there are increasing calls for the emerging economies with large surpluses and high reserve holdings to play a part in assisting Western economies facing budgetary and banking sector problems. With the balance sheets of many Western sovereigns already under pressure, there is hope for contributions from large reserve holders - they, after all, are the ones with the cash. It has to be observed, surely, that pressing reserveheavy emerging economies to lend into structures designed to smooth adjustment processes in the advanced world amounts to a call to perpetuate, to a fair extent and for at least a bit longer, some of the very 'imbalances' that so many have lamented for so long. What people are really saying is that they want to move only quite slowly away from the current constellation of resource flows and prices that, in other discussions, have been seen as constituting the problem. That may well be the best approach. But it is observable that large reserve holding countries are already getting uncomfortable with their degree of exposures to major Western governments. Hence, any offers of assistance are likely to be made with a careful eye to risk minimisation. This is likely to mean they will prefer to operate through international institutions, such as the IMF. Alternatively, they may prefer to take hard assets in return for their cash, rather than financial obligations, which, in turn, could easily raise the social and political tension level. At the very least, managing all this over the next decade will require level-headed analysis, far-sighted decisions on the part of national policymakers and a degree of international co-operation much greater than we usually see. Moreover, there will be some very important questions to be confronted. Not least among them will be that, with the relative economic weight of the emerging world rising quickly, and a rise in their financial weight flowing from their high rates of capital accumulation and increasing creditor status, they will expect an increased role in global financial governance as a condition of accepting more obligations to contribute to the global common good. The willingness of the established, post-war leadership countries to cede a degree of status and control to the emerging world will need to increase at the same speed as the emerging countries' willingness to grasp and accept their rising responsibilities. Will this occur? It is hard to judge. Much will depend on whether the various parties have the same general ideas about the purpose of the international monetary system. That is, at this point anyway, not clear. Another thing we might see is a certain tendency towards the financial repression that was a feature of the post-war world in which Warren Hogan first studied economics. A legacy of the 1930s was a much tighter regulatory regime for banks, elements of which lasted for decades. A legacy of the 1940s was a very large stock of government debt. Debt-to- GDP ratios were well into triple digits for countries for Australia). Yet from the 1950s through to the 1970s, debt-servicing dynamics were kept within manageable bounds. The rapid growth in economic output in the long post-war boom, which was aided by demographics and productivity performance, was a major help. But also contributing was a combination of central banks holding down longterm interest rates at government direction, and banks and other entities being forced to hold government debt. And of course, at the end of that boom, a period of unanticipated high inflation played a role in lowering debt-to-GDP ratios. In the current era, however, the rapid output growth will likely occur in the countries that don't have much government debt but do have productivity catch-up working for them, while in many of the countries that have a lot of debt the demographics will be going the wrong way. It is therefore conceivable that with slow-growing countries feeling pressed for solutions, regulatory actions might have certain attractions. Given this, and with many emerging countries having mixed feelings about many aspects of free financial markets anyway, it is conceivable that the current trend towards more assertive and intrusive financial regulation - which is occurring for very understandable reasons - will end up going much further than contemplated at present. The potential for an outcome that eventually involves significant inflation is also obvious. I have only touched the surface of many of these issues. As I said earlier, I cannot know what Warren Hogan would have thought of them, or whether he would agree with my views. I am sure, though, that he would have thought these matters worthy of further discussion and that he would have contributed to that discussion. Hopefully, I will have succeeded in stimulating some further discussion tonight. Once again, thank you to the University, and to the Hogan family, for permitting me this honour. I hope this marks the start of a successful series of lectures.

r120224a_BOA

australia

stevens

When we last met with the Committee in August, we had entered a period of heightened uncertainty about the global economy and financial system. The investment community was focusing increasingly on the high levels of public debt in major countries, and especially on the situation in the euro area, where budgetary pressures, banking pressures and competitiveness issues within the single currency area make for a very difficult set of problems. There was considerable instability in markets. But our view at that time - tentatively - was that we were not witnessing a repeat of the events of late 2008. Admittedly, the second half of 2011 saw some very anxious moments. There was a flight from risk that pushed up borrowing costs for major countries like Spain and Italy, but pushed them down for countries like Germany and the United States to the lowest levels for more than 50 years in spite of the fiscal challenges the US itself faces. Funding markets for European banks in particular effectively closed for a few months, and for other banks became much more difficult and certainly more expensive. The palpable fear before Christmas that Europe was on the brink of some sort of very bad financial event has lessened over our summer. The anxiety has not gone entirely away, and nor will it for some time. But the worst has not happened. Financial markets, while hardly brimming with confidence, have recovered somewhat over the past couple of months. Banks are able to access term funding markets again, albeit at higher cost. High-frequency gauges of business conditions and confidence have stabilised over the past couple of months in Asia and North America, and even in Europe. We have not seen the very steep fall that we saw in all these indicators in late 2008. The actions of the European Central Bank contributed greatly to the stabilisation of financing conditions, essentially by removing, for a time, questions over the funding of European banks. The efforts of European leaders to craft a stronger framework for euro-wide governance on the fiscal side have also continued. A great deal more needs to be done to place European banks and sovereigns onto a stable footing, and to boost potential growth in Europe. But progress is being made. Forecasts for the global economy in 2012 have been marked lower, mainly due to the effects of the problems in the euro area. Revisions to the IMF's forecasts in particular have been given great prominence. Our own forecasts have come down too, though they had already been a bit weaker than the IMF's. On these forecasts, global GDP will grow by about 3 1/4 per cent in 2012. That is down from about 3 3/4 per cent in 2011, which was about the average rate of growth over the past 15 years. On its face, this performance, should it occur, would be no disaster. After all, growth is going to be below average some of the time. If we look for things to worry about, we will certainly find them. The global outlook has a very uneven composition: some countries, particularly in Europe, will record very weak outcomes. Moreover it is unlikely that a moment will come any time soon when we will be able to say the problems in Europe are behind us. Progress will be slow and there will be periodic setbacks and bouts of heightened anxiety - that is the nature of these things. But equally, we should recognise that things have not been uniformly bad recently. The US economy has not experienced the 'double dip' some had feared six months ago, but instead has continued growing. The US corporate sector is in very strong shape, is cashed up and will at some point be able to start moving ahead more quickly. It appears American corporations have stepped up the pace of hiring in the past few months. In China, the slowing in growth we have seen seems to have been roughly what the policymakers were looking for, and they appear to be getting on top of their inflation and housing boom problems. Around the rest of Asia, activity has also slowed, in part reflecting trade links with Europe. But it has not slumped and as inflation comes down, policymakers have increased room to respond. The pressure on European banks to shed assets has led to some tightening of trade credit in the Asian region, but at this stage the system seems to be adjusting to that without major drama. We have not, to date, seen the collapse of trade credit and trade flows we saw in late 2008. Commodity prices, which had declined noticeably from their peaks in the first half of 2011, have actually moved sideways, or in some cases picked up a bit, for a few months now. They remain high by historical standards. That seems roughly consistent with the group of countries that makes up Australia's main trading partners expanding at a reasonable pace - expected by the IMF to be over 4 per cent this year, not very different from last year. Again, we do not, at this point, see the signs of the rapid collapse in global demand we saw three years ago. At home, most of the information coming in suggests the economy has grown at close to an average pace over the past year. This outcome was weaker than we had expected a year ago. It was partly due to the effects of flooding on resource production but also due to softer outcomes in the non-resource side of the economy. CPI inflation has come down, as expected, as the impact of last summer's floods on food prices reverse. In underlying terms, inflation was about 2 1/2 per cent over 2011, also a slightly lower outcome than we had, at one point, thought might occur. The labour market was generally softer in 2011 after a year of unusual strength in 2010 (though the unemployment rate at its latest reading was virtually unchanged from a year earlier). These changes to the macroeconomic picture, against a backdrop of a period of intensified international turmoil, saw the Board lower the cash rate by 50 basis points in the closing months of 2011. Perhaps surprisingly in the face of developments in wholesale funding costs, this was initially fully reflected in a reduction in most lending rates, though there has been a partial reversal of that recently. We have repeatedly made clear that the shifting relationship between the cash rate and other rates in the economy is a factor the Board takes into consideration in setting the cash rate. That will remain the case. Recent developments do not materially affect the capacity of monetary policy to achieve its goals. Looking ahead, the Bank's central expectation is for growth to be close to trend, and inflation close to the target, over the coming one to two years. There are, naturally, risks surrounding this central view. Those are spelled out in the latest . Perhaps what is most noteworthy about the Australian economy is the way in which the drivers of growth have changed in recent times. The Bank has spoken at length before about the terms of trade, and the resulting resource investment boom, which is still building and which will take the share of business investment in GDP to its highest level for 50 years. We have spoken also about how, on the other side, household behaviour has changed - people are saving more and borrowing less. Spending is growing in line with income, but people are spending their money differently. The retail sector is finding it has to adapt to this changed environment. Some other industries are struggling with the high exchange rate. Meanwhile certain service sectors are growing quite smartly. Hence, while the economy overall has recorded 'average' growth, few sectors are in fact experiencing 'average' performance themselves - some are clearly quite weak relative to average, while some others are much stronger. The Bank is quite aware of these differences and the pressures they bring to businesses and individuals. But we also know that monetary policy cannot remove the forces generating different paces of growth in our economy. We have to keep our eye on the overall performance of demand and prices. We are acutely conscious that history may offer limited guidance in assessing the net impact of the disparate and very powerful forces that are at work. Nonetheless, that is the assessment we must try to make. Our most recent assessment was that, with growth near trend, inflation consistent with the target, interest rates about average and an outlook suggesting more of the same, the setting of policy was about right for the moment. Of course, we continue to reassess things each month. My colleagues and I are here to respond to your questions.

r120319a_BOA

australia

NO_INFO

stevens

Thank you for the invitation to join this conference here in Hong Kong. Asia remains one of those parts of the world where prospects for growth are exciting, and where people expect - for good reason - the future to be better than the past. Yet for the past six months or more, global attention has been riveted on the 'old world' - continental Europe - where many have feared the best was in the past. The Reserve Bank of Australia has taken a very close interest in the events in Europe. At the purely analytical level, the sheer magnitude and complexity of the problems that have arisen will be a fertile area of study for students of economics and other disciplines for decades to come. Of course the adoption of the euro was not solely, maybe not even primarily, an economic decision, but it nonetheless had economic consequences. In several very important respects the euro area's first decade was a remarkable success. But there were important structural stresses underneath and some of these have suddenly become more visible in the past few years. Now the euro's future depends on whether the commitment of the Europeans extends to building more of the economic substructure consistent with the single currency, which will entail both fiscal and supply-side reforms. It is of course quite difficult to lay foundations when the house has already been erected on the site, but that is the job ahead in Europe. I think the evidence is that European policymakers understand the importance of their response and are going to great lengths to implement it. Progress has been made. But there is a long way to go yet. During that long journey, there will surely be numerous episodes of heightened anxiety, any one of which could erupt into a more extreme crisis if one or more of the key actors makes a serious mistake. In terms of the practical impact of these events, at present we can say that the euro area has been in recession for some months. Some individual countries have been in a deep downturn for much longer than that, but I am speaking here of the euro area in aggregate. The recession is expected by official forecasters in Europe, and bodies like the International Monetary Fund, to be a relatively mild one, though all would acknowledge that it is impossible to be sure, as is usually the case with such episodes. We see three potential channels of effects from these events to Australia. The first is a direct trade link. Australia's exports of goods and services to Europe are actually relationships these days are with Asia. Hence, a bigger impact of the euro crisis on Australia would come indirectly via trade with Asia. It is pretty clear that growth across much of East Asia moderated in 2011 and that there has been some effect of the slower euro area economy on Asian exports. There have been other forces at work too - the Japanese tsunami a year ago had significant effects on production chains around Asia. These effects had probably not completely disappeared when the floods in Thailand had another significant impact, which may still be affecting the data. So detecting the effects of weaker European growth against the backdrop of the supply disturbances to trade patterns following these natural disasters might be a little like trying to pick up one conversation in a crowded room: there's a lot of background noise. But most of the high-frequency data on trade and production did not seem to show the slowing intensifying as we went into 2012. It is too early yet to say that a new strengthening is under way. But we do not seem to be seeing the signs of a rapid fall in trade that we saw in late 2008. A reference to 2008 brings me to the third channel through which we think about the effects of the European crisis. And it is perhaps the most unpredictable and potentially most damaging kind: the financial link. It would not be the direct exposures of Australian institutions to the most troubled countries of Europe that would be of concern, because those are quite small. It would be the more general impact on global markets of a European problem. What we saw in late 2008 was effectively a closure of funding markets for financial institutions for a period, after the failure of Lehman Brothers. These sorts of events affect virtually all countries, because the impacts on credit conditions, trade finance, share prices, and household and business confidence - all of which lead to precautionary behaviour - occur almost instantaneously everywhere. There was a period late in 2011 where there was a genuine fear that this could happen again. Funding markets tightened up and effectively closed for many European banks. Interbank activity more or less ceased in Europe. The cocktail of sovereign credit concerns, large bank exposures to those sovereigns, possible bank capital shortfalls and prospective large debt rollover needs of banks, not to mention the unpredictable dynamics of the Greek workout, had everyone very much on edge. The effects were felt globally. The actions of the European Central Bank have alleviated the immediate funding issues for banks. Tensions eased a good deal, and this has been reflected in reopened term markets, falls in sovereign spreads for countries like Italy and Spain, and a rise in equity prices. We have also heard reports that some European participants in trade finance in Asia that had been pulling back in the last quarter of 2011 have begun to seek some business again recently. Yet much more needs to be done to put sovereigns and banks onto a sound footing longer term. activity remains constrained and Per cent five years (all of which were, of course, exceeded), Chinese GDP will equal that of the United States, in purchasing power parity terms, in about a decade. It will exceed that of the euro area within the next few years. There are issues of rebalancing the sources of growth in Asia, to which I shall return shortly. But the main point for now is that the global economy is faced at present with a year of sub-trend growth in 2012, according to international forecasters. This is a subdued but not disastrous outcome. And Asia in particular is well-placed to do fairly well, given sensible policies. Downside risks certainly do remain, and are easier at this point to imagine than upside ones. At this point though they remain risks, rather than outcomes. What then about Australia? At the moment, the viewpoints of those inside Australia differ somewhat from those of people outside Australia. Viewed from abroad, judging by what people say, observers see an economy that experienced only a relatively mild downturn in 2008-2009, that made up the decline in output within a few months, and that has continued to expand, albeit at only moderate pace, since then. They see an economy that has not experienced a significant recession for 20 years, that has strong banks and little government debt - and that debt remains AAA rated. Some observers worry about high levels of housing prices and household debt. This is understandable given the problems that have occurred in some other countries. But then others point out that the arrears rate on mortgages, at 60 basis points, is quite low, and that the rate of new construction of dwellings in recent years has been low relative to population needs. Foreign investors see a country that remains quite open to them, and that, reflecting its economic circumstances, offers rates of return that are high by international standards, even though they are low by Australian historical standards. They understand the potential returns on the mineral and energy wealth stored in or around the Australian continent, and unsecured funding remains expensive for banks. It is noteworthy that large corporates can borrow more cheaply than can banks with higher credit ratings, such is the odium investors attach to banks (though this is not confined to Europe). Much also has to be done on the supply side to generate growth in Europe, for without growth the fiscal arithmetic will always be challenging, if not impossible. The road to sustainability on these multiple fronts is a long one, which is why, as I say, there will be more periods of anxiety in the months (and years) ahead. While everyone has been fixated on Europe, the United States economy has avoided a 'double dip' recession, and continues grinding out a modest expansion. In recent times, the pace of jobs growth in the United States has picked up and other labour market indicators are showing signs of improvement. The United States has its own challenges of course, not least that it must sooner or later have some fiscal consolidation and that may slow growth. America's inherent dynamism and capacity to innovate, however, which is matched by few other societies, has to be seen as a positive over the longer term. Then there is China. The slowdown in Chinese growth - from 10 per cent to a mere 8 per cent! - is a major talking point, and some see it as portending a major crash. But some slowing was required to reduce inflation and, therefore, put growth on a more sustainable path. One can certainly think of ways in which China could have a 'hard landing' at some point. It is very difficult for anyone to know (doubly difficult, I think, if trying to know while sitting in a trading room in New York or London). But if the Chinese economy does slow 'too much', one could expect that the Chinese authorities will have both the will and the capacity to respond, the more so now that inflation has moderated. China will have cycles like other economies, but it seems likely that the Chinese economy will grow pretty strongly on average for a while yet. It will be a very large economy. Even at the new growth target of 7 1/2 per cent, a lower target than in the past in some parts of the Australian community and the tendency to focus on the difficulties, rather than the opportunities, which come with our situation. This difference in perceptions between foreigners and locals is quite unusual. For most of my career, the difference has tended to be in the opposite direction. We always seemed to struggle to get foreign observers and investors to give us credit for performance we thought was pretty reasonable. And it is only little more than a decade ago that Australia was being described as an 'old economy'. Now perceptions have changed, at least in a relative sense. The shift in global portfolio allocation that seems to be associated with this is potentially very important. In a more risk-averse world, the supply of genuinely low-risk assets seems smaller. Countries that have offered a reasonably stable economic environment and relatively sound public finances - of which Australia is one - are attracting greater flows of official capital now than they did a decade ago. This has recently been adding to the upward pressure on the exchange rate, independently of the rise in the terms of trade. As is so often the case in economics, there are two sides to this. On the one hand, the additional rise in the exchange rate pushes our cost structure in the tradable sectors of the economy up relative to other countries. This is a contractionary force and adds further to the already considerable pressure for structural change. On the other hand, it amounts to a reduction in the cost of international capital for Australian borrowers, particularly government borrowers. At the margin, this has to make the task of ensuring fiscal soundness a little easier. Even for private borrowers the unusually low level of long-term rates for the official sector offsets a good deal of the widening in spreads due to perceptions of higher private credit risk (that being, of course, a global phenomenon). A greater flow of cheaper capital to a country is an advantage. It is important, of course, that it is that our terms of trade have over the past year been higher than at any time for more than a century. There has been increased appetite for Australian dollar-denominated assets, particularly sovereign debt, and the Australian dollar has risen strongly, to be at its highest level in three decades. Those at home see this as well. As consumers, they have responded to the higher exchange rate with record levels of international travel. As producers, however, they also see, with increasing clarity, that the rise in the relative price of natural resources amounts to a global and epochal shift, which carries important implications for economic structure in Australia, as it does everywhere else. Some sectors of the economy will grow in importance as they invest and employ to take advantage of higher prices. Other sectors will get relatively smaller, particularly in the traded sector, as they face relatively lower prices for their products and competition for inputs from the stronger sectors. The exchange rate response to this shift in fundamentals is sending very clearly the signal to shift the industry mix, though this would occur at any exchange rate. The shift in relative prices is a shift in global prices that is more or less invariant to the level of the Australian dollar. In other words, while the global shift in relative prices is income-enhancing for Australians overall, it is also structural change-inducing. A former leader once quipped that 'microeconomic reform' was such a common topic in Australian discussion that even the parrots in pet shops were talking about it. I think the same is increasingly true of structural change: it is a term that will be on everyone's lips over the next few years. Structural adaptation is hard work. Few volunteer for it. But we have little choice but to do it, not just to make the most of the new opportunities that have been presented, but to respond to the changed circumstances that some industries face as a result. In this sense, Australia, though blessed with many natural endowments, is in the same position as most other nations. We have to adapt to changing times. This perhaps helps to explain the sense of concern used wisely. When risk appetite is strong, and risk assessment by lenders too loose, such conditions can result in problems. For example, it has been argued that the flow of capital to the United States looking for low-risk assets was channelled by the US financial system into structured products that had the illusion of high quality, but which ultimately resulted in the subprime mortgage crisis. At this point, however, we do not seem to have that problem in Australia. If anything, households, businesses and governments are looking, to varying degrees, to reduce their debt. The financial sector is quite risk averse in its lending practices, particularly towards some of the business sectors that might be willing to take on additional debt. In such circumstances, the competitiveness-dampening effect of the higher exchange rate on the traded sector that results from the portfolio shifts may, for some period of time, outweigh the expansionary effect of a lower cost of capital. The economic background to this shift is an economy where a range of indicators had been tending to suggest that growth was running close to average. Key business surveys, for example, have suggested average performance compared with the past 20 years; the rate of unemployment has been little changed at what remains, by the standards of the past three decades at least, a reasonably low level. On the other hand, recent national accounts data suggest growth in the non-farm economy somewhat below trend over 2011. Overall, recent economic performance in Australia is not too bad, particularly when compared, over a run of years, with a number of other advanced economies. But neither is it so good that it cannot be improved. The full range of policies - macroeconomic and structural - need to play their part in seeking that improvement. Monetary policy can play a role in supporting demand, to the extent that inflation performance provides scope to do so. But monetary policy cannot raise the economy's trend rate of growth. That lies in the realm of productivity-increasing behaviour at the enterprise, governmental and inter-governmental levels. Improving productivity growth is just about the sole source of improving living standards, once the terms of trade gain has been absorbed. This is increasingly being recognised in public discussion, but it is important we do more than just debate it. Nor can monetary policy obviate the pressure for the production side of the economy to change in response to altered relative prices. These changes in relative prices are essentially given to us by the world economy; they are not driven by any policy in Australia. So in Australia, reorienting our economy, adapting to structural changes and improving productivity performance are challenges we face. But we are hardly alone in facing adjustment challenges. More generally, reorienting economies in the Asian region, and around the world, remains a major challenge. Changes in the right direction have been occurring. Countries in this region have been prepared increasingly to develop and follow domestic policy frameworks that guide their behaviour in sensible ways (for example, inflation targeting). They have been prepared to accept some more movement in exchange rates, and to seek more domestic-led growth in demand. China in particular has seen the ratio of domestic demand to GDP rise over the past few years, reversing much of an earlier decline. More of this will be required, however, over time, for at least three reasons. First, it is not a sustainable model to expect developed world households to consume ever higher volumes of the output of Asian factories with borrowed money. That model cannot return, which means that the imperative to find domestic sources of growth is not just a cyclical one. Second, the eventual sheer size of the Asian economy is such that it will have to absorb more of its own output as it continues to grow. Continental-size economies such as the United States and the euro area have long done so. Here it is important to note that for East Asia outside of China and Japan, the decline in domestic demand relative to GDP that understandably occurred during the crisis of 1997-1998 largely remains in place, more than a decade later. Third, and most important, it will surely be the most enriching strategy for the people of this region to turn more of their own savings to developing their own physical and human capital. Yet at present trillions of dollars are lent by taxpayers in Asia to some highly indebted advanced world governments at yields that seem extraordinarily low. It seems very unlikely that there are not better risk-adjusted returns in Asia than that. So for all of us, the challenges are those of adaptation to changing circumstances and new opportunities. A fascinating journey lies ahead. We in Australia will be facing our own adjustment imperative. We will also be taking more than a casual interest in developments in the region in this 'Asian century'.

r120528a_BOA

australia

NO_INFO

stevens

I have not spoken publicly on payments system matters for some time, but it would be hard to find a better moment and a more appropriate event to take up the issue once more. This symposium of course marks 20 years of the Australian Payments Clearing Association (APCA) , which was set up as a vehicle to coordinate decision-making in relation to clearing and settlement following the recommendations of the Brady and Martin Reports in the years prior. It effectively replaced the Australian Clearing House Association, which was largely focused on cheques - the dominant payment system of the time. Sharing the stage with APCA in the early days was had been established in the 1980s as an advisory body to the government aimed at promoting and influencing the development of payment systems. The Council was wound up when the Payments System Board was established in 1998, following the recommendations of the Wallis Inquiry. APCA itself has evolved over the years. New clearing streams have been added and it has moved more into an industry representation role. Its make-up has also evolved; for instance I note that it was originally chaired by a representative of the Reserve Bank, an arrangement that ended in 1998. All this change over an extended period is a sure sign that there has long been recognition of how critical governance arrangements are to payments systems. The same debates that have occurred in Australia on these issues are repeated around the world. In fact, while the institutional arrangements for payments vary enormously from one country to another, it is remarkable how similar the debates are in each of those countries. I will be dealing with some of those issues today. The other reason that it is a good time to be speaking about payments is that, as I am sure many of you are aware, the conclusions of the Reserve Bank's Strategic Review of Innovation are due to be released very soon. In fact, they will be out within the next couple of weeks. I cannot pre-empt the detailed findings, but I will share with you some of the major themes. Naturally, most people will focus on the implications for the payments industry. But the conclusions will also have implications for the way that the Payments System Board goes about its business in relation to retail payments issues. That is as it should be. The Board is not a static entity either and its role evolves over time. My focus today, then, will be both innovation and the role of the Payments System Board. But with regard to the latter, I will talk not just about challenges in the retail payments sphere, but also about the other role of the Board that is probably less known to most of the people in this room - that is, the regulation of financial market infrastructure in order to preserve financial stability. This takes up a sizeable and increasing part of the Board's time. Why all the focus on payments innovation? It might, on its face, seem strange for the Reserve Bank to have devoted a considerable amount of time and effort to reviewing innovation in the payments system. For one thing, Australia has received great dividends from allowing, in most cases, commercial imperatives to drive the process of delivering new products, including payment products. We of course take a more cautious approach when it comes to matters of risk in the financial sector and we have seen how important those considerations are over the past few years. But in general, the notion that a regulator should be involved in matters of innovation might be seen as inconsistent with the regulatory philosophy has been reluctant to 'pick winners'. The other reason that it may seem slightly anomalous for the Reserve Bank to be preoccupied with payments innovation is that we see a great deal of it around us and every sign that there is significantly more around the corner. If we think about the rapid rise of PayPal, the spread of chip and now contactless card payments, and the enormous amount of energy that is being focused on mobile payments at the moment, there is clearly no shortage of innovation in payments. There is, however, a problem, and one about which the various players in the payments space themselves have become increasingly concerned. It is that the innovation in the customer-facing technology is moving at a pace much greater than the underlying infrastructure. This is a problem because innovation in a network industry is not like innovation in other industries. No matter how much time, effort and money a financial institution puts into its own systems and the ways in which customers interface with those systems, the payments service it can provide is only as good as the arrangements that allow payments to pass between institutions. These arrangements are in the cooperative space; not even the most innovative payments provider has the capacity to control these on its own. It is easy to see how this could act as a constraint on innovation. Cooperative decision-making between competitors is notoriously difficult. The implications of different business mixes, strategies and investment cycles can easily derail cooperation, not to mention the constraints of committee-based decisionmaking. These are classic coordination issues, where some external impetus may be required to initiate change. Even if coordination problems could be overcome for an innovation that is in the public interest, institutions collectively might find it difficult to make a business case to invest. Once again, this largely seems to be a quirk of the payments industry. Payment systems are 'two-sided markets'. In other words, the market must satisfy two distinct sets of customers; for instance, a point of sale payment system can be successful only if it is adopted by both consumers and merchants. In two-sided markets the price faced by each set of end users may be altered so that the party with the greatest decision-making power faces a low price. This is most evident in the credit card market, where consumers typically face a low or negative price while merchants face a relatively high price. The flow of interbank fees to support this has traditionally made issuing cards profitable for financial institutions. Because payment systems often do not simply operate on a user-pays model, establishing a business case can be more difficult than in other industries, even where there is a clear demand from end users. This means there is a case for some kind of mechanism to overcome coordination problems and to ensure that any disconnect between the public interest and the business case is properly managed. But any intervention by a regulator like the Payments System Board of the Reserve Bank must of course be carefully considered. The Payments System Board will be addressing the issue from two different perspectives. First, it will be expressing some views about the governance were valued by end users, as well as some that are important in payments system design. These included such things as: the timeliness of payments; accessibility; ease of use; ease of integration into other processes (such as business systems); and safety and reliability. Examining the services the payments system offers in terms of these attributes strongly suggests the areas where greater innovation in the payments system is needed, and where the underlying infrastructure might be imposing constraints on innovation. Second, the Board has considered developments in retail payment systems around the world. An understanding of what is available elsewhere and whether those things are valued and adopted by the users of payment systems is a very important commonsense test when considering what our own system ought to look like. This effort has in part been aided by interactions with many parties over the course of the Strategic Review, along with the work of the Committee on Payment and Settlement which has conducted an examination of innovation in retail payment systems. On the basis of this information, the Board sees the need to focus on the infrastructure capabilities of retail payment systems, rather than the specific products that are offered. Appropriate infrastructure can only be delivered cooperatively, but success in that delivery will allow payments providers to compete vigorously over the products and services they offer to customers. That should be true, not just for deposit-taking institutions, but for other innovative players that have something to offer in the provision of retail payments. I talked before about customer-facing innovation outpacing innovation in core infrastructure. What the Board is interested in is lifting the constraints imposed by that infrastructure. As to the specific areas on which the Board is focused, to those who have followed this process, and the documents that have been produced along the way, it will be no secret that one area on which the Board has focused is the timing of payments. It is very clear arrangements within the industry, with the aim of giving those the best possible prospects of successful collective decision-making and appropriate consideration of the public interest. More details on that will be included in the conclusions of the Second, the Board believes that in order to overcome coordination problems, it will need to take a stronger role in setting some general goals for the payments system, so as to help provide an appropriate focus for the innovation efforts of the various players. There will need, in the Board's view, to be greater interaction between the Board and the industry to establish and work towards shared goals. Our assessment of experience both in Australia and overseas is that superior industry outcomes have been achieved when there has been a policy influence promoting public interest goals. Examples range from reform of the ATM system in Australia to the establishment of the Faster Payments Service - for real-time retail payments - in the United Kingdom. Therefore, you can expect the conclusions of the Review to have more to say about a more constructive engagement between the Board and the industry in relation to payments innovation. The Board will not be picking winners, nor generally will it dictate the technical details of systems. The Payments System Board is a policymaking body. It would not seek to impose the technical details of solutions, unless it was aware of a very clear public policy basis for preferring one approach over another. In most cases, it is for the Board to provide guidance as to what outcomes it believes are required in the public interest, but not specific solutions. The latter are clearly the domain of industry experts, with their knowledge of the technical and business constraints. But it is important that they be informed by the Board's broader policy goals. The Board's thinking about those goals has been informed by two considerations. First, early in the Strategic Review of Innovation, the Board identified a number of attributes that and businesses are not unduly inconvenienced by this. But we receive enough complaints about this to suggest that expectations are changing. It is not that long ago that it was accepted that if a person wanted to ensure that they had enough cash to see them through the weekend, they had to make sure that they visited their bank branch by closing time on Friday. But we would all see that as completely unacceptable these days and I think we have reason to hold the rest of our payments system to the same standards. One question that we have come back to during the Strategic Review is what sort of payments system architecture would best allow us to deliver the features that we think are going to be demanded by payments system users in the years to come, including improved timeliness. Australia has had a long-running practice of operating payment systems that are based on both bilateral business agreements between participants and the bilateral exchange of payments between those participants. This model presents a number of problems, not least the complexity and cost of adding a new entrant, which must establish similar arrangements with each existing participant. Some of the significant changes we have seen in the payments system over the past few years have represented partial moves away from those bilateral arrangements. This includes the move to the industry community of interest network for clearing payments and the creation of eftpos Payments Australia Limited to centralise governance of the eftpos system. These changes denote recognition of the constraints of bilateral payment systems. While the Reserve Bank does not advocate walking away from some of the well-established and low-cost bilateral systems we have, we can see a strong case for any new architecture that is established to meet emerging needs to be based on centralised architecture; that is, a hub and spokes, rather than bilateral, model. So these are some of the things that will gain attention in the conclusions of the Strategic Review that both individuals and businesses are demanding greater immediacy and greater accessibility in all facets of their day-to-day activities. This includes payments. People expect to be able to book an airline ticket and choose their seat at any time of the day or night. They expect to be able to download music or a book while they are sitting on the bus. Our payments system supports these transactions by allowing the payment to be initiated, and goods or services exchanged, even though the funds will not be available to the merchant until some time later. This delivers the immediacy to the transaction itself, as people have come to expect. On the other hand, if a business or an individual wishes to receive funds into an account at a financial institution, that same immediacy is not available. For instance, if a business wishes to make timely use of the proceeds from a large shipment, or an individual is in need of emergency assistance from a government agency, options are very limited. This is because the infrastructure that underpins retail payments assumes that making funds available the next business day is sufficient. This has served acceptably well to date, but, with systems for real-time transfers available in countries ranging approach is starting to look a bit dated. It is our belief that availability of real-time transfers would fill some important existing gaps, but would also open up enormous potential for innovation on top of that system. This would contrast with the current situation, where a significant amount of effort is being put into finding workarounds for the current constraints of our systems. Another element of the timeliness of payments is the availability of the payments system out of standard banking hours. Some systems, such as card payment systems, give the impression of operating 24 by 7, but in reality no funds move between financial institutions out of hours, constraining the services that can be offered to end users of the payments system. Some would argue that anything more is unnecessary and that consumers of Innovation when they are released in the next couple of weeks. I do not mean to suggest that the issues identified by the Review will be solved quickly, but I think we - the industry and the regulator - owe it to the users we serve to embark now on the process that will get us on to the right path. As a first step, in the months following the release of the conclusions of the Review, I expect there to be a healthy dialogue with the industry on the sorts of goals that the Payments System Board has in mind for the payments system, along with more focused discussions on some specific solutions. I have been talking about the innovation review and the way it will alter, in some respects, the role played by the Payments System Board in the future. But it is also worthwhile to talk briefly about other developments that also have an impact on the direction of the Board more generally. The reality is that the Board's mandate of promoting stability, efficiency and competition requires it to play quite different roles in respect of two quite different sets of players in the financial system. Most people in this room would think of the Payments System Board as the body that capped credit card interchange fees and worked with the industry to achieve reforms in the ATM system. There is another set of players out there who think of the Payments System Board as the body that seeks to ensure the stability of key financial market infrastructure, or 'FMIs', such as securities settlement systems and, increasingly importantly, central counterparties - which stand between financial market participants in order to better manage risk. Much of this role came to the Board later than its initial payments mandate, when the adopted licensing arrangements for all clearing and settlement facilities in 2001. As important as the Board's work on payments system efficiency is, the stable operation of FMIs has a direct bearing on financial market and financial system stability. Oversight of FMIs therefore demands a significant proportion of the Board's time. It is also this work that is expanding most rapidly. In fulfilling its responsibility for the stability of financial market infrastructure, the Board has historically focused on the high-value payments system - the Reserve Bank Information and Transfer System - with which people in this room are more than familiar, along with the debt and equities settlement systems operated by the ASX and the equities and derivatives central counterparties also operated by the ASX. In addition, the Reserve Bank has for some years been part of an international cooperative oversight arrangement for the global foreign exchange settlement system, Continuous Two developments mean that the Bank's and the Board's workload in this area is increasing. First, while most financial market infrastructures serving Australian markets are currently operated by one entity, cross-border competition is increasing, particularly for central counterparty clearing services. It is likely that the Bank's oversight responsibilities will increase and become more complex as it has to deal with new entities offering services in the Australian market. The other development affecting the Board's role is the global push to strengthen financial regulation in the wake of the global financial crisis. That includes the push for OTC derivatives to be cleared through central counterparties and reported to trade repositories, as embodied in the G-20 commitments from Pittsburgh in 2009. All this means financial market activity that is important to Australia will be increasingly reliant on centralised financial market infrastructure. The logic of this reform is that it will reduce and simplify bilateral exposures between counterparties. But it will also increase the systemic importance of the financial infrastructure, because we will in effect be creating a small number of 'single points of failure'. Hence the resilience of that infrastructure will be critical, and the obligation of the official sector to provide proper oversight to ensure that resilience will correspondingly increase. These trends have been recognised in a number of areas that will affect the Payments System Board's work in the period ahead. The international standards used by central banks and securities regulators around the world as the cornerstone for oversight of FMIs have been comprehensively rewritten to reflect the lessons of the crisis and the increased importance of central counterparties and trade repositories. The revised standards were released just last month and it will be a substantial task for the Bank to reflect those changes in its own regulatory framework. a number of recommendations regarding the framework for regulation of FMIs in Australia, including that the Reserve Bank - along with Commission - be given the power to, in extremis , 'step in' and operate an FMI in the event that it suffers financial or persistent operational problems. The Bank has long had this capacity in regard to Austraclear, because of the systemically important nature of that system for the operation of the domestic money market. Domestic work in this area is occurring in parallel with international efforts to develop principles for the recovery and resolution of FMIs. Over the coming year, the Board will need to devote increasing attention to establishing how step-in and other recovery and resolution tools for FMIs would operate in Australia. Following further work by the Council of Financial Regulators, the Treasury is consulting on a legislative framework to support mandating of central clearing, exchange trading or reporting of OTC derivatives transactions, should this be warranted. Initially, however, the Council intends to rely on existing market and regulatory incentives to promote central clearing. The Payments System Board is likely to have a central role in the new regime, such as overseeing new central counterparties entering the market to clear these products, as well as input into decisions about when mandates for central clearing might be appropriate. It is inevitable that the Bank will become increasingly involved with cooperative oversight arrangements for financial market infrastructure that operates on a global basis. The upshot of all this is that the financial stability element of the Payments System Board's role is only going to increase. This is a continuation of a trend that has been under way for some time, and to which we have already responded with a significant boost in the resources we devote to these issues within the the regulatory framework complements the Bank's broader focus on financial stability, which is of course overseen by the Reserve Bank Board. There is a clear sense within the Payments System Board that our work over the next few years will in some respects take us into some different activities. The work for which the Board has mostly been known has focused on addressing problems or distortions in individual systems, albeit with knowledge that these distortions had significant effects on other parts of the system. The solutions have tended to be focused on the rules of those systems. Payments innovation requires something quite different because it is more clearly about solving coordination problems, which by their nature are likely to be ongoing and do not necessarily occur within the confines of an existing system. Addressing this issue will require a change in the nature of the conversation between the Board and the industry. That conversation began with the innovation roundtable earlier this year, and will continue in the period ahead, stimulated, hopefully, by the release of the conclusions from the innovation review. At the same time, the Board's mandate in relation to financial stability remains a key focus, and the global response to the financial crisis dictates that we take on a greater, and probably more complex, role as the global focus shifts to centralised financial market infrastructure. This doesn't mean that the Board will be paying less attention to the payments system efficiency matters for which it is perhaps best known. Much as we might want to live in a world where that type of regulation is not necessary, unfortunately the issues do not become any fewer or any less complex, and the Board is committed to continuing to meet its legislated responsibilities in this area. In fact, one challenge from innovation is that old tensions about competition might emerge in new ways. The Board will need to remain just as vigilant in these areas in the years to come.

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australia

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stevens

It is very good to be back in Adelaide. Thank you for the invitation. As we meet here, economic discussion in Australia has reached a rather curious position. Consider the background. Australia avoided a deep downturn in 2009, when most countries did not. A large number of businesses and jobs were saved by that outcome - though we will never know how many. Almost as a matter of arithmetic, the ensuing upswing was always going to be of the moderate variety. Rapid cyclical growth usually comes after a serious slump (and when it doesn't, it comes just before one). After small downturns, less spectacular growth is the usual experience. So it has proved on this occasion. Even so, three and a half years after the depths of the crisis in late 2008, this unspectacular growth has nonetheless seen real GDP per capita well and truly pass its previous peak. This is something yet to be achieved in any of the other nations shown here According to data published this week by the Australian Statistician, real GDP rose by over 4 per cent over the past year. This outcome includes the recovery from the effects of flooding a year ago, so the underlying pace of growth is probably not quite that fast, but it is quite respectable - something close to trend. Unemployment is about 5 per cent. Core inflation is a bit above 2 per cent. The financial system is sound. Our government is one among only a small number rated AAA, with manageable debt. We have received a truly enormous boost in national income courtesy of the high terms of trade. This, in turn, has engendered one of the biggest resource investment upswings in our history, which will see business capital spending rise by another 2 percentage points of GDP over 2012/13, to reach a 50-year high. To be sure, we face considerable structural adjustment issues arising from the mining expansion, and from other changes in the world economy. These are not easy to deal with (though they are not insurmountable). And we live in a global environment of major uncertainty, largely because of the problems of the euro zone. Nonetheless, an objective observer coming from outside would, I think it must be said, feel that Australia's glass is at least half full . Yet the nature of public discussion is unrelentingly gloomy, and this has intensified over the past six months. Even before the recent turn of events in Europe and their effects on global markets, we were grimly determined to see our glass as half empty. Numerous foreign visitors to the Reserve Bank have remarked on the surprising extent of this pessimism. Each time I travel abroad I am struck by the difference between the perceptions held by foreigners about Australia and what I read in the newspapers at home. I harbour no illusion that this can suddenly be lifted by anything I say today. But it is, hopefully, worthwhile to offer a few facts, and some perspective and analysis of the situation. Much of our public discussion proceeds under the rubric of the so-called 'two-speed economy'. It's become very much the description of the moment, and not only in Australia. One picks up the same theme in many other countries. Indeed it is a description of the global economy. Growth in the advanced industrial countries continues to be sluggish, and in some cases output is going backwards. Within Europe, Germany has been doing well, while other nations face huge economic challenges. Meanwhile growth in the 'emerging world' has been pretty robust apart from the effects of natural disasters. So in popular terms, we might say that there are varying lanes on the global growth highway: fast, slow, very slow. There are a few economies in the breakdown lane. Turning to Australia, we have long had a multi-speed economy. For example, it has been a very long-running trend that population growth tends to be faster in Western Australia and Queensland than in Tasmania or South Australia. Typically, certain industries such as housing construction show the expected differences due to population growth. Moreover while we debate the rise of mining and the much heralded 'decline of manufacturing', we might note that it has been a very long running trend that output and employment in manufacturing has grown more slowly than in the economy as a whole, and that output of various kinds of service provision has grown faster. That has been happening for at least five decades, and in most countries in the developed world. In the case of Australia's manufacturing sector, this decline reverses an earlier rise. In fact, the respective shares of mining and manufacturing in Australia's GDP at present are about where they were in 1900. It is obvious at present that the mining expansion is quite concentrated both in its industrial and geographical dimensions, and economic indicators do reflect that. But the mining sector is not the only sector growing. If the recent data are taken at face value, the non-mining economy has grown at about 2 per cent over the past year. Mining employment is indeed growing quickly - interestingly enough according to the available data, the increase in mining employment exceeded the fall in manufacturing employment over the past year. But the largest increase of all was in the sector called 'health care and social assistance', in which employment rose by about the size of the combined fall in manufacturing and retailing employment over the same period. And while there are clearly differing drivers by industry and by region, there are mechanisms that even out at least some of these differences. Spillovers do occur both in the private sector and via the tax and expenditure system. Remarkably, in the face of the understandable concern about job losses in particular regions and industries, the dispersion of unemployment rates by statistical region is no larger today than has usually been the case over the past 20 years. Hence, while there are clearly multiple speeds, the total speed seems to have been one of reasonable growth and low unemployment. But there is another aspect of the 'multi-speed' experience, which I suspect explains a good deal of the dissatisfaction we see, and it has to do with the behaviour of the household sector. Some parts of the economy that depend on household spending are still experiencing relatively weak conditions, compared with what they have been used to. But this isn't because the mining boom spillovers have failed to arrive. It is, instead, the result of other changes that actually have nothing to do with the mining boom per se , but a lot to do with events that occurred largely before the mining boom really began. The story is summed up in the two charts shown below. The first shows household consumption spending and income, both measured in per capita In brief, household spending grew faster than income for a lengthy period up to about 2005. The arithmetically equivalent statement is that the rate of saving from current income declined, by about 5 percentage points over that period. It was no coincidence that households felt they were getting wealthier. Gross assets held by households more than doubled between 1995 and 2007. The value of real assets - principally dwellings - rose by more than 6 per cent per annum in real, per capita Only a small part of this was explained by an increase in per capita expenditure on dwellings. The bulk of it came from rising prices. Moreover, a good deal of borrowing was done to hold these assets and household leverage increased. The ratio of aggregate household debt to gross assets rose, peaking at about 20 per cent. There was definitely a large rise in measured net worth, but relative to aggregate annual income, gross debt rose from 70 per cent in 1995, to about 150 per cent in 2007. Correspondingly, by 2007 the share of current income devoted to servicing that debt had risen from 7 per cent to 12 per cent, despite interest rates in 2007 being below those in 1995. It is still not generally appreciated how striking these trends were. I cannot say that it is unprecedented for spending to grow consistently faster than income, because it had already been doing that for the 20 years prior to 1995. That is, the saving rate had been on a long-term downward trend since the mid 1970s. But it is very unusual in history for people to save as little from current income as they were doing by the mid 2000s. And it is very unusual, historically, for real assets per person to rise at 6 per cent or more per annum. It is also very unusual for households actually to withdraw equity from their houses, to use for other purposes, but for a few years in the mid 2000s that seemed to have been occurring. Of course, Australia was not alone in seeing trends like this. There were qualitatively similar trends in several other countries, particularly English-speaking in income. But the gap between the current level of consumption and where it would have been had the previous trend continued is quite significant. If we then consider the growth of foreign online sales and so on, and the fact that consumers seem more inclined to consume services - experiences, as opposed to goods - we can see this is a significant change for the retail sector. No doubt reinforcing this trend towards more circumspect, but more typical, behaviour is that the earlier strong upward trend in real assets per head has abated over recent years. In fact, real household assets per head today are about the same as they were five years ago, with a dip during the crisis, a subsequent partial recovery and then a slow drift down over the past couple of years. Both dwelling prices and share prices - the two really big components of wealth - have followed that pattern . At some point, wealth will begin to increase again. After all, people are saving a reasonable amount from current income and placing the proceeds into various assets (especially, of late, deposits in financial institutions). That is, they are building wealth the old-fashioned way. Ultimately these flows will be reflected in higher holdings of real and financial assets, at least once debt levels are regarded as comfortable. Asset valuation changes can, of course, dominate saving flows in shifting wealth over short periods and they are inherently unpredictable. So no one can predict the course of these measures of wealth over any particular short period. But wealth will surely resume an upward track, sooner or later. countries that experienced financial innovation. The international backdrop to this period was the so-called 'great moderation', in which there was a decline in macroeconomic variability. There were still business cycles but downturns were much less severe than in the 1970s or 1980s, inflation was low and not very variable, which meant that nominal interest rates also were generally low and not very variable, and compensation for risk became very modest. This 'moderation' came to an end with the crisis beginning in 2007. And with a few years of perspective, it is increasingly clear that Australian households began to change their behaviour at that time, or even a little before. The rate of saving from current income stopped falling probably around 2003 or 2004, and began to increase (we now know), slowly at first as the income gains from the first phase of the resources boom started in about 2005 or 2006, and then more quickly in 2008 and 2009. Real consumption spending per head initially remained pretty strong in this period, reaching a peak in 2008. It then declined for a year or so, before resuming growth in the second half of 2009. That growth has, however, been much slower than had been observed previously. In the nearly three years from mid 2009 through to the March quarter 2012, real consumption per head rose at an annual pace of about 1 1/2 per cent. This is more than a full percentage point lower than the growth rate from 1995 to 2005. But this sort of growth is, in fact, quite comparable with the kind of growth seen in the couple of decades leading up to 1995. It is in line with the quite respectable growth This chart shows business investment, split into mining and non-mining, and measured in real, per capita terms, so as to be consistent with the earlier upward trend since the mid 1990s than it had been for a number of years before that. In particular, business investment in real per capita terms has grown, on average, by over 6 per cent per annum since 1995, more than double the average pace over the preceding 35 years. Moreover a lot of this was in the non-mining sector, and it began before the present run up in mining investment really got going. Some of this growth reflected the same 'consumer facing' growth sectors mentioned above. Of the four sectors that had the fastest growing investment spending over that period, three were finance, one called 'rental hiring and real estate services', and retail trade. Some of these sectors are slowing their investment rates now . Meanwhile, mining investment has recently been rising at an extraordinary pace. In 2005, mining investment was near its long-run average of around 2 per cent of GDP. By mid 2014 we expect it to reach at least 9 per cent of GDP. If that occurs, mining investment will be about as large as business investment in the rest of the private economy combined. As a result of that, total business investment will reach new highs this year, and next. When it does, however, it is unlikely to be at 6 or 7 per cent per year in real, per capita terms. I would guess that over the long term, something more like 3 per cent would be nearer the mark. I think this is a profoundly important point and worth emphasising. The decade or more up to about 2007 was unusual. It would be quite surprising, really, if the same trends - persistent strong increases in asset values, very strong growth in per capita consumption, increasing leverage, little or no saving from current income - were to re-emerge any time soon. That is, the gap between consumption today and the old trend level on the chart is not going to close. I noted to another audience about three years ago that the prominence of household demand in driving growth in the 1990s and 2000s was unlikely to be repeated. If there were business strategies that assumed a resumption of the earlier trend, they will surely be disappointed in time, if they have not been already. There were several parts of the economy that benefited from that earlier period, and that are finding the going much tougher now. Retailing was obviously one, but so was banking. Banks and other financial institutions enjoyed rapid balance sheet and profit expansion as they lent to households and some businesses. But they can see that period has now finished. Businesses that serviced rapid turnover in the dwelling stock (such as real estate agents, mortgage brokers) are seeing those revenue streams considerably reduced, and are having to adjust their strategies and capacity to suit changed conditions. For example, the rate of dwelling turnover is about one-third less than it was on average over the previous decade, and about half its peak levels. This is affecting state government stamp duty collections as well as the real estate sector. We can also see some echoes of these changing trends in household demand in business investment spending. One thing we should not do, in my judgement, is try to engineer a return to the boom. Many people say that we need more 'confidence' in the economy among both households and businesses. We do, but it has to be the right sort of confidence. The kind of confidence based on nothing more than expectations of ever-increasing housing prices, with the associated willingness to continue increasing leverage, on the assumption that this is a sure way to wealth, would not be the right kind. Unfortunately, we have been rather too prone to that misplaced optimism on occasion. You don't have to be a believer in bubbles to think that a return to sizeable price increases and higher household gearing from still reasonably high current levels would be a risky approach. It would surely be a false basis for confidence. The intended effect of recent policy actions is certainly not to pump up speculative demand for assets. As it happens, our judgement is that the risk of reigniting a boom in borrowing and prices is not very high, and this was a key consideration in decisions to lower interest rates over the past eight months. Hence, I do not think we should set monetary policy to foster a renewed gearing up by households. We can help, at the margin, the process of borrowers getting their balance sheets into better shape. To the extent that softer demand conditions have resulted from households or some businesses restraining spending in an effort to get debt down, and this leads to lower inflation, our inflation targeting framework tells us to ease monetary policy. That is what we have been doing. The reduction in interest rates over the past eight months or so - 125 basis points on the cash rate and something less than that, but still quite a significant fall, in the structure of intermediaries' lending rates - will speed up, at the margin, the process of deleveraging for those who need or want to undertake it. Hence, there is a very large build-up in the nation's capital stock occurring. If it is well managed and soundly based, that ought to allow the possibility of further growth in output and incomes. The investment phase of the mining boom will start to tail off in a couple of years' time, after which the shipments of natural resources should step up significantly . We might expect by then as well that some other areas of investment spending that are weak at present will be picking up. More generally, I suspect we will discuss the nature of investment quite a bit in coming years as we grapple with structural change in the economy and powerful shifts in the population's needs (think of investment in the aged-care sector, for example, or public infrastructure needs). We will also be looking for productivity pay-offs from the various investments . But the key message for today is that the multi-speed economy is not just about the mining sector squeezing other sectors by drawing away labour and capital and pushing up the exchange rate. It is doing that, but slower growth in sectors that had earlier done well from unusually strong gains in household spending would have been occurring anyway, even if the mining boom had never come along. It is these changes in behaviour by households, in asset markets and in credit demand, that I think lie behind much of the disquiet - dissatisfaction even - that so many seem to have been expressing. But this would, as I say, have occurred with or without the mining boom. In fact, without the mining boom and its spillovers, we would have been feeling the effects of those adjustments rather more acutely than we do now. The period of household gearing up could have ended in a much less benign way. What are the implications of these trends for economic policy, and particularly monetary policy? Does it have a role in helping the adjustment? We face a remarkable period in history. The centre of gravity of the world economy seems to be shifting eastwards - towards us - perhaps even faster than some of the optimists had expected. Granted, that is partly because the relative importance of Europe seems to be shrinking, perceptibly, under the weight of its internal problems. But even if the Europeans manage the immediate problems well, there is no mistaking the long-run trend. That this comes just as a very unusual period for household behaviour in Western advanced countries (including Australia) has ended, has been a remarkably fortuitous combination for Australia. Certainly it means we have the challenge of adjusting our behaviour and our expectations to new drivers for growth and new imperatives for responsiveness, but we do so with growing incomes, low unemployment and exposure to Asia. That is infinitely preferable to the sorts of adjustments that seem to be the lot of so many others at present. The Australian community has understood that we can't base growth persistently on falling saving and rising debt and that is forcing changes to business models. But it has to be said that the return of a certain degree of thrift actually strengthens our medium-term position. If we can marry that to a focus on incrementally improving the way we do things - lifting productivity - there is actually a lot to look forward to. For Australians, the glass is well and truly half full. In saying that, of course, we cannot neglect the interests of those who live off the return from their savings and who rightly expect us to preserve the real value of those savings. Popular discussion of interest rates routinely ignores this element, focusing almost exclusively on the minority of the population - just over one-third - who occupy a dwelling they have mortgaged. The central bank has to adopt a broader focus. And to repeat, it is not our intention either to engineer a return to a housing price boom, or to overturn the current prudent habits of households. All that said, returns available to savers in deposits (with a little shopping around) remain well ahead of inflation, and have very low risk. So monetary policy has been cognisant of the changed habits of households and the process of balance sheet strengthening, and has been set accordingly. As such, it has been responding, to the extent it prudently can, to one element of the multi-speed economy - the one where it is most relevant. What monetary policy cannot do is make the broader pressures for structural adjustment go away. Not only are the consumption boom and the household borrowing boom not coming back, but the industry and geographical shifts in the drivers of growth cannot be much affected by monetary policy. To a large extent, they reflect changes in the world economy, which monetary policy cannot influence. Even if, as a society, we wanted to resist the implications of those changes other tools would be needed . In fact Australia does better to accommodate these changes, and to think about what other policies might make adjustment less difficult and quicker for those adversely affected. It is in this area, in fact, that we need more confidence: confidence in our capacity to respond to changed circumstances, to respond to new opportunities, and to produce goods and services which meet market demands. It is also to be hoped that some of the recent positive data outcomes will give pause to reflect that, actually, things have so far turned out not too badly .

r120724a_BOA

australia

NO_INFO

stevens

Thank you for coming today to support the Anika Before I proceed I want also to thank Macquarie Bank for their support, once again, in providing today's venue and sustenance, and the Australian Business Economists for their continuing organisational support for these annual functions. It is slowly becoming better recognised that the Australian economy's relative performance, against a very turbulent international background, has been remarkably good. Many foreign visitors to Australia comment on this relative success and I have noticed an increase in the number of foreign companies interested in investing in Australia as a result, notwithstanding our domestic tendency towards the 'glass half empty' view. But some observers - admittedly not the majority - still harbour concerns about the foundations of recent economic performance and question the basis for confidence about the future. There are several themes to these doubts, but the common element is that recent relative success owes a certain amount to things that will not continue - to luck - and that our luck may be about to turn. Rapid growth in Chinese demand for resources, for example, has been of great benefit to date, but what if the Chinese economy suffers a serious downturn? Another potential concern is dwelling prices. Australia saw a large run-up in dwelling prices and household borrowing until a few years ago. Some other countries that saw this subsequently suffered painful corrections and deep recessions, associated with very stressed banking systems. Can Australia escape the same outcome? A further theme is the focus on the funding position of Australian financial institutions, insofar as they raise significant amounts of money offshore. Could this be a weakness, in the event that market sentiment turns? Actually, this is another version of the old concern about the current account deficit: what will happen if markets suddenly do not want to fund our deficit? It has long been a visceral fear among Australian officials and economists that global investors will suddenly take a dim view of us. The same sorts of concerns of organisations such as the International Monetary Fund and the ratings agencies seem to lie behind a perpetual question mark about Australia and its financial institutions. It is unlikely we will ever be able to change definitively the views of all the sceptics. And - let us be clear - we should welcome the sceptics. Perhaps some of their concerns are valid. The Reserve Bank gives a lot of thought to these issues; we certainly do not dismiss them. We should always be wary of the conventional wisdom being too easily accepted. We should never, ever, assume that 'it couldn't happen here'. It is in that vein that I wish to pose a set of questions that are thrown up by these sceptical views. In How much of the recent relatively good performance was due to luck? To what extent did we improve our luck by sensible policies, across a range of economic and financial fronts? Are there signs of any of the things going wrong that people typically worry about? And if there are, or were to be, such signs, could we do anything about it? To begin, I shall restate some key metrics. These charts really require no exposition (Graphs 1, 2 and 3). The message is clear. It is fair to conclude that, given the circumstances internationally, the Australian economy has exhibited more than acceptable performance over recent years. This conclusion would stand whether comparisons were made either against most other countries, or against our own historical experience. Why was it that Australia did not have a deep downturn in 2009 when so many other countries did? And why was it that we have returned to reasonable growth, when others have struggled to do so? These questions have been answered on numerous occasions. There are several elements. First, the Australian banking system went into the crisis in reasonable shape. To be sure, there were some poor lending decisions during the preceding period of easy credit and there was, in hindsight, too much reliance on wholesale funding. But among major institutions, credit quality issues have turned out to be manageable. Asset quality was not as good among some of the regional banks, and even less so among some foreign banks operating in Australia, but the problems have not been insurmountable. Some observers might counter that the banks received assistance with wholesale fundraising in the form of the government guarantee. But the banks paid for that, and it was an appropriate response at a time of massive market dislocation when all their peers were receiving like assistance - and much more. Moreover the banks have neither had, nor needed, access to this for some time now and the stock of guaranteed liabilities outstanding has fallen by about half from its peak level, as issues mature or are repurchased. So our banking system, while not entirely free from blemishes, was nonetheless in pretty good shape overall. Banks were able to raise capital privately in the depths of the crisis. The lowest rate of return among any of the major banks over a year during the crisis period was about 10 per cent. The Australian Government has not needed to take an ownership stake in a financial institution. Second, Australia had scope for macroeconomic policy stimulus, which was used promptly and decisively. Interest rates were lowered aggressively, from a high starting point, lowering debt-servicing burdens at a rapid rate. The fiscal stimulus was one of the larger ones, as a percentage of GDP, among the various countries with which we can make comparisons. The evidence suggests that these macroeconomic measures were effective in sustaining growth. Thirdly, the rapid return to growth of the Chinese economy saw demand for energy and resources strengthen again after a brief downturn in late 2008 and the first couple of months of 2009. This reversed the fall in Australia's terms of trade, and in fact pushed them to new highs, which led to a resumption of the historic investment build-up that had already begun. It benefited the whole of Asia, which staged a very pronounced V-shaped recovery on the back both of the Chinese measures and things other countries did themselves. A fourth element that many people add is that the exchange rate fell sharply, which was an expansionary impetus for the economy. But of course the exchange rate was responding endogenously to the various shocks and policy responses, and has since reversed the fall. It was doing what it was supposed to do. Perhaps the real point is that the right exchange rate system was implemented nearly 30 years ago, and that it was allowed to work. So Australia had these things going for it. Was this all just luck? We could not deny that our geography - thought for much of our history to be a handicap because of the distance from European and American markets - combined with our natural resource endowment has provided a basis for the country to ride the boom in Asian resource demand. We did not create that, though we still have to muster the capability to take sustained advantage of it. But a well-managed and well-supervised banking system is not an accident. Years of careful work both by banks and APRA went into that outcome. Nor was the ability to respond forcefully, but credibly, with macroeconomic policy just luck. You don't suddenly acquire the credibility needed to ease monetary policy aggressively while the exchange rate is heading down rapidly. Authorities in lots of countries would not feel they could do that. At an earlier point in time we probably would not have felt we could have done it either. The credibility needed to do it comes from having invested in a well-structured framework, and having built a track record of success in containing inflation, over a long period. The floating exchange rate is an integral part of that framework. Likewise, you can't have a major fiscal easing and expect it to be effective if there are concerns about long-run public debt dynamics, as recent debate elsewhere in the world shows. You need to have run a disciplined budget over a long period beforehand, so that the amount of debt you have to issue in a crisis does not raise questions about sustainability. In contraction. We did actually see Chinese IP contract for several months in 2008; we are not seeing that at present. The conclusion I draw is that the Chinese economy has indeed slowed over the past year or so. It was intended that a slowing occur. But the recent data suggest that, so far, this is a normal cyclical slowing, not a sudden slump of the kind that occurred in late 2008. The data are quite consistent with Chinese growth in industrial output of something like 10 per cent, and GDP growth in the 7 to 8 per cent range. To be sure, that is a significant moderation from the growth in GDP of 10 per cent or more that we have often seen in China in the past five to seven years. But not even China can grow that fast indefinitely and there were clearly problems building from that earlier breakneck pace of growth. Inflation rose, there was overheating in property markets and no doubt a good deal of poor lending. It is far better, in fact, that the moderation occur, if that increases the sustainability of future expansion. Moreover, the Chinese authorities have been taking well-calibrated steps in the direction of easing macroeconomic policies, as their objectives for inflation look like being achieved and as the likelihood of slower global growth affecting China has increased. Prices for key commodities are lower than their peaks, but are actually still high. So far, then, the 'China story' seems to be roughly on course. It is certainly true that we will feel the effects of the Chinese business cycle more in the future than we have been accustomed to in the past. That presents some challenges of economic analysis and management. But even so, it may be better to be exposed to a Chinese economy with a high average, even if variable, growth rate, than, say, to a Europe with a very low average growth rate that is apparently also still rather variable. Next I turn to dwelling prices. As everyone knows, dwelling prices rose a great deal over the decade or more from 1995, and not just in Australia. This occurred globally. The fact that it was a widespread both the monetary and fiscal areas, of course, having used the scope we had so aggressively, it was also necessary, as I argued in 2009, to reinvest in building further scope, by returning settings to normal once the emergency had passed. So, yes, Australia has had its share of luck. But to explain the outcomes, we need also to appeal to factors that didn't just happen by accident. Of course, that doesn't mean we still couldn't have problems. Even if success to date hasn't been due to luck alone, perhaps our luck could turn so bad that all our efforts at good policymaking could be overwhelmed. Let us then take a look at some of the potential pressure points that people sometimes worry about. The first is the Chinese economy. One of the data series people pay a lot of attention to is the Chinese version of the so-called 'Purchasing Managers' Index'. The usual commentary surrounding such indexes invariably refers to the '50' level as the threshold between growth and contraction in the sector of the economy being examined. But what have these PMIs actually been saying about the Chinese economy? Properly calibrated, as in this chart, they suggest that growth in China's industrial production has been running at about 5 percentage points below average, which means it is just under 10 per cent (Graph 4). But it is a long way from a phenomenon is a hint that we should be wary of explanations that are solely domestic in their focus. It suggests that the global dwelling price dynamic had a lot to do with financial factors - and there is little doubt that finance for housing became more readily available. In various countries prices have subsequently fallen. In the United States, for example, prices are down by about 30 per cent from their peak, though they look like they have now reached bottom. In the United Kingdom the fall was smaller - at about 15-20 per cent. In Australia, the decline since the peak has been about 5 to 10 per cent, depending on the region. There are of course prominent examples of particular localities or even individual dwellings where price falls have been much larger. Scaled to measures of income, Australian dwelling prices on a national basis have in fact declined and are now about where they were in 2002 (Graph 5). That is, housing has become more 'affordable'. Four or five years ago we supposedly had a housing affordability 'crisis'. Now it seems that the problem some people fear is that of housing becoming even more affordable. Are dwelling prices overvalued? It's very hard to be definitive on that question. There are two aspects to the claim that they might be. The first is that prices relative to income are higher than they were 15 or 20 years ago. If this ratio is somehow mean-reverting, then either incomes must rise a lot or prices must fall. It could be that this analysis is correct, but the problem is that there is no particular basis to think that the price to income ratio 20 years ago was 'correct'. There are reasons that might be advanced for why the ratio might be expected to be higher now than then - that the mean has shifted - though again there is little science to any quantification for such a shift. In any event, arguments that appeal to historical averages for such ratios lose potency the longer the ratio stays high. In Australia's case the ratio of prices to income on a national basis has been apparently at a higher mean level - about 4 to 4 1/2 - for about a decade now. The second support for the claim that dwelling prices are overvalued is the observation that they seem high in comparison with other countries. In seeking to make such comparisons, though, there are serious methodological challenges. The key difficulty is in sourcing comparable data on the level of prices across countries. Such data are, at best, pretty sketchy. With that caveat very clearly in mind, consider the following two charts. it is hard to avoid the impression that gravity will inevitably exert its influence on Australian dwelling prices. But if we put these two lines on a chart with a number of other countries with which we might want to make comparisons, the picture is much less To the extent that we can make any meaningful statements about international relativities, the main conclusion would be that Australian dwelling prices, relative to income, are in It is true that a low unemployment rate is a key factor helping here, but it is also true that the proportion of households that are ahead on their mortgage payments is also high - with some evidence pointing to over half - which would provide a buffer of some months for those households in the event a period of lower income was experienced. If we look at applications for possessions of dwellings, they have been running at about 0.15 per cent of dwellings on an annualised basis. Such applications have actually declined since their peak in both New South Wales and Victoria, though they have risen over the past couple of years in Western Australia and Queensland. In the United States the most comparable figure for repossessions - 'foreclosures started' - peaked at over 2 per cent of dwellings. The conclusion? We should never say a crash couldn't happen here, and the Reserve Bank continues to monitor property markets and the performance of mortgages quite closely, as we have for many years. But it has to be said that the housing market bubble, if that's what it is, seems to be taking quite a long time to pop - if that's what it is going to do. The ingredients we would look for as signalling an imminent crash seem, if anything, less in evidence now than five years ago. the pack of comparable countries. In this comparison, the United States seems the outlier. None of this can be taken to say definitively that Australian dwelling prices are 'appropriate', or that there is no possibility they will fall. It is a very dangerous idea to think that dwelling prices cannot fall. They can, and they have. The point is simply that historical or international comparisons, to the extent they can be made, do not constitute definitive evidence of an imminent slump. At the very least, the complexity of making these comparisons suggests we ought to look at some other metrics in thinking about the housing market. One would be the performance of the associated mortgages. Here, the main story is that not much has changed. Arrears remain low and if anything have been edging down over the past year. That in turn is not altogether surprising given that debt-servicing As a result of lower house prices and therefore lower loan sizes, somewhat lower interest rates and a good deal of income growth, the repayment on a new loan on a median-priced house as a share of average income is now at its lowest for a decade (except for the 'emergency' interest rate period in 2009). in Australia, compared with the world's trouble spots. Think for just a moment about the holdings of government debt on the books of banks in any number of other countries, and about the state of public finances of many of those countries. The arguments I have presented amount to saying that some necessary adjustments have been occurring gradually and reasonably smoothly. China's growth had to moderate. It has slowed, but it hasn't collapsed. Housing values and leverage in Australia couldn't keep rising. They haven't. Dwelling prices have already declined, relative to income, and it is in fact not obvious that they are particularly What then about funding vulnerabilities? The pre-crisis period saw too much 'borrowing short to lend long', and too much reliance on the assumed availability of market funding. Banks everywhere have been adjusting away from that model over recent years, Australian banks among them. The share of offshore funding has fallen, and its maturity The flip side of this is of course the rise in domestic deposit funding, which has occasioned such competitive behaviour in the market for deposits. Interestingly enough, while we have been told over the years how Australian banks were doing the country a favour by arranging the funding of the current account, they have stopped doing this over the past year without, apparently, any dramatic effects. As measured in the capital account statistics, there has been a net outflow of private debt funding over the past two years, offset roughly by increased inflow of foreign capital into government decline in government debt yields and a net rise in the exchange rate. The current account deficit has, in other words, been easily 'funded' without the assistance of banks borrowing abroad - in fact, while they have been net repayers of funds borrowed earlier. A reasonable conclusion is that the degree of vulnerability to a global panic of any given magnitude appears to have diminished, rather than grown, over the past few years. It hasn't completely disappeared, and it would not be sensible to expect it would, unless we were pursuing a policy of financial autarky. But there is little reason to assume that Australian institutions are somehow unusually exposed to these risks compared with most of their counterparts overseas. In the end, of course, any bank's ability to maintain the confidence of its creditors is mainly about its asset quality. That brings us back to lending standards, the macroeconomic environment, and so on. One would think that, overall, things look relatively good If the thing that goes wrong is a serious slump in China's economy, the Australian dollar would probably fall, which would provide expansionary impetus to the Australian economy. But more importantly, we could expect the Chinese authorities to respond with stimulatory policy measures. Even if one is concerned about the extent of problems that may lurk beneath the surface in China - say in the financial sector - it is not clear why we should assume that the capacity of the Chinese authorities to respond to them is seriously impaired. And in the final analysis, a serious deterioration in international economic conditions would still see Australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question. If dwelling prices in Australia did slump, then there would be obvious questions about how that dynamic could play out. In such circumstances people typically worry about two consequences. The first is a long period of very weak construction activity, usually because an excess of stock resulting from previous over-construction needs to be worked off. But we have already had a fairly protracted period of weak residential construction; it's hard to believe it will get much weaker, actually, at a national level. The second potential concern is the balance sheets of lenders. This scenario is among those routinely envisaged by APRA's stress tests over recent years. The results of such exercises always show that even with substantial falls in dwelling prices, much higher unemployment and associated higher levels of defaults, key financial institutions remain well and truly solvent. Of course, it can be argued that the full extent of real-life stresses cannot be anticipated in such exercises. That's a reasonable point. But we actually had a real-life stress event in 2008 and 2009. The financial system shows a few bruises from that period, but its fundamental stability was maintained. high compared with most countries. Housing 'affordability' has improved significantly; over 99 per cent of bank-held mortgages are being serviced fully. Banks have reduced their need for the sort of funding that might be difficult to obtain in a crisis situation. The current account deficit is being funded by a combination of direct equity investment, and flows into high-quality Australian dollar-denominated assets, the latter at costs that have been falling. In fact, the Commonwealth of Australia, and its constituent States, are at present able to borrow at about the lowest rates since Federation. Markets do not, then, seem to be signalling serious concerns about Australia's solvency or sustainability. But markets can be wrong sometimes. They can sometimes be too optimistic (and other times too pessimistic). So even though we don't face immediate problems, we should ask: what if something went wrong? Below I consider a few possibilities. If the thing that goes wrong is a major financial event emanating from Europe, the most damaging potential transmission channel would be if there were a complete retreat from risk, capital market closure and funding shortfalls for financial institutions. Let me emphasise, importantly, that this is not occurring at present and if it did occur it would be a problem for a great many countries, not just Australia. But in that event, the Australian dollar might decline, perhaps significantly. We might find that, in an extreme case, the Reserve Bank - along with other central banks - would need to step in with domestic currency liquidity, in lieu of market funding. The vulnerability to this possibility is less than it was four years ago; our capacity to respond is undiminished and, if not actually unlimited, is not subject to any limit that seems likely to bind. An alternative version of this scenario, if it involved the sort of euro break-up about which some people speculate, could be a flow of funds into assets. In that case our problem might be not being able to absorb that capital. But then the banks would be unlikely to have serious funding problems. The years ahead will no doubt challenge us in various ways, including in ways we cannot predict. But what's new about that? Even if the pessimists turn out to be right on one or more counts, it doesn't follow that we would be unable to cope. Acting sensibly, with a long-term focus, has as good a chance as ever of seeing us through whatever comes our way. Most of all, and to return to the whole point of today's event, we have much to live for. We want to do everything we can to ensure the next generation can share the positive outlook that most Australians have (almost) always had. That is why the Anika Foundation's work is so important, and why your presence here today is so valuable. Thank you again for your support. Most Australians I encounter who return from overseas remark how good it is to be living and working here. We are indeed 'lucky' in so many ways, relative economic stability being only one of them. But what matters more is what we do with what we have. Not every good aspect about recent performance is down to luck. By the same token there are things we can do to improve our prospects - or, if you will, to make a bit of our own future luck. Some of the adjustments we have been seeing, as awkward as they might seem, are actually strengthening resilience to possible future shocks. Higher - more normal - rates of household saving, a more sober attitude towards debt, a reorientation of banks' funding, and a period of dwelling prices not moving much, come into this category.

r120824a_BOA

australia

stevens

Since the meeting we had in February, assessments of the global and local economies have waxed and waned. In February, sentiment about the international financial system was recovering somewhat, after a scare late in 2011. The actions of the European Central Bank in extending its liquidity provision to euro area banks had taken major re-funding hurdles out of the picture for a time. This was a critically important action that bought time. It was clear that the European economy had slowed, that the United States was still growing, but at only a modest pace, and that China's growth was moderating to something more sustainable. But high-frequency indicators of the global business cycle were stabilising. So even though forecasts for global growth were at that stage being marked down a bit, we did not seem to be seeing a slump of the kind seen in late 2008. Subsequently, there were actually some small upward revisions to global growth forecasts. But, as we said at the last hearing, sorting out the problems in the euro area is likely to be a long, slow process, with occasional setbacks and periodic bouts of heightened anxiety. We saw one such bout of anxiety in the middle of this year, when financial markets displayed increasing nervousness about the finances of the Spanish banking system and the Spanish sovereign. The general increase in risk aversion saw yields on bonds issued by some European sovereigns spike higher, while those for Germany, the UK and the US declined to record lows. This 'flight to safety' also saw market yields on Australian government debt decline to the lowest levels since Federation. Meanwhile, many European economies saw a further contraction of economic activity. Share markets declined sharply. Over the past couple of months, assessments of near-term global growth, having gone up a bit between February and May, have been marked back down. Bodies such as the International Monetary Fund are forecasting world GDP growth of about 3 1/2 per cent this year, before picking up a little next year. These seem reasonable estimates at this stage, although the risks still seem weighted to the downside. It is worth noting that we still have not seen, thus far, the sort of collapse in production and trade across a wide range of countries that was observed in 2008. The global slowing we have seen has, so far at least, been of the more ordinary variety. That is not to make light of these developments, only to keep them in some sort of perspective. The kind of growth envisaged for the world as a whole is close to its long-run average. Of importance to Australia, and as we noted at the February hearing, the Chinese economy looks like it has slowed to a pace of growth that is likely to be more sustainable. This is, though, clearly below the pace seen for much of the recent past and the implications of this new pace of growth for the trajectory of demand for various commodities are still being worked through in the relevant markets. Commodity prices have declined. Australia's terms of trade peaked about a year ago. However, they remain high in comparison with most of the past century. Overall, the developments in key commodity prices do not seem out of line with what we can observe about the progress of the global economy. Of late, financial market sentiment has again recovered somewhat. This is seen most clearly by share prices in most markets recovering the losses seen in mid year, while interest rates on 'peripheral' European debt have fallen. It could not be said that confidence is strong: uncertainty is high and much of this stems unavoidably from the situation in Europe. European policymakers have continued their efforts both to stabilise the immediate situation, and to craft stronger pan-European structures for financial management so as to provide a more enduring stability. Their actions and commitments to future actions have been important but expectations for further progress are high. Realistically, it will be quite some time before the Europeans will be able to say these problems have been put behind them, even if things go well. Turning to the domestic economy, the sequence of changes in assessment has tended to be the obverse of what we have seen internationally. At the previous hearing we believed, on the basis of the available data, that overall growth had been close to trend over 2011. Subsequently we could not avoid revising that view downwards a bit, as there seemed to be some emerging evidence that growth had been weaker than that. The most recent data, on the other hand, are suggestive that the earlier assessment may, in fact, have not been too far off the mark. As recorded, domestic final demand rose by 5 per cent in real terms over the year to the March quarter, even with a small contraction in public spending. The strongest growth was by business investment in the resources sector but even consumption spending by households rose by about 4 per cent, according to the national accounts. A good deal of the growth in demand was supplied from abroad but, nonetheless, output is recorded as having expanded by a little over 4 per cent over the year to March. That result includes recovery from the flooding of Queensland coal mines in the summer of 2011, so it overstates the underlying pace of growth. Even so, and allowing for a more moderate expansion of real GDP in the June quarter than in the March quarter, an assessment that economic activity has been growing 'close to trend' over both the second half of 2011 and up to the middle of 2012 seems reasonable. Consistent with this, the rate of unemployment remains essentially unchanged from this time last year. Inflation, at the same time, has declined. The Consumer Price Index (CPI) rose by just 1.2 per cent over the past year. This was the lowest result for some years, though it partly reflects the unwinding of the large rise in some food prices that occurred in the first half of 2011 and which had pushed up the CPI. Using the various measures we have for underlying inflation, we would put it at about 2 per cent over the past year, which is still down a bit on the figure a year earlier. The rise in the exchange rate, most of which occurred over 2009 and 2010, has had a significant impact on prices for traded goods and services, but this dampening effect on the rate of change of those prices looks like it has now started to wane. As it does, the more moderate growth of domestic costs and prices that we have seen will need to continue, in order for inflation to remain consistent with the monetary policy objective. At present our forecast remains that this will be the case. In May and June, the Board eased monetary policy, lowering the cash rate by a total of 75 basis points, following the two adjustments made last year. These decisions were made based on the Board's assessment of economic conditions and the outlook, and with regard to the balance of risks. They have resulted in borrowing rates being a little below their medium-term averages. Since then, with growth close to trend and inflation consistent with the target, but the global outlook weaker than it was earlier in the year and confidence a bit on the subdued side, we have judged this to remain the appropriate stance. It is too early to tell how much difference the sequence of decisions to lower interest rates late last year and in the middle of this year has made to the economy, though we can observe that dwelling prices may have stopped their earlier gentle decline, and business credit has been growing at its fastest pace for three years. Consumption spending has been stronger over the first half of the year, but recent strength may in part be due to the effects of government compensation payments associated with the introduction of the carbon price. The exchange rate remains quite high, even with the decline in the terms of trade over the past year. Looking back, then, the economy appears to have been recording reasonable overall growth, relatively low unemployment, and low inflation. Looking ahead, the peak of the resource investment boom as share of GDP - the highest such peak in at least a century - will occur within the next year or two. After that the rate of resource investment is likely to decline, while the export shipments of the resources themselves will pick up. By then we might expect that some other sectors that have been weak of late, like residential and non-residential construction, might be starting to pick up. Overall, growth is forecast still to be close to trend, albeit with a different composition from that seen in the past year or two, and inflation consistent with the target. That is the central forecast. It is conditional, of course, on a range of assumptions and there are, as always, risks and uncertainties, some of which we spell out in the . At a time of significant global uncertainty, and of important structural changes in the Australian economy, the degree of confidence we can attach to particular forecasts is, unavoidably, reduced. We remain prepared to respond to significant deviations from the central outlook, to the extent that it is prudent and possible to do so, within the framework that aims to foster sustainable growth and inflation at 2-3 per cent over time. Madam chair, I feel that it is important for me to make an additional statement, anticipating that the Committee will be interested once again in the matters that we have been discussing for some time now in Note Printing Australia (NPA) and Securency, and which have been prominent in the media over the past few days. The Reserve Bank condemns corrupt or questionable behaviour of any kind. We have done a lot of work to tighten controls in the two companies. We have sought at all times to deal appropriately with all the issues that have arisen, and to cooperate with the legal authorities. We have also sought to respond honestly to questions from this Committee. I have previously given evidence to the Committee on the sequence of events as we saw them unfold. It is worthwhile to try to draw that together. In so doing, it is important to keep clear the distinction between the two companies in that sequence. In 2006, following the events at the Australian Wheat Board, the Reserve Bank Board asked questions about the policies for the use of overseas agents by the two companies. In the case of NPA, the Bank's questions prompted the company to begin a process of developing stronger policies. RBA management asked for an update on progress at NPA in early 2007, and the NPA Board appropriately sought a paper from management on dealings with sales agents. After considering that paper, the NPA Board decided that an audit should be undertaken of past practices and compliance. That audit raised several very concerning things. It recommended that, apart from discontinuing the use of agents, the NPA Board undertake an urgent investigation of the role of relevant management and staff in dealing with agents to ensure compliance with Australian law. On receiving this report, the NPA Board took the decision to cease the use of agents, and through a Board sub-committee commissioned Freehills to provide an assessment of the standards and compliance questions. It was while all these processes were under way that concerns held by a member of NPA's management over the company's conduct became known to a Reserve Bank Assistant Governor who sat on NPA's Board. The NPA manager was asked by the then Deputy Governor to make a written statement. This document was part of the material examined by the Freehills team that was asked by the NPA Board to examine the matters. I have conveyed these facts to the Committee over the course of questioning at previous hearings. The document provided by the manager at NPA was held in strict confidence at his request. This was a condition required by him, and the Bank agreed to it because it valued his willingness to come forward. Seeking professional legal expertise to assess the matters contained in this document, and the concerns raised in the audit, was a mark of how seriously they were taken. The decision to seek an external legal review was an important one. In the Bank's view, it was imperative to establish a process to investigate the issues thrown up by the audit findings and to ascertain and evaluate the facts regarding the NPA manager's concerns. This required an assessment by qualified experts on the legal questions. The Bank did not believe that it should itself seek to make such an assessment. There are many precedents in the private and public sectors for organisations adopting similar processes in such circumstances. In the Bank's view, this represented a proper, independent and rigorous process. That was the intention. The Freehills report was highly critical of NPA's practices, which were in need of major reform. It also concluded, based on the material then available, that there was no evidence of a breach of Australian law. That assessment was provided in good faith, and relied on in good faith. It was not proposed by Freehills or anyone else at that time that, having been through a process that concluded there was no evidence of a breach of the law, the next step should be to approach the police. When the Australian Federal Police (AFP) were called in 2009 by the Chairman of Securency regarding the allegations made about Securency at that time, the 2007 NPA matters were all disclosed to the AFP in a timely way. The Freehills report and audit reports were provided to the AFP when requested. There was no attempt to hide any information. It has been claimed by some that the written statement by the NPA manager contained clear evidence of corrupt behaviour. In 2007, two senior legal practitioners from a leading law firm, who received this material directly from the author as part of their review and interviewed the author and others, did not view it that way in coming to their conclusion that there was no evidence of a breach of the law. Even if it were ultimately to be concluded at some later time, with the benefit of hindsight, that the report reached an incorrect conclusion, it is completely without foundation to suggest that this process - seeking information, conducting audits, having an independent legal review, implementing the recommendations from the review and the audits, and relying on the independent advice received - represented an attempt at a 'cover up' by anyone in the Reserve Bank. I turn now to Securency. The RBA Board asked Securency for its policies on agents in 2006 and the company put in place additional and stronger policies and procedures. Following the audit at NPA in 2007, the Securency Board requested a similar audit and terminated one of its agents (which it shared with NPA). That audit found that, unlike NPA, Securency had a 'good and robust process' in place in relation to overseas agent contracts and payments. A follow-up audit was conducted in 2008, which made the same finding. It is for this reason that the Securency Board, and the Reserve Bank, had no reason at that time to discontinue the use of agents, as had occurred at NPA. With those audits having returned those findings, the Reserve Bank was completely surprised by the allegations that were published in the middle of 2009. We now know, including from a report conducted by KPMG for the Securency Board later in 2009, that critical information regarding the use of agents was withheld from the audit teams and the Securency Board in 2007 and 2008. Finally, I turn to the question of the provision of materials to this Committee. Currently, there are a number of court orders in place that place restrictions on the documents that the Bank is permitted to disclose. The non-publication orders have been made as a result of applications by the individuals facing criminal charges and are designed to protect their right to a fair trial before an impartial jury. Further non-publication orders have been sought and obtained by the Department of Foreign Affairs and Trade (DFAT) and the AFP. Among the material subject to such orders is the statement of the NPA manager. I received legal advice in relation to whether I could table the statement. The advice was that I could not. The Reserve Bank is, however, committed to transparency with this Committee and with the community. To that end we are compiling a folder of the documents the Bank has in relation to these matters, with the intention of tabling it for the Committee at the earliest opportunity. This will include relevant excerpts from minutes of meetings of the Reserve Bank Board, the NPA Board and the Reserve Bank's Audit Committee in the 2006-2007 period, papers prepared for the NPA Board on the use of agents, the audit reports on the use of agents in NPA and Securency, the statement by the NPA manager referred to above along with associated documents, the terms of reference for the Freehills review, the Freehills review itself, and the report to the NPA Board by its sub-committee that examined the issue. We are taking steps to seek the permission of the Court to allow the Bank to table those materials subject to orders. To the extent that I can shed further light today, while still respecting the legal processes, I am of course more than willing to do so. My colleagues and I are here to respond to your questions.

r121120a_BOA

australia

stevens

Thank you for the invitation to join you for your Financial markets and policymakers have been living in a more or less continual state of anxiety for over five years. While it was poor-quality lending in the US mortgage market that proved to be a key cause of problems, from quite early on it became apparent that European banks also had serious difficulties, because of their exposure to securities of doubtful quality, their high leverage and their need to fund US dollar portfolios on a short-term basis. It was in August 2007 that those acute funding difficulties first became apparent in European markets. Five years on, US banks have made a lot of progress in working through their asset quality problems and their capital deficiencies. At times the process was not pretty, but the US system is in better shape today as a result. US taxpayers have earned a positive return on the investments in major banks that were made at the height of the crisis. In Europe progress has been much slower. There are various reasons for that, not least the sheer complexity of coordinating the process of evaluating and strengthening balance sheets across so many countries, where the national capacities to assist are so different, and within the strictures of a currency union. This exacerbates, and in turn is compounded by, the deterioration in economic conditions in Europe, which feeds back to bank asset quality and sovereign creditworthiness. It is perhaps no surprise then that the news seems to have been dominated by the ebb and flow of anxiety over things like: whether or not the 'troika' will recommend further funding for Greece; whether a national constitutional court will strike down a government's participation in initiatives that will assist other countries; or whether the populace in a country under pressure will reach the end of its tolerance for 'austerity' - and so on. There is 'event risk' almost weekly. This is the European drama. Unfortunately, it is, I suspect, set to continue that way for quite some time. Over recent months financial market sentiment has improved, from despair to mere gloom, as a result of a number of important steps that have been taken and commitments that have been made. It is right that this improvement in sentiment has occurred - it recognises the determination of the Europeans to save the euro, which should not be underestimated. But there is much more to do, and it will take a considerable time. So while good progress is being made, we will not, any time soon, see a point at which the 'euro problem' can be seen as past. The world will have to live with euro area anxiety for some years yet as a normal state of affairs. In the meantime the US economy has continued its slow healing. The US housing sector has, it would appear, finally turned. Now the election is past, the so-called 'fiscal cliff' is rapidly coming into focus - a new source of event risk. But if one is prepared to assume that the US political system will not, in the end, preside over an unintentional massive fiscal contraction next year, the risks to the US economy probably look more balanced than they have been for a while. An upside surprise would be as likely as a downside one. It would be fascinating if, in another can show a decade-long average. The chart in fact shows an 11-year average, which allows the measure to be centred on the current year. To do this of course we need to make a 5-year-ahead assumption. We have assumed that the terms of trade decline steadily, at a pace a little faster than implied by forecasts of private analysts. What is unusual about this event is not just the peak level observed, but the apparent persistence of high levels. The terms of trade will very likely record over a decade an average level 50 per cent higher than the previous long-term mean. That is a big deal. Even with a more pessimistic assumption - say that commodity prices fall by twice as much over the next five years - there is no doubt that this is easily the biggest, and the most persistent, terms of trade event for a very long Still, the terms of trade have peaked, and will probably have fallen by about 15 per cent by the end of this year. Further declines over time are likely. So while a high level of the terms of trade continues to add to the level of national income, we can no longer expect that a rising terms of trade will be adding to growth in living standards. We are entering a new phase. This is not so much because of the 'end of the mining boom'. As a matter of fact, talk of the 'end of year, we find ourselves looking back at a US economy that had outperformed expectations. (There is still of course a critical need for the US to craft a measured and credible path back to fiscal sustainability. That particular drama could continue as long as the But it is appropriate to turn our gaze to our own part of the world, especially in the current period of discussion about 'the Asian Century'. Two years ago, when I last spoke to CEDA's Annual Dinner, a key feature of my presentation was this chart (Graph 1). This evening I can show how the chart looks when updated for two more years of data and our revised estimates for the near-term outlook. The terms of trade ended up rising further than assumed two years ago, and have then fallen back from the peak, though the level recorded in the most recent quarter is about 7 per cent higher than was in the forecast two years ago. The event is sufficiently unusual that we can add one twist to the chart. Instead of a 5-year average, we the mining boom' has been somewhat overhyped. The 'boom' is not so much ended as simply evolving, as these events would be expected to. Thoughtful commentators have already pointed out on a number of occasions that there are three phases to the 'boom'. The first was the rise in prices - something that began as far back as about 2004. The peak in prices was more than a year ago now. The Reserve Bank began noting that prices had declined in our monthly interest rate announcements in October 2011. But relative prices for natural resources are still high. At this point, the terms of trade are down to the ' peak ' seen in the September quarter of 2008, which was of course a 50-year high. The second phase of the 'boom' is the rise in resource sector physical investment. This is aimed at taking advantage of expected high demand for iron ore, coal, natural gas and other commodities over the medium term, at prices which are attractive relative to costs of production, including the cost of capital. The peak in this build-up lies ahead. It has, for some time, been our expectation that it will occur in 2013 or 2014; that expectation seems to be firming up. The actual level of the peak is probably going to be a bit lower than we thought six months ago, in view of the somewhat lower, and more variable, prices for iron ore and coal observed in recent months. But it's worth putting that downward revision into perspective. For 50 years, resource sector investment was typically between 1 and 2 per cent of GDP, with cyclical peaks at about 3 per cent (Graph 3). The uncertainty now is over whether it will peak at closer to 8 per cent of GDP than 9 per cent. What isn't uncertain is that either number is very high by any historical standard. It's also worth observing that, in any episode of this nature, there will always come a point when some potential projects, conceived at the time when prices were at their highest and when costs were about to start mounting quickly as well, have to be shelved. Actually, if projects that rely on extremes of pricing and optimism can be shelved before they get too far, that is preferable to having them continue. More generally, some important parts of the resources sector have now reached a point where the costs of further expansion in capacity, relative to those that might be expected elsewhere in the world, are a much more important factor in investment decisions than they were a couple of years ago. The third phase of the 'boom' is when the capacity to extract and export higher quantities of resources is actually used. This phase has begun for iron ore but it is mostly still ahead of us, especially for gas. The main uncertainty is really over the prices that will be achieved as higher supply - and not just in Australia - comes on stream. Such uncertainty is, and always has been, part and parcel of the business of investing in resource extraction. Perhaps what people have found a little unnerving over the past year is that as the prospect of rising supply of key natural resources gets closer, and prices have declined from their peaks, the Chinese economy has been in transition to slower growth. It was inevitable that China would slow to some extent, from the very rapid pace seen for much of the past decade. The signs it needed to do so were quite evident: increasing general price inflation, escalating property prices, doubts about the process of credit growth and credit risk management, and so on. But There is some tentative evidence that Chinese data 'surprises' have become increasingly influential in driving movements in Australian financial prices such as the exchange rate and share prices. Turning then to Australia, two years ago I noted that we could not know how much of the rise in the terms of trade would be permanent, and that there was therefore a case to save a good proportion of the additional national income until it became clearer what the long-run prospects might be. In a manner of speaking, we have, as a community, done something like that. The marked rise in the rate of saving by households in 2008 and 2009 has been sustained. Corporations have also increased their saving considerably over the past five years, opting to repay debt and lower their gearing ratios. Admittedly, government saving has been lower for a time, for countercyclical purposes, though that is now scheduled to rise as well. For the nation as a whole, the fact that the current account deficit has been lower on average in the past few years than in the period from 1985 to 2005, at the same time as the share of business investment in GDP has been exceptionally high, indicates that national saving has been higher. In fact it has been at its highest share of national income since the late 1980s. This change can be seen as a sensible response to an unusually high level of the terms of trade. Something else has also been at work, though, in household behaviour. I have spoken about this before but it bears saying again, because it is fundamental to understanding the current economic situation. After a period in which high levels of confidence, macroeconomic stability, easy availability of credit and rising asset values saw Australian households borrow more and save less, households have over recent years changed their behaviour in respect of just how big a slowing was occurring? For much of this year, that was the question that people have been trying to answer. My assessment is that the slowdown has been more material than had been expected a year ago, but not disastrously so. There are some signs that the moderation may have run its course, though further data are needed before such a view could be offered with confidence. So the Chinese economy has not crashed. But neither is it likely to return to the sorts of double-digit percentage rates of growth in real GDP, and 15 per cent growth rates for industrial production, that we saw for some years. People expecting that to resume are likely to experience disappointment. These trends are entirely consistent with two propositions that we have advanced over the past several years. The first was that China's economy would have an important and increasing weight in the regional and global economies. China's economy is nearly three times the size it was a decade ago. One corollary of this is that even 'moderate' growth in China is quantitatively significant. If China grew by, say, 'only' 7 per cent in 2013, that would add more to global GDP than the 10 per cent growth recorded in 2003. The second proposition was that China, like all economies, has a business cycle. It is affected by what happens elsewhere in the world, and by its own internal dynamics, including the decisions of its policymakers. Swings in China's economic performance are increasingly affecting Australia's economy and that of the region - and the world. Hence the focus on monthly data reports from China these days in our business press, in addition to the focus on the Chinese political situation. The Chinese 'purchasing managers index' is now as keenly awaited, and is as potentially market moving, as the original US PMI measure, known these days as spending, saving and borrowing. They have gone back towards what was once considered as 'normal'. This really had nothing to do with the resource boom. But it has had important implications for some key business sectors. Financial institutions are finding that growth in credit is now a single-digit number, not a double-digit one as it had been for so long. Businesses that in the earlier period of optimism derived earnings from high rates of turnover in asset markets - real estate agents, stock brokers, for example - face challenges, given that turnover is now greatly reduced. The retail sector now faces different consumers. It is not actually that consumers have no income to spend, nor that their confidence levels are that low, nor that their saving rate is that high. Measures of confidence that date back to the 1970s show it to be roughly at its long-run average. The household saving rate as measured by the Australian Statistician, at just over 10 per cent, is not, in fact, high in the To be sure, confidence was persistently very high for years up to 2008, and saving was very low - even falling to about zero, as measured, at one point. But that period was unusual. I don't think it will return. Moreover consumers are much more knowledgeable about prices as a result of information technology, and have at their disposal ways of responding to that information that a decade or more ago they did not have. This is putting pressure on retail business models, on wholesaling and distribution, and also on segments of the retail property sector. Given that the change to household behaviour was probably inevitable, the income boost from the terms of trade arrived at a rather fortuitous time. It helped to accommodate a rise in household saving and a slowdown in the build-up of debt in a fairly benign fashion. The weakness of some other parts of private demand, and openness to imports with a high exchange rate has also meant that a very large expansion in mining investment has been accommodated without overheating the economy overall. As it was, total real private final demand in Australia rose by 6 per cent in 2011/12, well above trend. With the peak in the investment phase of the mining boom now coming into view, the question naturally arises as to how the balance between the various types of demand in the economy will unfold. Mining investment will contribute less to growth in domestic demand in the current fiscal year than it did last year, and less again next year. Working in the other direction, it is likely that export volume growth will begin to strengthen as the capacity being installed in the resource sector is used. That would show up as GDP growth, though it may be predominantly reflected as higher measured productivity rather than generating a large volume of extra employment. The question will be whether other areas of domestic demand start to strengthen. Many households have made progress in reducing debt burdens. At some point that might be expected to lead to such households feeling more inclined to spend. But a complex interaction of factors - asset values and expectations about job security to mention two - will be at work in ways that are not amenable to accurate short-term forecasting. Overall, our assumption is that consumption will probably continue to grow at about trend pace, in line with income. Public demand is scheduled to be subdued as governments seek to return budget positions to surplus. The near-term outlook for business investment spending outside the resources and resource-related sectors is subdued, judging by currently available leading indicators. In most cycles, it takes time for this sort of investment to turn; this episode looks like no exception. The exchange rate may also have some role in helping the needed rebalancing. While it's not surprising that the Australian dollar has been very strong given the terms of trade event we have had, it is surprising that it has not declined much, at least so far, given that the terms of trade peaked more than a year ago. A lower exchange rate would, of course, need to be accompanied by a pace of growth of domestic unit costs below that seen for much of the past five years, in order to maintain low inflation. One area of stronger potential demand growth is dwelling construction, which has been unusually weak. It is not clear, actually, that the degree of weakness has been adequately explained. Various explanations have been offered - interest rates too high, housing prices falling, zoning restrictions, planning delays, construction costs, lack of 'confidence', all have featured. At present, at least some of the preconditions one might expect to be needed for higher construction seem to be coming into place. Interest rates have declined, dwelling prices seem to have stopped falling, rental yields have risen, and the availability of tradespeople is assessed as having improved. We have, moreover, seen a rise in approvals to build. So there is some evidence of a turning point, albeit a belated one. Will the net effect of these developments mean that aggregate demand rises roughly in line with the economy's supply potential over the next couple of years, or will a significant gap emerge? That is the question the Reserve Bank Board is trying to answer every month when it sits down to decide the stance of monetary policy. As of the most recent meeting, as the minutes released earlier today show, the Board felt that further easing might be required over time. The Board was also conscious, though, that a significant easing of policy had already been put in place, the effects of which were still coming through and would be for a while. In addition, the latest inflation data, while not a major problem, were a bit on the high side, and the gloom internationally had lifted just a little. So it seemed prudent to sit still for the moment. Looking ahead, the question we will be asking is whether the current settings will appropriately foster conditions that will be consistent with our objectives - sustainable growth and inflation at 2-3 per cent. Over the long run, though, the bigger question, for all of us here tonight and in the business and policymaking community generally, isn't about the monthly interest rate decision. The big question is: what is the sustainable growth rate of the economy? Beyond its role of preserving the value of money, monetary policy can do little to affect that sustainable growth rate. Moreover, the initial contribution of rising mineral prices to our standard of living has now run its course. To be sure, a higher capital stock devoted to extracting resources at high prices, assuming they continue, will make its contribution for many years - to the extent that Australians own some of that capital, work with it or receive tax revenues. But the biggest contribution to growing living standards will be what it has always been other than in periods (usually not long-lived) of exceptional luck, and that is productivity performance. I noted two years ago that while our terms of trade are handed to us, for better or worse, by international relative prices, the efficiency with which we work is a variable we can actually do something about. For some years there had been evidence of a slowing in productivity growth, beyond the unusual factors clearly at work in a couple of sectors (mining and utilities). The most recent data on productivity show signs of a pick-up in the year 2011/12, which is It is much too soon to conclude that a new, stronger trend is emerging - in this field much longer runs of data are needed. In my opinion, the accelerated structural change we are seeing in the economy for various reasons is likely to result in some improvement in productivity performance. But the most that can be said, at this stage, is that the data are not inconsistent with that hypothesis. At this point when talking about productivity, I usually become circumspect. One reason is that I know that people might ask what we might do to improve productivity performance, and I am acutely aware that the improvement has to be delivered in enterprises all around the country - the ones associated with CEDA and millions more. Productivity does not rise simply because of exhortation or official pronouncements. As for policy measures, at a meeting in Brisbane earlier this year, I said: That comment elicited some attention. The Chairman of the Productivity Commission was, I am led to understand, inundated with media demands for 'the list' and had to explain that it didn't quite exist in that form. But Chairman Gary Banks has very kindly drawn one together, in his final public speech at the end of a very distinguished tenure in that position. His list is a rather more complete one than mine. In fact, it is a set of lists, under three headings: things that affect incentives, things that affect capabilities and things that affect flexibility. What was perhaps most striking was the comment in the conclusion that no single policy offered the secret to success. It couldn't have been better put. As the 'mining boom' moves from its second to its third phase over the next year or two, the world economy will continue to present its own challenges. Australia will, as always, need to adapt to the changing circumstances. Looking much further ahead, to 'the Asian century', our opportunities are large. But to grasp them, that same adaptability, combined with a clear focus and steadiness of purpose will be key. We need to produce our sought after prosperity; it won't just come to us. All of us have our role to play, CEDA and its members included. I wish you every success.

r121130a_BOA

australia

stevens

Members of the Committee Thank you for the opportunity to attend today and for the opportunity to make a few introductory remarks. The Committee posed a number of questions to the Reserve Bank, some in relation to the lessons from the corruption allegations against Note Printing Australia (NPA) and Securency, and the majority in relation to the Bank's offshore operations. The Bank responded to these questions in late May. In regard to the corruption allegations, the companies have extended their full cooperation to the legal authorities. They have also done a great deal of work to reform policies and compliance over the past several years. Of course, these matters remain before the Courts. A key learning point for the Reserve Bank from these events is the extent of possible risks that can come from operating commercial ventures which export to a range of foreign jurisdictions. This has caused the Reserve Bank to re-evaluate its risk appetite insofar as such entities are concerned. As for the offshore operations of the Reserve Bank itself, there are three of them: in London, New York and, recently, Beijing. Of those three, the operations in London and New York are the largest and carry the greatest risks for the Bank. Those risks are overwhelmingly of a financial and operational nature, since a major part of those offices' function is to manage the bulk of the Bank's foreign currency assets. The key people in those offices are Australian staff well trained in the Bank's policies and controls for such activities. The Beijing office is, at this stage, small, purely representational, and is operated out of the Australian Embassy there, with the various protocols and controls associated with that. The staff there, who are bound by the Bank's Code of Conduct, also received appropriate training from the Department of Foreign Affairs and Trade. The Bank's control environment for the London and New York offices has been configured appropriately for the risks these offices take, with detailed policies, procedures and controls. As a general observation, given the nature of the operations and the jurisdictions in which they are operating, the risks of corruption in the London and New York offices are considered generally to be inherently no more, and no less, than associated with like activities in Head Office. That said, risks of any operation can increase with remoteness and, for this reason, there is, on a daily basis, close monitoring from Head Office of all transactions undertaken in London and New York. Extensive, on-the-ground auditing of these operations occurs every year. As to the integrity framework generally, the Bank has a Code of Conduct, which governs all the staff. Staff receive training in the requirements of the Code and additionally are required periodically to re-familiarise themselves with it. As it happens, a new version of this Code has recently been rolled out, following an extensive review. There is also a comprehensive Fraud Control Framework, which includes a Fraud Policy and a Reporting Fraud and Unethical Behaviour Policy. The Bank has drawn upon the relevant Australian standards and best practice guidelines, including the Commonwealth Fraud Control Guidelines and the Commonwealth Procurement Rules, in preparing and implementing its policies and its fraud risk management framework. Those policies place an obligation on staff to report any concerns they may have regarding compliance or unethical or illegal behaviour. There is an automatic process of escalation of such concerns, once expressed, to the Deputy Governor, and there are externally operated phone numbers staff can call if they wish to remain anonymous. The Bank undertakes to protect those who raise such concerns in good faith. Staff operating in the overseas offices, including locally recruited staff, are bound by these policies and the Code of Conduct. Staff in overseas offices are also, of course, bound by the laws of the country in which they reside. There is more detail in our responses to the Committee's questions on notice, supplied in late May. The Committee also asked about corruption risks associated with the Reserve Bank's participation in global and regional forums, in which participation has increased considerably over recent years. These are forums such as the G-20, the Financial Stability Board, the Asian central bank group known as , and international institutions such as the Bank for International Settlements, the IMF and so on. We believe the risks of corruption in such activities are inherently low, and made lower by appropriate controls on the way participation is conducted. I would be pleased to respond to any questions members of the Joint Committee might have.

r121212a_BOA

australia

stevens

Monday marked the 70th anniversary of the commencement of operations of the Bank of wartime occupation, the Bank has grown to be a key institution in Thailand. It is a pleasure and an honour to come to Bangkok to take part in one in a series of events to mark the anniversary, and I want to thank Governor Prasarn for the invitation. The Reserve Bank of Australia has long enjoyed a strong relationship with the Bank of Thailand. In 1997, the RBA was among those central banks to enter a swap agreement with the Bank of Thailand shortly after the crisis broke. This was the first part of Australian assistance to the regional partners who were under pressure, which later extended to Korea and Indonesia. In fact, Australia and Japan were the only countries that offered direct financial support to all three countries. It was a predecessor of mine, Bernie Fraser, who made the suggestion 17 years ago that cooperation in the Asian region might be improved by the establishment of a dedicated institution, along the lines of the Bank for International Settlements in Such a body has not come to pass - at least not yet! - but it is fair to say that this suggestion and others like it helped to spur the Basel BIS to reach out to Asia. The central banks of the region, taking the initiative Central Banks - EMEAP (not the most attractive acronym) - have improved cooperation substantially over the years. Thanks to long-term efforts at building relationships, and the vision of key governors and deputy governors, including at the Bank of Thailand, EMEAP has developed into a mature forum for sharing information, and continues to develop its ability to find common positions on global issues and to promote crisis readiness. Yet as the central banks have grown closer and become more effective in their cooperation, the challenges we face have only increased. Today I want to speak about three of them. First, I will talk about the framework for monetary policy and the need to allow that to consider financial stability. Secondly, I will make some observations about the more prominent role for central banks' own balance sheets that we are seeing in some countries. Then, thirdly, I will offer some observations about international spillovers. In so doing, I am not seeking to deliver any particular messages about the near-term course of monetary policy in either Australia or Thailand. It is more than two decades since the framework of inflation targeting (IT) was pioneered in New an enthusiastic early adopter from 1992. Australia adopted IT in 1993. Among the early adopters, the move to IT was driven by a mixture of principle and pragmatism. The key principle was that monetary policy was, in the end, about anchoring the value of money - that is, about price stability. The pragmatism arose because one or more previous approaches designed to achieve that - monetary targeting, exchange-rate targeting, unconstrained discretion - had proved at best ineffective, and at worst destabilising, for the countries concerned. Hence many of the adopters shared a desire to strengthen the credibility of their policy frameworks. As the initial adopters came to have a measure of success in combining reasonable growth with low inflation, other countries were attracted to the model. (IMF), more than 30 countries now profess to follow some form of IT. The euro area could also be counted among this group though it also professes adherence to the 'second pillar' of 'monetary analysis'. Even the United States can, I think, be counted as Market Committee is these days quite explicit about its desired inflation performance. The Bank of Thailand was one of a number of emerging economies that adopted IT around the turn of the century. Twelve years on, Thailand can boast an impressive record of price stability under this framework. A high level of transparency has ensured that financial market participants understand the framework, and view it as credible. Moreover, price stability has not come at the cost of subdued economic growth, with output expanding at a brisk pace in the 2000s. While inflation targeting is not for everyone, the Thai experience illustrates that, when done well, it can enhance economic outcomes. I can endorse the favourable verdict offered on the Thai experience delivered by Grenville and Ito (2010). So I think that the adoption of IT, including in Thailand, can be seen as a success in terms of the straightforward objectives set for it. To make such a claim is not, however, to claim that controlling inflation is, alone, sufficient to underwrite stability in a broader sense. If there were any thought that controlling inflation over a two- or three-year horizon was 'enough', we have been well and truly disabused of that by experience over the past half decade. Price stability doesn't guarantee financial stability. Indeed it could be argued that the 'great moderation' - an undoubted success on the inflation/output metric - fostered, or at least allowed, a leverage build-up that was ultimately inimical to financial stability and hence macroeconomic stability. The success in lessening volatility in economic activity, inflation and interest rates over quite a lengthy period made it feasible for firms and individuals to think that a degree of increased leverage was safe. But higher leverage exposed people to more distress if and when a large negative shock eventually came along. This explanation still leaves, of course, a big role in causing the crisis - the major role in fact - for poor lending standards, even fraud in some cases, fed by distorted incentives and compounded by supervisory weaknesses and inability to see through the complexity of various financial instruments. That price stability was, in itself, not enough to guarantee overall stability, should hardly be surprising, actually. It has been understood for some time that it is very difficult to model the financial sector, and that in many of the standard macroeconomic models in use, including in many central banks, this area was underdeveloped. Mainstream macroeconomics was perhaps a bit slow to see the financial sector as it should be seen: that is, as having its own dynamic of innovation and risk-taking; as being not only an amplification mechanism for shocks but a possible source of shocks in its own right, rather than just as passively accommodating the other sectors in the economy. Notwithstanding the evident analytical difficulties, the critique being offered in some quarters is that central banks paid too little attention in the 2000s to the build-up of credit and leverage and to the role that easy monetary policy played in that. It is hard to disagree, though I would observe that this is somewhat ironical, given that IT was a model to which central banks were attracted after the shortcomings of targets for money and credit quantities in the 1980s. It could be noted as well that the European but the euro area still experienced the crisis - in part because of credit granted in or to peripheral countries, and in part because of exposures by banks in the core countries to excessive leverage in the US. The upshot is that the relationship between monetary policy and financial stability is being re-evaluated. As this occurs, we seem to be moving on from the earlier, unhelpful, framing of this issue in terms of the question as to whether or not monetary policy should 'prick bubbles' and whether bubbles can even be identified. The issue is not whether something is, or is not, a bubble; that is always a subjective assessment anyway in real time. The issue is the potential for damaging financial instability when an economic expansion is accompanied by a cocktail of rising asset values, rising leverage and declining lending standards. One can remain agnostic on the bubble/non-bubble question but still have concerns about the potential for a reversal to cause problems. Perhaps more fundamentally, although the connections between monetary policy and financial excesses can be complex, in the end central banks set the price of short-term borrowing. It cannot be denied that this affects risk-taking behaviour. Indeed that is one of the intended effects of low interest rates globally at present (which is not to say that this is wrong in an environment of extreme risk aversion). follows that broader financial stability considerations have to be given due weight in monetary policy decisions. This is becoming fairly widely accepted. The challenge for central banks, though, is to incorporate into our frameworks all we have learned from the recent experience about financial stability, but without throwing away all that is good about those frameworks. We learned a lot about the importance of price stability, and how to achieve it, through the 1970s, 80s and 90s. We learned too about the importance of institutional design. We shouldn't discard those lessons in our desire to do more to assure financial stability. We shouldn't make the error of ignoring older lessons in the desire to heed new ones. Rather, we have to keep both sets of objectives in mind. We will have to accept the occasional need to make a judgement about short-term trade-offs, but that is the nature of policymaking. And in any event, over the long run price stability and financial stability surely cannot be in conflict. To the extent that they have not managed to coexist properly within the frameworks in use, that has been, in my judgement, in no small measure because the policy time horizon was too short, and perhaps also because people became too ambitious about finetuning. We also must, of course, heed the lesson that, whatever the framework, the practice of financial supervision matters a great deal. Speaking of supervisory tools, these days it is, of course, considered correct to mention that there are other means of 'leaning against the wind' of financial cycles, in the form of the grandly labelled 'macroprudential tools'. Such measures used to be more plainly labelled 'regulation'. They may be useful in some instances when applied in a complementary way to monetary policy, where the interest rate that seems appropriate for overall macroeconomic circumstances is nonetheless associated with excessive borrowing in some sector or other. In such a case it may be sensible to implement a sector-specific measure - using a loan-to-value ratio constraint or a capital requirement. (This is entirely separate to the case for higher capital in lending institutions in general.) We need, however, to approach such measures with our eyes open. Macroprudential tools will have their place. But if the problem is fundamentally one of interest rates being too low for a protracted period, history suggests that the efforts of regulators to constrain balance sheet growth will ultimately not work. If the incentive to borrow is powerful and persistent enough, people will find a way to do it, even if that means the associated activity migrating beyond the regulatory perimeter. So in the new-found, or perhaps relearned, enthusiasm for such tools, let us be realists. That policy measures of any kind have their limitations is a theme with broader applications, especially for central banks. The central banks of major countries were certainly quite innovative in their responses to the unfolding crisis. programs to provide funding to private institutions, against vastly wider classes of collateral, were a key feature of the central bank response to the situation. In essence, when the private financial sector was suddenly under pressure to shrink its balance sheet, the central banks found themselves obliged to facilitate or slow the balance sheet adjustment by changing the size of their own balance sheets. This is the appropriate response, as dictated by long traditions of central banking stretching back to Conceptually, at least initially, these balance sheet operations could be seen as distinct from the overall monetary policy stance of the central bank. But as the crisis has gone on such distinctions have inevitably become much less clear as 'conventional' monetary policy reached its limits. It was fortuitous for some, perhaps, that the zero lower bound on nominal interest rates - modern parlance for what we learned about as the 'liquidity trap' - had gone from being a textbook curiosum to a real world problem in Japan in the 1990s. Japan subsequently pioneered the use of 'quantitative easing' in the modern era. This provided some experiential base for other central banks when the recession that unfolded from late 2008 was so deep that there was insufficient scope to cut interest rates in response. So in addition to programs to provide funding to intermediaries in order to prevent a collapse of the financial system when market funding dried up, there have been programs of 'unconventional monetary policy' in several major countries over recent years. These have been varyingly thought of as operating by one or more of: reducing longer-term interest rates on sovereign or quasi-sovereign debt by 'taking duration out of the market' once the overnight rate was effectively zero reducing credit spreads applying to private sector securities ('credit easing', operating via the 'risk-taking' channel) adding to the stock of monetary assets held by the private sector (the 'money' channel, appealing to quantity theory notions of the transmission of monetary policy) in the euro area in particular, commitments to lower the spreads applying to certain sovereign borrowers in the currency union (described as reducing 're-denomination risk'). As a result of such policy innovation, the balance sheets of central banks in the major countries have expanded very significantly, in some cases approaching or even surpassing their wartime peaks again, the Bank of Thailand has made an excellent contribution to the international discussion here, having recently held a joint conference with the BIS on central bank balance sheets and the challenges ahead. The difference is that in Asia the risks arise from holdings of foreign currency assets which have been accumulated as a result of exchange rate management. There is obviously valuation risk on such holdings. There is also often a negative carry on such assets since yields on the Asian domestic obligations which effectively fund foreign holdings are typically higher than those in the major countries. In effect the citizens of Asia continue to provide, through their official reserves, very large loans to major country governments at yields below those which could be earned by deploying that capital at home in the region. For the major countries a further dimension to what is happening is the blurring of the distinction between monetary and fiscal policy. Granted, central banks are not directly purchasing government debt at issue. But the size of secondary market purchases, and the share of the debt stock held by some central banks, are sufficiently large that it can only be concluded that central bank purchases are materially alleviating the market constraint on government borrowing. At the very least this is lowering debt service costs, and it may also condition how quickly fiscal deficits need to be reduced. There is nothing necessarily wrong with that in circumstances of deficient private demand with low inflation or the threat of deflation. In fact it could be argued that fiscal and monetary policies might actually be jointly more effective in raising both short- and long-term growth in those countries if central bank funding could be made to lead directly to actual public final spending - say directed towards infrastructure with a positive and long-lasting social return - as opposed to relying on indirect effects on private spending. It is no criticism of these actions - taken as they have been under the most pressing of circumstances - to observe that they raise some very important and difficult questions for central banks. There is discomfort in some quarters that central banks appear to be exercising an unprecedented degree of discretion, introducing new policies yielding uncertain benefits, and possible costs. One obvious consideration is that central banks, in managing their own balance sheets, need to assess and manage risk across a wider and much larger pool of assets. Gone are the comfortable days of holding a modest portfolio of bonds issued by the home government that were seen as of undoubted credit quality. Central bank portfolios today have more risk. To date in the major countries, this has worked well in the sense that long-term yields on the core portfolios have come down to the lowest levels in half a century or more. Large profits have been remitted to governments. But at some point, those yields will surely have to rise. Of course large central bank balance sheets carrying sizeable risk is hardly news around Asia. Once One fears, in short, that while the central banks have been centre stage - rightly in many ways - in the early responses to the crisis, and in buying time for other adjustments by taking bold initiatives over the past couple of years, the limits of what they can do may become more apparent in the years ahead. A key task for central banks is to try to communicate these limits, all the while doing what they can to sustain confidence that solutions can in fact be found and pointing out from where they might come. Talking about the challenges associated with large balance sheet activities leads naturally into a discussion about international spillovers. In one sense, this is not a new issue. It has been a cause of anxiety and disagreement since the latter days of the Bretton Woods agreement at least. The remark attributed to the then Secretary of the US Treasury in regard to European concerns about the weakness of the US dollar in the 1970s of 'it's our currency, but your problem' was perhaps emblematic of the spillovers of that time. There have been other episodes since. In a much earlier time there was, of course, the 'beggar thy neighbour' period of the 1930s - something which carries cogent lessons for current circumstances. In recent years, as interest rates across a number of major jurisdictions have fallen towards zero and as central bank balance sheet measures have increased, these developments have been seen as contributing to cross-border flows of capital in search of higher returns. The extent of such spillovers is still in dispute. And, to the extent that they are material, some argue that a world in which extraordinary measures have The problem will be the exit from these policies, and the restoration of the distinction between fiscal and monetary policy with the appropriate disciplines. The problem isn't a technical one: the central banks will be able to design appropriate technical modalities for reversing quantitative easing when needed. The real issue is more likely to be that ending a lengthy period of guaranteed cheap funding for governments may prove politically difficult. There is history to suggest so. It is no surprise that some worry that we are heading some way back towards the world of the 1920s to 1960s where central banks were 'captured' by the Government of the day. Most fundamentally, the question is whether people are fully understanding of the limits to central banks' abilities. It is, to repeat, not to be critical of actions to date to wonder whether private market participants, and perhaps more importantly governments, recognise what central banks cannot do. Central banks can provide liquidity to shore up financial stability and they can buy time for borrowers to adjust. But they cannot, in the end, put government finances on a sustainable course and they cannot create the real resources that need to be found from somewhere to strengthen bank capital. They cannot costlessly correct earlier misallocation of real capital investment. They cannot shield people from the implications of having mis-assessed their own lifetime budget constraints and as a result having consumed too much. They cannot combat the effects of population ageing or drive the innovation that raises productivity and creates new markets. Nor can they, or should they, put themselves in the position of deciding what real resource transfers should take place between countries in a currency union. been taken to prevent crises may still be a better place for all than the counterfactual. The degree of disquiet in the global policymaking community does seem, however, to have grown of late. Perhaps one reason is the following. In past episodes, expansionary policies in major countries, while having spillovers through capital flows, did demonstrably stimulate demand in the major countries. It is open to policymakers in those countries to claim that unconventional policies are having an expansionary effect in their own economies compared with what would otherwise have occurred. But the slowness of the recovery in the US, Europe and Japan, I suspect, leaves others wondering whether major countries are relying more on exporting their weaknesses than has been the case in most previous recoveries. One response to that can be efforts in emerging economies to make their financial systems more resilient to volatile capital flows, such as by developing local currency bond markets and currency hedging markets. This type of work is underway in various fora, such as the G-20 and EMEAP. But that takes time. Meanwhile people in the emerging economies, and for that matter several advanced economies, feel uncomfortable about the spillovers. At the same time, it has to be said that spillovers go in more than one direction. While it was common for Asian (and European) policymakers to point the finger at the US for many years over the US current account deficit, with claims that the US was absorbing too great a proportion of the world's saving, the fact was that those regions were supplying excess savings into the global capital market because they did not want to use them at home. That surely had an impact on the marginal cost of capital, to which borrowers and financial institutions in parts of the advanced world responded. We may want to say, in hindsight, that policymakers in the US and elsewhere should have worried more about the financial risks that were building up by the mix of policies that they ran. But we would also have to concede that the US policymakers sought to maintain full employment in a world that was conditioned by policies pursued in parts of the emerging world and especially Asia. Not only do spillovers go in more than one direction, but those which might arise from policies in this region are much more important now than once was the case. The rapid growth in Asia's economic weight means that policy incompatibilities which partly arise on this side of the Pacific have greater global significance. The traditional Asian strategy of export-driven growth assisted by a low exchange rate worked well when Asia was small. Asia isn't small anymore and so the rest of the world will not be able to absorb the growth in Asian production in the same way as it once did. More of that production will have to be used at home. This is understood by Asian policymakers and progress has been made in reorienting the strategy. I suspect more will be needed. For central banks in particular, there has been talk about spillovers from monetary policy settings being 'internalised' into individual central banks' framework for decision-making. Exactly how that might be done is not entirely clear, and discussion is in its infancy; a consensus is yet to emerge. The IMF does useful work on spillovers and the IMF offers, at least in principle, a forum where incompatibilities can be at least recognised and discussed. One more far-reaching proposal is for there to be an 'international monetary policy committee'. seems a long way off at present. on at least some issues. Internationally, the BIS of course is also a key forum for 'truth telling' in a collegiate and confidential setting and one in which the central banks of this region are playing an increasingly prominent role. There will need to be much more of this in the future. Australia have, in our respective histories, faced challenges, some of them severe ones. We have learned much from those experiences. In recent years, we have had our own distinct challenges. Fortunately, we have not been directly at the centre of the almost unprecedented challenges faced by our colleagues in major countries, though we have all been affected in various ways. The future in Asia is full of potential, but to realise that we have to continue our efforts to strengthen our own policy frameworks, learn the appropriate lessons from the problems of others, and continue our efforts to cooperate on key issues of mutual interest. As the Bank of Thailand moves into its eighth decade, I am sure you will rise to the challenge. Thank you again for the invitation to be here, and For spillovers to be effectively internalised, mandates for central banks would need to allow for that. At the present time most central banks are created by national legislatures, with mandates prescribed in national terms. (The ECB of course is the exception, with a mandate given via an international treaty.) It would be a very big step to change that and it certainly won't occur easily or soon, though national sovereignty over monetary policy within the euro area was given up as part of the single currency - so big changes can occur if the benefits are deemed to be sufficient. Whether or not such a step eventually occurs, it is clear that spillovers are with us now. All countries share a collective interest in preserving key elements of the international system, even as individual central banks do what it takes to fulfil their current mandates. It is vital, then, that central banks continue to talk frankly with each other about how we perceive the interconnections of global finance to be operating. We may be limited at times by the national natures of our respective mandates, but those limitations need not preclude cooperative action altogether, as has been demonstrated at various key moments over the past five years. In this region, the EMEAP forum offers great potential to further our mutual understanding and ability to come to joint positions

r130222a_BOA

australia

stevens

In the six months since the August hearing, economic and financial conditions abroad have generally improved. We can see three key sets of developments. First, the threat perceived in the middle of last year of extreme financial instability arising in the euro area - and, in the eyes of some, possible disintegration of the euro - has abated. This followed various important steps taken by European policymakers. Interest rates faced by some of the key sovereigns which were under acute pressure have declined markedly, and funding conditions for many European banks have improved to the point where some of the central bank funding that had been supplied has been repaid. These countries, and Europe generally, still face immense challenges and it is, as usual, important to stress that sentiment remains vulnerable to setbacks. But a truly disastrous outcome was, once again, avoided. Second, the United States has continued its gradual recovery and has avoided the worst of the so-called 'fiscal cliff'. Some of the headwinds for the US economy are subsiding - the housing market seems to have turned, for example. There are still some key decision points in the fiscal area ahead, but if they can be satisfactorily managed, the US has as good a chance of delivering an upside surprise as a downside one over the period ahead. Third, the slowdown in China's economy has come to an end. The medium-term outlook for China is for a less hectic pace of growth than we saw on average over the past decade, and with more attention paid to the various risks - financial and environmental included - associated with that growth. Having said that, the greater absolute size of the Chinese economy now means that even less hectic growth is still of global significance and of importance to Australia. Conditions have improved in international financial markets as the perceived probability of very bad events occurring has declined and as major central banks have maintained highly accommodative policies. Share prices have risen around the world, with global indexes up by about 20 per cent from the lows in June last year. Borrowing conditions in capital markets for creditworthy borrowers internationally remain extraordinarily favourable. For investors, conversely, returns on 'low risk' assets are very low and the 'search for yield' has intensified. World GDP growth is thought to have been about 3 1/4 per cent in 2012 - a little below average. Forecasts for 2013 are for something a bit higher than that, with a further pick-up in 2014. Those seem reasonable guesses at this point in time. Risks now seem less tilted to the downside than they were. Australia's terms of trade have declined by about 17 per cent since their exceptional peak in the middle of 2011. We are assuming they will fall further over the next couple of years. Even with that, however, they will probably be more than 50 per cent above their twentieth century average over that period. This amounts to an external environment for Australia that, while not without some challenges, is still broadly positive. Turning to the Australian economy, the information we have at present suggests that growth was close to trend over 2012 as a whole. There was, though, some softening around the middle of the year, and sentiment among many businesses, including some that had seen important positive spillovers from the mining boom, became less optimistic. Associated with this, the labour market softened in the second half of the year, with job vacancies declining, employment growth slowing, and unemployment increasing somewhat. Labour force participation also declined. Looking ahead, it appears that the peak in the level of resource sector investment is now close. It is a very high peak, but we do not think that there will be a rapid decline in the near term after the peak. However, it seems pretty clear that this type of investment will not be to demand for much longer. Investment spending by businesses in other sectors has thus far remained somewhat subdued in comparison. There are good reasons to expect it will strengthen in due course, but the available indicators at present do not suggest that is going to happen in the very near term. We will get another reading on the investment outlook next week. The outlook for public spending is being constrained as a result of the budgetary restraint being pursued by governments. It is also noteworthy that in several sectors of the economy a combination of factors is putting pressure on business models, and firms have been responding with an emphasis on lifting productivity and paring back costs. This process, while unavoidable, doubtless feeds into measures of sentiment. Sentiment of households, in contrast, has improved. Despite continual commentary that households are very cautious, actual measures of confidence have in fact shown an upward trend since the middle of last year and are currently a bit above longer-run average levels. Admittedly, households do not feel the same ebullience they did for some years prior to the financial crisis in the major countries. But that degree of confidence, with its associated patterns of saving and increasing leverage, was unusual, and is not likely to recur. Our expectation is that consumer demand will record growth roughly in line with the trend rise in income over the period ahead. Housing investment should strengthen given that several factors are supportive - interest rates are low, housing prices are tending to rise, gross rental yields have increased, population growth remains strong and is even picking up a little. Admittedly, we are as yet very early in this phase. The increased capacity to extract and ship raw materials will see export volumes continue to strengthen, probably quite substantially, over the next couple of years. Some other categories of exports seem to have stopped declining, notwithstanding that the exchange rate remains high. Putting all that together, while growth was probably about trend in 2012 as a whole, our sense is that the economy has entered 2013 at a pace a little below that. We have been inclined to think that the near-term outlook could be for more of the same, but things are likely to strengthen further out. We are, of course, conscious that forecasts have a considerable margin of error. We have put some emphasis on this point in the way we present our forecasts in recent times. Stepping back from the numbers, in broad terms, the economy will be adjusting to the peak of the mining boom and some other areas of demand will have room to grow more quickly than they have in recent years. This transition will not necessarily be seamless - these things seldom are - but there are reasonable prospects of it occurring over time. As we go through this period, the pressures to adapt business models, contain costs, increase productivity and innovate will remain. But such adjustments are actually positive for longer-run economic performance. Inflation is currently consistent with the target. The high exchange rate has lowered prices for tradable goods and services and so helped to hold down measures of inflation over the past couple of years. But some domestic costs have also slowed, in response to softer demand conditions in some areas, even as prices for things such as utilities have risen sharply. The effect of the carbon price on the CPI so far has, as best we can judge, been broadly as expected. Our assessment is that inflation will be consistent with the target over the next one to two years. Taking account of the evolving outlook for growth and inflation, the Board eased monetary policy further in the last quarter of last year, following up its easing actions in mid year, and earlier actions in the last quarter of 2011. The cash rate has been reduced six times over the past sixteen months, for a total decline of 175 basis points. Allowing for some change in the gap between the cash rate and other rates, lending rates nonetheless have fallen to be not far from their historic lows. The share of household income devoted to interest payments has likewise declined considerably. Indeed housing 'affordability' as conventionally measured, for purchasers, has improved a lot over the past two years. That represents quite a substantial change in policy settings. It is having an effect. Housing prices have been rising since last May, having declined for a period prior to that. Share prices have also risen quite significantly, and if anything by a little more than in comparable markets overseas. The returns available to savers on safe assets - like bonds and bank deposits - have fallen by enough to prompt Australian savers to consider shifting their portfolios towards other assets. These are channels of monetary policy at work. At the same time, as we have noted repeatedly, the exchange rate remains somewhat higher than one might have expected given the decline in export prices so far observed. This has been a relevant factor in the setting of interest rates. It is not that interest rates are seeking a particular exchange rate response, but they are being set with a recognition of the exchange rate's effect on the economy. Overall, there is a good deal of interest rate stimulus in the pipeline. At its meeting earlier this month the Board judged that it was sensible to allow it time to do its work. The Board believed that the inflation outlook, at least as we assess it at present, would provide scope to ease further, should that be necessary to support demand. But for now, the Board decided it was prudent to sit still. Turning briefly to other areas of the Bank's responsibilities, in June last year the Payments System Board released the Conclusions from its Strategic Review of Innovation in the Payments System. The review identified areas in which innovation in the Australian payments system could be improved through more effective cooperation between stakeholders and regulators. One of the gaps identified in the review was the inability of businesses and consumers to make payments through the banking system that are received immediately, including when the payer and receiver have their accounts with different institutions. The Payments System Board believes that Australia should develop such capability over the medium term, and proposed a target for the payments industry to achieve that goal by the end of 2016. The Board met last week and reviewed an industry proposal for real-time payments that was submitted to the Bank in late 2012. The Board considers that the industry has made good progress and endorsed the proposal in an announcement earlier this week. There are many details to be resolved that will require the Bank and industry to work closely together over the next few years, within a governance framework that gives appropriate voice to the various stakeholders. But we view this as a very positive development and we welcome the industry's commitment to deliver world-class improvements to the payments system by the end of 2016. My colleagues and I are here to respond to your questions.

r130326a_BOA

australia

stevens

The title of this session is 'Australia as a Global Citizen'. Accordingly, I will seek to set financial and regulatory developments in Australia in a global setting. This is worth doing for its own sake, since local discussion is better informed if we can see how the various initiatives fit in to the broader setting. It is also important to remember that Australia, along with all other jurisdictions that sign up to international standards, will be evaluated by our peers. So it's worth spelling out our approach to some key issues. In addition, from the end of this year Australia will have responsibility for chairing the G20 for a year, and financial reform and regulation have been prominent on the G20's agenda in recent years. So Australia's political leadership will have some responsibility for shaping, for a brief period, the oversight of the process. It is worth starting to think about how this might be done. As a 'global citizen', Australia has the responsibilities and rights of that 'citizenship'. The responsibilities are to uphold and play by the rules that are globally agreed, which include implementing global standards in regulation and oversight, and encouraging others to do so. The rights we have are the same as those of others: to have our say and to play our own part, however modest and small, in the development of those standards. Something that is a bit new and, overall, refreshing is that Australia actually does have a place at more of the relevant tables than it used to. ASIC has long been a member of the International Organization of Securities Commissions (IOSCO) as were its predecessor organisations the ASC and the NCSC. It is quite a feather in the cap for ASIC that its chair has this month assumed the chair of the IOSCO Board. The expanded membership of the Basel Committee on Banking Supervision (BCBS) now allows Australia two members - APRA, naturally, and the Reserve Bank - where we had none before. The Financial Stability Board (FSB) likewise allows us two seats, compared with one previously, and membership of some of the key committees. In the wake of the crisis that swept Europe and North America, the international regulatory environment for the financial system has changed significantly. An expanded Financial Stability Board, with the political backing of the G20 Leaders, has acted to coordinate this process, working with existing standard-setting bodies and also by developing its own processes. There have been several main streams to the reforms. The first is the Basel III prudential reforms, which aim to improve the resilience of financial institutions by strengthening capital and liquidity requirements. Compared with Basel II, minimum capital ratios are higher, capital has been defined more strictly to refer to genuinely loss-absorbing instruments, and use of counter-cyclical capital add-ons is contemplated, all supplemented by a simple constraint on overall leverage. More attention is focused on liquidity management by banks. The second key stream of work has aimed to address the problem of 'too big to fail'. Global systemically important banks (G-SIBs) have been identified, and capital surcharges will be set to strengthen their resilience, beginning in 2016. Cross-border crisis-management groups have been established for nearly all of these institutions, and one of their key tasks is to review the recovery and resolution plans that are being developed for these firms. Intensity of supervision is also being increased. For domestic systemically important banks, a principles-based regulatory framework has been developed. While banks have been the major focus thus far, the overall policy framework for systemically important financial institutions (SIFIs) applies more broadly, and an identification methodology is close to being finalised for global systemically important insurers. A third element is aimed at improving the functioning of markets for over-the-counter (OTC) derivatives, so as to reduce risk of contagion in the financial system. This is to be achieved by promoting or mandating central clearing of standardised OTC derivatives contracts, and adding to transparency through requiring trade reporting. A fourth stream is aimed at addressing risks arising from shadow banking - that is, those entities and activities outside the regulated banking system that are associated with credit intermediation and maturity transformation. The FSB released key proposals last year for consultation and they are being refined on the basis of feedback received, for consideration at the G20 Leaders' Summit in September 2013. Australia was not as badly affected by the crisis as some other countries. Our banking system overall, though hardly without blemish, stood up fairly well. This was testament to generally sound management in most institutions and a robust supervisory approach. But there were still lessons to be drawn for Australia and the regulators here have given careful thought to them and to the associated global reforms. APRA finalised its prudential standards to implement the Basel III capital standards in late 2012. Australia, along with 10 other jurisdictions, adopted the capital elements of Basel III as from 1 January this year. Some major jurisdictions - the EU and the US in particular - are a little behind, though all the BCBS member jurisdictions had at least released draft regulations by mid-February. Australia is considered an 'early adopter' of the Basel III reforms. Given the relatively healthy capital positions of authorised deposit-taking institutions (ADIs), APRA is requiring ADIs to meet a number of the main capital measures two or three years earlier than the rather extended timetable required under Basel III and it is not using the discretion available under Basel III to provide a concessional treatment for certain items in calculating regulatory capital (e.g. deferred tax assets). APRA has also moved ahead on the liquidity standard, in conjunction with the Reserve Bank. We have established the Committed Liquidity Facility (CLF) - a mechanism by which the Basel III liquidity standard can be met, in a world in which government debt in Australia is relatively scarce compared with other jurisdictions. Let me say a little about this facility. It is not a 'bail-out' fund for banks. 'Bail-outs' usually mean stumping up public funds to inject capital to an institution whose solvency is in question. The CLF does no such thing. It is a facility, for which the institutions concerned will pay a fee, which would provide cash against quality collateral pledged by institutions that the Bank and APRA judge to be solvent. The fee structure is designed to replicate the cost the institutions would incur if there were sufficient ordinary high quality collateral - i.e. government debt - for them to hold to meet the Basel liquidity requirements - which, of course, there is not. If we are to meet the global standards, we either have to have a facility like this, or have the government issue a few hundred billion dollars in extra gross debt so the banks can hold it. The relevant ADIs will pay a fee of 15 basis points per annum for the facility whether they use it or not. If they do use it, any funding will be at an interest rate that is 25 basis points above the market rate. This has been developed openly, and under the scrutiny of the international regulatory community. It was approved by the Reserve Bank Board in November 2010. With regard to the 'SIFI' reforms, Australia's large banks cannot realistically be assessed as globally systemic. Hence there was no good reason for them to be classed as G-SIBs. But it cannot be denied that they are domestically systemic, which is why it is appropriate that the Basel Committee's domestic systemically important bank framework capture them. This will involve some additional minimum loss absorbency on the capital side but also an intensity of supervision that is greater than applied to the 'average' ADI - an aspect that is already a key part of APRA's supervisory approach. In the area of resolution, a number of steps have been taken in recent years, including a strengthening in APRA's crisis management powers in 2008 and 2010. So far as derivatives markets are concerned, legislation was passed in Australia in December 2012 to help meet emerging international standards. Given uncertainties around both the final shape of key regimes internationally, and the broader market and economic effects of regulation in this area, the final legislative framework contains considerable flexibility. In particular, the legislation does not directly introduce any trade reporting, central clearing or trade execution obligations for OTC derivatives transactions. What it does do is create a mechanism by which such obligations may be implemented by supporting regulations, which would be developed and administered by ASIC. There is more focus generally on what are known as 'Financial Market Infrastructures' (FMIs). In April last year, the Committee on Payment and Settlement Systems (CPSS) and IOSCO released new Principles for Financial Market Infrastructures, the culmination of two years of detailed standard-setting. The Reserve Bank has revised its own Financial Stability Standards for Central Counterparties and Securities Settlement Facilities, so as to align them with the Principles. It has also committed to assessing Australia's high-value payment system, RITS, against the Principles on an annual basis. ASIC similarly updated its Regulatory Guide for Clearing and Settlement Facility licensees to reflect the new Principles and aims to ensure consistency with the Principles in the regime it is designing for trade repositories. With regard to shadow banks, the Reserve Bank presents an annual review of shadow banking developments to the Council of Financial Regulators. Our assessment is that the shadow banking system in Australia is relatively small compared with the formal ADI sector, which means that the recommendations being developed internationally are not as important an issue here as they may be for other jurisdictions, at least from a stability perspective. Separately, there is the dimension of investor protection. Here ASIC and APRA are working on strengthening the regulatory framework for retail debenture issuers. ASIC has proposed minimum capital and liquidity requirements, while APRA's proposals, which are forthcoming, will aim to make clearer that the products offered by these entities are not the same as the deposit products offered by banks. From this very quick tour of the key regulatory themes, it should be obvious that much has been achieved, but that significant challenges remain. It is, I think, fair to say that as time has passed and implementation has come into focus, various difficulties and complications are coming to the fore. Some aspects of the Basel standards are being tweaked. It has been necessary for standard-setting bodies to issue additional guidance, to provide further clarity regarding new reforms, and to ensure consistency in interpretation and implementation. To some extent this was to be expected. Reforms that seemed so simple and obvious, so bold and so sweeping in the immediate aftermath of the crisis of 2008, have turned out to be harder to implement than first expected. This is hardly surprising really, since so much is being attempted at the same time. It is not that attempting much is a mistake: there were serious problems to be addressed and a lot needed to be done. But in so doing, there was always a pretty good chance that the compounding effects of multiple reforms would contain some unexpected and unintended consequences. To take one example, there is concern in some quarters about a potential shortage of high-quality collateral. This arises because regulatory reforms around bank liquidity and centralised clearing are likely to add to demand for high-quality liquid assets. This is spawning great interest by intermediaries to offer collateral transformation services - turning relative risky assets into ostensibly safe ones - that could present new risks. OTC derivatives reforms have been a particularly thorny issue, not least because of the cross-jurisdictional reach of international regulation in this area. European OTC derivatives regulation and US regulation under the Dodd-Frank Act are clear examples of measures that potentially have a strong impact on other jurisdictions. A grouping of market regulators, including ASIC, has been convened to develop some common understandings around the cross-border application of rules. Particularly in a global market such as that for OTC derivatives, consistency with other jurisdictions' rules is an important consideration in the development of the domestic framework. As OTC derivatives markets make this transition to central clearing, interest is emerging from overseas-based central counterparties in providing their services directly to Australian-based participants. Many international participants in the Australian interest rate swaps market already clear their trades through the UK-based global central counterparty, LCH.Clearnet Limited (LCH). LCH has announced that it will be seeking a licence to provide these services directly to Australian-based participants, alongside a competing offering being developed by the domestic derivatives central counterparty, ASX Clear (Futures). To the extent that participants in smaller markets choose to clear via overseas-based central counterparties it is important that they can do so on appropriate terms, and also that the interests of regulators in these jurisdictions be given due weight. In July last year, ASIC and the Reserve Bank jointly published a document setting out the measures that would be taken to ensure appropriate regulatory influence where an overseas-based central counterparty was operating in Australia. These measures would be applied in the oversight of LCH or any other overseas-based central counterparty that might obtain a licence to provide such services. In a world of more central clearing, the question of how the official sector would deal with a situation of FMI distress assumes more importance. As a result of a review by the Council of Financial Regulators in 2011, work is in progress to develop legislative proposals that would give effect to a 'step-in' power as part of a comprehensive resolution regime for FMIs. This is to be designed in accordance with international standards. These are just a few examples of how the world of regulation and financial oversight is growing more complex. Whether it is the additional demand for high-quality collateral arising from reforms on bank liquidity and centralised clearing, or the extra-territorial reach of US reforms under the Dodd-Frank Act, or the likely difficulties in maintaining systems of reference interest rates in a world where banks are now extremely wary of the legal risks involved in voicing an opinion about where market pricing might be, or the likelihood that some activities will migrate beyond the regulatory net, complications from regulatory activism are in evidence. My guess is that we don't yet know what all the compounding effects of multiple reforms may be and it may be years before we do. A principle that the Reserve Bank, for its part, has sought to uphold in our own participation in the various reform streams is that we should proceed with all appropriate urgency where needed, but with deliberate care wherever possible, being conscious of the limits to our own knowledge as regulators and the likelihood of unintended consequences from steps we might take. The financial reform agenda post 2008 has been very large and comprehensive. There has been a prodigious amount of work across a wide front. It is worth thinking about how this agenda might be managed in the future. It is of course inappropriate to discuss in detail how Australia might approach its responsibilities in the G20 in 2014. The Russian G20 presidency is in full swing and will remain so until at least November. Our job until then is to assist in any way we can for a successful conclusion to that presidency. On financial regulation, the Russian chair has, to date, focused on the G20 working towards completion and implementation of previously announced reforms. This is a multi-year task and one we will inherit. One area the Russian presidency has identified for particular attention is the possible effects of regulatory reforms on the supply of long-term financing, given that one of their major themes is promoting long-term financing for investment. To date the FSB has found little evidence to suggest that global financial regulatory reforms have significantly contributed to current long-term financing concerns, but they have been asked to continue to monitor the possible effects. Australia's approach will, of course, be a national one, adopted by government, not simply one established by the Reserve Bank. Subject to all those constraints, I would simply observe that, in my opinion, by 2014 we will have reached a point in the financial regulatory sphere where the G20 should be looking for careful and sustained efforts at implementation of the regulatory reforms that have already been broadly agreed, but being wary of adding further reforms to the work program. Absent some major new development, which brings to light some major reform need not hitherto visible, to task the regulatory community and the financial industry with further wholesale changes from here would risk overload. Lest this be considered too weak a position, let us remember how much is being attempted. And since we are already seeing the need to 'tweak' some earlier agreed proposals, it is surely clear that the details of implementation should increasingly be our focus over the next few years. The G20 will need to remain open to the possibility - the likelihood even - that as experience is gained with implementation and we grapple with the inevitable difficulties, and as we learn more about how the financial system is likely to operate in a new world, we will want to make occasional adjustments to the rules. None of that ought to be seen as a retreat from the high level objectives that have guided efforts to date: the desire for a more stable, more resilient and simpler financial system, that is better able and more inclined to play its 'handmaiden of industry' role and better able to withstand failures of individual institutions. But in pursuing these goals, it is important that we: Keeping the regulatory structure fit for purpose across a broad range of jurisdictions around the world is in fact a task that will never be complete, since the financial system evolves - in response to technology and innovation, but also in response to regulation itself. It is important for Australia not only to keep abreast of the developments and implement the key elements of global regulation here, but also to continue to play our own part in helping to develop them, and refining them in light of experience.

r130411a_BOA

australia

stevens

We are here this evening at the Royal Sydney Yacht Squadron, founded in 1862 for the enjoyment of sailing by its members. I am not a sailor; aviation is more my hobby. But one can see that in sailing, key elements to a successful voyage would be similar to those in aviation. These would include: All these are important. Without wanting to push the analogy too far, many elements of policy making and financial development could be said to share many of these attributes. We need to understand how systems work, and their limitations. We want the participants, regulators and supervisors to have appropriate training and skill. We need to keep in mind our desired destination and retain some flexibility of choice in the route depending on circumstances. We need to think about how to respond in the event problems occur and to have a clear idea of whose interests need to be protected. We need a realistic assessment of how much we can't know. And so on. Meetings such as this one are good opportunities to learn about how the system is developing, to improve our understanding of how it works, and to have a conversation about desired destinations and routes to get there. And I think after the events of the past five years, we are all conscious of the limits of our knowledge. It would be apparent from your deliberations today that Asia's financial markets are continuing to develop rapidly. To take the market for fixed interest securities, the total size of the bond market in Asia, excluding the very large Japanese market (which has been highly developed for a long time), now amounts to about US$7 trillion, having increased substantially over the past five years. This is an amount equivalent to around 60 per cent of the area's GDP. While in absolute terms a lot of this growth has been in China, in many of these countries debt markets are equivalent to at least 50 per cent, and in some cases well over 100 per cent, of national GDP. Issuance of corporate debt in 2012 was about US$700 billion, which is not far short of the amount in the euro area, though still a long way below the pace of issuance in the United States. Metrics of liquidity suggest an improving trend, with reasonable turnover and in most cases bid-ask spreads on sovereign debt coming down to a handful of basis points. Equity markets are likewise of substantial size. For several Asian countries, and leaving aside markets like Singapore and Hong Kong, market capitalisation relative to GDP is broadly similar to or even larger than in the United States. The Chinese equity market is considerably smaller in relative terms, but that is not surprising given the history of being a centrally planned economy. Banks in Asia continue to play a central role in providing finance, which is reflected in the relatively large size of banking systems in the region. A number of countries in the region, including China and Japan, have banking system assets exceeding 200 per cent of GDP - although some other countries, where financial deepening and liberalisation still has some way to run, have relatively smaller banking systems. After being severely affected by the Asian financial crisis in the late 1990s, the region's banking systems were fairly resilient to the more recent (global financial) crisis and are today well capitalised with sound asset performance. So the size of Asia's financial system has grown substantially. Some have said that Asia's financial development and integration lags behind the progress being made on the trade and economic fronts. The striking growth of intra-Asian trade reflects the general trade orientation of the Asian growth strategy but also, in recent years, the growing organisation of production processes across borders. Where it is possible to adopt a set of agreed technical standards - global standards for IT components, or communications protocols might be examples - and impediments are removed, it seems that economic networks spanning national borders can quickly emerge. If it is true that this has outpaced financial integration, perhaps that is because it may be harder to align and streamline legal and regulatory processes insofar as they bear on financial activity than it is for trade. Having said that, I'm not sure that growth in Asian finance is lagging all that far behind. The statistics on growth of markets seem a bit too compelling to push that argument too far. Moreover, further growth in Asia's capital markets is surely likely. The region continues to have, in the main, high rates of saving and investment. So its real 'wealth' is growing. (So is its human capital, which will improve the productivity of its physical capital stock.) In addition, many countries continue to see the normal pattern in which the markets that intermediate the flows of saving and investment, and that develop the tradeable financial claims over the stock of real wealth, grow faster than income. The experience of the advanced countries suggests that this process of 'financial deepening', while it may ultimately have some limit, has a long way to go in the emerging world. So the task for policy might be not so much to promote growth , as to shape the growth. What sort of financial system do we want to see develop in the region? What, in other words, is our destination? Three desirable descriptors come to mind. We want a financial system that is sound, efficient and integrated. 'Sound' does not mean refusing to take any risk. The yachts outside are probably safest when tied up to the mooring. If that's all that ever happens, though, they are not fulfilling their purpose. Similarly we want some prudent risk-taking in the financial sector - that is its job. It could be argued that the world's financiers swung in 2008 from insufficient regard for risk to excessive risk aversion. But as is the case when the yachts move off from their moorings to catch the winds in the open water and perform as they were designed, a degree of risk is involved. And, like sailing, the context for that risk-taking has to give due weight to safety. In years past, excessive leverage, inadequate attention to liquidity and funding risk, and poor lending standards all played a part in a serious erosion of confidence in banks and various 'shadow banks' in the United States and Europe. We would have to say as well that supervision was found wanting. Once the crisis hit, the complexity of operations across borders then greatly complicated efforts by policymakers to address the resulting problems. The financial system in this time zone, in contrast, has come through this episode in much better shape. Thanks partly to the painful lessons of the Asian crisis and other episodes, banks had generally stronger capital positions and higher lending standards, while supervisors had also done their job in the years prior to 2007. Moreover, several banking systems in the region are among the earliest adopters of the new, tougher, Basel standards. It goes without saying that we want this prudence to continue. But unlike the case in some other countries, the financial sector in the region is well placed to play its role in supporting the sustainable growth of economic activity and trade. It is noteworthy that as European banks sought to pull back from some activities in the region, including trade finance, banks from within the region have stepped up. So this is a point for confidence. This is not to say that there are no sources of vulnerability. In particular, concern has been expressed about the risks that may be growing in the 'shadow banking' system in China. In recent years, an increasing share of financing in China has been provided by non-bank entities and through banks' off-balance sheet activities. In no small part, this growth in shadow banking reflects restrictions on both the quantity of bank credit, and controls on loan and deposit rates. Such restrictions lead to demand for credit exceeding the formal banking sector's ability to supply it, and also provide an incentive for savers to seek alternatives to low-yielding bank deposits. The Chinese authorities have introduced a number of measures to mitigate the risks, and many types of shadow banking activities in China are now subject to some regulatory oversight. Hopefully, this will lead to a stable outcome. But China's experience is one that others have had at various times: as long as there are incentives to by-pass the formal banking sector, the shadow banking system may keep on growing together with the risks. More generally the risks associated with prolonged low interest rates globally are very much on the minds of policymakers right around the region, and will be for a while, I would think. Turning to the second and third on the list of desirable attributes for finance, namely efficiency and integration, it may be that these will naturally go together. An efficient financial system intermediates savings at a low cost, and directs them to the uses that are expected to produce the highest risk-adjusted return. As in most industries, a degree of competition in the system is helpful in producing this efficiency. Competition from foreign firms can be a powerful force in this regard. So openness to cross-border investment flows will remain important, as will openness to the innovative new domestic entrants. Of course, as in any industry, and perhaps more so in finance, there have to be boundaries to competition. We don't want lending standards to be competed down too far, for example, any more than we would want competition between airlines to lead to lower maintenance standards in pursuit of lower costs. That is where the regulatory framework and the supervisors come in. Moreover, greater integration in the region, insofar as that is possible and remains consistent with legitimate national sovereign objectives, offers efficiency gains as well. A large regional capital market would be expected to offer a greater field of choice for savers and borrowers and lower intermediation costs. Progress towards this is being made through efforts to make regulatory frameworks more consistent and improving infrastructure across regional markets, even as demand increases for locally issued debt securities. These developments have been aided, in part, through regional cooperation on initiatives such as the Asian Bond Fund and the Asian Bond Markets Initiative. Ongoing cooperation will help to continue the development of regional capital markets. I would simply observe that it may take a degree of commitment to keep progress occurring, not least because some responses to the financial crisis around the world may work towards a lessening of the degree of globalisation of finance. To these observations about safety, efficiency and integration, I would add two further thoughts. The first is that Asia will in all likelihood continue to have multiple currencies for a long time yet. A decade ago it was becoming fashionable for Asia to look at Europe and wonder whether that was a model for an Asian currency area in due course. But we can now see all too clearly how demanding it is to be in a currency union, and how much supporting financial and political structure is needed for it to work. This may one day be built in Asia, but it takes a long time: Europe's prodigious efforts over 50 years or more did not, as it turns out, produce fully the conditions for currency union. It follows from this that Asian markets for foreign exchange in Asian currency may need to continue developing. It probably means as well that unless something serious goes wrong in China, the RMB will eventually become the dominant currency in the region. That may be stating the obvious, but there could be a profound adjustment for many countries in the region from membership of what is, at present, a US dollar zone, to membership of an RMB zone. To some extent this has begun with the use of RMB for trade settlement, which is growing quickly. Full development will require liberalisation of the Chinese capital account. This will presumably continue to occur, but on a timetable decided - as it should be - by the Chinese authorities. The second and final observation is related to exchange rates in some ways. It is that Asia surely will want to see its own financial sector doing more of the intermediation of its own saving. That is, Asia will want to send less of its saving abroad to hold supposedly 'low risk' - and certainly low return - obligations issued by the 'old' world, and do less re-importing of that saving, in the form of risk capital intermediated by the major financial centres at higher cost. Why not deploy the region's own saving at home, for higher return? It is not as though there are no productive opportunities in the region. By most accounts Asia's infrastructure needs over the next couple of decades are very large. Moreover, as the region's own financial sophistication and strength grows, and as its capacity to accept risk grows commensurately, the need for costly self-insurance against capital flow disruptions surely lessens. That does not deny the logic for what Asia did for many years in building foreign reserves, but the cost benefit analysis is surely looking different today from 15 years ago. So to use the language from the beginning of my remarks, perhaps there are now more direct routes to the destination of development and prosperity for Asia than there were a decade or two ago. All of this is tied up with the debate about 'global imbalances', the reorienting of Asia's growth towards domestic sources, the role and governance of the international institutions, and so on. These are issues worthy of discussion, including in the G20 process as well as in regional fora. But that is a discussion for another day. Once again, welcome to Sydney and I hope your deliberations will be a great success.

r130703a_BOA

australia

stevens

It is a great pleasure to be in Brisbane once again. Yesterday the Board, at its monthly meeting, left the cash rate unchanged. I don't propose to comment about yesterday's decision in particular, or to send any particular messages about the next decision. Instead I want to step back to look at the broader picture. The economy grew at about its long-term average rate in 2012, but more of that growth was in the first half of the year than the second. According to the latest national accounts, growth in real GDP has been running at an annualised pace of about 2 1/2 per cent over the past three quarters. Our guess is that sub-trend growth will continue in the near term. Consistent with that, the rate of unemployment has tended to increase. Employment is growing - the number of jobs in the economy is at a record high - but not quite as fast as the supply of labour. Over the past five years, the economy has expanded by about 13 per cent. The corresponding figure for the United States is 3 per cent. For Japan, the Euro area, and the United Kingdom, the figures are negative. Some of our Asian neighbours and trading partners have also done well, which has certainly helped us. Korea has recorded growth about the same as Australia's (13 per cent), Singapore more (about 18 per cent). And of course China's growth over this period has, despite frequent talk to the contrary, been rather stellar. Chinese GDP has risen by over 50 per cent since early 2008. China's growth over the past year or two has moderated, to be more like 7 1/2 per cent, not the 10 per cent plus seen for some years. Most of the data we are seeing from China are consistent with that pace. This is what the Chinese authorities have been saying they want to achieve. It's worth noting that while Australia has done relatively well, the economy's average growth rate over the period since the financial crisis erupted in earnest has been only about 2 1/2 per cent. In the preceding decade it had averaged almost 3 1/2 per cent. That was a period in which the rate of unemployment declined from about 7 1/2 per cent to just over 4 per cent. In contrast, the unemployment rate today, while still quite low by longer-run historical standards, at about 5 1/2 per cent, is higher than it was. There are a couple of points to make here. The first is that Australia's economy was overheating by 2008. Capacity was stretched as the resources sector was in the first phase of its investment build-up while household consumption was still growing briskly and credit growth was still in double digits by the end of 2007. Inflation rose, peaking at about 5 per cent. This was substantially due to domestic pressures, not just international ones (though they were not helping). These were all clear signs that we were not going to be able to keep growing at a pace like that seen in the decade up to 2008. The Reserve Bank had made this point many times, though it was not very popular. While inflation did subsequently abate, this experience showed that if there was to be a very large rise in resources sector activity, other sectors could not continue as they had been doing. The second observation is that similar declines in rates of growth have been observed in other countries - even the ones which have come through the financial crisis with relative success. Around our region, Korea, Taiwan, Singapore, Hong Kong, New Zealand and Malaysia, although navigating the crisis pretty well, have seen their growth rates decline by at least as much as Australia's. So Australia seems to be part of a broader pattern here. While we have benefitted a lot from China's ongoing emergence in this period, so have those countries. The fact that no country has managed to return to the sorts of growth seen prior to the crisis is highly suggestive that that growth was to some extent being driven by forces that could not be sustained. Perhaps this has to be a conditioning factor when we think about our own growth aspirations and the way we seek to achieve them. At this point, we have unemployment at about 5 1/2 per cent, inflation 'in the 2s', the banking system is strong and government finances overall sound. Growth on the slow side, inflation is low. That combination means that we have low interest rates (the lowest for fifty years in fact). Significant structural change is occurring, which is always challenging. But set in context, the macroeconomic data over recent years show a pretty respectable set of outcomes. Those who have memories of the 1970s or 1980s or the 1990s would surely recognise them as such. Now it has been said that we were 'lucky' to have the mining boom, the effect of China and so on. Otherwise, we would have seen much more economic weakness. It's hard to disagree with that proposition as a piece of arithmetic. As a piece of analysis, though, it is incomplete. It could equally be said that we were 'lucky' that the effects of the global economic downturn worked to help reduce inflation in Australia from its peak in 2008 of 5 per cent - which was way too high - to something acceptable. It could also be said that we were fortunate that the sub-prime crisis in the US emerged from early 2007, and not later. Although such lending was less prominent in Australia at that time, it was growing fast and would have become a much bigger vulnerability had it continued at that pace. The fact that things went wrong in the US when they did meant that what was a small problem here stayed small. It could be added that we were lucky that the change in behaviour of households - slower borrowing, more saving - came when it did. For a start, had households continued as they were, they would have become more financially extended, and it is obvious now that that would have been risky. Moreover, this changed behaviour of households has helped us absorb the resources investment boom. Of course the story is not yet finished. We have to negotiate the downward phase of the investment boom over the next few years, which appears likely to pose significant challenges. How will we meet them? A good way to begin is to have a reasonable starting point, and we have a better starting point going into this episode than we might have had, or than we have had on other occasions. Had we followed the pattern of previous terms of trade booms, we would have had much more inflation, faster credit growth and more asset price inflation, and more excesses generally. And then, when the terms of trade began to fall, we would have been much more likely to have a very big slump. This was the case in the early 1950s, the mid 70s and the late 70s (Graph 1). In each case domestic excesses arose resulting both from flow-ons from high commodity prices with a fixed exchange rate and policy weaknesses, which then made the ensuing downturn worse. It hasn't been that way this time. On this occasion, the resources boom - a bigger one than anything seen for at least a century - was accommodated without a big rise in inflation, or a big run-up in leverage or an unsustainable asset price boom. In fact, for most of the past several years we have had various industries or regions complaining that they had not felt the benefits of the boom. There were actually positive spillovers. But the excesses were not as great as had been the case on other occasions. Quite evidently one major feature has been a flexible exchange rate, something Australia did not have in previous resources booms. The exchange rate played the role it is supposed to play when the country receives a large expansionary external shock: it rose. It has been correctly noted by other commentators that the real exchange rate has in recent times been at its highest since the float thirty years ago. Indeed, it has been just about as high as any time in the past century. In the broad that is not a total surprise, given that the terms of trade rise and ensuing increase in resources sector investment has been bigger than anything seen in a century (Graph 2). Actually, the exchange rate might have been even higher but for the changes in behaviour by households, which have not returned to their earlier spending habits, instead maintaining a saving rate much more in line with longer-run historical norms. Corporations have tended to have a reasonably conservative mindset too, putting an emphasis on reducing debt and maintaining high levels of liquidity. Had they not done that, all other things equal, we would have had lower national saving, a larger gap between saving and investment, and a larger current account deficit. Interest rates would have been higher and the exchange rate presumably even higher than it was. Some largely non-traded business areas - retailing or real estate or banking - might have enjoyed an even longer period of households gearing up and spending. I conjecture that some other trade-exposed sectors would have had an even harder time than they did have. Moreover, we would, I think, have been more exposed to the effects of the decline in the terms of trade that we are now seeing. So the more 'cautious' or, more accurately, more prudent behaviour of households, together with some genuine caution by many firms, has been a force that has meant that Australia has accommodated a 100-year high in resource investment. Higher saving by the private sector has helped to 'fund' the resources investment boom at lower interest rates, and a lower exchange rate, than might have been the case otherwise. I am not convinced we should lament that performance as much as we seem to do. That is not to deny that, for many areas of the economy, the exchange rate has been 'too high' given the level of costs and productivity in place. But realistically, it is the nature of the shock we experienced that certain high cost or low productivity parts of the economy would struggle with the implications of a big rise in the terms of trade. In fact, I suspect that many sectors would still have struggled even if the exchange rate had not risen. At a 70c dollar, the resources companies would have had expected profits and an even greater ability to bid for labour and capital. Inflation of wages and prices would have been higher, and in the scramble to keep up many of the same companies that have struggled in recent times would still have struggled. Admittedly, higher inflation might have concealed the problems to some extent, since everyone's nominal revenues would have risen faster, but only for a while. In the end, relative prices had shifted and, at any exchange rate, some sectors were going to find that to their advantage and others to their disadvantage. Moreover, taking the inflationary route would have left a much bigger legacy of problems to come home to roost as the resources boom matured. That said, the exchange rate was somewhat too high for a period. It is no secret that I, for one, have been surprised that the foreign exchange market has taken as long as it has to reflect the fact that the terms of trade peaked some time ago - nearly two years ago, in fact. In the end, though, market-based exchange rates do eventually adjust - and usually in a less disruptive way than those that are maintained artificially. A flexible exchange rate is an important part of adjustment over all phases of the cycle and it remains a major advantage that we have one. If the economy 'needs' a lower exchange rate, it will probably get it. So I would argue that, as we face the undoubted challenges of the decline in resources sector investment, our starting position is in several important respects a better one than we have usually had at this point of previous episodes of this kind. Still, a starting point is just that. It is understandable, as we go into this phase, that people will ask 'where will the growth come from?' The conventional discussion at present has turned its attention to just this question. Not so long ago people were worried that there were no positive spillovers of the boom, or that there were even, in net terms, adverse effects. Some almost seemed to feel that it would have been better if there had never been a boom. Now suddenly people are worried that there were positive spillovers from the boom after all and that their absence or reversal will be disastrous. The question of where will the growth come from is one that recurs periodically at moments of uncertainty. Twenty years ago there was an almost despairing pessimism about economic prospects in the wake of what was admittedly a pretty big recession. It was thought likely by many observers that unemployment, then in double digits, would remain so for a long time. In fact, as we now know, we were on the cusp of two decades of good economic performance, at the end of which our country's relative standing for economic management would have improved out of sight. Who predicted that? Moreover, areas of the economy that we often don't think about have proven to be major drivers of - and participants in - that growth. Over the 21 years to mid 2012, real GDP rose by about 100 per cent. Only 3 percentage points of that 100 per cent came from manufacturing. The largest contributions came from financial services (13 percentage points), mining (10 percentage points), construction (9 percentage points), professional services (8 percentage points) and health care (7 percentage points). The number of jobs in the economy has increased by around 50 per cent over the same period, with around two-thirds of this increase attributable to household and business services of various kinds. Within these sectors, health care (around 9 percentage points) and professional services (around 7 percentage points) have made particularly notable contributions. In other words, most of the time the answer to the question 'where will the growth come from' is that only part of it will come from the old traditional areas, and a fair bit of it will come from new things, often things of which we are only dimly aware. That is, in fact, the nature of a dynamic, evolving economy. Turning to the current conjuncture, it can be observed, in conventional expenditure accounting terms, that some key areas are well placed to expand once they have the confidence to do so. Non-mining business investment, for example, as a share of GDP has been unusually weak - it is not much above its recession lows of the early 1990s. Many companies, rather than extending themselves, have been financially conservative over recent years and are sitting on very substantial sums of cash. It's hard to believe that this configuration will not change at some point over the next few years. Likewise, dwelling investment has been low for an unusually long period, with at least some households intent on reducing debt, thereby strengthening balance sheets. Households have accumulated a good deal of cash as well over recent years. Meanwhile, population growth is quite solid and it has been picking up a bit of late. If anything, we will need to build more dwellings than we have been over recent years. Meanwhile, interest rates are low, dwellings are more 'affordable', and finance approvals for housing purchases have risen by 16 per cent over the past year. So there are 'fundamentals' that favour a pick-up in these sectors. Of course, we have to add two things. The first is that no-one can pretend to be able to fine tune this 'handover', to guarantee that the non-resources sectors strengthen, on cue, by just the right amount. We have, in fact, had a few handovers over the past five years - from private demand to public in 2009, then to mining investment subsequently. Now we are looking back to household dwelling spending, non-mining investment (and exports). Previous handovers have occurred, largely successfully. That doesn't guarantee the next one will, though it does mean that we shouldn't assume that it won't occur. The second thing to say is that much depends on 'confidence' - that intangible thing that is hard to measure and very hard to increase. We are talking here about confidence that the future will be characterised by growth, that there will be customers for products, that innovations are worth a try, and so on. That confidence seems pretty subdued right now. To the extent that subdued animal spirits reflect global issues, which they must to some degree, there is not a great deal we can do about it beyond tending to our own national affairs as diligently as possible. More generally, while there are various ways policy measures can damage confidence, there is no simple policy lever that can be quickly pulled to improve it. Rather, confidence-enhancing conduct of policy involves having well-established and understood frameworks, and acting consistently with those frameworks over time. The Reserve Bank, for its part, has a well-established monetary policy framework. Guided by this, we will be able to continue to do our part, consistent with our mandate, to assist the transition in sources of demand that is needed. We cannot fine-tune it - no-one can promise that - but we will do what can reasonably be done. The conduct of other policies likewise needs to be principled and consistent. Notwithstanding the difficulties of achieving a budget surplus in any particular year, which will always be hostage to what happens in the economy and the vagaries of forecasting, there remains a strong commitment to fiscal responsibility in Australia across both sides of politics, even if there are different views about how to achieve it. The importance of that commitment will, if anything, be heightened in the future, given that significant challenges exist over the medium term in funding government initiatives that the community appears to want. Consistency in other areas that have a bearing on costs and productivity is also important. My assessment is that at the level of enterprises, efforts to improve productivity have been stepped up under the pressure of the high exchange rate and structural change. But we should still be asking whether there are things in the way of faster improvement. Is the combination of regulatory structures of various kinds - however well-meaning and valid in their own terms - imposing unnecessary and excessive costs of compliance, or creating undue complexity for business? At a previous presentation in Queensland, when asked about this, I made reference to the Productivity Commission's 'list'. The list is a substantial one. The good side of that is that there are many things that can be done to foster the improvement in living standards we all seek. We have continued to live in interesting times. Major challenges have been faced, but significant ones lie ahead. No-one can pretend that things will be simple and easy. But, by the same token, prudent policies, within the right frameworks and coupled with private initiative responding to the right signals, can - if we are prepared to accept their requirements - provide Australians with reasons for confidence about the future.

r130730a_BOA

australia

stevens

Thank you for coming out to support the Anika Foundation once again. This annual occasion is one of our key fundraising events and your generosity is greatly appreciated. Today would not be possible without the support of The Australian Business Economists and the Macquarie Securities Group, and so on behalf of the Board of the Anika Foundation, I thank them for their continuing contribution to combating adolescent depression and suicide. We have for the past five years or so lived in 'interesting times'. The shocks to which the economy has been subject have had larger magnitudes than had been the case during 'the great moderation'. The world economy, our terms of trade and the international availability of credit have been a good deal more variable since 2007. For example, the variability of world GDP has roughly doubled - compared with that in the decade or so prior to 2007 - while the volatility of Australia's terms of trade has, on some metrics, quadrupled. In response, our interest rates and exchange rate have also been more variable. There hasn't been much additional variation, though, in the real economy or the rate of unemployment. Depending on your preferred measure, the variability of real GDP has either increased a little, or declined slightly; a similar story holds for the unemployment rate. There was a pronounced cycle in inflation, peaking in 2008, but since then inflation has been much better behaved. This suggests that the various policy responses and the economy's own adjustment capacity have generally been working as they should towards stabilising overall outcomes, in the face of the much bigger external shocks we have faced. That said, achieving the sort of growth we aspire to has become more difficult. Average output growth has been lower over the past five years in Australia, as it has in all other advanced economies. Moreover, the challenges ahead are substantial and will require the appropriate responses. In shaping those responses, we need to be sure to draw the right conclusions and lessons from the experiences of recent years. In that vein, as I offer some remarks about the period ahead, I will also draw on those conclusions from recent history that seem pertinent. In so doing I shall be reiterating some themes I have touched on before, including at earlier lunches in this series. It is now well understood that the 'mining boom' is shifting gear, and that we are entering a new phase. The story of the boom has always had three phases. In the first phase, commodity prices rose to very high levels. As a result, Australia's terms of trade rose to levels not seen in a very long time. These prices had a hiatus in 2009 with the global downturn but resumed their upward trend quite quickly. In historical context, the high prices have been quite persistent. This led to the second phase, in which resource producers ramped up their investment to take advantage of demand for raw materials, in particular iron ore and natural gas, and to a lesser extent coal. Resource sector investment rose from an average of about 2 per cent of GDP, where it had spent most of the previous 50 years, to peak at about 8 per cent. That big rise is now over, and a fall is in prospect, with uncertain timing. It could be quite a big fall in due course. The third phase is now under way, in which we will see investment spending fall back, but a lift in volumes shipped of the various commodities. The latter has already started - for iron ore, volumes are rising at about 15 per cent per year - but shipments will probably increase further yet for some time and then stay high. Shipments of natural gas will not start increasing strongly until 2015, and will probably have several years of very strong growth, and then remain high for a few decades. In that third phase, real GDP will get a lift. National income measured in current dollars will also get a lift from the higher volumes, but that is likely to be offset in part, at least, by lower prices. The lift in real GDP coming from this rise in exports will be driven more by higher output per person; in fact, the level of employment needed to extract and ship the materials will be less than the level needed to build the capacity to do so. Let's be clear that Australians will continue to benefit from the higher level of resources output for a very long time. There has been a large lift in the global demand for natural resources that our country happens to have in abundance. Most people agree that the of that demand will be lower in future than it has been in recent years; some say much lower. But the lift in the of demand we have already seen is permanent enough, and large enough, to have a quite persistent effect on our economy. Australian production is meeting much of the additional global demand for iron ore and, prospectively, natural gas. This will be at prices that, although lower than prices observed today, are likely to be higher than the average seen for many years up to the middle of the past decade. Even allowing for the high degree of foreign ownership in the resources sector, flows of income accruing to Australians, through a few different channels, will be high over a long period. The end of the second phase, the investment phase, of the boom is nonetheless quite a challenging time. The investment spending by the resources sector will no longer be adding to growth in demand in Australia. In due course it will, instead, be subtracting from it. To be sure, a significant part of that investment spend has been supplied by imports, and to that extent its decline will affect imports rather than domestic production. But even allowing for that, there has still been substantial demand for Australian product and labour from the resources sector, which appears likely to abate over the years ahead. Since we wish to see aggregate demand in the economy sufficient to utilise the productive resources of labour and capital that we have, this means that we would like to see a 'rotation' to other sorts of demand as the resources sector demand slows. The 'post boom' growth story of the economy would desirably involve stronger expansion in some other sectors, including those that have seen weaker than normal conditions in the past couple of years. It is reasonable to expect that there will be some pick-up in these other areas, for reasons I have outlined elsewhere. In brief, business capital spending outside the resources sector has been subdued; housing investment likewise has been on the low side. There is ample scope for both to rise. This is by no means a certainty though and while there are signs of an increase in dwelling investment getting under way, a stronger trend in non-resources business investment looks like it is a while off yet. For a benign outcome to occur, a few things need to be in place. Reasonable global growth outcomes obviously would be a major help. At this stage global growth is sub-par, though not disastrous, with most forecasters saying next year will be better. Most of them quickly add a long list of things that could go wrong. There is nothing we can do about that. The second condition, which we can do something about, is that macroeconomic policy settings need to be appropriate. Fiscal policy is in consolidation mode, and that seems broadly appropriate. Monetary policy is, by historical metrics at least, very accommodative. The exchange rate has also declined since its recent highs, and doubts about whether it will play its normal role as a shock absorber have lessened of late. A third condition is that Australian businesses need to be internationally competitive. The exchange rate is helping here but productivity and cost performance will also be key. On these fronts, I think firms have stepped up their efforts considerably. This combination is a necessary, though not in itself sufficient, set of conditions for the sort of demand rotation likely to be necessary. The fourth ingredient is 'confidence'. It is somewhat concerning that the business community's confidence has been quite subdued in recent times. To the extent that substantial structural change has been occurring, and there is inevitable uncertainty over the international outlook, it is quite understandable that some business segments have found the going hard and don't feel very confident. Moreover, the phase shift of the mining boom itself is dampening confidence in some areas. That said, it would be good if there was a bit more confidence in the business community about the future. Unfortunately, it is not a straightforward thing to turn sentiment around. There's no such thing as the 'confidence policy lever'. Rather, we have to rely on: All the more reason, then, to make sure that the accretion of regulatory actions being undertaken does not inadvertently make it harder for businesses to plan with confidence, to achieve better cost and productivity performance, or to take a chance on a new product, a new investment or a new worker. In the case of households, according to surveys sentiment is neither particularly weak nor particularly strong at present. It is reasonable to expect that households will play a role in driving demand over the years ahead - and in due course that will help to lift business confidence. But in thinking about that role we need to understand the ways in which household behaviour has changed. The title of this talk, 'Economic Policy after the Booms', uses the plural quite deliberately. There were two 'booms'. Before the mining boom, or at least before its full flowering from about the middle of last decade, there was an earlier boom. It was global, but Australians took part in it. I am referring of course to a boom in credit, which saw a very significant increase in borrowing by households in particular, and a rise in asset values, especially dwellings. This was associated with a lengthy period of unusually strong growth in consumption. This boom did not end in Australia as painfully as it did in some other places, but end it did. Consider two charts I showed at the Anika Foundation lunch two years ago in July 2011. These have been updated, and use revised data. It is even clearer now than it was two years ago that the behaviour of households has changed in a very important way. Real consumption per person had risen faster than real income per person for 30 years, from the mid 1970s until about 2005. (Only the last third of that period is shown here.) That changed some years ago now, and after a noticeable fall in consumption in late 2008 and early 2009, spending and income have grown roughly on parallel tracks. Since 2009, trend growth in per capita consumption has been about 1.4 per cent per annum, half what it had been from 1995 to 2005. One contributing factor is seen in the second of the two charts, where it's clear why people's sense of wealth has not been rising at anything like the pace that it had been up until the financial crisis. Financial assets have begun to grow again, since the share market has risen over the past year and households have also accumulated other financial assets such as deposits. But the value of non-financial assets in particular - mainly dwellings - is lower today in real per person terms than it was five years ago. Total assets per person have risen at a pace of 2 1/2 per cent in real terms since the middle of 2009, which is much slower than in the preceding decade, and even a bit slower than in the period 1975-1994. The slowdown in asset values has been associated with a lift in saving and a slower path for consumption, which has had important implications for the economy. The table below suggests that slower consumption growth is prominent in explaining the slower pace of overall demand growth and output since the middle of 2007. One's assessment of prospects for consumption will be driven mainly by one's assessment of the outlook for income, but will also be affected by expectations about asset values and in particular one's view on whether housing prices are overvalued. Those who think they are will be drawn to the conclusion that a number of additional years of flat or declining real per capita asset values lie ahead, for non-financial assets at least; those who are not so worried about housing prices may expect that stronger growth, in real per capita terms, might occur. Either way, however, it would seem unlikely that we could bank on a resumption of sustained growth in assets, in real per person terms, of 7 per cent per year over the next few years. It follows that the saving rate is unlikely, any time soon, to decline back to where it was in 2005. Average saving rates well above that earlier level seem more likely for some time, even though there will presumably be cyclical ups and downs. While current saving rates have been described as 'high', a look at longer-run history suggests that 'normal' would be a better description. Implications that might flow from these observations would include the following. strengthening in consumption from recent rather subdued growth rates is a reasonable expectation, but we should not expect a return to the sorts of growth seen in the 1995-2007 period. Nor, surely, should we try to engineer one, at least . Households continue to service their borrowings well - the household arrears rate is low and has fallen slightly over the past year - but we would be risking future problems were we to see a big run-up in debt from here. This does not preclude prudent levels of borrowing by new entrants to the housing market, or by investors, nor does it preclude gains to consumers as costs are squeezed out of the system. It doesn't mean that consumers won't respond with their customary alacrity to new products offered at attractive prices. Trend changes in habits - more consumption of services and 'experiences', more online shopping and so on - will presumably continue. Moreover, factors that lift disposable incomes - such as higher real earnings on the back of productivity improvements, or sustainable reductions in taxes - could be expected to lift consumption on a sustainable basis. But we are unlikely to see a return to the earlier boom conditions. Second, all other things equal, interest rates are likely to be lower in such a world than they were in a world in which households were extending their finances. This is a global phenomenon, but it holds in Australia too. A higher desired rate of saving means that the return to saving will, other things equal, be at a lower level as the market clears. Those who have long been savers no doubt feel aggrieved that the returns they have earlier enjoyed cannot be found as easily now. That is in large part because other savers have joined them and the market prices reflect that. Having said that, it is still possible to earn a gross interest rate on a bank deposit that is a bit above the inflation rate. Third, a desire to hold savings in a less risky form means that the yield give-up to hold a safer asset is larger. The way this is usually expressed is that lower risk appetite, or perhaps more accurate assessment of risk that was there all along, means risk spreads are higher. Spreads are well down on their peaks reached at the height of risk aversion a few years ago, but do seem to have settled at a higher level than in the mid 2000s. Absolute borrowing costs for most borrowers are very low despite higher spreads, because the return on one of the least risky assets - the cash rate - is the lowest for 50 years or more. The market yields on government securities, the lowest risk assets of all, have likewise been very low. In other words, with many investors wanting safety, the price of safety has risen. It has to rise by enough to prompt at least some people to start to shift their portfolios in the direction of taking more risk - by holding equities, physical assets and so on, though obviously we don't want risk-taking. One of the things we have been watching for as we have been reducing interest rates has been an indication of savers shifting portfolios towards some of the slightly more risky asset classes, as that is one of the expected and intended effects of monetary policy easing. There are clearly signs of policy working in this respect, though not, to date, by so much that we see a serious impediment to further easing, were that to be appropriate from an overall macroeconomic point of view. In the third phase of the 'mining boom' and post the credit boom, our economic challenges are changing in nature. In the next few years our task will involve supporting, so far as it is in our power, a change in the sources of demand that affect the economy. As resources sector investment declines, other sources of demand need to strengthen, but in a way that is sustainable. The fact that consumption is likely to provide only a modest impetus to any acceleration in domestic demand suggests that other areas will be important. As I noted earlier, at least some of the conditions are in place for stronger trends in dwelling investment and, in time, non-resources business capital expenditure. And exports of resources will continue to pick up strongly. But successful 'rotation' of demand will probably also involve more net foreign demand for other Australian output of various kinds. Given that, the recent decline in the exchange rate seems to make sense from a macroeconomic perspective. It would not be a major surprise if a further decline occurred over time, though of course events elsewhere in the world will also have a bearing on that particular price. The conduct of monetary policy must, and does, take account of the various features of the environment we face. Calibrations drawn from an earlier part of history can't be assumed to have the same reliability. Elements of the monetary policy transmission process are probably working somewhat differently than on other occasions. To take one example, the fact that policies in major economies have been at very unusual, or extreme, settings for some time is a complication because of the potential effects on the exchange rate - though, as noted, the exchange rate appears to have been behaving more normally of late. The fact that the rest of the world has had such low interest rates, that the desire for safe assets has been so strong, that the spreads between the cash rate and the rates that matter most for the economy have widened, and that people have sought to get to a position of lower leverage - all these have been important in explaining why the cash rate has been so low compared with what we had been used to until the mid 2000s. That this has occurred while we have had the peak of the resources investment boom is all the more remarkable. This has been guided by the flexible inflation targeting framework we have had in place for 20 years now. This framework has prompted appropriate and timely action when needed. It has seen a substantial easing in monetary policy since late 2011. We have been saying recently that the inflation outlook may afford some scope to ease policy further if needed to support demand. The recent inflation data do not appear to have shifted that assessment. More generally, the credible and sensible approach to policies is: Failure to do this would be costly. But the rewards from consistent application of good policies are known, from our own experience, to be big, even if not immediate. Remembering that is the challenge we face. Thank you once again for coming along today.

r131018a_BOA

australia

stevens

It could have been the Dutch who started European settlement in Australia. In their journeys to the East Indies numerous Dutch traders saw the western and northern coastlines of the continent and some came ashore. But the conditions were not hospitable and, finding nothing in the way of commodities that they could exchange for value at home, they left. Or it could have been the French: Jean-Francois de Galaup La Perouse arrived in Botany Bay only a few days after Arthur Phillip's fleet in 1788. Apparently the English and French mariners, despite the rivalry of their countries, enjoyed cordial relations for a brief interlude before La Perouse sailed off into the South Pacific, never to be seen by Europeans again (Dyer 2009). But it was the English who came to start a colony. Eighteen years after James Cook landed at Botany Bay, the First Fleet anchored there in January 1788. After only a few days, finding the shallow, sandy bay too exposed and short on potable water, they sailed 20 kilometres or so north to Port Jackson, which they regarded as a superior location to found the settlement. Looking at Sydney Harbour today, it appears they made the right call. The contrast with today's prosperity could not, however, have been more pronounced. In time the Great South Land would help to feed the world, but in 1788 the new arrivals couldn't feed themselves. Geoffrey Blainey's book records how the fledgling settlement nearly starved - and how, later in 1788, HMS was sent to a suitable supply station to bring back food and seed. That station was the Cape of Good Hope (now Cape Town, South Africa) - 11,000 kilometres away - a measure of the degree of isolation the First Fleeters must have felt. The return journey took about seven months, shorter than it would have been had Captain Hunter not ignored the advice of his superiors. After proceeding south from Sydney, he turned east, rather than west, so picking up a favourable wind for the outward journey. He sailed more miles, but in a shorter time. And so began the inflow of people, capital, and know-how that ultimately resulted in the modern Australian nation. Today Australia is still a nation of immigrants, where almost one-quarter of our 23 million inhabitants were born somewhere else (ABS 2012). Just about every nationality is here and we face the 'Asian Century' with the sense that - for the first time in our modern history - our geographical position is an economic advantage. For a long time, the economic and financial relationship with the UK dominated, despite the distance. In colonial times, the UK was by far Australia's most prominent trading partner - in the 1880s the UK was the source of 70 per cent of Australia's imports and the destination for up to 80 per cent of exports (Vamplew 1987). By the turn of the 20th century still more than half of Australia's trade was with the UK. Though overall Australia accounted for less than 10 per cent of the UK's bilateral trade in the 19th and early 20th centuries, Australia was among the UK's largest sources of wheat imports and at times accounted for more than 50 per cent of the UK's wool imports (Mitchell and Deane 1962; Mitchell and Jones 1971). The Australian Pound was linked to the pound sterling and the Australian banks kept reserve balances in sterling - 'London funds'. In time, Australia created its own central banking arrangements, and by the 1930s the Commonwealth Bank was serving as a basic central bank (though without, at that time, the same full central banking mandate and obligations that the RBA has today). Still, the links with Britain were strong. The decision to devalue the Australian currency with sterling in 1967 was a departure from previous practice. When Australia got into financial difficulties meeting its obligations in the late 1920s, Sir Otto Niemeyer was despatched from the Bank of England in 1930 to offer advice to the Australian Government. Niemeyer's diagnosis - that Australia had lived beyond its means, and should accept lower living standards in order to service its international debts - was not, shall we say, universally welcomed, but his influence lived on. The monthly statement of Commonwealth Government finances, which he devised, was still known as the 'Niemeyer' statement until well into the 1980s, when I was a junior economist in the Reserve Bank. So the links were strong. But of course the world was changing. Two world wars saw the UK's financial strength diminish and its weight in the global economy decline, as that of the United States rose. In the 1970s the UK also increasingly turned towards Europe, with EU-directed trade increasing strongly in the two decades after joining the EEC. By then, Australian trade had long turned towards first the US, then Japan. Trade with the USA had been increasing steadily since the late 1940s and the USA replaced the UK as Australia's largest bilateral trading partner in the mid 1960s. Similarly, trade with Japan grew rapidly and overtook that with the UK by the 1970s (and began to rival that with the US as well) (Vamplew 1987; RBA 1996). In the subsequent decades Australia's trade focus continued its shift towards Asia generally and, in the past decade especially, towards China in particular. Today nearly three-quarters of our trade is with the Asia Pacific, while half of the UK's trade is with Europe (ABS 2013b; ONS 2013). Historically, the UK was a top destination for Australians travelling abroad - 'falling towards England' as Clive James memorably described it. In 1950 around 30 per cent of Australian outbound tourists were destined for the UK and Ireland. That had fallen to 6 per cent by 2013. Australians' travel to the USA has remained fairly consistent since the 1970s at around 10 per cent. Travel to Asia increased dramatically with destinations in South-East Asia now accounting for more than 30 per cent of the total. The UK is, though, still a major source of tourism for Australia. Despite a decline since the GFC, UK citizens account for around 10 per cent of all arrivals in Australia, remaining close to the historical (post-1950) average of around 15 per cent. These days, China is the biggest source of Australia's inbound arrivals after New Zealand, and is usually the fastest growing. Interestingly, however, recent data show that in the year to August 2013, UK arrivals grew faster than arrivals from China (Vamplew 1987; ABS 2013c). Those picture postcards of sun and blue skies must be very appealing during the European winter! It will take a good deal more time yet for these shifts in trading relationships to be mirrored in the accumulated stock of invested capital. The UK's foreign investment in Australia during the country's formative years was large, even for the UK. Between 1870 and 1913 about 8 per cent of Britain's total foreign investment went to Australia. As recently as the mid 1950s, the UK's investment in Australia dwarfed that from any other country, and was more than double the investment of our second largest investment partner, the USA (Vamplew 1987; RBA 1997; Ukhov and Goetzmann 2005). As at the end of 2012 the stock of foreign invested capital that came via the UK amounted to almost $500 billion, and it is still growing (it rose at an annual average compound rate of more than 6 per cent over the past 10 years) (ABS 2013a). The stock of Chinese inbound investment has been growing at 20 per cent over the past decade, but is estimated at only 2 per cent of the combined total from the US and UK. Similarly, and perhaps more surprisingly, the stock of Australian investment abroad remains concentrated in the UK and the US - though that is beginning to change now, with a bigger focus on Asia. That accumulated inbound investment has helped Australia become a very affluent nation, augmenting our own national savings to a significant extent. According to Angus Maddison's data set, within 80 years of the founding of a penal colony on the shore of Sydney harbour, about a kilometre from our present location, Australia's real GDP per head matched the UK's (Maddison 2003). Today, Australia's real GDP per head of about $44,600, measured at purchasing power parity, is noticeably higher than the UK's ($36,900), though for the UK that comparison is adversely affected by the economic weakness in recent years. Such an outcome is perhaps not surprising given the endowment of land and natural resources that Australia has. Opening up of large areas of land for agriculture enabled Australia to enter powerfully the markets for grain and wool. Agriculture was a major source of wealth over most of our history (and many predict will play a big role in future). The gold rush of the mid-nineteenth century helped to propel the city of Melbourne in particular to globally significant size and affluence (though there were later excesses that led to a serious depression). The things the Dutch and others couldn't see under the ground when they surveyed the inhospitable northwest four centuries ago are the source of massive wealth today. About 1.5 million tonnes of iron ore, valued at about $150 million at current prices, leave those shores each day in ships about 250 times the size of Cook's . A combination of those endowments with a willingness to accept international capital, including very prominently from the UK, has given Australians the opportunity to grow our economy quickly. But it wasn't just money, land and minerals. There are other countries with resources and land that do not enjoy the same incomes. And there are nations with very little in the way of resources or land that are wealthy. It was other things about the British heritage that were of higher value. It turns out that the English language is just about everyone's second language, which means even with our broad accent, we can communicate with educated people virtually everywhere and engage in commerce in most places. The common law and parliamentary democracy provide a foundation for the sorts of property rights and governance processes that are widely and rightly regarded as fundamental to building a prosperous modern economy. That property rights could become so well established in a society in which the 'immigrants' of 1788 had no such rights is, perhaps, an ironical outcome. And we are still coming to terms with the property rights of those descended from the inhabitants who were here before 1788. But the point is that this heritage, so important for enterprise, is something we have in common with the UK. One has to observe as well that Britain traded with and invested in her former colonies, however imperfectly, rather than simply extracting the rents. The fact that so many prominent English-speaking former colonies are counted among the rich of the advanced world today is perhaps not entirely a coincidence (Grier 1997; Acemoglu, Johnson and Robinson 2001 and 2005). In my own field of central banking, we have a good deal in common. The Bank of England and the Reserve Bank of Australia conduct monetary policy using the approach of a medium-term target for consumer price inflation, endorsed by government, with operational independence for the central bank, and a flexible exchange rate. We are not alone in this - there are quite a few countries that follow a version of this approach these days - but the Bank of England and the RBA were, after the central banks of Canada and New Zealand, fairly early adopters of the approach. There is a very practical level of cooperation between the two institutions, exemplified by staff exchanges as well as contact at the highest levels. I well remember a phone call from Mervyn King on the morning of 15 September 2008, to ask how our markets were absorbing the news of the Lehman failure that had been announced just after trading started. (The answer was: reasonably calmly, initially, but that subsequently changed.) In the ensuing five years, Australia and the UK have both faced the challenges arising from the global financial crisis (GFC). For various reasons the UK has had a harder time of it, with bigger problems in its banking system, which is also bigger relative to its economy, and a higher exposure to a troubled Europe, in contrast to our exposure to a resilient Asia. Hence, while Australia has experienced growth, albeit slower than average, in the years following the GFC, the UK suffered a painful and rather protracted recession. It seems of late though that there are more signs of expansion in the UK economy, which will no doubt be very much welcomed by citizens and policymakers alike. The UK still warrants the label 'major economy'. Its GDP is still among the top 10 in the world. Perhaps more significantly London remains easily the world's pre-eminent international financial centre. New York, being in the US, boasts bigger domestic markets of course, but London services the world. In the councils of global governance the UK holds an important position - in bodies like the IMF, the BIS, the UN and others, it holds its own seat and acts with influence. Australia, with a third the UK's population and about half its absolute GDP, as the eighteenth largest economy, and with a correspondingly more modest stature on international bodies, cannot see itself in quite the same way. We have well-developed financial markets and there are plans to develop more as a regional financial centre, but realistically Sydney will never rival London. Nonetheless we have our contribution to make, and our UK partners have always been welcoming in hearing it. And this has to be because there is so much in common today, in the modern world. The ties that bind are not just history. They extend beyond a fascination and affection among Australians for the royal family - strong though that is - or the long-contested rivalry between 'old enemies' for one of the world's smallest sporting trophies. There is a real sense in which the UK and Australia share an outlook, at a very basic level, on how an economy should be organised and governed. They share a perspective on the role - and the limits - of markets in setting prices and allocating resources. They share a commitment to a world economy in which trade is free and capital, in general, is free to move. We have had some differences of nuance in recent years about matters financial, reflecting mainly our differing experiences of the crisis, but in the broad the perspective of the role of the financial services sector in facilitating the real economy is very much shared. The business communities of the two countries have strong links, evidence for which is your attendance here today. I'm sure that this association will continue to strengthen and mature over the years ahead, even though the two countries are at opposite ends of the globe. Perhaps the most important thing the two countries have in common is the strong belief that societies prosper when policies are debated in an open way, when evidence, reason and judgement can be brought to bear on decisions, and where accountability and evaluation are key attributes of the process. That set of commonly held values will be important for us over the year ahead, as Australia assumes the chair of the G20. What issues will be on the agenda? And how can the business communities of the two countries contribute? The full agenda is of course for the Australian Government to determine, in consultation with other G20 member governments. It will certainly have a strong focus on growth, and on the role of the private sector in driving growth, including its role in infrastructure investment. So I expect there will be significant call for engagement of the business communities of Australia and the UK, and other member economies, over the year ahead. I will make just two points here. First, in the area of financial regulation, there is a major agenda for reform, on which very good progress has been made, but on which there is still much work to do. In my view, having developed a very substantial pipeline of work since 2008, our energies need now to be devoted to careful and systematic implementation of the already agreed reforms. That is not to preclude new regulatory initiatives, which are still being put forward. But the implementation task arising from the pipeline of reforms already agreed, either in detail or at a conceptual level, is very large indeed. Of these, the most important ones are the Basel III package, the reforms for OTC derivatives trading and clearing, establishing appropriate oversight of 'shadow banking', and work to address the problem of 'too big to fail', including cross-border resolution of systemically important financial institutions. This by no means exhausts the list of work streams, but these are the key ones. Each is individually very demanding for regulators and industry players alike. Taken together, they are, in a word, daunting. We need to avoid reform fatigue, and to sustain our support to those doing the hard grind of devising the new rules and making them work. To do that, we need, in my opinion, to contain the growth in the regulatory agenda, and to respond only to the most important calls for further major work streams, at least for the next little while. Let me be clear this is NOT a call for current reform efforts to stop, or to be watered down. It is about ensuring we focus our finite energies and resources on the most important problems, and getting industry to do the same. The second point is that the business community, both in the UK and Australia, and generally under the auspices of the 'B20', can contribute to meaningful progress towards the G20's broader goals. That contribution will be most constructive if it can avoid being dominated by particular national or industry interests, if it can adopt a genuinely global perspective, if it can have realistic aspirations and if it can understand the constraints under which policymakers operate. A contribution like that will be key to achieving the G20's goals: an open world economy, characterised by strong, sustainable and balanced growth. I hope that Australian and UK business leaders, along with their peers from around the other G20 countries, will seize that opportunity and that responsibility.

r131029a_BOA

australia

stevens

As ever, the times remain 'interesting'. You will have much to talk about. I will confine myself to some brief remarks, firstly about the global scene, and then about the situation in Australia. From this distance, the US economy appears to be healing. The 'headwinds' from the housing sector are lessening, corporations are in a strong financial position and the labour market is improving, albeit slowly. Much financial repair has been made. The new sources of abundant energy in the US will also act as a growth enhancer. The biggest remaining problems are how to put the US budget onto a sustainable long-run footing, and how to manage the exit from extraordinary monetary policy settings. In Europe, numerous downside risks that were top of mind a year ago have not, in fact, materialised - which is no small achievement. Moreover, there are signs of a modest cyclical upturn in economic activity. That said, those downside risks still exist and the recovery has been described by ECB President Draghi as weak, uneven, fragile and starting from very low levels. China, meanwhile, has continued to grow, more or less in line with the objectives of the Chinese authorities. This is more moderate than the double-digit rates China recorded in earlier times. But it is still a robust performance and China is now a big economy whose performance matters for the rest of the world. The key question in China would be whether the 'shadow-banking' system, where much of the growth in financial activity has been occurring, can be adequately controlled and kept stable. The 'emerging market' economies have experienced some turbulence. Until May this year, their problem was inward flows of capital, resulting in part from 'spillovers' from the extraordinary measures taken by the major countries. This put upward pressure on exchange rates, and made for easier financial conditions, which was conducive to rising credit and asset values. It was also a permissive environment for the continuation of any underlying imbalances or weaknesses. When the Federal Reserve began to lay out the conditions under which it would consider scaling back its extraordinary measures, and the possibility became real that such a scaling back might begin this year, capital markets reacted by scaling back their own purchases of assets in emerging markets. The situation then became much less permissive. Financial conditions for a number of countries tightened, exchange rates started to come under downward pressure, and policymakers were faced with the need to accelerate the crafting of responses. That pressure was lessened when the Fed did not, in the end, begin the 'taper' in September. Since then, stock markets have advanced, long-term interest rates have edged down and the US dollar has weakened. The outflows from emerging markets slowed. Even in the face of the impending deadline for lifting the US debt ceiling, markets experienced a relatively limited amount of disruption (though it is very doubtful that they would have accepted a default event with the same equanimity). There was a distinctly more relaxed tone to the discussions in and around the IMF and G20 meetings in Washington in October than there had been at like meetings earlier in the year. But it would be a mistake to relax for very long in the face of this delay. Surely the 'taper' will come. We should hope it will, since it will signal that the US economy is well established on a recovery track, and it will start to lessen some of the uncomfortable spillover effects unavoidably associated with the present set of policies. For some countries, including Australia, the beginning of a return to something resembling more normal conditions, in at least one major advanced country, would lessen some of the difficulties we face in our own policy choices. For some other countries, this may see some resumption of the less welcome pressures seen earlier this year. The good news is that we have had a dress rehearsal of what the beginning of tapering will probably look like, so we have a sense of the pressure points, and there is now a window within which to address some of them. It would be wise for policymakers to use that window. Turning to the Australian economy, we have seen, over the past couple of months, evidence of a lift in sentiment in the business community. A lessening of political uncertainty has no doubt helped this, though we should note that this follows an improving trend in measures of household confidence that began in the second half of last year. That uptrend had a setback in mid 2013, but then resumed. One force helping household and business confidence has been a positive trend in asset markets. Over the past year, the stock market, as measured by the ASX 200 accumulation index, has returned about 25 per cent. The median price of a dwelling in Australia has risen by about 8 per cent over the past 18 months, reversing a previous decline. Overall, the net worth of Australians has increased by around 15 per cent, or more than $800 billion, since the end of 2011. It is not yet clear to what extent, or when, these more favourable trends in 'confidence' will translate into intentions to spend, invest and employ. The pace of new dwelling construction is starting to respond to higher prices in the established property market, as we need it to. But at this stage, the available information suggests that broader investment intentions in the business community remain subdued. It may be a while yet before we can expect to see conclusive evidence of a change here. In the interim, some commentators have taken the view that the property market dynamics are worrying. My own view, thus far, has been that rise in housing prices is part of the normal cyclical dynamic, that it improves the incentive to build, and that a price rise reversing an earlier decline probably isn't something to complain about too quickly. Moreover, credit growth, at between 4 and 5 per cent per annum to households, and less than that for business, does not suggest that rising leverage is so far feeding the price rise. Hence it has been a little too early to signal great concern. There are, however, two caveats. The first is that, notwithstanding the above comment, credit growth may pick up somewhat over the period ahead. So this is an area to which we will, naturally, pay close attention. Secondly, while overall credit growth remains low at present, borrowing is increasing quite quickly in some pockets. Investor participation in housing in Sydney, in particular, is becoming noticeably stronger. Over the past year, the rate of finance approvals for this purpose has increased by 40 per cent. We have certainly experienced higher rates of growth of finance than that in the past, and it may be that we are seeing some catch-up from a delayed initial response to fundamentals favouring more investment in housing. Nonetheless, as this activity continues, lenders and borrowers alike would be well advised to take due care. It is very important that strong lending standards remain in place, and that decisions be based on sensible assumptions about future returns. That's what we need if we are to experience a long and sustainable expansion in housing investment that houses our growing population at acceptable cost, and pays reasonable returns on the capital deployed. That's the sort of outcome we want, as part of the more balanced growth path for the economy we are seeking over the years ahead. Another part of the balanced growth path would involve an expansion in some of the trade-exposed sectors that have been squeezed by the high exchange rate. The foreign exchange market is perhaps another area in which investors should take care. While the of the exchange rate's response to some recent events might be understandable, that was from that were already unusually high. These levels of the exchange rate are not supported by Australia's relative levels of costs and productivity. Moreover, the terms of trade are likely to fall, not rise, from here. So it seems quite likely that at some point in the future the Australian dollar will be materially lower than it is today. The high exchange rate has also had a significant impact on the Reserve Bank's own balance sheet. It led to a decline in the value of the Bank's foreign assets and hence a diminution in the Bank's capital, to a level well below that judged by the Reserve Bank Board to be prudent. This has been a topic of some interest of late. Our annual reports have made quite clear over several years now that, while this rundown in capital in the face of a very large valuation loss was exactly what such reserves were designed for, we considered it prudent to rebuild the capital at the earliest opportunity. It has been clear that the Bank saw a strong case not to pay a dividend to the Commonwealth during this period, preferring instead to retain earnings, so far as possible, to increase the Bank's capital. That rebuilding could in fact have taken quite a few years, given the low level of earnings. That is the background to the recent decision by the Treasurer to act to strengthen the Bank's balance sheet, in accordance with a commitment he made prior to the election. The effect of this is that instead of it taking many years to rebuild the capital, it will occur in the current year. This results in a stronger balance sheet on average, and makes it likely that a regular flow of dividends to the Commonwealth can be resumed at a much earlier date than would otherwise have been the case. With those few remarks, I wish you well in your deliberations at your conference today. Thank you.

r131121a_BOA

australia

stevens

In just a few weeks' time we will pass the anniversary of one of most profound economic policy decisions in Australia's modern history. I refer of course to the decision taken by the Hawke Government in December 1983 to float the Australian dollar and to abolish most restrictions on the international movement of capital. The decision had been a long time coming. The possibility of a float had been contemplated for years. But the right combination of intellectual climate and circumstances did not arrive until 1983. When it was taken, the decision was a key part of a sequence of very important decisions that opened up the Australian economy and its financial system to international forces, and which changed it profoundly. Much has been written about that broader reform process. I will speak just about the floating of the dollar itself. I shall pose, and offer answers, to several questions. Why did we float? How has the market developed? How has the exchange rate behaved? What difference did the float make for monetary policy in particular and the economy in general? Has the currency been 'misaligned' in ways that have been damaging? And what can be said about intervention? In a nutshell, I think it is true to say that Australia finally floated the exchange rate because the feasible alternatives had been shown to be ineffective. We had tried just about all the currency arrangements that were known to human kind, with the exception of a currency board: a peg to gold/sterling, a peg to the US dollar, a peg to a basket and a moving peg. All proved ultimately unsatisfactory. From first principles it could be questioned whether Australia, a country that on occasion experiences quite large shocks in the terms of trade, should have had a fixed exchange rate. The background was the complete breakdown of the international trade and financial system in the 1930s followed by war, which left private capital flows small, central banks and governments dominating capital markets and a distrust of the price mechanism generally. The experience of the early 1950s, however, showed how hard it could be to maintain stability in the face of terms of trade shocks with a fixed exchange rate. By the early 1980s the intellectual climate had clearly changed. Things had moved on from the post-Depression set of assumptions. More people were conscious of the shortcomings of the regulated era, and were prepared to argue for allowing market mechanisms to set prices and allocate resources. So there was a case for exchange rate flexibility on 'real' or resource allocation grounds. There was also one based on monetary grounds. On the one hand, a fixed exchange rate with a suitable major currency can serve as a 'nominal anchor' if we are prepared to accept the monetary policy of the other country through all phases of the cycle. The countries to whose currencies we had pegged, however, had their own circumstances and policy imperatives that evolved differently from our own. Private capital flows had become much larger and our commitment to make a price in the foreign exchange market meant we could not control liquidity in the domestic money market. Inflows of funds in anticipation of a revaluation led conditions to become too easy, and outflows in anticipation of a devaluation tightened up the system. By the early 1980s, with inflation quite high, the lack of monetary control was a serious problem. This was the situation in the lead-up to the decision to float. Thirty years ago, the Australian foreign exchange market was relatively small and underdeveloped. At the time of the float, the participants in the market were primarily the domestic commercial banks, though this quickly changed after a number of foreign banks were given licences, increasing competition significantly. After the float, the market matured and grew. Today the Australian dollar is one of the most actively traded currencies. Global daily turnover runs at about $460 billion. The AUD/USD is the fourth most traded currency pair, accounting for just under 7 per cent of global foreign exchange turnover. Compared with the US dollar, the euro or yen, these are small numbers but compared with currencies of several other countries whose economies are noticeably larger than Australia's, the size of the AUD market is remarkably large. It offers the full range of foreign exchange products. These days more of the trading activity in our currency occurs outside our jurisdiction than inside it, a pattern that is common to most currencies. This reflects the role of international financial centres such as London, which retains a dominant role as a financial hub. Other centres such as Singapore and Hong Kong have made it part of their national 'business model' to provide an environment conducive to major financial firms setting up to offer a full menu of financial services to the global investor community. Most countries that are not themselves international financial hubs find that an increasing proportion of trading in their currency takes place 'offshore'. At the time of the float, the Australian dollar against the US dollar was actually not very different from its current value (Graph 1). It was worth about 90 US cents in December 1983. That was down from its highest point in the 1970s under the fixed exchange rate system, of US$1.4875. The trade-weighted index was 81 (today about 72), down from a high of around 120. People forget how high the exchange rate was for much of our history. Initially after the float, the exchange rate rose for some months before settling back. There was a further very distinct leg down beginning in early 1985. There was quite a lot of drama at the time - this was the era of credit rating downgrades and 'banana republics'. I think there was a genuine fear at various times that the currency might simply collapse to some ludicrously low value. With the benefit of that most powerful of tools, hindsight, one can observe that the currency had by the mid 1980s adjusted to a lower mean value, around which it fluctuated for nearly 20 years. One can further note that those trends had some association with developments in Australia's terms of trade (Graph 2). From this vantage point, the market might be argued, on the whole, to have moved the exchange rate to about the right place. And despite the occasional worries about large downward movements, there was probably less high drama associated with them than would have accompanied decisions to devalue a fixed exchange rate. Some trends did seem less explicable, such as when the exchange rate fell below 49 US cents in March 2001 and lingered at very low levels for a while. This was in the wake of a slowdown in the Australian economy, but was also the era of excitement over America's so-called 'new economy', and the sense that Australia was an 'old economy'. The 'old economy' elements like mining would come into their own only a few years later. In 2001, the terms of trade were already rising, and a powerful upswing ensued over the next decade. Even those who were prescient enough to understand the importance of the rise of China have, I suspect, been surprised by the extent of increase in Australia's terms of trade and its longevity. And of course this trend has carried Australia's currency to historically high levels - back, in fact, to about where the floating journey began thirty years ago. Has the mean value around which the currency fluctuated from the mid 1980s to the mid 2000s now given way to something higher, or will it reassert itself? That is a fascinating question. For the Reserve Bank in its monetary policy responsibilities, the float made all the difference in the world. We no longer had an obligation to stand in the foreign exchange market at a particular price. An earlier decision of the Fraser government to issue government debt at tender meant that the Reserve Bank did not have to stand in the government debt market either. As a result of these two decisions - and they were both important - for the first time the Bank had the ability to control the amount of cash in the money market and hence to set the short-term price of money, based on domestic considerations. This is the hallmark of a modern monetary policy. The extent of short-term variability in interest rates declined while, naturally, that of the exchange rate rose somewhat (Graph 3). A flexible exchange rate is also a critical component of inflation targeting, which is Australia's monetary policy framework of choice. Admittedly, for some years exchange rate considerations were still sometimes seen as something of a constraint in the conduct of monetary policy. This has been progressively less the case, though, as the credibility of the inflation target has increased. Even if all the flexible exchange rate did was to allow monetary policy to operate effectively, that was a major benefit. But the float did more than just that. Real exchange rates move in response to various forces affecting an open economy, even if the nominal exchange rate is fixed. Given the slow-moving nature of the bulk of prices, allowing the nominal exchange rate to change makes the process more efficient unless there is excessive short-run variability in the nominal rate. As hedging markets develop the cost of short-run noise is usually lessened. In my view the flexible exchange rate has helped adjustment in the real economy in its own right. The combination of allowing monetary policy to operate effectively and fostering real economic adjustment is very important. One very telling comparison is between the macroeconomic performance in the most recent commodity price upswing and that in the episodes in the early 1950s and mid 1970s (Graph 4). It is obvious that there has been a first-order reduction in macroeconomic variability on this occasion. The flexibility of the exchange rate has been a major contributor to that outcome. The currency has certainly moved through a very wide range over the thirty years since the float. If our metric were some constant target level of 'competitiveness' measured, say, by relative unit costs, then we would be drawn to the conclusion that it has been 'misaligned' much of the time. But such a simple calculation alone isn't the right metric. For a start, over the course of a business cycle the exchange rate should move in ways that help to maintain overall balance between demand and supply. In a period of strong demand it will rise, spilling demand abroad by lowering prices for traded goods and services. This lessens 'competitiveness' in the short term, but helps preserve it in the longer term by maintaining discipline over domestic costs. Moreover, the level of relative unit costs in, say, manufacturing, that is 'needed' is a function of several factors, including the terms of trade. A country with an endowment of natural resources will find that when those resources command high prices, it will have a high exchange rate and low manufacturing 'competitiveness', compared with the situation when the terms of trade are low. The high resources prices draw factors of production towards the resources sector, pushing up labour costs for other sectors and drawing capital from abroad, so pushing up the exchange rate. The terms of trade rise is an income gain, and may well prompt an expansion in investment in the resources sector. Hence aggregate demand is likely to increase, which among other things will also require a higher exchange rate than otherwise to maintain overall balance. These forces diminish 'competitiveness' for other traded sectors. At a later stage, when those adjustments to the capital stock have occurred, the exchange rate may be lower than at its peak, though still higher than what would have been observed had the terms of trade not risen. So it is not surprising that the exchange rate responds to changes in the terms of trade. It is nonetheless striking how close the empirical relationship has turned out to be. Of course it is not to be assumed that the parameters of that particular empirical relationship are necessarily optimal. But nor is the contrary to be assumed. Over the thirty-year period since the float, that relationship seems not to have led to long periods of the economy either having excess demand or supply. Australia has had one serious recession in that time, in 1990-91, and the principal cause of the depth of that downturn was asset price and credit dynamics, not the exchange rate. Overall, variability of the real economy has been lower in the post-float period. While there are several factors at work in producing that result, the flexible exchange rate is clearly one. My conclusion, then, would be that evidence of large and persistent exchange rate misalignments is actually rather scant over the floating era as a whole. Arguably some of the bigger misalignments occurred under previous exchange rate regimes. But what of recent levels of the exchange rate? They have been blamed for many disappointing corporate results and triggered numerous restructurings, instances of 'offshorings' and job shedding. The only other factor so frequently offered to explain disappointment is 'consumer caution'. One can imagine that many people would see this as prima facie evidence of the exchange rate being significantly misaligned. There are a few difficulties in evaluating that claim. First, very high terms of trade can be expected to lead to some loss of 'competitiveness', as noted above. Just how much of this would be expected depends, among other things, on how permanent the terms of trade rise is, but this episode has been very persistent so far. The euphemism 'structural adjustment' hardly conveys the difficulties faced by firms and their workforces affected by these forces. But a big and persistent shift in relative prices, which is what the terms of trade shift amounts to, was always going to produce some such effects. A further difficulty in assessing the exchange rate's level lies in that very persistence. The relationship between the exchange rate and the terms of trade has, broadly speaking, continued to hold (Graph 5). Nothing looks very unusual right at the moment. But this relationship is estimated over a period in which the changes were generally cyclical. It is at least conceivable that a large and persistent rise in the exchange rate may have effects on the economy beyond those discernible from the experience of the past thirty years, if previous rises in the exchange rate were not long-lived enough to cause significant structural change. This is a possibility the Reserve Bank has noted in the past couple of years. There is at least one more complication in assessing the exchange rate's recent behaviour and that is the extraordinary monetary policy measures that are being undertaken in the major economies of the United States, Japan and the euro zone. These too are outside any historical experience. Such measures are in place because they are required by the circumstances of those economies, but there is no doubt that they have fostered the so called 'search for yield'. That, after all, was the whole point. Added to this is the lessening, even if only at the margin, of perceived creditworthiness of a number of sovereigns, while our own sovereign rating has remained at the highest level. This has contributed to an increase in 'official' holdings of Australian assets as reserve holders sought diversification. These 'yield-seeking' and 'diversification' flows have, no doubt, pushed up the Australian dollar. Quantifying that effect is not straightforward. Models suggest that interest differentials have had an effect on the exchange rate, but that effect is dwarfed by the estimated terms of trade effects. But again, the conditions we have seen are unlike anything seen in the period over which the models are estimated. The flows have surely been important at times, though not necessarily lately. The available data suggest that foreign holdings of Australian government debt stopped rising in the middle of last year. Earlier flows into Australian bank obligations have also generally continued to reverse over that time. As my colleague Guy Debelle has noted, the most obvious capital inflows in the past couple of years have been in the form of direct investment into the mining sector. Those flows were of course responding to expected returns, but not ones that were affected very much by the interest rate policies in the major economies. In the end it is not possible to come to a definitive assessment on the extent of currency misalignment at the moment, (and having regard to the statistical imprecision of such metrics). Having said that, my judgement is that the Australian dollar is currently above levels we would expect to see in the medium term. In the early period after the float the Reserve Bank undertook market transactions for the purposes of so-called 'smoothing and testing'. As the market developed and the Bank gained more experience, intervention became less frequent but more forceful. A key motivation for intervention was often trying to avoid the currency moving downwards too quickly. For most of the floating era, until recently at least, a currency that seemed prone to weakness seemed more frequently a problem than the reverse. As has been well documented, the Bank's intervention strategy has tended to be profitable over the long run. The success of this strategy was helped considerably by the fact that, for much of the floating era, the exchange rate's behaviour could be characterised as fluctuating around a stable mean. If a situation came along that shifted the mean, the strategy might need to be altered. It might be argued that this is what has happened over the past five years or more. The terms of trade event we have lived through is without precedent in its size and duration, at least in the past century. The exchange rate has responded. Notwithstanding that, in my view, the Australian dollar is probably above its longer-run equilibrium at present, it is far from clear that we can assume that the mean level we saw in the 1980s to the early 2000s will be the relevant one in the future. In evaluating the merits of intervention, the Bank has been cognisant that the current episode is unlike the experience of the first twenty or twenty-five years of the float. Some very powerful forces have been at work. A further factor relevant to intervention decisions has been cost. Intervening against the Australian dollar would have involved selling Australian assets yielding, say, 3 per cent, and buying foreign assets yielding much less - in fact earning almost nothing over recent years at the areas of the yield curve where the Bank operates. This 'negative carry' would be a cost to the Bank's earnings and therefore Commonwealth revenue. Now it be argued that a negative carry for the Reserve Bank, and therefore the Commonwealth, and an acceptance of the associated very large valuation risks, would be a price worth paying, if it corrected a seriously misaligned exchange rate. If such a policy were effective, it turn out to be profitable, if a fall in the exchange rate offset the negative carry. The point is simply that costs have to be considered alongside the likely effectiveness. Often those who argue for intervention don't work through those costs, or they assume it would be entirely costless. That can't be assumed and the idea should be considered in a cost-benefit setting. Overall, in episode , the Bank has not been convinced that large-scale intervention clearly passed the test of effectiveness versus cost. But that doesn't mean we will always eschew intervention. In fact we remain open-minded on the issue. Our position has long been, and remains, that foreign exchange intervention can, judiciously used in the right circumstances, be effective and useful. It can't make up for weaknesses in other policy areas and to be effective it has to reinforce fundamentals, not work against them. Subject to those conditions, it remains part of the toolkit. When the foreign exchange market opened on 12 December 1983, without the Reserve Bank making a price for the first time in decades, people would have been uncertain what would happen. Yet policymakers had tried all the alternatives and the float was an idea whose time had come. It was a profound decision - part of a recognition that Australia was part of a wider world, and that we had to reform our own policy and economic frameworks in order to have the sort of prosperity that we wanted as a society. On 12 December this year we can expect the exchange rate to move a little, one way or the other, and for this to be reported in a very matter-of-fact way on the news broadcasts. We will be able to get updates on our smart phones and to read seemingly limitless quantities of analysis about why it moved the way it did, and predictions about what it might do next, most of which we shall (sensibly) ignore. We would be able, if we wished, to trade foreign currencies from those devices in a way unimagined thirty years ago. (For the record, I am not recommending the practice.) For the dollar to move around in the market as the various players balance supply and demand is now considered normal, and most of the time it is considered no more newsworthy than the price of milk or petrol, and less newsworthy than the price of houses. Over the past thirty years, the exchange rate has on occasion been the subject of excitement, concern, even shock. It has acted as a shock-absorber, as intended, but it has also served as a disciplining constraint at times. Generally speaking, that was good for us. At various times we have worried that the market was behaving irrationally, believing that the exchange rate should have been somewhere other than where it was. And sometimes we were right about that. Yet, looking back, on balance the evidence suggests, I think, that the market has mostly moved the exchange rate to about the right place, sooner or later. We sometimes didn't like the pathway. But if I ask the question of whether I would have consistently done a better job setting that price, even had that been feasible (which it wasn't), I don't think I could confidently answer in the affirmative. No doubt at some Australian Business Economists' occasion on a future anniversary of the float, these matters will be re-examined. We cannot know what the conclusions will be. But for now, and probably for quite some time to come, we remain best served by the floating Australian dollar.

r131218a_BOA

australia

stevens

Members of the Committee Thank you for the opportunity to meet with you today. I look forward to constructive engagement with you during the 44th Parliament. As we reach the close of an eventful year, it is perhaps worth reflecting on some key themes, starting with the global economy. At the meeting with the previous Committee early in the year, we noted several developments. Fears of a euro area break-up had abated. The United States economy was gradually recovering, and the slowdown in China had run its course. These outcomes were roughly as expected, though perhaps of greater significance at that time was the fact that various 'downside risks' had not materialised. Global growth was running below average, though not disastrously so. It was thought likely to pick up a bit in 2013. The period since then has been largely more of the same. The euro area economy contracted in the first part of the year, but may be starting to grow again. It still faces immense challenges with its banks and public finances, and some years of uncertainty. But once again the worst fears have not been realised. The United States continues a path of gradual recovery, despite the budget 'sequester' and the divisive debate about the debt ceiling. The recovery is more gradual than policymakers there would like but that often is the nature of things after a financial crisis. China is growing at a solid pace, about in line with policymakers' announced intentions, despite concerns it might slow more sharply. Global growth was probably about 3 per cent in 2013, just a little less than in 2012. The pick-up expected has not eventuated as yet, though most forecasters still seem to see reasonable prospects of it occurring next year. So the past year can perhaps be labelled as: not quite good as hoped for, but not as bad as feared. Looking ahead, the issue that most people are focusing on is the so-called 'tapering' of US monetary policy. What is meant by this is that the Federal Reserve is expected, at some point, to moderate the rate at which it buys securities in the market, which is presently US$85 billion per month, and eventually to stop purchases. We don't know when that process will begin. The Fed has said that it will depend on economic conditions, as obviously it must. Moreover it will only be a step on what is likely to be a fairly long path back towards 'normal' monetary policy. We can be fairly sure, though, that there is ample potential for this shift in direction to reverberate around global markets. That's what usually occurs when the Fed changes course. The anticipation of this has already been a factor affecting markets, including in particular those in some important 'emerging market economies', at various points this year. It is sensible to assume that this will be the case over the period ahead, as 'tapering' begins and as market participants try to ascertain its extent and pace. Turning to the Australian economy, in February we felt that growth had moderated somewhat and would be below trend for a while, within a range of 2-3 per cent for 2013. Broadly speaking that is what has occurred. Our most recent , released in November, put likely GDP growth within that range. The recently released September quarter data don't cause any material change to that view. This result reflects quite subdued growth in private domestic demand, partly offset by quite strong growth in exports. The very large run-up in mining investment has reached its peak, while non-mining investment remains at a low ebb, and dwelling investment spending is only in the early stages of an upturn. Consumer spending has been rising, but at a below average pace, as people adjust to slower growth in income and look to contain or reduce debt. Inflation has remained consistent with the 2-3 per cent target. For the year to December, it looks as though the Consumer Price Index will have risen by about 2 1/2 per cent, with underlying inflation perhaps a little below that. Our assessment is that inflation will remain consistent with the target over the next one to two years. Looking ahead, resource sector investment will decline - gradually at first but more quickly thereafter. It will most likely fall considerably over the next few years. There is therefore scope for other forms of private demand to grow more quickly, the more so as government spending is scheduled to be subdued. Investment in dwellings shows clear signs of a significant increase, and exports of resources will continue to rise strongly. It is likely that capital spending by firms in some sectors outside the resources sector will eventually pick up, but this will take some time yet and it will be against the backdrop of a challenging environment. Consumer demand is likely to grow at a rate close to that of income. Higher wealth and confidence could see the saving rate decline a little, but consumption will not be the same driver of growth that it was before the financial crisis. Putting all this together, our expectation is that the below-trend growth in GDP we have seen for a while now will probably continue for a bit longer yet. Over the more medium term, there are good grounds to think that growth can strengthen. Eventually more capital spending will be required in some of those sectors where it is very low at present. The corporate sector in aggregate has high reserves of cash, financial intermediaries and capital markets are willing to lend, and interest rates are low. If the nascent improvement in 'confidence' we have seen can be sustained, that will help to achieve better growth. In fact, we could aspire to a period during which growth could be a bit above trend for a while, since spare capacity in the economy has increased a bit over the past eighteen months or so. Monetary policy has been playing its part to support demand. Because inflation has been consistent with the target, the Board has been quite comfortable in easing policy by a significant amount. The cash rate has been reduced twice more since we last met with the Committee, and by a total of 225 basis points over the past two years. Borrowing rates are at their lowest levels in a long time. The returns to savers for holding safe assets have commensurately declined, and this has clearly prompted substitution towards other assets, including equities and dwellings. The rate of credit growth has remained quite low thus far, though it is now increasing a little, as housing loan approvals have moved up quite noticeably over recent months. Low interest rates are doing the sorts of things we expect them to do. This is the way expansionary monetary policy works. The exchange rate has also behaved, of late, more as might be expected in such circumstances: that is, it has declined. From about US$1.03 at the February hearing, it has fallen by about 13 per cent. The Bank has described the exchange rate as 'uncomfortably high', and suggested that balanced growth in the economy would probably require a lower exchange rate. The Board has maintained an open mind about whether we may need to lower interest rates further. At this point, however, there are few serious claims that the cost of borrowing is holding back growth. On the contrary, monetary policy is supporting higher spending by altering incentives as between spending and saving, and working to create an environment in asset and credit markets that eases the restraints on some sorts of activity. In the end, though, firms and individuals have to have the confidence to take advantage of that situation. They have to be willing to take a risk - on a new project, a new product, a new market, a new worker. Monetary policy can't force spending to occur. That is why the conduct of other policies is also important. The myriad things which can make it harder or easier for businesses to innovate, to change their ways of doing things, to avoid unnecessary costs and to be more productive, all matter. No single one is decisive in itself; but collectively, they are crucial. It is hard to escape the feeling that we as a society have tended, for quite a long time now, to go about our decisions on such matters while making the assumption, perhaps without realising it, that solid growth of the economy will simply continue, and that it won't be affected by these other choices of various kinds. We are at a moment now when that assumption has to be questioned. The path of pro-growth, pro-productivity, confidence-building reforms would mean that the basis for investment and growth in real incomes would improve. That would allow consumption to grow without recourse to excessive borrowing. It would provide a revenue base for governments to provide the services and infrastructure the community needs. And so on. The alternative path is a much less attractive one. Before I conclude, a few words on payments and regulatory matters. As I mentioned at the February hearing the Payments System Board has been working to encourage industry to put in place the infrastructure to make real-time payments capability for the community a reality over the next few years. Good progress has been made, though there is a long way to go. An early milestone was reached a few weeks ago when the settlement of direct entry payments, amounting to about $50 billion per day, moved to same-day settlement, as opposed to the previous practice of settling the next day. Quite substantial changes to operational arrangements in the private sector, and in the Reserve Bank itself, were required to achieve this. But it was worth doing because it lowers risk in the system and helps faster access to funds. On financial regulation, the global effort at building a stronger framework continues. The Financial Stability Board has been clear about the priorities over the coming year, under the headings of implementation of Basel III changes, continuing towards completion of a regime for 'too big to fail' financial institutions, making derivatives markets safer and making sure 'shadow banking' activities have appropriate oversight. Australia, as chair of the G20 this year, welcomes this prioritisation and has indicated that it supports the FSB as it seeks to achieve concrete results by the time of the Leaders' meeting in Brisbane next November. Australian regulatory authorities continue, meanwhile, carefully to implement internationally agreed reforms, with due regard to local conditions. With those remarks, Chair, we are here to respond to your questions.

r140307a_BOA

australia

stevens

Members of the Committee Thank you for the opportunity to meet with you today. When we met with the Committee just prior to Christmas, I suggested that, taking an international view, 2013 could be described as a year that turned out not to be quite as good as hoped for, but not as bad as feared. Nothing that has occurred in the period since then would change that assessment. One prominent international event was that, within hours of that hearing, the US Federal Reserve commenced the 'tapering' of its monthly asset purchases. This was a possibility we talked about at the time and, although the timing of it wasn't known, it was considered likely that it would begin before long. A further reduction in asset purchases was decided at the Fed's January meeting. After all the anticipation of this change, the actual announcement of the Fed's decision caused little disruption in markets in December. During January there was more volatility in markets, and a few emerging economies came under pressure, with bond yields spiking and exchange rates declining. It is important to keep this in perspective. Periods surrounding changes of course by the Fed have often been times when market participants re-assess their positions and their appetite for risk, and this occasion has been no exception. It isn't necessarily the Fed action that is most important, but rather what it conveys about the overall economic and financial environment. At such times investors sometimes start to focus on risks to which they had hitherto been attaching little significance. Investors have not, however, fled from risk indiscriminately on this occasion, at least to date. They have drawn distinctions between alternative classes of investment and different countries. Long-term sovereign yields of the core advanced countries have increased a little, but they remain low. With compressed risk spreads, this means that borrowing costs for many private-sector borrowers remain very low. The spreads over German yields for European sovereigns have continued to fall. This suggests that actions by European policymakers have had more influence on European markets than actions by the US authorities. This is as one would expect, but it hasn't always been the case in the past. Moreover, not all emerging markets are experiencing the same pressure. Some that experienced considerable turbulence in the middle of last year, when tapering was first mooted, have seen less of that recently. This owes something at least to policy responses in those countries in the intervening period. Among those countries that have been under most pressure of late, genuine domestic sources of risk can be observed in most instances. In several cases the market pressure has resulted in policy responses, which were perhaps needed anyway. In general then, tapering is proceeding, so far, about as well as can be expected. In the meantime, forecasts for the global economy haven't changed much in recent months. If anything they have inched higher. They suggest that 2014 growth will be higher than in 2013, and at about average pace. More of the growth is coming from the advanced countries, and proportionately not quite so much from the emerging ones. That, too, is probably a welcome re-balancing in some respects after the weakness of the advanced countries in recent years. Australia's terms of trade have been little changed over the past year, though we still assume they will decline further in the future. Turning to the Australian economy, for some time our view has been that growth has been running below its trend pace. The national accounts released a couple of days ago don't significantly change that assessment. For the year to the December quarter of 2013, real GDP rose by about 2 3/4 per cent. This is roughly in line with the forecasts we have had for a while. The drivers of growth are shifting. As we have been saying for some time now, and as confirmed in the recent survey of capital expenditure intentions by firms, the very high level of investment spending by mining companies has turned down, and the decline will accelerate over the coming year. Other areas of demand will provide at least some offset. Export volumes for resources are growing strongly, as the capacity that has been put in place by the high levels of investment comes on line. For example, iron ore shipments have risen by about 85 per cent from their levels of five years ago, to around 1.5 million tonnes per day. They will rise further over the coming year or two. It is clear that dwelling investment activity will rise strongly over the period ahead. Over the past three months, approvals to build private dwellings numbered almost 50,000. That is an increase of about 27 per cent from the figures of a year earlier, and is the highest three-month total in the 30-year history of this series. Consumer demand has had a firmer tone over the summer, after a fairly lengthy period of more subdued outcomes. This is evidence in the retail trade and national accounts data and is confirmed in information from the Bank's liaison. Consumer sentiment does still seem a little skittish, though, and while we expect consumption spending to grow in line with income or perhaps a little faster, consumers are unlikely to be the drivers of growth that they were prior to the financial crisis. Business investment spending outside mining, which has been very low indeed, is bound to pick up at some stage. The signs of improved conditions and confidence that we have observed in some sectors will help, and the early indications of an improvement in capital spending expectations are apparent. Those are, however, quite tentative at this point and firms are looking for recent signs of improved conditions to persist before committing to expanded investment spending. Public final spending is scheduled, according to the announced plans of federal and state governments, to be quite weak. The expected ongoing effects of very low interest rates and a somewhat lower exchange rate have resulted in a slight lift in forecast growth for the second half of this year and in 2015. This was reflected in our most recent published forecasts released last month. We haven't made any further changes since then. With growth having been below trend, job vacancies declined, employment growth weakened and unemployment rose in 2013. Some forward indicators have stabilised and then improved a little of late, which is promising. But even with this, and with a slightly better growth outlook, the labour market will probably remain soft for a while yet, given that it lags changes in activity. This has seen the pace of growth of wages decline noticeably. Turning to consumer price inflation, the recent data show inflation in underlying terms at about 2 1/2 per cent over the course of 2013, and a pace higher than that in the second half of the year. This is a change from the middle of last year, when we were receiving data that were lower than expected. Part of the increase in inflation is explained by the effect of the depreciation of the exchange rate, which has resulted in increases in prices of traded goods and services. But that does not account for all the result and it is, at least on the surface, something of a puzzle that underlying inflation moved up while growth in labour costs moved down. There may be a re-building of margins in some areas, particularly those where demand conditions have improved a little from the very weak situation earlier. There may also be an element of noise in the quarterly data. The view we have taken, pending further evidence, is that there is probably both noise and signal in the result. Hence, our assessment is that inflation is not quite as low as it might have looked six to twelve months ago, but nor is it accelerating to the extent a literal reading of the latest data might suggest. The general situation - of below-trend growth, a rise in unemployment, a marked slowdown in wages - is not one that would be obviously associated with a sustained rise in price pressures. Our view remains that the outlook for inflation, while a little higher than before, is still consistent with the medium-term target. Monetary policy is very accommodative. The cash rate has been unchanged since August last year. It and most borrowing rates are at multi-decade lows. The sorts of things that are normally expected to result from low interest rates are increasingly in evidence: On the whole, then, accommodative monetary policy is playing its part in supporting sustainable growth in demand, consistent with the inflation target. Of course, the outlook contains many uncertainties, not least the 'hand over' from mining investment spending to sources of demand outside mining. In some important respects, the basis for such a handover is coming into place, as I have just described. The question then is: will the additional demand likely to be generated outside mining as a result of these trends be just the right amount to offset the large decline in mining investment spending, so keeping the economy near full employment? No-one can answer that question with great confidence. Moreover, even if it were possible for forecasts to be much more accurate than experience could possibly lead us to hope, it could not be assumed that a shortfall in demand could necessarily be made good in short order by monetary policy. Monetary policy can have a powerful effect on the general environment, but it cannot hope to fine-tune the quarterly or even annual path of aggregate demand. At the present time we judge monetary policy to be doing the things it can reasonably be expected to do in the circumstances we face. We have signalled the likelihood, if the economy evolves more or less as expected, of a period of stability in the cash rate. As well as the low level of interest rates generally, a sense of stability should be of some help for businesses and households as they form their plans. My colleagues and I are here to respond to your questions.

r140326a_BOA

australia

stevens

When I last spoke at this conference two years ago, the United States had just avoided a feared 'double-dip' recession. Europe was in the news, with acute concerns over the feedback loop between weak economies, bank asset quality and sovereign finances. China's growth had moderated, and many feared it would decline sharply. Since then, the world economy has continued its expansion. Growth in global GDP was a bit below trend in 2013, with reasonable prospects of some pick up this year. None of the downside scenarios that have exercised minds over the past couple of years have, as yet, come to pass. That doesn't mean they won't, only that the world economy has been climbing the 'wall of worry' for a few years now. Overall, in 2014 economic global growth is thought likely by major forecasters to be a bit higher than in 2013, and at about average pace. More of the growth is coming from the advanced countries, and proportionately not quite so much from the emerging ones. That is probably a welcome re-balancing in some respects, after the weakness of the advanced countries in recent years. The United States continues its recovery led by private demand and over the second half of last year the economy expanded at an annualised rate of just over 3 per cent. With the current agreement over the US Federal budget, one headwind from last year will abate somewhat. Of course there have been effects of the recent severe weather and it will still be a little while yet before US policymakers get a clear reading on the pace of expansion. But there is no obvious reason to expect that the expansion will be de-railed. The euro area has resumed growth, albeit in a somewhat hesitant fashion and with noticeable differences in performance by country. Some quite pronounced adjustments to cost structures are occurring in some of the so-called 'peripheral' countries, as needed under the single currency area arrangement. In Japan, the initial results of the policy measures over the past 18 months have been quite positive, though of course the proposed 'third arrow' reforms are yet to be fully delivered. The much anticipated 'tapering' of the US Federal Reserve's monthly asset purchases commenced in December. The initial expectation of tapering in the middle of 2013 caused more market ructions than the event itself. That said, as often occurs when the Fed changes course, investors have taken the opportunity over this period to re-assess their positions and their appetite for risk. So far, investors have not fled from risk indiscriminately. They have drawn distinctions between alternative classes of investment and the differing outlook across countries. Long-term sovereign yields for the core advanced countries remain low and, with compressed risk spreads, borrowing costs for many private-sector borrowers also remain low. A few emerging economies have lately come under pressure, with bond yields spiking and exchange rates depreciating. In most of these instances, country-specific issues can be identified as sources of legitimate concern for investors. It is notable that the number of such countries under pressure is smaller than in the middle of last year, because some have made credibility-enhancing policy adjustments in the intervening period. So far, so good, then for tapering. In my opinion, we should welcome it. There is a tendency, though, to talk about 'normalisation' of monetary policy in major advanced countries as though it is happening in all of them. It isn't: it is really only happening in the United States. Even there it is at a very early stage but the United States is actually on a path that neither the euro area nor Japan is even contemplating yet. In those jurisdictions, so far as I can tell, the discussion is about whether further easing may be in order. In fact were the Bank of Japan (BoJ) to step up its current program of quantitative and qualitative easing, it would soon be adding more cash to the global financial system, in absolute terms, than the Federal Reserve. Intriguingly, the BoJ's actions attract rather less attention than the Fed's. I am not in a position to opine about whether or not such further easing might occur, but the point is simply that the monetary policy trajectories of the major currency areas could diverge, and increasingly so, over the next couple of years. One interesting question is how fully this possibility is reflected in major exchange rates. Turning to the Asian region, China's economy grew close to, and in fact a little faster than, the government's target last year. Strong and about equal contributions to growth were made by household consumption and investment. Consumer price inflation continues to be stable. Recent indicators have shown possible signs of slower growth in the early part of 2014: growth of industrial production slowed; retail sales and passenger vehicle sales moderated; and fixed asset investment growth was a little lower in January and February, though quite stable in year-ended terms. Given that the growth target was more than met last year, and given that the Chinese New Year holiday period makes it more difficult to assess trends in the data, it may be a little too early to draw strong conclusions. Spot prices for steel and iron ore have fallen lately though, on movements to date, seem within the range seen in recent years. In fact, people may be too inclined to fret over what are still relatively small movements in monthly PMIs, and the like, in China. Sometimes they fret even more than they do over small bumps in the US economic data. The greater concern is the risks involved with the build-up of credit in so-called 'shadow banking' over the past five or so years. To a considerable extent this growth in financial activity surely reflects the natural tendency to avoid the effects of price and quantity constraints imposed on the core banking sector, in an environment of strong demand for credit. In certain respects, it arguably provides genuine services to the economy. The potential problems, on the other hand, are all too familiar and well understood, at least in a qualitative sense. They include excessive maturity mismatches, where long-term loans are funded essentially by short-term borrowings; less-than-ideal transparency about asset quality; distorted incentives for provincial government entities; assumptions on the part of investors in wealth management products about major bank or government support - and so on. Recent credit events in China have increased focus on the possibility of failure of entities with non-viable business models. There has been a widening of risk spreads for lower quality credits. To some extent this could be seen as a positive development, as a clear-eyed assessment and pricing of underlying economic risks is critical for sound longer-run development in China no less than in any other nation. But of course we cannot know how much further this re-assessment of risk may have to run, nor how disruptive it could turn out to be for the Chinese financial system and the economy. It is clear that the Chinese authorities are across the issue, and in all likelihood they have the ability and resources to manage the situation. Some reforms have already been implemented, which will help to manage such risks in future, while steps taken to moderate the flows of total social financing seem, so far, to have had some success. In the meantime, a broader set of other recent reforms represent further incremental steps towards greater financial market liberalisation: the removal of restrictions on most lending rates and some liabilities, with those on deposit rates expected to follow; the recent widening of the renminbi's trading band, as part of the central bank's commitment to let markets play a greater role in the economy; and the introduction of the Shanghai Free Trade Zone with some associated easing of capital account restrictions. These are all welcome moves and are in China's long-run interests. Around the Asian region generally, at this stage, our sense is that economic growth is continuing at about its trend pace. All countries will be watching closely both developments in China and the impacts on capital flows and risk-pricing as the Fed tapers and other major central banks implement their own chosen policies. Turning to the Australian economy, I continue to find a fascinating divergence between the views of foreign observers, especially in Asia, many of whom say to me 'Australia is doing very well' and the tone of the commentary at home, which is typically a lot more pessimistic. My reading of the actual data is that they suggest that the economy has been doing a bit better than much of our domestic commentary over the past couple of years would have you believe, but not quite as well as many foreign investors seem to have thought. Australia certainly weathered the financial crisis well, and with a real GDP some 13 per cent larger than it was at the beginning of 2009, compares well with many other advanced countries. It is the case, though, that growth while positive, has been running at a pace a bit below its trend pace for about 18 months now. The rate of unemployment has increased by something like a percentage point over the same period. Most people are familiar with the fact that there have been very strong conditions in the natural resources sector. The biggest positive terms of trade shock in at least a century drove a mining investment boom of truly epic proportions, and that added a major impetus to demand in the economy. But the terms of trade peaked about two and a half years ago; the capital spending by the resources sector has also now peaked and is expected to decline significantly over the next couple of years. In the rest of the economy, households have spent most of the past five years behaving more conservatively, or rather more normally, than they did over a long period up to the mid 2000s when they had been in a very expansive mood. Both consumption and residential construction have been soft for a while. I have spoken at length about these trends before and explained why they were to be expected. Nonetheless, many businesses exposed to those sectors, including retailers, builders and banks, have found the going harder. In addition, because the mining boom was associated with a very high exchange rate, other trade exposed sectors have also faced more challenging conditions. Looking ahead, as the resources sector's capital spending continues to fall, it will be desirable to see some other sources of growth strengthen. One is export volumes for resources, which are already growing strongly, as the additional capacity put in place over recent years becomes utilised. For example, iron ore shipments have risen by about 85 per cent from their levels of five years ago, to around 1.5 million tonnes per day. Exports will rise further over the coming year or two, as additional resource projects are completed and, at the margin, some other areas face slightly less of a headwind from the exchange rate. It is unlikely, though, that a pick-up in resources exports, as important as that will be, will be enough to keep overall growth on the right track. It will be helpful if some of the other areas of domestic demand that have been subdued start to grow faster. For that to occur, households would need to have made progress on their desire to sustain higher saving, and to consolidate debt where needed. Businesses outside of mining would need to have made some progress in containing costs, and raising efficiency. They would also need a bit more confidence about the future than they did before, as a pre-condition to making plans to lift their investment and add to their workforces. There are some promising signs in this regard. Recent data shows stronger household consumption over the summer. The latest surveys and our own liaison confirm this, and suggest that retailers are more optimistic than they were a year ago. That said, we expect consumption spending to grow in line with income or perhaps a little faster, but not at the pace seen in the years prior to the financial crisis. We certainly see abundant signs of confidence in the housing market. Dwelling prices have seen a broad-based rise of 10 per cent in the past year and are now about 5 per cent above the previous peak in 2010. Initially this was not associated with very much at all in the way of faster housing credit growth. That has now picked up a little, though it remains far below the rates seen in the 1990s and 2000s. The pick-up is most noticeable for investors, who need to take care with the amount of leverage they take on. It is clear that dwelling construction activity will rise strongly over the period ahead. Over the past three months, approvals to build private dwellings were at the highest rate for at least three decades. This increase is welcome, certainly at an aggregate level, since on most estimates Australia's additions to the dwelling stock have been running at a rate below population growth over recent years. Measures of business confidence have improved over the past six months. Businesses seem, so far, to be taking a cautious approach to investment, however: they are waiting for stronger, more persistent signals of improved conditions before committing to significant increases in capital expenditure. That's actually pretty normal in a cyclical upswing. In their hiring decisions there are some early promising signs of improvement, though it is too soon to see much in the way of concrete evidence of stronger gains in employment yet. So there is encouraging early evidence that the so-called 'handover' from mining-led demand growth to broader private demand growth is beginning. Putting all this together, we think economic growth will continue, and may strengthen a little later this year and pick up further during 2015. It is important to stress that this outlook is, obviously, a balance between the large negative force of declining mining investment and, working the other way, the likely pick up in some other areas of demand helped by very low interest rates, improved confidence and so on, as well as higher resource shipments. The lower exchange rate since last April and the improved economic conditions overseas also help. Because we are trying to assess the balance between very different forces, however, there is inevitably a very substantial range of uncertainty surrounding this central outlook. That is simply unavoidable. The fact is that no one can say with certainty just how smooth a 'handover' will occur. Nor can anyone pretend to be able to fine-tune it. On inflation, our view is that it will be a little higher than we thought three months ago. This takes account of the most recent data, which was higher than expected, and allows that the result conveyed at least some genuine information. Nonetheless, we think it unlikely that this signifies persistent and serious inflation pressures. Unemployment has been rising, and will probably rise a bit further yet; growth in labour costs have slowed noticeably in response. Indeed, growth of the wage price index is around the lowest in the 15-year history of the measure. Measures of unit labour cost growth are correspondingly quite low. So, absent continually rising profit margins on the part of businesses, we don't see the conditions for persistently higher consumer price inflation, even though tradable goods prices are expected to rise due to the lower exchange rate. Measures of inflation expectations remain well-anchored and are around or below their long-run averages. Our view remains that the outlook for inflation, while a little higher than before, is still consistent with our medium-term target. Trends in asset prices are an area to watch. In particular, we need to be alert to the possibility that the past year of strong rises in dwelling prices leads people to assume that this is the norm. Were such an assumption to lead to increasing speculative activity, accompanied by a renewed increase in household leverage with all the associated risks to the housing market and the economy more generally, that would be unwelcome. This is a theme discussed in some detail in our latest , released earlier today. We are watching this closely, and we remind people that house prices can go down as well as up. In fact there have been two episodes where prices fell for a year during the past decade. The Australian Prudential Regulation Authority will also be emphasising with lenders and their boards, as it has been for some time now, the need to maintain high lending standards. There is, of course, the full panoply of other 'risks' that can be identified. As always, the exchange rate is a source of significant uncertainty. Much of Australia's outlook also depends on developments overseas. Further progress towards the full treatment of banking problems and the return to sustainable fiscal budgets in Europe will be important. With greater certainty in the United States over their fiscal policies and the path of monetary policy, the risks there may now be more on the upside. On the other hand, if some event - like a geo-political shock - led to a wider retreat from risk taking, this could have a significant dampening impact on the global economy. China's outlook is important for Australia as, for that matter, it is for other countries. China is now the largest or second largest trade partner to most significant economies. Not only the way China manages the current financial issues, but its implementation of structural reforms, so as to maintain robust economic growth in the long run, will have an impact on all of us. Our monetary policy settings have been unchanged since last August, at what by any standard is a very accommodative level. This is playing its part in supporting sustainable growth in demand, consistent with the inflation target. We have signalled that if the economy evolves in line with the present set of forecasts, a period of stability in interest rates could be expected. Having said that, let me return to a more global perspective, to make the point that sustainable growth over the long run has to rely on more than just monetary policy. Strong long-run growth won't be achieved in any country simply by manipulating interest rates (or, for that matter, exchange rates). Monetary policy's main contribution over the long run is to provide a stable monetary standard. That is a necessary condition for strong growth but it is not a sufficient one. Nor will fiscal expansion serve as more than a temporary boost to growth. Indeed the limits to fiscal activism are surely all too clear in many countries now. Other conditions need to be right for growth. These include ensuring the environments for competition, innovation and investment, including in human capital, are sound. In those areas, various other government policies must come to the fore. That is the spirit in which the countries of the G20 recently committed to coming up with measures that could raise the level of world GDP by 2 per cent above what it would otherwise have been, over a horizon of five years. This isn't to be achieved by a program of cheap money or debt-financed spending. Many of the needed measures are likely to be politically demanding for governments to introduce. But if signing up to the challenge helps to galvanise efforts for the sorts of reforms that need to be made, then it will have been a worthwhile initiative. Thank you for your attention.

r140403a_BOA

australia

stevens

Thank you for the invitation to be in Brisbane again. Economic conditions in Queensland have been quite varied over recent years. In some ways the forces at work have been in parallel to those in the national economy. On the one hand, the expansion of the mining and gas sectors has driven strong growth in some of the regions. In the past four years, business investment in Queensland rose by 75 per cent, totalling $230 billion over that time and almost $70 billion during 2013 alone. The proportion of national investment occurring in Queensland has been unusually high. Investment in the mining sector may now have peaked, but the capacity put in place is supporting strong growth in exports. Queensland's coal exports reached record highs over the past year and exports of LNG are expected to commence in late 2014. On the other hand, more prudent behaviour by households, after an earlier period of fairly free spending and borrowing, has kept demand in the urban areas more restrained. There was also a marked slowdown in the property sector in the southeast of the state, perhaps more so than in other states, which has been a dampener on economic activity. Part of the story here is that in an earlier environment of fairly easy access to credit, dwelling prices rose too high relative to incomes in some areas. There was also perhaps, in some instances, too much construction of the wrong sort of dwelling. Some people involved in or exposed to the property sector also had too much leverage. When credit conditions tightened and there were not enough buyers, prices fell and construction slowed down significantly. After growing at an annual average pace of 12 per cent between 2002 and the peak in late 2009, dwelling prices in Brisbane fell and remain around 5 per cent below their peak. About a third fewer dwellings were constructed in the year to September 2013, compared with the peak in 2008. Building approvals have been relatively strong in the resource-exposed regions in recent years, but elsewhere in Queensland approvals for new detached houses are at around half the 2008 level. This is something that American members of AmCham who are exposed to the US housing sector would have also felt over recent years. The US construction sector, while now established on the path of recovery, is still building only half the number of dwellings it was at the peak in 2006, and in fact is producing at two-thirds of the rate of 20 years ago. At present there are welcome signs that the Queensland housing sector is now lifting off the bottom. But this has been a long cycle. The price of Brisbane dwellings was historically about 60-65 per cent of those in Sydney. At their peak some years ago they reached about 85 per cent of Sydney levels. Now they are back to about 60-65 per cent of Sydney levels again. The cycle has taken about a decade. That the cycle can be so drawn out is a salient lesson, including for those outside Queensland. Even if a full-blown crisis does not eventuate, as was true of Australia, overdoing it on housing on the way up is usually followed by a fairly extended period of working off the problems. We have heard much of the effects of severe weather on the US economy over the recent northern winter, with these impacts complicating the task of assessing the strength of the US expansion. Weather events have also been important in Queensland in recent years, and some of them have been very costly. Not so long ago, the problems were those of floods (and indeed some areas of South-east Queensland experienced flooding over the weekend) but at present much of the State is in the grip of drought. Crops have been substantially reduced and the livestock industry will take a number of years to recover from reduced herds. Farm incomes are estimated to be falling to their lowest levels for at least three decades. I don't think this will complicate our task of reading the pace of the national economy as much as in the US case, but these are nonetheless significant effects in regional economies. Our discussions with tourism operators, on the other hand, suggest that conditions have started to improve, partly as a result of the depreciation of the exchange rate since its peak. Over the year to September 2013, visitor spending in Queensland increased by more than 4 per cent, which is a little higher than its average historically. Tourism operators have also been tailoring their services to suit rapidly growing segments of the market, including the Chinese market, which grew by 25 per cent over the year to September 2013. Speaking of tourists, there are some rather high-profile visitors coming here later in the year. For a few days in mid November, the city of Brisbane will be the focus of the world, when the leaders of the G20 come to town. I'm not sure, actually, whether you all know what you're in for! But on the weekend of 15-16 November, you can expect the biggest gathering of global leaders ever assembled in Australia to be in your city. Australia can host this meeting with a strong reputation for economic performance. While you might not know it from the tone of much domestic discussion, most - if not all - of the G20 membership looks at our relative growth, financial stability, banking soundness and public finances with a good deal of admiration. This has given Australia, at the margin, just a little bit of additional credibility in putting forward our agenda. Just what is that agenda? In essence, it is about growth. The Australian presidency of the G20 is focused on trying to improve global growth, with a focus on enabling investment, including infrastructure investment, and enacting structural reforms to raise the potential growth of the economies of the G20. At their meeting in Sydney in February, the G20 Finance Ministers and Central Bank Governors agreed to come to future meetings with proposed policies that would have the effect of lifting the level of the G20's collective GDP by a little over 2 per cent by the end of five years. Let me be clear what this means. The goal is that the level of real GDP in the G20 is 2 per cent (actually a little over 2 per cent) higher by the end of five years. That could be achieved by lifting the rate of growth by 0.4 per cent per year in each year, or by a little more than that in the out years if the reforms take longer to have their effect, which they probably would. It doesn't mean growth is 2 percentage points higher in each year ( would be a very big effect indeed). Just in case you think this doesn't sound like such a big deal, let's contemplate the magnitudes. Were the 2 per cent aspiration to be achieved, it would mean something of the order of US$2 trillion of additional output in the world economy, something like 15 million extra jobs spread around the G20 countries, and hundreds of billions of dollars of additional revenue for governments. It's serious money. Let's also be clear what this doesn't mean. This goal is not to be achieved by clever programs of cheap money devised by central banks. Nor is it to be the result of fiscal adventurism. We are trying to shift the conversation away from the 'growth versus austerity' framing of recent years, which is ultimately a rather sterile discussion. No-one has ever achieved growth simply by austerity, but equally the approach of simply ignoring the gaping hole in public finances in many countries has reached the limits of its credibility. We need a refocused conversation, around doing things that spur growth potential, which would mean, among other things, that the accommodative policies of central banks could get more traction. These things are, however, demanding. There is something of a tendency for governments, when asked to outline their growth plans, to list the things that they already want to do for political reasons, and then to claim that they will help growth. Some of those things may well help growth, but in fact many of the things that are needed to spur growth seem not to make it onto such lists. Things that boost competition in markets, that genuinely free up trade, that reform the governance and financing of infrastructure projects (and the pricing of use of infrastructure), that put retirement income streams on a sustainable footing, that re-align incentives, that allow exchange rates to be more market determined, that encourage labour market mobility and participation, that enhance human capital, and that minimise distortions from tax - many of these often don't make in onto 'to do lists' in the way that perhaps they should. So there is some hard thinking to do. Time will tell whether the countries of the G20 will rise to the challenge. But if not now, when? These issues are very real ones for Australia. For we face considerable challenges. In saying this, I am not referring to the short-run ones, to do with the 'handover' from mining to non-mining investment, as difficult a challenge as that is at present. By now the proverbial pet shop residents are all talking about this: where will the growth come from after the mining investment boom ends? I suspect that plenty of the people who never thought the mining boom would do much to boost growth are among those asking the question of what will replace it as a source of growth. I've spoken about this a good deal in other speeches, so I will not repeat the detail today. If we manage to absorb the upward phase of the biggest terms of trade boom in more than a century without overheating, and the downward phase without a slump, that would be a major achievement. We have, by and large, managed the first part and there are some promising early signs that things may turn out not too badly in the second. But early signs are just that: early. It is far too soon to think about counting any chickens yet. Let's also be clear that the capacity to fine-tune these outcomes is very limited. Most importantly, for today's discussion, even if we do manage this episode as successfully as we might dare hope, major long-run challenges will remain. These are the things I want to highlight today, two of them in particular. First, fiscal sustainability. The debate here has, I would have to say, been overly- focused on budget outcomes in particular years. The real issues are medium-term ones. Put simply, there are things we want to do as a society, and have voted for, that are not fully funded by taxes over the medium term, as is starting to become clear in the lead up to the May budget. Here I refer to the very important speech given last evening by my colleague, Treasury Secretary, Martin Parkinson. Our situation is not dire by the standards of other countries but neither are the issues trivial. A conversation needs to be had about this. Second, demographics. More people will be moving into retirement, and fewer people entering the workforce, over the years ahead. Our regular discussion doesn't pay much attention to this. It's understandable that with very public announcements of job losses - albeit many of them several years into the future - people become worried about jobs. They ask: where will future jobs come from? There are two things to say. One is they will come from areas we don't see yet. In the middle of 1991, at the low point of the last serious recession, people were very pessimistic about future employment prospects. The rate of unemployment was in double digits. But today, over 20 years later, there are nearly 4 million more jobs in the economy than there were then. The rate of unemployment, even though it has gone up recently, is just slightly more than half what it was at its peak in the 1990s. It's worth noting that none of those additional net jobs came from manufacturing. The manufacturing sector in fact shed about 100,000 jobs over that 20-year period. But other sectors increased their employment. Mining employment tripled and that alone more than offsets the reduction in manufacturing, without taking into account the growth in construction, health care and a number of other services sectors where the number of jobs has roughly doubled. As of today, even with some recent weakness, there are more jobs in the economy than ever before. The second thing to say is that, cyclical things aside, the more likely problem in the medium-term future won't be one of not enough jobs, but instead, not enough workers. At present the number of new entrants to the labour force after finishing education each year exceeds the number retiring. Ten years from now those numbers could be roughly equal, absent a further rise in labour participation in the older cohorts. The question will be less 'where will the jobs come from?' and more 'where will the workers come from?' It's true that migration adds to the workforce as well, though migration also adds to the number of people not working and retiring. So demographic trends point in the direction of a smaller proportion of the population working, and a larger proportion needing support in their later years, even as other demands on the public finances for the provision of social goods increase. That looks like a pretty uncomfortable combination of trends. How do we reconcile them? The answer - the only answer - is growth. To some extent we will, hopefully, be able to lessen the problem through higher labour participation, for longer. But most of all we will need higher productivity of those working. That means making the system as flexible as possible and as encouraging as possible to innovation. That's why the G20 agenda is very pertinent for Australia, notwithstanding that we have enjoyed 20 years of reasonably steady growth. I dare say it is for the United States too. We are not just talking idly about other countries lifting their growth as an intellectual exercise. We are asking how to lift our own trend growth performance. For Australia, one potential source of productivity improvement lies in the very fact that across a range of sectors the level of US productivity is much higher than our own. There may be various reasons for that, some of which we may be unable to emulate. But it's hard to believe that there are not some, possibly substantial, 'catch-up gains' available to us by adopting better practices. For the United States, it is in some ways harder because generally it is the productivity leader, so 'catch-up' is not available. Observers have differing views about the ability of the United States to push up its own productivity growth in future. My own view is that the United States remains an immensely innovative society, which I think is ground for cautious optimism. In the end, increasing the potential growth of the G20 economies, and our own economy, is a challenge of the first order. The '2 per cent' goal, while subject to uncertainty and based on numerous assumptions and so on, nonetheless will hopefully force us all to confront the right set of questions. Before I finish, it is appropriate, particularly given the Financial System Inquiry now under way, to mention the role of finance in supporting growth. The Reserve Bank has made a submission to the Inquiry. It points out that there are a few essential things that we want a financial system to do. Over the past couple of centuries, the provision of such services has contributed to the accelerated pace of growth of living standards in the market economies. Recent history has been one of innovation and growth. The development of new products, efficiencies in process, and the use of information technology all held promise. They still do. Unfortunately, and this is stating the obvious, the problems that developed in the international financial system, due to serious shortcomings in key markets and institutions in some of the world's most important economies, have meant that finance has, globally, too often been growth-reducing over the past five years. Moreover, we have to question, in hindsight, the basis of some of the apparently easy growth for a few years before the crisis broke. The world learned, or rather re-learned, the lesson that finance has its own cycle - of risk-seeking and then risk-aversion; of leverage and de-leveraging; of confidence, then over-confidence followed by fear or even panic. The financial system is capable of providing support for the economy and of helping it absorb shocks. But it is also capable of being a source of shocks itself. That being so, it is not surprising that, internationally, the focus since 2008 has been one of repair, re-thinking and regulatory reform. It remains a big part of the G20 agenda, with some important milestones to be passed this year. In Australia, our crisis experience was not as wrenching as for some other places. Our supervisory framework stood up to the test. Our key institutions proved to be robust and generally prudent behaviour of our financial institutions stood us in good stead. Nonetheless, there were lessons to be learned, and adjustments to be made, both for supervisors and financial institutions. It is very much in our interests to absorb the lessons, and to make the sensible changes, including those that are part of international standards. The Inquiry offers the opportunity to distil those lessons, and also to contemplate the future. A financial sector that reliably and efficiently offers the services the community needs - the 'handmaid of industry' - is a boon to growth and prosperity, and can play an important role in achieving the growth we want to see.

r140610a_BOA

australia

stevens

The Federal Reserve Bank of San Francisco has long looked to the west, to the Pacific Basin. The Center for Pacific Basin Studies was established here nearly 25 years ago, and it was a professional highlight for me to be a visiting scholar here at the time. It is a particular pleasure to return to San Francisco to take part in this Symposium on Asian Banking and Finance. It is apt that the Symposium should focus on some of the regulatory challenges we are collectively seeking to address in the wake of the crisis of 2007-2008, and particularly welcome that it gives voice to partners from the Asian time zone. More than ever, finance has been global over the past couple of decades. That has brought many benefits but also certain vulnerabilities. It has also brought challenges for the regulatory community. There is a prodigious effort underway to work together to produce a regulatory framework that is genuinely international. Yet many important responses to the crisis are, and will remain, national. As such, they are at least partly driven by the circumstances and imperatives of the nations concerned. Nothing else could realistically be expected, but ensuring that all those national responses dovetail into a coherent international framework, and one that preserves what is good about globalised finance, is a difficult job. Moreover, the economic and financial importance of the Asian region is greater now than on past occasions when international regulatory standards were put together. So engaging Asia in the search for genuinely global approaches to regulation is important. To that end, the Financial Stability Board (FSB), and some of the standard-setting bodies that attend it, have adjusted their membership over the past five years in a way that recognises the importance of the Asian countries (and those of some other regions too). The FSB is currently undertaking a further review of the structure of its representation. It is nonetheless sometimes the case that the Asian members, and perhaps some other emerging market members, cannot avoid the feeling that the agenda is still driven by the major advanced economies. To the extent that those countries - the G7, say - are used to working together, and given that the financial crisis was so strongly centred in the north Atlantic countries' financial systems, perhaps that is no big surprise. However, while that historical cooperation is a strength on which to build, it is also important that the system we build looks forward, and acknowledges that much of the future growth will be in Asia. It is also important that those of us in the Asian time zone continue to strengthen our capacity to engage effectively in the international groups of which we now have the privilege and responsibility of membership. There are many components to the international agenda for regulatory reform. The G20 is the body that has accepted, or perhaps asserted, high-level oversight over these efforts. The FSB is the body that has accepted the task of trying to ensure a coordinated effort, respecting the integrity and independence of the standard-setting bodies and addressing risks itself where required. As you know, Australia has the responsibility of the G20 presidency this year. Australia is highly supportive of the way the Chair of the FSB has structured the efforts around four key themes. They are: Highlighting these four themes doesn't mean other things are forgotten. But it is an attempt to prioritise, to focus energies and to use the opportunity of the Leaders Summit in Brisbane, Australia, in November as a focal point for our efforts to get some important things across the line this year. The Basel III process is well on track. Most countries are well placed to implement the new international capital and liquidity standards in line with agreed timetables. Remaining policy details are being ironed out, with the leverage ratio requirement recently finalised, and further proposals on the net stable funding ratio released by the Basel Committee on Banking Supervision (BCBS). The Committee is continuing its important work to address the excessive variability in the calculation of risk-weighted assets. On the question of capital standards, it is frequently claimed that pressing major banks to hold more capital will impair economic growth. There are two points to make about this. The first is that, in situations of acute capital deficiency, it is best to address the problem as quickly as possible. Consider the contrast between the United States and Europe over the past five years. In 2009, US authorities conducted a public stress-test exercise on the balance sheets of major US banks and insisted that, where the tests revealed weaknesses, banks strengthen capital positions. They could carry out this exercise confident that a backstop capital delivery mechanism, in the form of public injections of capital, was available if private capital was not forthcoming. But it has taken much longer to get to this position in Europe. There were stress tests in earlier years but they do not seem to have had the same credibility in the eyes of markets as those undertaken by the Fed in 2009. Moreover, Europe did not have a European public capital delivery device; it was left to individual national governments to address any need for that. It is apparent that, while American banks carried out balance sheet repair early, and have for some time been in a position to help the US economy in its recovery, European banks have, in aggregate, continued to seek to deleverage by lowering their risk-weighted assets. This cannot have helped the euro area's growth prospects. This is being rectified. Later this year the ECB will release the results of its Asset Quality Review, which should be a highly credible exercise. And Europe is in the process of building a single supervisory mechanism for large banks. Over time, though rather a long time, Europe is also committed to creating a single resolution capability and a Europe-wide capacity for injecting capital from a single resolution fund if needed. These are all important steps but the respective US and European experiences do, I think, show that prompt efforts to fix serious problems of capital deficiency are ultimately pro-growth. What about in more stable times? Can banks with more capital support growth as well as those with less capital? Equity is more expensive than debt for banks, and so a financial structure with more equity does mean, other things equal, that the cost of intermediation to the community is higher. Even without appealing to propositions of a Modigliani-Miller kind, which would dispute this assumption, the question is whether this apparently higher cost is a serious impediment to growth. Bankers often claim it is. The empirical estimates published by the FSB and BCBS suggest the effect is small, particularly when compared with the costs of large financial crises. Stepping back from that debate for a moment, and this is my second point, we might reflect on the following question: did the highly leveraged expansion of some parts of the financial sector in the period prior to the crisis really add much, sustainably, to growth? It is far from obvious that it did. It seems more likely, to me, that it was the other way around: a period of good global growth and, in particular, unusually stable growth, led to a rise in leverage. The reasons for that growth stability were mainly not, I suspect, things that happened in the financial sector. But people concluded that macroeconomic stability meant that higher leverage was safer than before. In acting on that conclusion, they inadvertently sowed the seeds of instability, since leveraged balance sheets left borrowers and lenders more exposed when an adverse shock occurred. The feedback effects from economic growth, or lack of it, to the capital positions of financial institutions are powerful. The big question is not, in fact, what more demanding capital standards will do to economic growth. The question is: what will economic growth, or lack of it, do to banks' capital positions? It is noteworthy in this context that the phase-in for the Basel III capital standards extends until 2019. One has to ask: how likely is it that we will go another five years without an economic downturn of some kind? Even if we do, even if we assume that growth in the United States and Europe extends to the end of this decade, by that stage these expansions would be fairly mature. Given that, one would hope that by 2019 major financial institutions would not only have reached new international minima for capital, but would have risen above them. One would hope that balance sheets by that time would be at their strongest position for the cycle. This is a reason to go faster, rather than slower, in accumulating capital to higher minima, while one can. This point is of some relevance to the discussion in my own country at present. On the second core regulatory theme of derivatives, efforts to achieve more reporting, more platform trading and more central clearing are running behind original timetables. That is in large part due to the complexity of the issues involved in crafting mutually consistent sets of regulations at the jurisdiction level, for a market that is highly globalised in operation. The regulations of the major jurisdictions - the United States and the European Union - have considerable extraterritorial effects. It is critical that there be a high degree of consistency if we are to avoid fragmentation and unnecessary cost. The smaller jurisdictions, such as my own, feel this acutely, but it is not just a concern for the smaller jurisdictions. Even large jurisdictions would bear costs from unnecessary fragmentation. What is needed is a good understanding in the various jurisdictions of each other's regulatory arrangements, and of the areas in which they can give recognition to those arrangements. But it takes more than just verbal commitments to the concept of mutual recognition to achieve this. It requires confidence that the application and enforcement of sets of rules in other jurisdictions, which have the same intent as one's own but which differ in precise wording or form, will in fact produce broadly equivalent outcomes. It takes time to establish that confidence, based on careful analysis, lengthy discussion and building of trust. Progress is now being achieved here, including between the two biggest jurisdictions. And the efforts of the authorities in the United States and the European Union to assess the regulatory arrangements in the various other jurisdictions, which is no small task, must be acknowledged. But we have a way to go yet. Progress could be improved if relevant international standards were the benchmark for assessments of regulatory equivalence, and if regulators clearly communicated the basis of their decisions and provided regulatory certainty by clarifying the scope for transitional relief in a timely manner. In respect of the third theme, there have been considerable efforts by the FSB and the standard-setting bodies to address the risks posed by shadow banking - those entities and activities beyond the perimeter of prudential regulation. As the crisis showed, this sector can be a source of systemic risk, especially in the jurisdictions where shadow banks account for a relatively large share of the financial system or are important in credit intermediation. Authorities also have to be alert to any new build-up in shadow banking risk resulting from the likely migration of some activities in response to tougher prudential regulation of banks. However, a balance needs to be struck. The jurisdictions where these problems are likely to be serious are few, and we do not want efforts to contain shadow banking activity unnecessarily to stifle genuinely productive intermediation and innovation. The FSB, International Organization of Securities Commissions (IOSCO) and the BCBS have worked on addressing risks in several areas, such as money market funds, securitisation, banks' links with shadow banks and securities financing transactions (SFTs). Broad policy frameworks have largely been finalised in these areas, with work ongoing in relation to SFTs (such as an assessment of the impact of proposed recommendations). It has been important to retain a degree of flexibility in the policy recommendations, given that some shadow banking markets are relatively small and not likely to be a major source of systemic risk. On the fourth area, addressing the problem of 'too big to fail' entities, a key area of work this year is to put forward a proposal for 'gone-concern loss-absorbing capacity', or 'GLAC', for global systemically important banks (G-SIBs). The idea is that, even though additional capital surcharges above the (now higher) standard Basel III minima make it less likely that a G-SIB could fail, they do not make it impossible. Such entities are sufficiently large and interconnected that an uncontrolled failure could easily cause systemic disruption. Therefore, it is argued that further loss-absorbing capacity is needed, to be called on at the point of non-viability, so as to allow vital functions to continue and non-critical operations to be wound down in a controlled way. This limits adverse spillovers to the system and the economy. Generally, this loss-absorbing capacity is to come from a 'bail-in' of certain classes of private creditors, so as to avoid calling on the public purse for a 'bail-out. This is an appealing idea, though it comes with the caveat that, to my knowledge, it has not successfully been done for a major institution to date. There are several important issues to resolve in the process of crafting a proposal. Among them are the questions of what instruments count towards any GLAC, how much GLAC may be appropriate, and what measures can be taken to mitigate risks of contagion from GLAC holders bearing losses. On the matter of what instruments should count, a key question is whether or not equity capital above regulatory minima should qualify. The view against doing so is that equity 'buffers' may turn out to be illusory in a stress situation. That is, the uncertainty over asset valuations may be such that a presumed equity buffer is not, in fact, there. The 'illusory capital' problem is certainly not unknown in the annals of crisis management. The alternative view, which, it is fair to say, is more widely held, is that not to count equity above minimum requirements as GLAC would act as a disincentive for banks to hold or maintain higher than minimum equity buffers. From a risk perspective, higher equity buffers are unequivocally a good thing. Such a disincentive would therefore be unhelpful. This view is held quite strongly in Asia where banks tend to have high levels of equity capital. Under this approach, concerns about 'illusory capital' could be addressed by enforceable triggers to allow early intervention when excess capital runs down to a point that breaches the GLAC requirement. Moreover, the more genuine equity a bank has, the more likely it can remain a concern in the face of a given shock. It would still need to have a degree of recapitalisation, by a share issue, and perhaps would need to call on contingent capital instruments, triggered by some sort of capital threshold. But that would be a recapitalisation as a going concern, not a resolution as a gone concern. One would have to have a lot of confidence in a resolution regime not to prefer working with an injured but still living G-SIB, as opposed to resolving a 'gone concern' one. There could still be a tail event big enough to exhaust even a higher level of equity in a G-SIB, therefore requiring resolution. And we might be uncomfortable about how quickly equity might be burned through in such an event, and we do want to be sure we can resolve a G-SIB. So some GLAC is helpful in that situation. Unless we have draconian capital standards for equity, some requirement for bail-in debt in addition to equity may well be sensible for G-SIBs. But overall it is appropriate, in my judgement, to allow equity capital in excess of regulatory minima to be counted towards GLAC requirements. Another important consideration is to mitigate the risk that imposing losses on holders of GLAC will trigger destabilising contagion among investors. Measures to protect against this risk could include: the subordination of all GLAC liabilities, to reduce creditor uncertainty about the position of GLAC liabilities in the hierarchy of claims; limitations on the term of GLAC liabilities, to guard against the potential for runs on GLAC; and measures to limit cross-holdings of GLAC by other financial institutions, to reduce the prospect of losses on GLAC holdings significantly weakening other parts of the financial system. We have seen that in times of uncertainty financial markets often shoot first and ask questions later, so the task of protecting against contagion should not be underestimated. These and other issues on GLAC will be debated over the coming months, with the intent to put a proposal to the G20 Leaders Summit in Brisbane in November, which would then go to public consultation and a Quantitative Impact Study. Other elements in addressing 'too big to fail' come under the heading of international cooperation, of a kind that goes beyond high-level statements of good intentions. By definition, the smooth resolution of a global systemically important bank would have to be an internationally cooperative one. Hence cross-border cooperation agreements, in which home and key host jurisdictions accept and agree to be bound by a framework setting out their obligations and rights, would be central. Settling these agreements is running behind the timetable originally envisaged, partly reflecting existing statutory hurdles to information sharing. Recognition of resolution actions taken in another country in respect of a G-SIB, which may involve stays of various kinds, would also be key. This will require, among other things, legislation in a number of jurisdictions. More generally, legislatures need to ensure that the relevant regulators have a mandate to cooperate effectively and share information with their counterparts elsewhere in the world and the legal tools to take part in relevant resolution actions. So there are a number of issues on which we need to make further progress by the time of the G20 Leaders Summit in November. It is to be emphasised that the work ahead is mainly not so much new regulation as the fulfilment of commitments already made, and made some time ago. What about beyond that? In particular, at what point does the agenda for better, and frankly more, regulation reach a natural conclusion? When does our focus shift from regulatory redesign, under the duress of a crisis, to operating the system in (hopefully) more normal times? And to evaluating how the strengthened regulations are working? I'm sure that is a question the regulated institutions ask. It is one the regulatory community asks as well. Central to addressing the question is the need to remember what we are trying to achieve. Put simply, we are applying the lessons learned during the crisis about the extent and nature of risk, the set of incentives that allowed it to build up, the channels of contagion for distress once the extent of risk became apparent, and the weaknesses in our collective capacity to manage a crisis when one emerged. This does not equate to a desire to eliminate all risk. In fact, risk-taking is, to a point, good. We want it to occur. That is how society advances. A problem right now, arguably, is that there is not enough genuine entrepreneurial risk occurring - judging by the low levels of private capital spending in many advanced countries. (That is a different thing from saying that there is not enough risk-taking occurring - various people argue that, in some respects, there is too much of that.) We do need, however, risk to be recognised, and we need to be clear about who bears it. Standard capital requirements are about ensuring shareholders accept the risks run by the firms they own. With appropriate capital structures, shareholders in financial institutions should be able to expect a reasonable, risk-adjusted, return - remembering that banking is a leveraged business and that when things go wrong the shareholders' return can quickly become a large negative. With additional loss absorbency requirements for G-SIBs, we are asking shareholders to internalise some of the externalities very large and complex firms create for the system in the event of distress. And with the GLAC requirements, we are asking some of the other creditors to accept the risk that they may, in the face of a truly exceptional event, in effect become equity holders as part of a resolution of a G-SIB. But the risk/funding cost curve is not linear, at least not over its entire length. At some point requiring more and more loss absorbency to be provided by the private sector will come at an increasingly steep price. There must be events sufficiently far into the tails of the relevant distributions that no private balance sheet can reasonably be expected, , to bear the associated loss, no matter what the price. Should such an event occur, policymakers will still face the decision of whether to close or support the institution. The policy task is not, in my view, one of ensuring that the probability of such an event is absolutely zero, but of making it acceptably low at an acceptable price. Most particularly, we need to prevent a recurrence of a situation in which outcomes that are not, in fact, especially remote put the system in need of a public rescue. It equally follows that we are not trying to extend the regulatory 'perimeter' indefinitely. There will always be some risky activity around the fringes of the system, and there is nothing particularly wrong with that. Those who seek high returns, and are prepared to accept the risk, should be allowed to do so. There is value in that occurring. The proviso is that as well as allowing such risk-takers to accept the rewards of their activities, we have to be able safely to allow them to wear the losses. We cannot have them generating significant spillovers to the parts of the financial sector that are publicly underwritten or that are key to the day-to-day functioning of the economy. Where such spillovers do exist, rules that serve to isolate the risk-taking activities, to keep them genuinely on the fringe, are in order. This is perhaps the greatest regulatory challenge for the future: assessing when an activity that is technically outside the 'perimeter' might be about to present a threat to overall stability. Devoting a lot of resources to ever greater refinements to the details of existing regulatory structures will not help us do that. Having the big things inside the perimeter about right should be good enough. After that, we need to make sure we devote adequate resources to keeping a general weather eye on the broader situation, beyond just the area illuminated around our current lamp post. With the pace of technological change, it probably will not become easier to do that. The possible rise of 'virtual' currencies, the potential for the distinction between regulated financial institutions and, say, telecommunications and technology companies to become blurred, to name just two developments, may pose challenges. They doubtless will not be the only ones. It probably will still pay dividends, though, to keep our antennae tuned for the nature of the promises made by the various players, the extent of leverage involved and the frequency with which we hear the cry that 'this time is different'. Thank you for your attention. I wish you well in your deliberations.

r140703a_BOA

australia

stevens

Thank you for the invitation to visit Hobart - in winter! - and to take part in this conference. This year marks a century of economics at the University of Tasmania, dating from the time Herbert Heaton took up duties as a lecturer in History and Economics in 1914. Heaton's pacifist and somewhat left-leaning views apparently caused some controversy, both in Tasmania and subsequently at the University of Adelaide. He left Australia in 1925 for Canada, and later had a successful academic career at the University of Minnesota. Over the ensuing period, some of the greatest names in Australian economics studied here, taught here or otherwise carried out some part of their professional duties here. It's quite a line-up. There was LF Giblin, born in Tasmania, sportsman, student at Cambridge, sometime acquaintance of the Bloomsbury Set, Yukon adventurer, enlisted soldier in middle age and wounded three times in the First World War, Tasmanian Government Statistician, adviser to government on economic policy in the 1930s Depression and board member of the Commonwealth Bank. Then there were those called 'Giblin's Platoon' in the very nice book of that name by William Coleman, Selwyn Cornish and Alf Hagger chronicle the way the relationships between these four bore fruit. It was a remarkable period of activity for the fledgling profession in this country, and people who had been or were associated in some way with the University of Tasmania were in the thick of it. It might be said that, in many respects, much of the genesis of modern policy economics in Australia occurred here in Hobart. Every generation has its own challenges. In the careers of today's generation of economists we have had, as described by various authors, 'the Great Inflation', 'the Great Moderation', 'the Great Recession'. The ensuing slow recovery in the advanced countries could be described as 'the Great Disappointment', though one commentator has used stronger language - describing it, rather biblically, as 'the Great Tribulation'. Maybe there is undue devaluation of the adjective 'great' in such characterisations. Or maybe not. The generation of Giblin faced enormous challenges, especially given the much more limited stock of accumulated knowledge at that time and the scarcity of trained economists. But plenty of writers, including some who have been intimately involved in policymaking, have seen the recent episode as potentially as catastrophic as the 1930s, averted only due to interventions framed with the lessons of the 1930s in mind. But a fuller evaluation of those issues may need to wait for another occasion. Today I propose something less ambitious. In early May, the Bank published its latest . Since then we have had the federal and some state budgets, and some further data as well as a couple of interest rate decisions. Hence, it seems appropriate to provide a brief update and some comments on a few issues connected with monetary policy. It appears that the economy's pace of growth increased somewhat in the second half of last year, and that this persisted in the first few months of 2014. Real GDP expanded at an annualised pace of about 3 per cent in the second half of 2013, up from just under 2 1/2 per cent in the first half. Business survey readings are broadly consistent with this picture. The March quarter of 2014 saw a further pick-up, to something that was above trend, measured either in the quarter or over the year. A key question is the extent to which these recent national accounts data in particular illustrate the likely ongoing pace of growth. The results owed a lot to a very substantial rise in resource exports. This in turn reflected new capacity coming on stream and also unusually benign weather. While further rises in resource export volumes are expected, they are unlikely to be at the same pace. Hence, the most recent set of GDP figures, while certainly encouraging, probably overstate somewhat the true ongoing pace of growth in the economy. The Bank's forecasts from early May, which we have not materially changed, embody ongoing growth but, in the near term, probably a little below trend. We will provide an update of forecasts next month. What are some of the key features of this outlook? The world economy continues to show moderate growth, probably a little below average but not by all that much. The advanced countries are seeing somewhat better outcomes than last year overall, while some emerging market economies slowed somewhat during the first half of 2014, including China. Looking at domestic economic policies, the stance of monetary policy is very accommodative, certainly when measured by the metric of interest rates. The level of rates, including for borrowers, is at a 50-year low. The cash rate measured in 'real' terms is approximately zero. In either nominal or real terms the cash rate is well below 'normal' levels, and comfortably below even the mooted lower 'new normal' levels. Moreover, we still have 'ammunition' on interest rates - we have not got close to the zero lower bound that has afflicted some other countries. The low interest rates have been having many of the effects they normally do. Savers have altered their behaviour to look for returns in slightly more risky assets; asset prices have risen; demand for credit has strengthened; and interest sensitive areas of spending, like some areas of consumption and especially dwelling construction, have firmed. The exchange rate also declined, though not by as much as might have been expected. The full effects of the very accommodative stance of policy have not been seen at this stage. It will be supporting demand for some time yet. The federal budget seems unlikely materially to change the near-term outlook. Over the next couple of years the estimated impact of the budget is not very different from what we had previously been assuming, and the extent of fiscal contraction, as conventionally measured, is actually not particularly large when compared with past episodes of fiscal tightening. Beyond that period, the measures in the budget will result in a more significant consolidation than earlier assumed. It was over that more medium-term horizon that the Commonwealth's finances, left unattended, looked like they were going to start going more seriously off course. So the timing of the intended consolidation seems broadly sensible. That having been said, the fact that the real issues with public finances are medium-term ones is not a reason to put off taking decisions to address them. On the contrary, as experience in so many other countries demonstrates, by the time these sorts of problems have gone from being out on the horizon to on our doorstep, they have usually become a lot more difficult to tackle. Early, measured actions that have effects that build up over time are a much better approach than the much tougher response that might be required if decisions were delayed. There has been discussion about confidence effects of the budget. Some surveys do suggest some decline in household confidence of late. It is important, though, to ask how persistent such effects might be. Last year's budget, which contained some tough messages, also seemed to be associated with a decline in such measures of confidence. They recovered after a few months. We can only wait to see whether that pattern will be repeated this year. Measures of business confidence don't show any obvious response to the budget. While there has been much focus on budget measures, the biggest sources of uncertainty about the pace of private demand growth remain the speed of the impending large decline in capital spending by the resources sector, and the timing of the recovery in non-mining capital spending and non-mining activity more generally. The biggest and most persistent terms of trade gain in at least a century ushered in a capital spending response by mining and energy companies that saw the private business investment share of GDP reach a 50-year high, even though investment outside the mining sector approached recession-level lows. Now, the terms of trade are falling, and the investment part of the boom has peaked. Mining investment, as a share of GDP, has probably already declined by about 1 percentage point, and is expected to fall by another 3 or 4 percentage points over the next few years. Unlike in all previous such booms, we did not experience serious overheating in the upswing. What is being attempted now is to negotiate the downswing phase without the slump that characterised the aftermath of all the other booms. The fact that the upswing was managed without the excesses of the previous episodes is no guarantee of success in the next phase, but it has to be a good starting point. We have seen some encouraging early signs of the 'rebalancing' taking place. Consumer demand has been rising moderately, even if recently perhaps a little more slowly than it did over the summer. Residential construction is moving up strongly, and intentions to invest outside the resources sector have started to improve, from very subdued levels. The labour market has also shown some early indications of mild improvement. But these signs remain early ones. There is quite some way to go yet before the episode is completed. Meanwhile, the environment seems likely to be one in which a number of sectors are making serious efforts to contain costs and lift productivity (Graph 1). That amounts to an outlook for wages and prices that does not appear to threaten the inflation target, even were we to see a somewhat lower exchange rate. Perhaps more fundamentally, a better trend for productivity, if we can sustain it - and especially if it can be further improved - would be a reliable basis for optimism about the longer-run prospects for the economy and our living standards. It is in that context that the Board has left the cash rate unchanged at 2.5 per cent for almost a year now. For rates to have been stable for this long isn't unprecedented. But since markets and media commentators find the idea of masterly inaction neither appealing nor interesting, this has put more focus on communication. The Bank's language has evolved, given the passage of time and the flow of new information. Up to the time of last August's meeting, the post-Board statement for some months included language about the inflation outlook, as then assessed, providing 'scope' to ease further should that be appropriate to support demand. At the May and August 2013 meetings the Board used some of that scope. Subsequent post-meeting statements did not include that phrasing. The minutes of those meetings simply recorded the Board's view that 'the Bank should neither close off the possibility of reducing rates further, nor signal an imminent intention to reduce rates further'. That phrasing was retained until the December minutes. The data that emerged over the summer saw somewhat firmer growth, a lower exchange rate and higher inflation than had been embodied in the outlook as at the end of last year. This led the staff forecasts for both growth and prices to be revised higher for the February meeting and the subsequent . The December quarter CPI in particular was something of a surprise. We interpreted those data as containing a degree of noise but could not entirely discount the possibility that they may also contain some signal. Hence, the inflation forecast was revised up somewhat. With both growth and inflation forecasts moving higher, it would have been odd to continue with the earlier language. After all, policy had been eased a great deal, it seemed to be having many of the expected sorts of effects, inflation wasn't threatening to be too low and, if anything, was going to be higher than earlier expected, and there was mildly better news on output. Accordingly, the Bank's communication continued to evolve in light of new information. Although this shift in language was quite gradual, the problem we can sometimes have in such periods is that people may react by thinking that, if the Bank is not thinking about easing, then it must be thinking about tightening. But we were not contemplating tightening. In fact, the conclusion we had reached was that we might be on the brink of sitting still for some time. That is why we adopted language about 'stability' in interest rates, the intended effect of which was to be clear to people that we did not think that higher interest rates were imminent. That has not stopped people from opining about the timing of possible future increases - or, indeed, decreases. That's what makes a market - people have differing views, for various reasons. Overall, I judge that language to have served its intended purpose. Present market pricing suggests that market participants expect interest rates to remain low for some time yet. If anything, pricing in recent days has suggested that, if a move were to occur over the next several months, markets expect it would be down, not up. Any increase in rates is thought by market participants, on average, to be unlikely for quite some time. The evolution of language should be expected to continue, as more time passes and further information comes to hand. Long before any thought were to be given to an increase in rates, it would probably be sensible for the Board to cease references to a future 'period of stability' and revert to the more normal formulation that the stable policy settings 'remained appropriate' or something like that. Such an evolution would amount to no more than a recognition that a 'period of stability' had in fact already been occurring and wasn't in the future, but wouldn't imply any particular change in the Bank's views about the future course of policy. It should go without saying that those seeking to understand our thinking should, in any event, look not just at the wording in the post-Board statement, nor just that in the minutes, but also at the whole analysis of the economy and the outlook in the regular . Another issue in communication has been how to describe the exchange rate. For a period we described it as 'uncomfortably high'. It subsequently declined, though we suspect that was due more to a change in mood in global capital markets than to our words . We altered our language to reflect that decline, and then adjusted it again as the currency retraced some of that rise. There seems to have been a very strong focus on whether the adjective 'uncomfortable' would be put into use once more in the post-Board statements. It hasn't been, though I don't regard that to be as significant as many people seem to think it is. We have tried to avoid frequent and large language shifts about the exchange rate. It can vary enough from month to month that we risk chasing our tails if we seek to engage too actively in 'jawboning' each month. But lest there be any uncertainty about this, let me be clear, again, that the exchange rate remains high by historical standards. There is little doubt that significant parts of the trade-exposed sectors still find it quite 'uncomfortable': it continues to exert acute pressure for cost containment, productivity improvement and business model change. When judged against current and likely future trends in the terms of trade, and Australia's still high costs of production relative to those elsewhere in the world, most measurements would say it is overvalued, and not by just a few cents. Of course, we live in unusual times, with interest rates at the 'zero lower bound' in several major jurisdictions. Nonetheless, we think that investors are underestimating the likelihood of a significant fall in the Australian dollar at some point. Finally, on communication and monetary policy generally, there is the question of housing prices. Few issues seem as capable of sharply dividing opinions as this one. Some use the 'B' word, sometimes followed by calls for interest rates to be higher. Others regard it as unthinkable that interest rates would ever respond to housing prices. Still others call for regulatory actions to constrain housing lending, which, by the way, has overall remained quite moderate so far. The Bank's views on this have been quite consistent. We have made four points. First, with dwelling prices having fallen between 2010 and 2012, some recovery was not in itself particularly cause for concern, certainly not initially. Moreover, if we think there is a need for higher construction, which we do, an environment of declining prices is probably not conducive to that outcome. Some pick-up in housing prices as a result of lower interest rates was to be expected; it shows that monetary policy is working and is part of the normal transmission process. Of course, this argument becomes less persuasive if valuations reach new highs and keep rising. So, second, were there to be a further big run-up in prices, with past increases leading to overconfident expectations of continuing gains, it would be a different matter. If this were accompanied by a return to significant increases in household leverage, from already high levels, that would be a matter for concern. It would be adding risk to the system. But, third, to date the amount of new borrowing does not appear, overall, to be imprudent. The rise in the value of loan approvals over the past year of around 20 per cent is certainly significant. It's important to note, however, that scaled by the amount of credit outstanding, the rate of this flow over recent months, while clearly well off its 2011 low point, is actually not that high compared with longer-run history (Graph 2). It's only a little above 2008 lows, in fact. The growth of credit outstanding for housing is about 6-7 per cent per annum, or slightly above trend nominal income growth. It's hard to mount the soap box to complain about that pace. Nonetheless, fourth, investors should take care in the Sydney market, which is the main area where a large increase in borrowing has been occurring. The total value of credit approvals for investor loans in New South Wales as a whole is about 130 per cent higher than in 2008, and it is in the investor segment where there has been evidence of some increase in lending with loan-to-value ratios above 80 per cent in the past couple of quarters. Here we continue to have two messages. The first is that in forming expectations about future price gains and deciding their financing structure, people should not assume that prices always rise. They don't; sometimes they fall. The second is that banks and other lenders need to maintain strong lending standards. APRA has helpfully been reinforcing this point directly with bank boards, as well as stressing the importance of having adequate, higher, interest rate buffers in place, given the current very low level of rates in the market. The maintenance of strong standards will be all the more important given the significant improvement in access to funding via the securitisation market over the past year and the associated increase in competition to lend. Some segments of the housing market do appear to have been calming down lately. Prices have flattened out in several cities and even in Sydney the pace of increase has lessened. It remains to be seen whether this slower pace of growth in dwelling prices is temporary or more persistent. It would in my opinion be good, for a range of reasons, if it did persist for a while. If the next couple of years saw an unremarkable performance on prices, and construction staying at the higher levels that will clearly be reached over the coming year, it would be an outcome that would contribute to a balanced growth path for the economy and to housing more people at manageable cost. Overall, the Bank has not seen developments in the housing market as warranting higher interest rates than the ones we have had, in the current circumstances. This isn't because we think that financial stability considerations should be ignored in the policy decision. On the contrary, they should be, and have been, given due weight, along with all the other factors we have to take into account, in deciding the interest rate path we have chosen. We judge that path to have best balanced, to date, all the various considerations. I wonder whether Giblin and his 'platoon' could have imagined a meeting like this: hundreds of economists and econometricians converging, from around the country and around the world, on Hobart for just a few days, travelling not at stately pace in ships and trains, as they would have, but through the stratosphere at just under the speed of sound. Probably not. But at least some of the issues about which we talk today would sound familiar to them. Swings in the terms of trade, the effects of massive international financial events with all their spillovers, policymakers grappling with events they had not seen before, come to mind. They would have seen a need, as should we, for the economics profession to make a constructive contribution to national debate about economic matters. I hope the discussions today and over the course of the conference will help us all to play our parts.

r140722a_BOA

australia

stevens

Thank you for once again coming to support the Anika Foundation , on the eighth of these annual fundraising occasions. Once again my topic is 'challenges for economic policy'. It always seems as though there are some challenges to talk about. The challenges I want to focus on are those involved in dealing with and then recovering from the financial crisis that enveloped the major European countries and the United States (US) (and, briefly, the whole world) in late 2008. My view is that policies were very effective in averting a potential catastrophe five years ago. But fostering a strong recovery has been much more difficult. I think this reflects the nature of the shock policymakers have been dealing with. We have learned, once again, about the limits to what monetary policy alone can achieve. I wish to be clear at the outset that my remarks today are about global issues, and contain no particular message specific to Australia. I begin with some remarks on the crisis itself. I've observed a number of economic and financial episodes over the past 30 plus years. In just about every one of them of any significance, people have claimed it was the worst episode since the 1930s. One of the earliest substantive pieces of research I was involved in at the Reserve Bank sought to bring some evidence to bear on the claim that the recession in 1983 was somehow comparable with the 1930s. It wasn't, of course - not even close. Almost all such claims are greatly exaggerated. But when those who lived through 2008 and 2009 say that there was the potential for an outcome every bit as disastrous as the 1930s, I don't think that is an exaggeration. Any account of the events of September and October 2008 reminds one of what an extraordinary couple of months they were. Virtually every day would bring news of major financial institutions in distress, markets gyrating wildly or closing altogether, rapid international spillovers, and public interventions on an unprecedented scale in an attempt to stabilise the situation. It was a global panic. The accounts of some of the key decision-makers that have been published give even more sense of how desperately close to the edge they thought the system came, and how difficult the task was of stopping it going over. One 'advantage' the current generation of policymakers had was that, although they had never lived through a 1930s-style episode, they had at least some understanding of what had happened, and had absorbed the lessons of the sorts of things to do, and to avoid, once a crisis erupted. This was a result of a large output of scholarship, including by one scholar who happened to end up being Chairman of the Federal Reserve Board at the critical moment. Among those lessons, though this is hardly an exhaustive list, are the following: Policymakers understood these lessons. There were naturally mistakes and misjudgements made along the way - that will always be the case. But by and large, these lessons informed the response to the crisis. Liquidity in most jurisdictions was ample. Central banks were, when needed, quite generous and inventive supplying it. A point made many times was that liquidity cannot redress a solvency problem. That's true, but not providing liquidity to a stressed system will ultimately make solvency problems worse. Authorities in all jurisdictions understood the need to prevent a spiral of defaults of large financial institutions further adding to already tightened credit conditions. In October 2008 the G7 finance ministers and central bank governors said pretty explicitly there would be no more failures of systemically important entities. Countries were prepared to use guarantees, and there was public injection of capital into banks in a number of instances. People will rightly worry about moral hazard and perpetuating 'too big to fail' and so on. That's a legitimate concern and a powerful reason for reform for the future, but it wasn't a basis for policy when facing imminent disaster. As for macroeconomic policy, just about every country adopted more expansionary settings. The major central banks, and most smaller ones, reduced interest rates aggressively after the 2008 failure of Lehman Brothers. Governments were advised by international bodies like the International Monetary Fund (IMF) to pursue fiscal expansion, to the extent they had 'fiscal space'. Most of them did, even in cases where 'space' was rather limited. The spirit of international cooperation, so often honoured in the breach in normal times was, at critical moments, actually pretty good. For example, the swap lines between central banks were put into place quickly, and around US$500 billion in US dollar liquidity flowed into the global system during the last quarter of 2008. Agreement on the broad contours of other elements of the responses at the height of the crisis was found fairly quickly. At moments when the world needed to hear that the people in charge had a plan, the G20 Leaders sounded like they had one. As well as stabilising the financial system, they committed to avoiding protectionism and eschewed competitive exchange rate devaluations. . The decline in global output and trade in the last quarter of 2008 was at a pace that rivalled the contraction in the 1930s. Had it gone on, we can be sure that tens of millions more people would be unemployed and trillions of dollars more wealth would have been destroyed. But it didn't go on. It was arrested. As a result, we talk about the 'Great Recession', but we don't talk about the 'Great Depression Mark II'. These initial interventions achieved what they were supposed to. We might not like the politics or the optics of it all - all the 'bailouts', the sense that some people who behaved irresponsibly got away with it, the recriminations, the second-guessing after the event and so on. But the alternative was worse. I think all that would be more or less accepted by most reasonable people. But what about the efficacy of policies in generating a robust recovery? It is that set of issues to which I now want to turn. It is one thing to staunch the tide of bank failures by public intervention. But to help secure a recovery in the financial system and the economy, banks' balance sheets have to be fixed. There were genuine problems with asset quality and it would have done little good to pretend otherwise. There had to be an honest accounting of these problems. Until there was, counterparty risk aversion would persist, because no-one knew whom to trust. An honest accounting of the assets meant owning up to the shortage of capital. There never had been enough capital for many entities to have run the risks they carried, and what capital there had been was in many instances reduced or gone. So that had to be fixed, either by raising capital from the markets or accepting it from the government. The stress tests conducted by the US authorities in 2009 were designed with this dual purpose in mind. They were effective in getting clarity on asset quality and in strengthening capital positions. This has been harder to achieve in Europe, for various reasons to do with the complexity of the European project, and remains something of a work in progress. Nonetheless, the lesson would still hold that fixing the balance sheets is a necessary condition for recovery. But fixing the banks, while a necessary condition, isn't a sufficient one. A sound financial system can accommodate growth by supplying the necessary credit, but a sound financial system alone isn't the initiating force for growth - at least, not the kind of soundly based growth needed. Macroeconomic policies have a role too. One of the difficulties has been that public debt burdens rose sharply. This was partly as a result of the cost of fiscal stimulus measures and bank recapitalisations in some cases, but it was mainly because of the depth of the downturn in economic activity. A financial crisis and deep recession can easily add 20 or 30 percentage points to the ratio of debt to GDP, and did so in a number of cases. Moreover, since it appears that economic activity isn't going to be back on its previous trend levels any time soon in many of the crisis-affected countries, and hence government revenues seem to be persistently on a lower track, public finances have been left in a fragile condition. That some countries went into this episode having avoided serious efforts at fiscal consolidation for quite a long time, and hence already had significant debt burdens, only heightened the problems. So fiscal policy has not had as much scope to continue supporting recovery as might have been hoped. Policymakers in some instances have felt they had little choice but to move into consolidation mode early in the recovery. That has left monetary policy trying to support demand, but monetary policy has had its own difficulties in doing so. The Fed and some other central banks quickly found themselves in a situation in which the short-term interest rate reached, for practical purposes, the 'zero lower bound'. This has echoes of the 'liquidity trap', something we had learned about as a textbook possibility, but which now seemed to have become a real-life experience. This had already been noticed for Japan in a memorable paper by Paul Krugman as long ago as 1998. The liquidity trap was a hypothesis of Keynes, who contemplated the possibility of a world in which additional injections of money into the economy become ineffective at reducing interest rates, because people become content simply to hoard the extra cash. In the original specification this was supposed to happen at some positive interest rate. In fact, the short rate could fall all the way to zero. But it couldn't realistically get much lower. That still left long rates, though, and in countries like the US and the euro area these rates matter a great deal. The central banks did not accept that the policy rate reaching zero meant the end of effective easing in policy. Enter 'quantitative easing', or 'QE'. QE is essentially unsterilised intervention in asset markets, meaning that the central bank expands its own balance sheet by buying assets for cash. The market for long-term government debt, agency securities and some types of private paper all were affected by QE or similar measures at one time or another in the United Kingdom (UK), the US and of course Japan. Such interventions also occurred in Europe, though with slight differences in the motivating narrative, given the particular circumstances of the single currency arrangements. By definition, since it is unsterilised, QE results in a rise in settlement balances at the central bank. Sometimes people point to this as indicating a failure of the policy, as though banks have 'failed to lend out the extra cash'. But this isn't an accurate description of what has happened. Those extra settlement balances to remain in the system, however hard the market participants try to lend them out to others, until the central bank decides to take them out again. In fact, QE mainly works not by some credit multiplier mechanism, but by pushing down the cost of capital for the economy. Long-term rates fall below where they would otherwise be as the central bank bids for securities in the market. The former holders of those securities then have to redeploy the cash they now hold. Unless they are all content simply to absorb extra cash - unless, that is, the liquidity trap is fully in operation for all asset classes at all maturities - their efforts to acquire other assets with similar duration but somewhat higher risk will bring down yields on those other assets (including foreign assets), lowering risk premia and so on. This 'search for yield' means that financial conditions, broadly defined, ease: that is, the cost of capital to the non-financial sector declines. It has been noted that this amounts to more risk-taking among investors. Indeed it does. While in some discussion it seems to be implied that this is a bad thing, actually prompting more risk-taking is the whole point. Assuming we accept the notion that there is a role for stabilisation policy, when appetite for risk evaporates its job is to respond in a way that helps to restore that appetite, up to a point. The key question is: what kind of risk-taking? In particular, to what extent is the lower cost of capital to the non-financial sector resulting in more risk-taking in sector? To what extent are businesses in the 'real economy' becoming, as a result of accommodative monetary policies, more prepared to take a risk - on a new product, a new factory or process, an innovation, a new market or a new employee? For if some increased risk in the financial sector is part of the process of getting more genuine entrepreneurs in the economy to take the sorts of risk that are part and parcel of restoring the dynamic of growth, that is probably a trade-off worth making. On the other hand, if some years from now we find ourselves looking back and concluding that such 'real economy' entrepreneurial risk-taking has not really taken place, and all that has happened is that financial risk-taking and leverage have risen, we would be disappointed. Unfortunately, it is very difficult, at this stage, to evaluate how well the trade-off is operating. It is certainly clear that, globally, financial conditions have been extraordinarily accommodative and that the 'search for yield' has been a pervasive force. Risk spreads are low, overall costs of borrowing are exceptionally low, and yields on all manner of assets are being bid down to very unusual levels, around the world. But as for the effects filtering through to risk-taking in the real economy, I think the only honest assessment is that the evidence is hard to read. The US economy, where the QE actions have been the most aggressive, certainly has seen recovery, though at only a moderate pace. Business capital spending, perhaps a high level gauge of 'real economy' risk-taking, has risen in the US, but has hardly been strong and it remains quite weak in several other major economies. Some would take that to indicate that the unconventional monetary policy has not been all that effective, and too risky; others would see it as a sign that policy did not try hard enough. Still others, myself among them, remembering that it always takes time for an economy to heal after a financial crisis, and that as usual we don't know the counterfactual, might simply feel that it is impossible to draw strong conclusions. One cannot help but observe, though, that monetary policy's ability to help growth can be impaired by things that the central bank cannot influence. One of monetary policy's key effects is thought to come by lowering the cost of borrowing relative to the expected rate of return on real capital - the so-called Wicksellian 'natural rate'. But if for some reason the natural rate is very low, then for monetary policy to impart this expansionary impetus to the economy requires low policy rates. Perhaps the natural rate could for some reason fall so low that it becomes impossible for monetary policy to impart very much stimulus, because a wide range of nominal interest rates approach or reach the zero bound and that is not low enough. , a persistent case of this would amount to conditions that might be described as 'secular stagnation', as recently discussed by Larry Summers. In that sort of world, central banks can still carry out some of their critical functions. They can make portfolios more liquid, and cut short an incipient spiral of falling asset values, contracting credit and so on that might otherwise be much more devastating. They can significantly lessen the burden on those with too much debt as they seek to deleverage, admittedly at the cost of lowering the incomes of savers. But if people simply don't wish to take on new business risks, monetary policy can't make them. What sorts of things might result in a very low 'natural' rate of return on real capital? And have they been in operation? The Austrian tradition would point to previous over-investment, after which, expected returns are perceived to be low. That seems to have been part of the story of Japan after the 'bubble economy' era. In the more recent episode, there was clearly some over-investment in the housing stock in the US and one or two other countries (Spain, for example). But a casual look at investment in most advanced countries does not suggest obvious over-investment prior to 2008. Visitors to the US would not readily conclude that America had over-invested in infrastructure (nor would they when visiting the UK or, for that matter, Australia). A decline in an economy's potential growth rate, driven by lower population or productivity growth could be a factor. Japan has a declining population and the dynamics of some of the European countries are not much better. But this isn't obviously the case for a country like the US. If the process of innovation that is a precursor to productivity growth is impaired, or if research and experimentation simply has periods of fewer discoveries, just by chance, that could also lessen the perceived opportunity to deploy capital profitably. But since 2008, the number of patents granted in the US has risen by nearly two-thirds. While only a crude measure, that doesn't suggest the desire to innovate has collapsed. Perhaps the answer is simply subdued 'animal spirits' - low levels of confidence. After all, the natural rate is an rate. If people think, for whatever reason, that returns for future possible investments will be low, or subject to high risk, then they will be reluctant to invest even if past and current returns are quite satisfactory. Conceivably, this could be a self-reinforcing equilibrium. Assessing this is difficult and there is the potential for multiple equilibria. But it does seem, to me, that businesses in many places are much more conscious of risk, relative to return, than they were in the pre-crisis period. At some stage, hopefully share market analysts and the investor community will ask fewer questions about risk reduction, and more about the company's growth strategy. Suppose some such forces have, in fact, been in operation. Will we be stuck in a low-return, pessimistic equilibrium for a long time? Or will such forces abate, and if so, when? I would argue for realism, as opposed to either naive optimism or determined pessimism. Certainly earlier expectations about risk and return were too optimistic. We have been through a period of adjustment. But it's doubtful that the desire to experiment and innovate has entirely disappeared. And it seems unduly pessimistic to think that everything that can be invented has been, or that every improvement to existing ways of doing things has already been implemented. And unless we think the tendency for human optimism has been completely drummed out of us, animal spirits in the 'real economy' will surely improve at some point. The question is what might be done to help that happen more quickly. It is highly unlikely that the answer will come, in any country, from monetary policy. But this is where the G20 agenda on growth can, if it is well used, be of considerable help: then the growth potential of the world will look, and actually be, improved. The highly accommodative financial conditions will then have a more powerful effect in engendering real growth. A rising confidence dynamic could unfold. The prospects for profitable investments by businesses would be significantly improved. And then, at a future event of this kind we would be able to conclude that the challenges facing economic policy had been met. For now, it remains for me to thank you once again for coming out today to support the Anika Foundation's work in raising awareness about adolescent depression and suicide. On behalf to the Board of the Foundation, I thank you for your generosity.

r140820a_BOA

australia

stevens

Members of the Committee Thank you for the opportunity to meet with you today. Since the hearing in March, the global economy has continued its expansion at a moderate pace, and Australia's trading partner group has been growing at about its long-run average rate. With the abatement of the adverse winter weather, the US economy recovered in the June quarter and the labour market has continued to strengthen. Growth in China has remained close to the target of 7.5 per cent, though Chinese residential property prices have declined in recent months. Chinese authorities at various levels are responding to these developments with the aim of maintaining stable macroeconomic and monetary conditions. In Japan, consumption and output grew strongly in the March quarter ahead of the increase in the consumption tax in April, and then contracted sharply in the June quarter. This is a normal pattern surrounding such tax changes, but complicates reading the underlying pace of Japan's economy. Economic growth in the rest of east Asia has continued. Commodity prices important to Australia have declined this year, as global supply - including from Australia particularly - has increased. The terms of trade have now fallen by about 18 per cent from their extraordinary peak three years ago, but they remain over 50 per cent higher than their twentieth century trend level. Perhaps the most remarkable feature of the international scene at present is the exceptionally low volatility of financial prices - the lowest observed over the past 25 years for sovereign bonds, equities and foreign exchange. Yields on sovereign debt of the major countries are also very low, the lowest on record in some cases. Spreads on investment grade and financial corporate bonds have reached multi-year lows and in Europe yields on so-called 'peripheral' sovereign bonds have in some cases fallen below previous historic lows. It is not as though there has been a dearth of geo-political or financial events which might ordinarily trigger more caution among investors. But compensation for risk on financial instruments remains scant. The reasons for these remarkable trends, including the extent to which they reflect the effects of the exceptional monetary policies being conducted by the major jurisdictions, or other things, could be debated at length. What is clear though is that a combination of forces has resulted in financial conditions remaining remarkably accommodative. This has been reflected in a decline, at the margin, in interest rates in Australia, even though the Reserve Bank has not changed the cash rate for a year. Australian governments have continued to borrow at or around the lowest rates since Federation. Similarly, funding costs for financial institutions have been declining. This, and an increase in competition to lend in an environment of still fairly moderate credit growth, has contributed to a reduction in the rates on housing and business loans. Economic growth was, as recorded, clearly above trend in the March quarter. The quarterly result was, to a large extent, driven by a substantial increase in resource exports, as new mining capacity came on line and mining operations experienced fewer weather disruptions than usual. Data for the June quarter suggest a 'payback' of lower exports, and also a period of more subdued consumer demand. There are relatively few readings for the September quarter as yet, though at least some suggest that there may have been a reasonable start to the quarter. Having printed lower for a few months, the rate of unemployment has recently been recorded at a higher level, though most leading indicators of the labour market seem to have improved a little this year. Consumer prices rose by 3 per cent over the year to the June quarter, higher than the pace a year earlier. This partly reflects factors such as the increase in the tobacco excise but measures of underlying inflation also increased. A faster pace of increase in prices for tradable goods and services featured, a reflection of the depreciation of the exchange rate since April last year. The rate of inflation for 'non-tradables' has actually declined over the past year, helped by growth of labour costs falling to its lowest rate for many years. There is some evidence that productivity performance may be starting to improve, though this is notoriously difficult to evaluate over periods less than several years. When we look ahead, a key feature of the outlook, as everyone knows, is that the capital expenditure phase of the 'mining boom' is winding down, while the export phase is gearing up. The fall-off in investment spending by resources companies has a long way to go yet and will probably accelerate in the coming year. This impending further fall is captivating most of the commentators. Meanwhile growth in non-mining activity has been increasing. A recovery in dwelling investment is well under way, with spending in this area rising by 8 per cent in the year to the March quarter. Forward indicators for non-mining business investment suggest a modest improvement over the coming year, though intentions have remained, to date, a bit tentative. Consumer spending, though soft in mid year, could be expected to grow in line with income, or perhaps a little faster, given the rise in household net worth. But it seems unlikely that households will revert to their behaviour of a decade ago, when they were expanding their balance sheets quickly, saving much less of their incomes and increasing their consumption well ahead of the growth in incomes. Public spending is scheduled to remain quite restrained. The overall growth rate of the economy is the sum of these various forces, and is also affected by factors not confined to the mining sector or even to Australia. Forecasting is an imprecise art at the best of times. At present, given the size of the mining boom, the extent of the shift in global relative prices over the past years, and the very unusual global economic and financial environment in which we still find ourselves, forecasts are likely to be even less reliable. With that caveat, my guess is that over the year ahead the growth of real GDP will be around 2-3 per cent: close to trend, but probably a bit below it in the near term. Further ahead there are some reasons to think that growth could speed up somewhat and be a bit above trend. This outlook would mean that it will be a while before we see sustained reductions in the rate of unemployment. Conditional on the usual set of assumptions about oil prices, the exchange rate and so on, inflation should be consistent with the 2-3 per cent target over the horizon relevant for monetary policy. The depreciation of the exchange rate last year is likely to continue to contribute to higher prices for tradable items for a while yet. But domestic inflation is likely to remain contained given how slowly labour costs have been rising. The removal of the price on carbon will lower inflation temporarily over the coming year. To say that growth is close to trend, but probably a bit below in the near term, will be disappointing to many people. And that is with very accommodative monetary policy - with the cash rate held at its lowest in 50 years for a year now and widely expected to be held at or close to these levels for some time yet. The low returns on offer on safe investments in Australia, and the ultra-low returns on such assets internationally, are certainly having an effect by prompting investors to 'search for yield'. Not only are returns on financial instruments low, but yields on the existing stock of physical assets - houses, commercial property, infrastructure assets - are being bid down. Some of that search is of course coming from offshore. That's a big part of how accommodative monetary policy works. It prompts substitution towards higher-risk assets; it raises asset prices, which increases collateral values and makes credit extension more viable; it improves the cash flows of debtors; and so on. All those things have been happening in Australia. Admittedly, the exchange rate, another channel through which monetary policy usually has an effect, is probably not doing as much as it might usually be expected to do in achieving balanced growth. But the thing that is most needed now is something monetary policy can't directly cause: more of the sort of 'animal spirits' needed to support an expansion of the stock of existing assets (outside the mining sector), not just a re-pricing of existing assets. There are some encouraging signs here. Nonetheless, if reports are to be believed, many businesses remain intent on sustaining a flow of dividends and returning capital to shareholders, and less focused on implementing plans for growth. Any plans for growth that might be in the top drawer remain hostage to uncertainty about the future pace of demand. That's actually nothing new. It's pretty normal at this point of the cycle. There is always a period in which people can see that many of the conditions for expansion are in place but aren't yet fully confident it will happen. Nor is it confined to Australia. The gap between financial risk taking and 'real economy' risk taking is seen globally at present. It is reasonable to expect that, at some point, this will change. After all: Business will need to respond to trends that foreshadow sustainable increases in demand and incomes. Not all that response will come from the large established players; a significant proportion will come from smaller and newer players, most of which operate 'below the radar'. The financial capacity to provide credit prudently will help them do so. At some point, if these responses start to gather pace, the sorts of forecasts we are setting out at the moment will very likely prove to be conservative. The frustrating thing is that no one can say when that will happen, or just what might be the proximate trigger. In the interim, monetary policy's contribution to this process is to lend support to demand, consistent with its obligations to seek full employment and price stability as set out in the inflation target, and taking due account of financial stability considerations. This has resulted in very low interest rates, and as noted earlier financial conditions in Australia have in fact eased a little over recent times even though the cash rate has not changed. In reaching its decisions, the Board has been mindful of allowing time for measures already taken to have their effects, and of the very considerable limitations for monetary policy in fine-tuning economic outcomes over short periods. It has also seen some value, in the present circumstances, in maintaining a sense of steadiness and stability. My colleagues and I await your questions.

r140903a_BOA

australia

stevens

Thank you for the invitation to visit Adelaide. As you know the Reserve Bank Board met here yesterday and decided to leave the cash rate unchanged. The statement issued after the meeting gave the reasoning for the decision, in the usual concise fashion. Today I will give some broader remarks about the global and domestic economies and financial conditions. The global economy has continued its expansion this year. Estimates for global growth are running at about This is a bit better than the 2013 outcome and close to, albeit a little below, the three-decade average, which is 3.6 per cent. We are now in September, so unless something pretty dramatic happens soon in one of the large economies, those estimates should be a pretty accurate guide to the annual outcomes. For Australia's particular group of trading partners, weighted by export shares, growth is running at about which is somewhat the 30-year average. This strength reflects the continued increase in the weight of China as a destination for exports. Even though China is growing more slowly than it used to - at a mere 7 1/2 per cent this year - the fact that its growth is so much stronger than most others combines with its increased weight to push up the weighted-average growth of our trading partner group. The determined pessimists among us will see the increased weight of China as a concern: what if something goes wrong and the Chinese economy experiences a sharp slowing in growth? In fact this is a question that could be put for most economies now - nearly 50 economies, including the United States, European Union, Japan, Russia and Canada, now have China as their number 1 or 2 trading partner. The full ramifications of the continuing rise in the weight of China's economy and, in time, its financial system in world affairs will be the topic for numerous lengthy books. But in short, the whole world is now more dependent on China than it was. For today, probably the most important point to note is that the near-term task of the Chinese authorities is to manage the desired slowing in credit growth and moderation in asset values. Housing prices are falling in many Chinese cities at present. This is not unprecedented - it is the third time in the past decade this has occurred. (Yes, house prices fall, even in China.) This area - the asset price and credit nexus - is the one to watch, more than the monthly exports or PMIs and so on. One of the most remarkable features of the international scene is the exceptionally low volatility of financial prices and the compression of risk premia. Yields on sovereign debt of the major countries are very low, the lowest on record in some cases. Spreads on investment-grade and financial corporate bonds have reached multi-year lows. Nowhere is this phenomenon more striking than in Europe. Two years ago, some major European countries faced a crisis of sovereign credit. Their governments were experiencing borrowing rates that suggested that markets had very serious questions about their budgetary sustainability. Now, these same countries are borrowing more cheaply than they did in 2007, prior to the eruption of the crisis - even though they are now carrying considerably more debt than they were back then. Corporate borrowing costs are similarly low. Investment grade bonds in the US and euro area and Australia are yielding only around 100 basis points more than the equivalent government bonds and even 'junk' bonds from these countries are, on average, yielding around 6 per cent or less. Some entities (Graph 1) have issued debt with 50 or even 100-year maturities. Given the uncertainty about the state of the world over that horizon, the returns on offer to investors in financial claims seem strikingly low. Another pricing puzzle is exchange rates. Many in Australia have commented at length about the relatively high value of the Australian dollar against the US dollar. The Bank has made its views on this pretty clear and so I won't reiterate them today. But it's worth noting that many other countries have had a similar puzzle to ours - so the real question is why the US dollar has remained as low as it has. Overall then, the global environment remains 'interesting', with significant challenges, uncertainties and puzzles. All that said, from Australia's point of view, the world economy continues to grow, inflation remains contained, our terms of trade though falling remain high, and financial conditions are remarkably accommodative. On the domestic front, we had the latest estimates of national income and spending today. The latest quarter was expected to be one of slower growth than the preceding one, which had been quite a strong one, in part because of some temporary factors which could not continue. Taking the two quarters together suggests a picture of moderate growth. There will no doubt be a huge amount of breathless analysis of these data and intense speculation about what they mean. It will be worth remembering to take a step back and look at the longer perspective. In that spirit, allow me to offer an update of a chart from a speech I gave here two years ago (Graph 2). Compared with last time I showed you this, it is pleasing that the US and the UK have recorded some solid growth, and New Zealand - one of Australia's closest trading partners - has been growing particularly well, as the task of re-building much of their second largest city gets into full swing. Some of these countries have been recording growth faster than ours lately. That they have sped up, and may even be starting to close the gap, should be welcomed. This chart was prepared prior to today's data so the line for Australia is not quite up to date. Even so, there is still not much doubt about which country, among this group, has had the most consistent performance. Of course these data are already somewhat dated. We can ask what has been happening more recently. The answer is that growth is continuing. Most survey indications are that business conditions have improved a little, and that household sentiment has recovered a fair bit of the fall seen in April and May. Those measures are close to average. We have seen the unemployment rate print higher in July, after several months where it had not changed much. Because of measurement issues, interpretation of that monthly figure is even more hazardous than usual, and this may remain so in the months ahead. Nonetheless, the data cannot be dismissed and are, on their face, concerning. Other indicators have mostly suggested a slight improvement in the labour market this year, not an accelerating deterioration. The Bank's reading, which we have had for a while, is that the labour market has a degree of spare capacity, and that it will be a while before we see unemployment decline consistently. Looking ahead, ideally, the non-mining part of the economy would see a further pick-up to grow a bit above trend for a while, having been below trend for a while up to recently. We may not be quite there yet, but we are I think slowly building a foundation for better performance. What can we do to help this? The main thing the Reserve Bank can do is run an accommodative monetary policy so as to lend support to demand in the non-mining areas of the economy. Rates of interest are at very low levels, and have been steady there for over a year now. Most observers expect they will be there for some time yet. The rate we actually set, the overnight rate, is as low as it has been on a consistent basis in my lifetime. Rates of interest that matter more for most borrowers are similarly very low, and in fact have been declining slightly even though the Reserve Bank Board has not changed the cash rate for over a year now. They are lower than in recent previous cycles, even though the economy today is nothing like as weak as it has been on most of those occasions. Monetary policy doesn't just work on the borrowers; the savers or investors matter too (and in fact there are more of them). The low returns on offer on safe investments in Australia, and the ultra-low returns on such assets internationally, are certainly having an effect by prompting investors to 'search for yield'. Not only are returns on financial instruments low, but yields on the existing stock of physical assets - houses, commercial property, infrastructure assets - are being bid down. Some of that search is of course coming from offshore. That's a big part of how accommodative monetary policy works: by prompting substitution towards higher-risk assets; raising asset prices, which increases collateral values and makes credit extension more viable; improving the cash flows of debtors; and so on. All those things are quite normal parts of the so-called 'monetary transmission mechanism'. In some ways that term is a misnomer because while some of the 'transmission' is somewhat mechanical, a lot of it isn't. It depends on the behaviour and general frame of mind of the myriad households, businesses large and small, investors and financial market players and so on. The final linkages in the 'mechanism' are those that connect changes in financial behaviour to changes in spending on real goods and services. And while high enough interest rates really can, more or less, force people to curtail their borrowing and spending, low rates can't them borrow and spend. They have to want to. The power of monetary policy to boost domestic demand depends importantly on some sectors of the economy being in a position to respond to lower costs of debt, higher collateral values, reduced incentives to save and so on, by spending more today, with confidence that their income in the future will allow them to service and repay the debt. Which sectors would be available to lead such an expansion? In the broad, there are three. There are households, governments and firms. Let's think about each briefly. Households being willing to increase their debt and lower the share of current income being saved was a striking feature of Australia's economic landscape from the early 1990s until just prior to the financial crisis. Consumption spending consistently rose faster than income and the ratio of debt to income went from about 60 per cent in 1993 to 150 per cent by 2006. Households are servicing that higher debt quite well - mortgages make up most of their debt and arrears are running at about one half of 1 per cent, which is low by global standards. But as I have argued before, it seems unlikely that household debt can rise like that .Nor would it be desirable. So while we can expect that household consumption spending can grow in line with income, or maybe a little faster given the rise in net worth over the past two years, the odds are against households being a driver of strong growth the way they were a decade ago. What about the government sector? Most governments in Australia are trying to strengthen their own balance sheets by containing the build-up in debt that has been occurring. Public final spending is scheduled, according to the stated intentions of federal and state governments, to be subdued over the next couple of years. In fact, it is forecast to record the most subdued growth for a long time. By and large then, the public sector is not in the phase of using its balance sheet to expand demand faster than normal. That leaves the business sector. What can we say about its balance sheet? The business sector is of course very diverse. But in the broad we can observe that its leverage is mostly low, and probably lower than it was a decade ago in most instances, in contrast to either households or governments. It also seems that holdings of cash have been increasing of late (Graph 3). The available data from the listed company sector show a modest increase, leaving aside the resources sector. Looking at data from the financial aggregates, we can compare the evolution of business credit and business holdings of deposits and like products, over time (Graph 4). This data includes fund managers' holdings of cash assets, which from other data appear to have risen by close to $200 billion since 2006. But overall, this comparison suggests a very marked improvement in the liquidity of the business (and fund management) sectors' balance sheet over the past five years. My conclusion would be that many businesses are in a position to play their part in the growth dynamic over time. The fact that in some areas outside of mining the level of gross fixed capital spending is barely above depreciation rates suggests that, over time, capital spending in those areas will have to increase. The forward estimates of non-mining business capital spending released recently do show a further upgrading of intentions. That won't offset the impending fall in mining investment and it would be good to see further, and more substantial, upgrades over time. But the available data suggest that things are at least heading in the right direction. This is not some call for business leaders to play a role in driving growth out of a public-spirited desire to help the economy. That would be a fruitless call because doing that isn't their job. Their responsibility is to run their companies in the interests of the companies' owners. My argument simply is that, at some point, it is going to be in the interests of the owners for investment to take place in new technologies, better processes, new lines of business and, in time, more capacity. At some stage, the equity analysts, shareholders, fund managers, commentators and so on will want to be asking not 'where's your cost cutting or capital return plan?', but 'where's your growth plan?' As business responds to trends that foreshadow sustainable increases in demand and incomes, some of the response will come from smaller and newer players. Some of these will probably be among the most innovative enterprises. There isn't much focus on what these entities are doing in the general commentary on the economy, perhaps because there are fewer established data sets. Measuring innovation and so on is less straightforward than measuring how many building approvals were issued in any given month. But my suspicion, admittedly based on some rather indirect measurement, is that innovation is occurring. For example, according to a regular ABS survey on innovation in Australian companies, the trend over recent years is for more companies to be developing innovations and fewer to be abandoning attempted innovations (Graph 5). We can also observe that growth in labour productivity per hour has picked up in the past couple of years, which suggests changes to practices in work places. And one crude gauge of 'animal spirits' - the number of new companies registered with ASIC - has been rising quite strongly since 2011 (Graph 6). No doubt there are all sorts of reasons for registering corporate entities, but perhaps this shows that there are some out there taking a And in the end, that's the vital ingredient for private sector growth. Having talked a little about what monetary policy can do to help the current situation, I need to be clear that there are also things that it can't do, and some things that it shouldn't do. Monetary policy can create conditions of easier funding and help the ability of the financial sector to extend credit. But it can't, for example, add to the supply of land zoned for housing, or improve the responsiveness of the construction sector to demand for additional housing stock. Other policies have to do that - and it's important that they do if we are to see easy credit result in more dwellings as opposed to just higher prices for the existing dwellings. Monetary policy can't create the additional infrastructure that most people agree we need. Funding conditions are not, in fact, an impediment to infrastructure. The real issues are governance, risk-sharing and pricing - areas where other policies have to be right. Monetary policy can't directly cause the innovation and technological change that is so important for wellbeing of our citizens over time. Other policy areas have to be right - and then the innovators and their backers have to be willing take the necessary risk. As for things that monetary policy should try to avoid, we are also cognisant of the fact that monetary policy does work initially by affecting financial risk-taking behaviour. In our efforts to stimulate growth in the real economy, we don't want to foster much build-up of risk in the financial sector, such that people are over-extended. That could leave the economy exposed to nasty shocks in the future. The more prudent approach is to try to avoid, so far as we can, that particular boom-bust cycle. It is stating the obvious that at present, while we may desire to see a faster reduction in the rate of unemployment, further inflating an already elevated level of housing prices seems an unwise route to try to achieve that. The future has no shortage of challenges, but that is hardly new. Sensible policies in many areas are needed to help with the required adjustments. That includes monetary policy, within the limits of its powers. A very accommodative interest rate structure, and a degree of stability and predictability, has been in place for some time now. Indeed the conduct of policy could perhaps be described as boring. If so, I would regard that as a small success. While the financial markets like to think about almost nothing else than what will happen to interest rates next month, I suspect most people are happy not to have to think about such things, and prefer focusing on issues of more enduring importance for their business or their lives. And it's those things that, well attended to, will deliver our future prosperity and wellbeing.

r140925a_BOA

australia

stevens

Well, thank you, Ross, and thank you for the invitation to be here, and I very much enjoyed listening to Kevin's introduction to a number of the issues. What I'm going to do is to talk a little bit about the context. I was invited to come and talk about things to do with the inquiry, not macroprudential tools per se, or monetary policy for that matter, which will disappoint many, no doubt. But I want to talk about some of the context in which the inquiry has been working and a few observations about some of the issues that they're taking up. The context is quite interestingly different to the context of predecessor inquiries. If you think back to Campbell, it was overtly deregulatory. That came after a long period of intense regulation by which time, I think, we had become quite attuned to the limitations of that regulatory world. And so Campbell was very deregulatory. Actually, it took quite a long time for the implications of that liberalisation to work through. Probably the regulatory changes themselves and the admission of foreign banks and the float of the dollar and so on, that was all completed by the mid-eighties, but it wasn't until the mid-nineties that we then had the burst of new banks in the system, a very big run-up in credit, the leveraged entrepreneurs flew high and then crashed. The banks licked their wounds and began to recover. So that takes you up to about the mid-1990s. Then we had Wallis. And that, I would say, responded to some very interesting and important trends that were taking place. It had a focus on regulatory architecture, on payments issues - some of the ones Kevin has just talked about - technology and so on. Some of the things foreshadowed by Wallis perhaps didn't turn out, but I think the regulatory architecture that resulted from that work that we still have, has turned out to work reasonably well. Of course, Wallis, we now know, reported right in the middle of what internationally is known as the Great Moderation, the nicest period of macroeconomic stability globally, at least since the sixties. And certainly in this country, relative economic performance compared to the rest of the world, the best, probably, since World War II. So that was a very benign period. This inquiry, of course, comes post a very serious crisis. That crisis had a less deleterious effect on Australia than elsewhere. I think it's fairly well accepted that the regulatory setup in Australia, largely a Wallis era design, serves us pretty well. That isn't to assert it's perfect - I wouldn't assert that - or that no adjustments might be made or that there are no lessons; there certainly are. But basically, it worked reasonably well. And so, it strikes me that proposals for radical reform there are probably not getting much traction, though ideas for some adjustments may deservedly get attention. So we were able to stabilise the system actually fairly quickly and fairly effectively when the crisis really erupted seriously. And I think one reason for that is that the major institutions were actually adequately well capitalised ex-ante. And they are able to go to the market credibly - not long after Lehman failed, actually - and get more capital. And they stayed strong throughout, which says something about their management and, I think, supervision. But, of course, globally - so that's Australia - globally, the crisis was easily the worst of its kind for a very long time. And so that has fundamentally changed the pre-existing balance between liberalised markets and regulation. The conclusions that are being drawn, you all know them. The largest banks globally had nothing like enough capital. There was inadequate visibility of risks they were running. There was a lot of interconnection through capital markets and derivative markets, more than had been appreciated, and a lot of so-called shadow banking turned out to be quite risky. Some segments of capital markets closed. Interestingly, in Wallis, the capital market and its role in funding the economy was seen as very important. It turns out that some segments of those markets actually closed post-Lehman. Extensive public intervention was required to stabilise this internationally, and even now that intervention continues. It's certainly not behind us in some jurisdictions; think of Europe, for example. And then that's before we mention the conduct issues that Kevin talked about. So, on the one hand, the inquiry has the Australian experience, which has actually worked out reasonably well - not perfect, but pretty good - and on the other hand, globally, a sense of regulatory failure prior to the crisis, and the scope and intensity of regulation globally has gone up by orders of magnitude. I can tell you from personal experience just trying to keep up with all the initiatives and the 72 work streams that the Financial Stability Board has - that is not an exaggeration - is a full-time job. So that's a very different global environment. And so the inquiry, I think, has the opportunity to help us develop a nuanced understanding of why we did relatively well through the crisis; also to help us avoid complacency about that success; and it can help us think about what we can learn from the lesson - the problems and experiences of others - what other challenges might come our way and what further developments of our own system might be in order. One thing that is clear in the inquiry, I think, from the interim report is the need for Australia to continue to adopt international standards. Well, I very much agree with that. It's sometimes inconvenient to adopt international standards, but we have a good record of doing so. We have a good record, also, of, I would say, adopting them in a way that's sensible for our circumstances. A good example of that is the liquidity coverage requirements which will come in in another year or so. There's not enough government debt in Australia for our banks to comply with that, so we invented another way of doing it - the Reserve Bank and APRA designed it - through our Committed Liquidity Facility, that will enable compliance with the same sort of pricing as there would've been had there been enough government debt for the banks to hold. So that's an example of applying the international standard, but doing it in a way that works and makes sense in our setting. It's sometimes objected that we're going above the international standards, maybe in how quickly we moved to Basel III, or in the fact that we have, in certain ways, more demanding standards for what you can call capital in Australia. Well, what I would say about that is the international standards are minima, not maxima. It's served us well to be above them at times in the past - I think we tend to forget that - particularly on the definition of capital, where the rest of the world, if anything, has moved in the direction of the place where APRA has always been on that. And I think the evidence that being more demanding in these various respects, having led to material difficulties for our banks in raising funds or growing their businesses or returning profits to shareholders, well, I don't think there is all that much evidence of any significant adverse affect from high standards. The interim report of the inquiry has a balanced view on regulation, accepting that while we don't assume it's needed in every case, sometimes it is. There is, I think, generally, support for the overall structure of regulation, and there is a call for regulators to be strong, independent and accountable. I want to emphasise that. I think that's very important. It's long been accepted that central banks ought to be independent within their mandate, and also accountable. I think it's equally important for bank supervisors and other financial regulators to be just as independent. And it's important that we maintain that as we go into an era of restraint on government resourcing. I think it's very sensible that the inquiry has a focus on the efficiency of the administration of the superannuation system. I don't start with a presumption that there's a problem there. I simply observe that something that's 100 per cent of GDP in size probably matters. If it's run efficiently or not, and that's a question at least worth asking, without having any particular predisposition as to what the answer might be. One of the important issues that the inquiry is grappling with, and we all are, is too-big-to-fail. That is very much in the minds of the international regulatory community. And the responses here - I guess you know them all. They're mainly in two dimensions. One is more capital and better capital, so as you lower the likelihood of failure of a globally systemic institution, and the other part is building better resolution capability in the event that a failure is about to happen. That does involve - at least the proposal that will come forward ahead of the leaders' summit in Brisbane, and which we talked about in Cairns just last week, will involve proposals for bailing-in certain classes of creditor when an entity is on the brink of failure. And the intent of all that, of course, is to at least obviate the need, if it all possible, for public funds to step into the situation. This is a complex area, as Kevin laid out, I think very well. There are many reasons for caution here. Not least that, as far as I know, there are very few, if any, examples of large scale bail-in of senior unsecured creditors to resolve a large bank working successfully. You know, in theory, this is possible. To my knowledge, it hasn't been done in practice. It doesn't mean it can't be done, but there are various considerations to think through here, and great care in design is required. And I think the inquiry has understood that very clearly. So that's very welcome. The other thing to say about resolution, of course, is that it's more than just about bail-in. Actually, equally important, is the requirement to have extensive cross-border cooperation. We're talking about G-SIBs here, globally systemically important banks. Inevitably, a failure is a cross-border event, so cooperation across borders, recognition of resolution actions that are taken in other countries, stays on derivative contracts temporarily so people don't rush for the exits and try to grab all the collateral, all these things are just as important, in the resolution of an entity like that, as being able to bail-in creditors. And I think it's fair to say that the experience post-Lehman showed how hard it is to do that cooperative action across borders. So there are many issues in addressing too-big-to-fail. It's complex. It's possibly intractable. We should proceed carefully. But I suppose the other thing to say is, if we think if we just sort of ignore it and it'll go away, probably that's not the right strategy. The best course, surely, is for some concrete proposals internationally to come forward, as they will in Brisbane. They're proposals - they're not an agreement - they'll be tested with a quantitative impact assessment, extensive consultation and so on, and that'll take probably a year before final proposals could be agreed, and then it will take some years, I would guess, for the proposals to actually come into force. These are for global systemic banks. They're not for domestic ones; so not directly applicable in our case. But the thinking and the analysis no doubt will inform our own contemplation of those issues for Australia. I suppose I would say that if we're going for more loss-absorbing capacity generally, personally I think if a fair chuck of that actually came from equity, that will be a good thing, though the international proposals will include some kind of minimal requirement for bail-in-able debt. Stepping back from all that, just before I finish, I guess we can ask, what is it we want the financial system really to achieve? And we set this out in our submission to the inquiry. I think there are four things. We want allocation of savings efficiently. We want liquidity services provided to the community. We want payments services to be provided. And we want - we want risk to be priced, properly allocated around the system to those who wish to bear it and know what they're doing. For that to happen, we need risk to be recognised fully, and we need to be clear about who bears it. Let me say clearly that there is a very important sense for the economy in which risk-taking is good. Risk-taking is good. Risk-taking is not, per se, bad. Right now, of course, a feature of the world economy is there's a lot financial risk-taking, not all that much real economy risk-taking, the entrepreneurs with a project, an idea, a market, a product, a new worker, that kind of risk-taking, which is the one we really want. There's less of that than we would like, and quite a lot of financial risk build-up, and that's the inherent tension that the global central banking and regulatory community are grappling with. But that risk-taking, that real economy risk-taking, is good, and we want the financial system to be able to be support that, effectively support the economy but not bring the economy down. In the words of Ed Friedel, a former colleague from the Federal Reserve Bank of New York years ago, we want the financial system to be the handmaiden of industry, not the Queen of England. I think that is key. So we want risk to be recognised in the system. We want it to be clear who bears it. And the right kind of risk-taking is good, provided it's clear who bears it and that those who are bearing the risk and getting the return can be left to bear the losses when it turns out to be losses, and that of course brings you to too-big-to-fail and why this is inherently so hard. One final point about too-big-to-fail, I guess, is the proposals that will come for it are about idiosyncratic events. So if they're about a set of events that might push one major systemic institution to the brink of failure, with all the attendant spillovers that they may bring, they're not really going to be able to be adequate protection against the systemic situation where all of the large institutions are in trouble, and I think on that, to be frank, there will be events sufficiently far out in the tail of the probability distribution where the private sector risk absorbency will never be able to be enough, at least not at any sensible price. And so if one of those events happens, God forbid, then the public sector, the regulators, are still going to be faced with a difficult decision of what to do. I think what the too-big-to-fail agenda, globally, is trying to do is address the problem that we face that events which were not that far in the tail, actually, turned out to have a sufficiently big impact on the global banking system that the system needed a public rescue. So we don't want to repeat that. We want to make sure that the tail events that would really bring in the public purse really are very much right out in the tail and not just a 1 in 10 or 1 in 20 sort of event. So they're my reflections, Mr Chairman, and I think as I say, the inquiry comes at an interesting time, and it provides the opportunity for us as a community to grapple with some of these issues in a timely and thoughtful way, and I think it's on a very good track to achieve that.

r141023a_BOA

australia

stevens

Thank you for the invitation to speak on the occasion of Australian Payments Clearing Association's (APCA) Annual General Meeting. The Reserve Bank and APCA have a long history of working constructively as they carry out their respective responsibilities in Australia's payments system. We both have an interest in ensuring a safe, efficient and competitive payments system that meets the needs of end users. When I last addressed an APCA gathering in May 2012, we were at a particularly interesting juncture for the payments industry. The Bank was approaching the end of a two-year period of public discussion and consultation about innovation in the payments system. This extensive public process, involving all the key industry players and users of the payments system had not been done before. After a roundtable attended by most members of the Payments System Board, numerous meetings at staff and management level, extensive feedback about published material and so on, the Bank released the conclusions of its Strategic Review of Innovation in the Payments System in June of that year. The Reserve Bank regards that document, and the process that led up to it, as a landmark for the payments system in Australia. Interestingly enough, the Innovation Review was not mainly motivated by concerns, on our part, that innovation was not occurring, even though it was sometimes claimed that the regulatory regime inhibited it. On the contrary, we were seeing, and continue to see, rapid innovation in some elements of the system, as financial institutions, payment schemes and a variety of other players seek to deploy new technology to compete with one another or to draw business away from traditional payment forms like cash and cheques. The most obvious recent example is the use of contactless payments. In mid 2012 relatively few of us would have made a contactless payment. Now they have become second nature to most of us and Australia has become the leading contactless market in the world. While this does not represent a fundamental change in underlying payment systems, it is a quite significant change in the way consumers interact with the payments system and changes the cost of payments to both merchants and consumers. Our recent diary survey suggests that the adoption of contactless has largely reflected a switch from traditional contact-based card presentment, but that there has also been some displacement of cash, particularly at smaller transaction sizes. We are also now seeing the roll out by several players of mobile-phone-based point-of-sale card acceptance facilities, where an intermediary provides a merchant some form of attachment to a smartphone or tablet, turning that phone or tablet into a card-acceptance device. This has significant potential to spread further the appeal of electronic payments to smaller businesses. At the same time, a clear trend towards online commerce and online banking is leading to a rapid increase in remote - as opposed to point-of-sale - payments. This is likely to be an area of increased competition, but is also the focus of increased efforts to improve the security of payments. Overlaid on all this is a proliferation of new models for using existing payment methods and indeed some proposals to change fundamentally the way we think about payments. The one area where there has been less progress than we might have expected in 2012 is 'mobile wallets' for point-of-sale payments, i.e. where a consumer's card or account information is incorporated into a phone application and the phone becomes the consumer's payment device. Of course, this may well change quickly at some point. So innovation is proceeding. It would seem premature to expect that we have seen the apogee of technological development in the payments space. More likely it will continue, in ways that are impossible to predict but are likely to be 'disruptive' - the adjective of choice these days. But there is a key caveat here. Innovation in the payments system is not just a matter of technology - as remarkable as the extent of technological advance has been. We have had rapid innovation in areas where individual entities can innovate on their own, or where a central scheme has the capacity to push innovation out to its members and/or users. These innovations can provide significant benefits, but by themselves are not enough, in the Bank's view, to deliver the policy goals set for the Payments System Board in its mandate. The setting within which innovation occurs also matters. The Innovation Review recognised that, in networks, where the ability of one institution to deliver value to its customer is dependent upon how well it can connect with all the other institutions and their customers, the full flowering of innovation depends to no small extent on system architecture, as well as governance. The technical architecture - for example, hub-and-spoke architecture versus bilateral links - can make it easier for new or established players to take advantage of technological change to bring new services to customers, or harder. Governance around processes can be accommodating to change or resistant to it. Overall, the record in Australia in instances where innovation requires cooperation between established players, especially where one or more of them feels the need to protect an existing line of business, is mixed. We are all aware of important cases where things have run into the sand. This isn't just a problem for the industry. It's a problem for the users of the system as well. Innovation in the 'cooperative space' - where no single entity has control - is critical because it is this space that determines the limits on the services that the rest of the payments system can provide. These issues have been a matter of concern for the Payments System Board for quite a long time. The Board has always seen fostering innovation as part of its 'efficiency' mandate under the . An important speech by Philip Lowe as long ago as 2005 focused on payments system architecture (in particular the bilateral nature of a number of important payment systems), the limitations of governance arrangements and the challenges for the industry in making cooperative investment decisions. His overall observation was that the then-existing arrangements were hindering innovation. Of course the technical architecture of systems is largely a legacy of decisions taken in an earlier era, probably for good reason at the time. Changing that architecture is difficult and costly, though that is not a reason not to try, and certainly not a reason not to adopt, better architecture for new systems. The establishment of ePAL, for example, has provided an opportunity to improve the network architecture of the eftpos system to allow it to better adapt to the demands of the modern economy. There have also been some important developments in industry governance. First, APCA itself has this year implemented some significant reforms to its governance. The new board structure includes representatives of the major banks, the mid-sized and foreign banks and the credit unions and building societies. It also includes an independent chair and two other independent directors. New types of players are also represented at other levels within the APCA structure, better reflecting the make-up of the modern payments system. APCA's willingness to make these changes is to be commended. Second, APCA and the Reserve Bank have also worked jointly towards the formation of a new body that is intended to take a higher-level, more strategic view of the payments system. This is a direct response to one of the important conclusions of the Innovation Review - that some of the difficulties that institutions faced in undertaking collaborative innovation might be alleviated by the creation of a body that would have senior-level representation from a wider range of organisations than have traditionally been members of APCA. The resulting body is the Australian Payments Council. The Council, which will have its first meeting next week, comprises 14 members, including from institutions typically represented on APCA's Board, plus representatives of payment schemes, retailers with their own payments infrastructure and other payment services providers. The Council will have an independent chair and representatives from APCA and the Reserve Bank. The formation of the Council is a very important development. The Payments System Board expects it to take an industry-wide view as to how the payments system can better meet the needs of end users. On that basis, the Board looks forward to active engagement with the Council. That in no way indicates that we see a lesser role for APCA. On the contrary, APCA's role continues to be very important, including in some aspects of self-regulation and facilitating industry collaboration in determining rules and standards for the five different clearing streams that APCA oversees. APCA has also been active in thought leadership and advocacy for the payments industry. For example, APCA is currently playing a role in thinking about transitioning payments to the digital economy. It has published a series of 'Milestones' reports - the most recent in July - looking at developments in the use of payments, and in particular the decline of cheques and the transition away from cheques and cash towards electronic payments. Not surprisingly, the reports highlight that use of electronic payments is continuing to grow strongly, while use of the traditional paper-based payments is falling. This, I might add, is consistent with the findings in the Bank's recent consumer use survey. Our study - the third of its type - provides transaction-level data from a survey of over 1,000 consumers. It found that cash remained the most frequently used means of payment in 2013, though its use had declined noticeably over the previous three years. Cash accounted for 47 per cent of the number and 18 per cent of the value of all payments in 2013, down from and 29 per cent respectively in 2010. Cash was used particularly intensively for low-value transactions, with consumers using cash for around two-thirds of payments under $20. While the use of cash is declining relative to other payment mechanisms, it will continue to have a role in the economy. Indeed, as the Bank has noted previously, banknotes on issue have for a long period grown broadly in line with the nominal growth in the overall economy. And the consumer use survey suggests the amount of cash in respondents' wallets grew between 2010 and 2013. Together, this evidence suggests that cash continues to have a significant role - not just for small-value transactions, but also both as a store of value and for precautionary use when other means of payment are not available. This is one of the reasons that the Reserve Bank is undertaking its Next Generation Banknote program, which will ensure that Australians can continue to have confidence in the nation's banknotes as an effective means of payment and secure store of wealth. But this is not inconsistent with the Bank's desire to encourage the efficient use of electronic payments. A more marked decline is evident in the use of cheques. The number of cheques written in Australia peaked around 1995. Since then, the number of cheques written each year per capita has fallen by more than 80 per cent (from ). Over the same period, the number of electronic payments per capita has risen by more than 400 per cent. As the use of cheques has fallen, the per-cheque cost to financial institutions and businesses has generally risen. The market has, and continues to, respond to these pressures by looking for more efficient ways to process cheques, but they are clearly the highest cost payment instrument, as will be confirmed when the Bank releases its payments cost study later this year. This decline in the use of cheques, a very expensive payment instrument, is one that the private and public sector will have to manage. Part of that will involve the introduction of effective and readily available substitutes for users, and initiatives such as Superstream and eConveyancing are likely to be part of this. Central to the industry's efforts to develop new payment products and services will be the New Payments Platform (NPP). I would like to use my remaining time to make some comments about this important project. A key point in the Innovation Review process was the industry roundtable held in 2012, focusing on the familiar themes of payments system gaps, governance and architecture. My recollection of the discussion was that there was fairly widespread acceptance that the industry would need to find a way to make some bold decisions about cooperative investments in payments system infrastructure not too far down the track. This has been echoed in subsequent views expressed by some of the key players. The Reserve Bank agreed. The Payments System Board has seen its own role as acting as a catalyst for that cooperative investment. In the Conclusions to the Innovation Review, the Board announced its intention periodically to set some strategic objectives or general goals in terms of the services that the payments system should be able to provide to end users. The five strategic objectives that the Board set in 2012, after lengthy consultation and with, I think it can be said, a wide consensus within the industry, were as follows: The first of these, the same-day settlement of direct entry payments, was achieved in 2013. It is therefore now possible for recipient financial institutions to make funds available to their customers sooner, without incurring credit risk. The Bank worked closely with the industry to facilitate same-day settlement, including the introduction of new liquidity arrangements for exchange settlement accounts at the Reserve Bank. These new liquidity arrangements will also be important as the industry moves to meet the other four objectives from the Innovation Review. On those other objectives, the Payments System Board set out a proposed time frame. It also offered one piece of guidance, namely the suggestion that it would be desirable to have all payments system participants connecting to a central hub or hub-like arrangement in any new payments infrastructure, as opposed to continuing with the numerous bilateral linkages that have proved to be not particularly conducive to either innovation or competition. Beyond that, the Board did not seek to dictate particular technical details of the solution, accepting that the industry itself should provide the road map to the agreed destination. One initial concern was that industry participants might respond with a number of separate solutions, but no clear path forward. APCA has played a constructive role in helping the industry to come together to form a project that will meet these four strategic objectives. Initially, a small committee developed a proposal for new payments infrastructure that is now being called the New Payments Platform. After this proposal was welcomed by the Payments System Board in February 2013, a broader group of 17 institutions came together to fund the initial development of the project. The participating institutions have been going through the final stages of vendor selection in the recent period. This has been an industry-driven process, in pursuit of the goals articulated by the Board, and to which the industry has committed. We have detected considerable interest internationally in this approach - not just the design features being proposed for the NPP, but also the way the central bank and the payments industry are seeking to work collaboratively to achieve major change. This approach, however, is not without its challenges. It requires that industry leadership and collaborative spirit be maintained over a sustained period. At various key moments the project faces the risk of that spirit breaking down. The Reserve Bank is fully aware of how complex and far reaching this project is, and how costly. Our own contribution to the settlements architecture is a major project for us as well. Having said that, let me also say, very clearly, how important the Bank sees it that the industry deliver on its collective commitment to deliver real-time, accessible payments to the community. The Bank is also aware that there could be a temptation along the way to seek to constrain the system, so as to conform to existing boundaries and business models. This is where the broader governance arrangements now in place need to take into account the interests of users and the need for the system to be open to competition, not just the interests of the existing players. We - the industry and the Reserve Bank itself - are building a piece of national infrastructure. We should take every opportunity to increase its potential value to the nation, rather than limiting it for fear of where it might take us. The biggest risk with this project is probably not a technical one. It is the risk that, in 10 or 15 years' time, we will look back and see that we missed an important opportunity to provide something that will fully and efficiently support the payments needs of our economy. We owe our citizens a better outcome than that. We have to deliver, one way or another, the architecture and products that they will need into the future. It is not as though things are standing still in other jurisdictions. In the area of real-time payments, we have seen major initiatives launched in Sweden and Singapore - countries we would often view as comparators in terms of their income levels and market structures. The Swedish system was launched in December 2012 with a service known as Swish, which enables households to send real-time payments via their mobile phones on a 24/7 basis, 365 days a year. Singapore's system, known as FAST, was launched in March this year. These two initiatives have wide participation, including by all the larger banks in those countries and many of the smaller institutions. There are some other countries, with lower income levels, lower penetration of electronic payments and without universally 'banked' populations, that have also made the leap to fast retail payments. These include Mexico with its SPEI system, South Africa with Real-Time Clearing and India with its Immediate Payments Service. Is there a plausible reason to accept Australia falling behind? Delivering the NPP is also, in my opinion, in the interests of the Australian financial institutions, which are at the heart of payments today. It can be expected to lead to further growth in electronic payments and a reduction in costs. It will maintain the ongoing relevance of the current players. If those players do not provide Australian end users with the services they want, surely others will seek to do so. Alternatively, the Reserve Bank would be duty bound to consider a regulatory approach. So our message to the industry is: stay the course. Continue the goodwill and prodigious effort that has brought you to this point. Deliver on the commitments you have collectively made. Let us together build a payments infrastructure that is efficient, open to competition and that will support innovation into the future. I thank APCA and its officers in particular for the efforts they have made, and continue to make, in the NPP and across the payments landscape. And I wish the broader payments industry success in its efforts to improve Australia's payments system and look forward to ongoing cooperation between the Bank and the industry.

r141118a_BOA

australia

stevens

Thank you again for inviting me to address CEDA's Annual Dinner. Tonight marks the fifth time I have done so, and it continues a long tradition. My first venture to your gathering in 2006 talked about the role of finance in economic development. An important part of the story was that, through history, financial development and innovation went hand in hand with the extraordinary growth in living standards that flowed from the industrial revolution. Another part was that financial development did not come without its risks, which on various occasions in history had materialised in damaging, or even devastating, fashion. In 2006 we were talking, among other things, about the rise in debt of Australian households and the various risks that might accompany that. We had had a 'stress test' focused on such issues, conducted as part of the International Monetary Fund's Financial Sector Assessment Program. The results had been pretty good actually, but we were not sure how reassured we should be by them. And we talked about an increase in risk-taking in certain parts of the corporate sector that was occurring at the time, and wondered how that would all turn out. We didn't have to wait long for answers to those questions. The next time I came to CEDA in 2008 the global financial crisis had erupted and the global economy and financial system were facing their darkest moments since the 1930s. The G20 Leaders had just met in Washington and taken the first steps towards putting the global financial system back on a sound footing. By then economic growth in Australia had already begun to moderate, but we feared a much more significant slowing could be in prospect. Confidence was shaken and, understandably, households and businesses became much more cautious about spending, taking on more debt, or investing in a new process or idea. The deteriorating global outlook also led to large declines in asset prices and the prices of commodities important for Australia. The feeling at the time was that the terms of trade, which had risen substantially as prices for minerals and energy had reached very high levels, had probably peaked. The falling terms of trade were expected to subtract noticeably from growth in national income over the subsequent period. It's a matter of record that, due to a combination of factors, Australia's economy and its financial system came through that real-life 'stress test' remarkably well, all things considered. And, as it turned out, the boom in our terms of trade had further - a lot further - to run. By the time of the 2010 dinner, it was time to introduce this chart, which has been a feature of my presentations since then. The terms of trade had just broken through the peak of two years earlier and, on a five-year moving average basis, were at their highest level since Federation (Graph 1). Our assumption was that the terms of trade would probably peak that year, in 2010, before declining steadily over the next few years. Updating the chart two years later, that assumption was shown to be somewhat pessimistic. The terms of trade peaked in September 2011, about 12 per cent higher than we had previously forecast and 12 months later (Graph 2). The chart was by now sporting a decade-long average, to emphasise not just the level of the terms of trade but the persistence of the episode - even though we were not assuming it was 'permanent'. The terms of trade had, however, finally started to decline. It has been a standard assumption since then that they would fall further. And so they have. In the latest version of the chart, the terms of trade have fallen by about 13 per cent since two years ago and by 22 per cent since their peak (Graph 3). As additional supply of commodities comes on line (including particularly from Australia) and demand grows perhaps more slowly than it has until recently, our best guess is that the terms of trade will fall further but remain at a level well above the standard of the past century. But of course, as this history amply demonstrates, such forecasts - all economic forecasts - have a wide range of uncertainty. This is something the Bank has emphasised more strongly over the past couple of years in our published material. The increase in the terms of trade prompted a surge in investment to increase supply of the commodities that were now commanding very high prices. Two years ago we expected capital expenditure by resources firms to peak at about 8 per cent of GDP and then decline. This updated chart shows what an extraordinary period of investment this was (Graph 4). The peak has been reached and mining investment has since declined to about 7 per cent of GDP. The detailed information we receive from liaison suggests that this decline has quite a long way to go yet, though there are still some large projects ongoing in the gas sector that will hold investment for a few years at what would once have been seen as very high levels. As the expansionary effect of very high levels of mining investment is unwound, even if only partly, other sources of demand will need to play a stronger part in driving growth in the economy. It's very clear that growth in export volumes for resources is very strong. Indeed, the contribution of 'net exports' to growth in real GDP has over the past year or two been the largest for more than a decade. Even so, we need stronger growth outside the resources sector. After several years of quite subdued growth, we estimate that non-mining activity has picked up some speed over the past year (Graph 5). But it would be good to see some further strength here, as the decline in mining investment activity continues. There are sufficient spare labour resources such that we could probably enjoy a couple of years of non-mining sector growth somewhat above its trend rate before we needed to worry too much about serious inflation pressure. The non-resource traded sector could contribute to such growth. The decline in the exchange rate will be of some help here, but the currency remains above most estimates of its fundamental value, particularly given the further declines in key commodity prices in recent months. An exchange rate more in line with fundamentals would be a helpful contributor to a balanced growth outcome. As for domestic sources of demand, an obvious contributor is the set of forces at work in the housing sector. Investment in new and existing dwellings is rising. It ought to be possible, if we are being sensible both on the demand management side and the supply side, for this to go further yet and, more importantly, for the level of activity to stay high for longer than the average cyclical experience. A high level of construction, maintained for a longer period of time, is vastly preferable to a very sharp boom and bust cycle. That alternative outcome might give us a higher peak in the near term, but then a slump in the housing sector at a time when the fall in mining investment is still occurring. A sustained period of strong construction will be more helpful from the point of view of encouraging growth in non-mining activity - and also, surely, from a wider perspective: housing our growing population in an affordable manner. Considerations such as these are among the reasons we ought to take an interest in developments in dwelling prices, the flow of credit towards housing purchases, and the prudence with which these funds are advanced. It is perhaps opportune to offer a few observations on this topic. Having fallen in late 2010 and 2011, dwelling prices have since risen, with the median price across the country up by around $100,000 - about 18 per cent - since the low point. Prices have risen in all capitals, with a fair degree of variation: the smallest increase has been in Canberra, at about 6 per cent, and the largest in Sydney, at . Credit outstanding to households in total is rising at about 6-7 per cent per year. I see no particular concern with that. When we turn to the rate of growth of credit to investors in particular, we see that it has picked up to about 10 per cent per annum over the past six months, with investors accounting for almost half of the flow of new credit. It is not clear whether this acceleration will continue or abate. It is not clear whether price increases will continue or abate. Furthermore, it is not to be assumed that investor activity is problematic, . A proportion of the investor transactions are financing additions to the stock of dwellings, which is helpful. It can also be observed that a bit more of the 'animal spirits' evident in the housing market would be welcome in some other sectors of the economy. Nor, let me be clear, have we seen these dynamics, thus far, as an immediate threat to financial stability. The Bank's most recent made that clear. So we don't just assume that all this is a terrible problem. By the same token, after all we have seen around the world over the past decade, it is surely imprudent not to question the comfortable assumption that it is all entirely benign. A situation where: should prompt a reasonable observer to ask the question whether some people might be starting to get just a little overexcited. Such an observer might want to satisfy themselves that lending standards are being maintained. And they might contemplate whether some suitably calibrated and focused action to help ensure sound standards, and that might lean into the price dynamic, may be appropriate. That is the background to the much publicised comment that the Bank was working with other agencies to see what more could be done on lending standards. Let's be clear what this is not about. It is not an attempt to restrain construction activity. On the contrary, it is an attempt to stretch out the upswing. Nor is it a return to widespread attempts to restrict lending via direct controls. That era, that some of us remember all too well, was one in which the price of credit was simply too low and credit growth too high all round. We don't have that problem at present. That growth of credit to many borrowers remains moderate suggests that the overall price of credit is not too low. In fact the level of interest rates, although very low, is well warranted on macroeconomic grounds. The economy has spare capacity. Inflation is well under control and is likely to remain so over the next couple of years. In such circumstances, monetary policy should be accommodative and, on present indications, is likely to be that way for some time yet. But for accommodative monetary policy to support the economy most effectively overall, it's helpful if pockets of potential over-exuberance don't get too carried away. Turning from housing investment to investment more generally, a more robust picture for capital spending outside mining would be part of a further strengthening of growth over time. Some of the key ingredients for this are in place. To date, there are some promising signs of stronger intentions, but not so much in the way of convincing evidence of actual commitment yet. That's often the way it is at this point of the cycle. Firms wait for more evidence of stronger demand, but part of the stronger demand will come from them. With respect to consumer demand, I should complete the picture by showing an updated version of the relevant chart from last time. In brief, not much has changed. The ratio of debt to income remains close to where it has been for some time (Graph 6). It's rising a little at present because income growth is a bit below trend. Household consumption growth has picked up to a moderate pace and has actually run ahead of income over the past two years. Given that household wealth has risen strongly over that period, and interest rates are low, a modest decline in the saving rate is perhaps not surprising and indeed we think it could decline a little further in the period ahead. As I've argued in the past, however, we shouldn't expect consumption to grow consistently and significantly faster than incomes like it did in the 1990s and early 2000s, given that the debt load is already substantial. When last I was here there were early signs of a pick-up in productivity growth, after a number of years of much slower growth. The most recent data, as measured, confirm that labour productivity has now grown faster over the past three years than it did on average over most of the 2000s (Graph 7). This is observable across a wide range of industries outside of the utilities and mining sectors, where some unusual forces have been at work. The standard caveats apply, of course, and it is too soon to draw strong conclusions. Nonetheless, the evidence is at least consistent with the hypothesis that productivity growth is on a better track than it was. Business models have been challenged by the substantial change occurring in the structure of the economy, itself a response to changes in relative prices, in technology, the high exchange rate and other forces. The good news is that businesses can respond to that, and they are doing so. This process will need to continue and, as you will recall, there is the 'to do list' set out by the Productivity Commission. But there is also, I think, a broader set of questions increasingly being asked, about whether our overall business environment is conducive enough to risk-taking and innovation, and whether we are doing enough to develop the relevant competencies. The questions would include ones like: how easy is it to start a business? If the business fails, as many small ones do, is it easy enough to try again? How easy is it to hire employees? And to let them go if things don't work out? The harder it is to do the latter, the more difficult it is to do the former. Are the rewards to a scientific/research career sufficient to attract a share of the best and brightest? What is the role of private sector support for research and development - as distinct from our rather heavy reliance historically on government support? Is business itself doing enough? Does industry want to get more involved in research and developments? Does academia want to let it? Can private finance - be it banks, venture capital, 'angel investors', private equity and so on - get more involved in supporting innovation? Are the entrepreneurs who would like to receive such support prepared to submit to the accompanying discipline? We are talking about a much broader set of issues than just 'competitiveness' as conventionally defined and discussed. We are really coming at the question of whether we have the competencies, across multiple dimensions, to be effective in the modern global economy. It is hard to evaluate that. These questions are not within my area of responsibility or competence, and I would hesitate to attempt a definitive answer. I note that others more qualified than I am have expressed various views and CEDA itself has done some interesting work relevant to these matters. But lest it all seem too hard, let me offer one perspective based on something that I have observed reasonably closely. Australia has just hosted the G20. Here was something global, complex and requiring careful leadership. Since we last hosted this gathering in 2006, the scale and complexity have grown almost beyond recognition. These days the Leaders meet annually and there are a host of ministerial and other meetings at various levels - around 60 formal meetings and related seminars in a year. There is the B20, C20, L20, Think 20, Youth 20 and various other groups. All these groups need to be accommodated and engaged. They all have their own agenda, but somehow we have to make them come together with the G20's main agenda. At the same time, the main G20 agenda seriously needed to be streamlined and focused. The G20 needed to show that it could effectively meet the challenges of securing better economic performance - 'strong, sustainable and balanced growth'. Australia is one of the smaller members of this group by GDP and certainly by population. We cannot match the scale of human resources available to larger countries in the various workstreams. We are geographically remote. We are not powerful enough simply to command attention or demand others follow our lead. If we are to be effective, we have to try harder than the average country. And it was our job this year to run this unwieldy body effectively. The feedback I have received from my counterparts has been universally and strongly positive. They judge that the Australian presidency has, by the metrics that count, been very successful. Prodigious efforts by exceptionally dedicated people in the public and private sectors ensured improvements to the agenda, process, logistics and conduct of meetings. Substantive things have been achieved by way of pro-growth commitments that, if carried through by the various jurisdictions over time, will make a material difference to wellbeing around the world. Achieving all this was costly in human and financial resources. It required coordination between multiple organisations. It was not on the scale of running the Olympic Games, but it was nonetheless a big deal and it was done well. It wasn't achieved by any effortless superiority; it owed to careful preparation, astute use of some of our natural advantages and continuous effort over a long period. But that's where success always comes from, really. The only question is: how badly do we want it? Responsibility for the G20 now passes to Turkey. We can bask in the glow of success for a few weeks and then get on to other matters. The point simply is that this has gone well as a result of the determined efforts of a range of people who were clear about what they wanted to achieve and who mobilised the necessary resources and effort to get there. One other result of Australia's leadership of the G20 is that the whole issue of infrastructure is well and truly on the table. No one doubts the need for infrastructure provision and it has clear economic attractions. Spending on infrastructure supports aggregate demand during construction but, if done well, also augments the economy's supply capacity for the long run. It is also clear from the various discussions over the past year that there is not a shortage of capital in global markets to fund infrastructure projects. The issues to be overcome don't include finding the money. They concern appropriate project selection criteria, long-term planning, governance, contract design, appropriate risk sharing between public and private sectors, pricing usage of the infrastructure and so on. There is an opportunity here, including for Australia, to do something of value over the years ahead. Of course, we will need to be serious and to put in the effort over an extended period - in all the above areas. If we don't put in that effort, not much actual infrastructure will be delivered. But if we serious, a lot could be achieved. I imagine that the Committee for the Economic Development of Australia would be keen to be involved. I have reached the limits of our time this evening. Australia's economy is continuing to grow, moderately. It has been responding in ways you would expect to the remarkable set of circumstances it has faced over the past decade. There is continuing adjustment ahead and doubtless no shortage of challenges. But beyond these challenges of the next couple of years, maximising our economic possibilities in the modern world requires sustained efforts at adaptation and innovation, at doing things better and, perhaps most of all, a willingness to take the occasional risk. I would be confident that we have, or can develop, the relevant capabilities. The only question is whether we are sufficiently determined to succeed in deploying them.

r150209a_BOA

australia

Remarks at the Launch of the Official Australian Renminbi Clearing Bank

stevens

Premier, Consul General, Mr Chen, distinguished guests, colleagues, ladies and gentlemen, thank you for the invitation to say a few words on the occasion of the launch of the Bank of China (Sydney) as the official renminbi clearing bank here in Australia. Today's events mark an important step in the further development of a local renminbi - or RMB - market. But more than that, they mark one more step in a lengthy and very important journey that has seen the flowering of trade relations between China and Australia, and which promises benefits from the maturing of financial ties. On its own, the key benefit of the official Australian RMB clearing bank is that it can more efficiently facilitate transactions between Australian firms and their mainland Chinese counterparts using the Chinese currency. Bank of China (Sydney)'s 'official' status - which was granted by the People's Bank of China (PBC) - affords it more direct access to the Chinese financial system, with flow-on effects for local financial institutions and their customers. But an official Australian RMB clearing bank also confers some benefits on the Australian financial sector and its customers, particularly when viewed as one element of a broader range of initiatives. In particular, the establishment of the clearing bank helps to raise awareness among Australian firms that the local financial system has the capacity to effect cross-border RMB transactions on their behalf. This is important, because over the long run, Chinese firms may increasingly wish their trade with Australian firms to be settled in RMB. To be sure, today the bulk of global trade is settled in US dollars. But with China now a very large trading nation, and continuing to grow into a 'continental sized' economy, it would be surprising if at some point we do not see much more use of China's currency for trade purposes. Already its usage is growing quickly, if only from a small base. So Australian firms and the Australian financial system need to be well prepared. To that end, the RBA has been directly involved in several initiatives, with the aim in each instance being to ensure that there are mechanisms in place that allow the private sector to increase its use of the Chinese currency as and when it chooses to do so. This of course included the signing of a Memorandum of Understanding with the PBC to enable the establishment of an official RMB clearing bank in Australia, in November last year following the G20 Leaders' Summit in Brisbane. In addition, there was the establishment of a bilateral local currency swap line with the PBC in 2012, which is designed to provide confidence to both Chinese and Australian financial institutions that appropriate RMB and AUD liquidity arrangements are in place in the event of dislocation in the market. More recently, there was the negotiation of a quota to allow financial institutions based in Australia to invest in approved mainland Chinese securities under the Renminbi Qualified Foreign Institutional Investor Scheme - better known as RQFII. Finally, I note the RBA has invested a small proportion of Australia's foreign currency reserves in RMB. Official initiatives like these help to lay the groundwork. But ultimately, the development of an RMB market in Australia will depend on the extent of benefit the private sector sees in using RMB for trade settlement and investment purposes. It is worth noting that private sector-led initiatives are now becoming increasingly important drivers of the RMB market's development. For example, forums such as the Australia-Hong Kong RMB Trade and Investment Dialogue and the 'Sydney for RMB' Working Group are beginning to have a more prominent role in raising awareness of the financial sector's capacity to conduct RMB business and in identifying any further market development issues that may need to be addressed. Looking ahead, and as my colleague, Deputy Governor Philip Lowe has noted a number of times, the process of RMB internationalisation and the associated opening of China's capital account are likely to have significant implications for the global financial system - much like the opening up of China's current account has had a very large impact on the global economy. The Chinese authorities have indicated that they intend to continue RMB internationalisation and capital account liberalisation in the coming years. As a result, the opportunities for Australian and Chinese investors to invest in each other's financial markets could grow significantly in the coming years. By increasing their familiarity with the RMB as an international transaction currency, local financial institutions, investors and firms are likely to be better placed to take advantage of these future opportunities as they arise. I congratulate the Bank of China (Sydney) on the official launch of RMB clearing facilities in Sydney. This is a further important step in what continues to be a fascinating journey.

r150213a_BOA

australia

Opening Statement to House of Representatives Standing Committee on Economics

stevens

Members of the Committee Since the hearing in August last year, the economy has continued to grow at a moderate, but below-trend pace. Inflation as measured by the CPI has been affected by movements in energy prices and government policy changes, but even aside from these effects, inflation is low and appears likely to remain so. The international context is one in which the global economy likewise is growing, but according to most observers at a pace a little below its longer-run average. There are some notable differences in performance by region. The US economy has picked up momentum, growing above trend with a falling unemployment rate. China's economy met its growth target in 2014. A slightly lower target seems likely to be set for 2015, perhaps something like . But that would still be robust growth for an economy of China's size. On the other hand, the euro area and Japan have recorded lower growth rates than expected a year ago. Commodity prices have fallen, in some cases quite sharply. These trends appear to reflect primarily major increases in supply, with some moderation in demand playing a role. That would appear to be the case for iron ore and oil prices (and, prospectively, liquefied natural gas prices, which are typically tied to oil prices). Base metals prices, where few significant supply changes have occurred, have fallen by much less. So there has been what economists refer to as a 'positive supply shock': more of the product is available with lower prices. The effect of this on individual countries will vary, depending on whether they are a producer or a consumer of such raw materials. On the whole for the global economy, however, this is a positive development. Inflation is quite low in a range of countries, and very low in some. The decline in energy prices is temporarily pushing headline CPI inflation rates even lower. The very low interest rates in evidence around the world when we last met have fallen further. This has been most pronounced in Europe, where yields on long-term German sovereign debt have fallen to be about the same as those in Japan. German sovereign debt has recently traded at negative yields for terms as long as 5 years. Official deposit rates are negative in the euro area, and the European Central Bank has announced a large-scale asset purchase program - colloquially referred to as 'quantitative easing'. The euro has depreciated. Some surrounding countries to which funds tend to flow in anticipation of further depreciation - such as Switzerland - have reduced interest rates to significantly below zero and indeed 10-year Swiss government debt has traded at a negative yield. The Swiss National Bank took the decision to remove the cap on the Swiss franc, as it assessed that the size of the intervention likely to be required to hold it was becoming just too large. This move occasioned considerable turbulence in foreign exchange markets. Meanwhile, the US Federal Reserve, faced with a strengthening US economy and having ended its asset purchase program last year, is expected to begin a gradual process of lifting its policy rate in a few months from now. So the monetary policies of the major jurisdictions look like they will be heading in differing directions. This means there is ample potential for further turbulence in financial markets this year. The falls in prices for key export commodities are lowering Australia's terms of trade and hence the purchasing power of our national income. This is a well-understood mechanism and has been the subject of much discussion. It will continue to constrain income growth for households and mining companies, and revenues for both state and federal governments, over the period ahead. Resource export shipments are increasing strongly, as the capacity put in place by the period of high investment is put to use. At the same time, the high levels of capital spending by the resources sector, which had been a strong driver of domestic demand for several years, peaked during mid 2012 and turned down. All indications are that this downswing will accelerate this year. That has always been our forecast. The recent declines in commodity prices don't change it, though they do reinforce that this trend is well and truly under way. The various areas of domestic demand outside mining investment are mixed. Dwelling construction is rising strongly and commencements of new dwellings will reach a new high over the coming 12 months. Consumer spending is responding both to income trends and financial incentives, which are pulling in different directions. Growth in wages, by historical standards, is quite subdued. This and the fall in the terms of trade is working to restrain growth in disposable incomes. Working the other way, the fall in petrol prices, assuming it persists, is adding noticeably to the real incomes of consumers. Increased asset values, which push up gross measures of wealth, and low interest rates are also working to push consumption up relative to income. The net effect of these opposing forces is producing moderate, though not strong, consumption growth. Meanwhile, at this point non-mining business investment spending is still very subdued. While several key fundamentals are in place for stronger performance, clear signs of a near-term strengthening remain unconvincing at this stage. This is a weaker outcome than we had expected six months ago. Public sector final spending - about one-fifth of aggregate demand - is fairly subdued, and the intent of governments, as you know, is to restrain their own spending over the period ahead. The lower exchange rate is likely to help export volumes outside the resources sector, and of late better trends have been observed in some services export categories including tourism and education. Overall, growth in non-mining economic activity has picked up, but is still a little below average. Our expectation had been that a further pick-up would occur in 2015. When we reviewed our forecasts in late January, we didn't feel that growth in the recent past had been materially different from what we had estimated a few months ago. But when we tried to look ahead, we concluded that there were fewer signs of a further pick-up in non-mining activity than we had hoped to see by now. As a result, the revised forecasts we took to the February Board meeting embodied a longer period of below-trend growth, and a higher peak in the rate of unemployment, than earlier forecasts. They also suggested that inflation was likely to remain pretty low over the forecast horizon. The inflation outlook was revised slightly lower, in part reflecting the effect of declining oil prices as well as the weaker outlook for economic activity. At its meeting in February the Board considered that this revised assessment - that is, sub-trend growth for longer, a higher peak in the unemployment rate, slightly lower inflation - warranted consideration of some further adjustment to monetary policy, after a fairly long period during which the cash rate had remained steady. These were incremental changes to the outlook but all in a consistent direction. Another factor in our consideration was dwelling prices, which have continued to increase. Price rises in Sydney are very strong, and they are pretty solid in Melbourne. On the other hand they are much more mixed elsewhere. Excluding Sydney, the rise for Australia as a whole over the past year was about 5 per cent. That is a healthy pace but not alarming, and some cities have seen price falls. Developments in the Sydney market remain concerning, but in the end we did not see these trends as overwhelming a case for a further easing in monetary policy that was made on more general grounds. I note that, on the regulatory front, APRA has announced its supervisory approach to managing the potential risks posed by the rise in lending to investors in housing. This involves more intense scrutiny of investor loan portfolios growing at over 10 per cent per year, with the possibility, ultimately, of additional capital being required if APRA deems it necessary. APRA has also reiterated its expectations for other elements of lending standards such as interest rate buffers and floors. And ASIC has begun a review of interest-only lending in the context of consumer protection legislation. The Bank welcomes these steps and will keep working with other regulators in these areas. The Board is also very conscious of the possibility that monetary policy's power to summon up additional growth in demand could, at these levels of interest rates, be less than it was in the past. A decade ago, when there was, it seems, an underlying latent desire among households to borrow and spend, it was perhaps easier for a reduction in interest rates to spark additional demand in the economy. Today, such a channel may be less effective. Nonetheless we do not think that monetary policy has reached the point where it has no ability at all to give additional support to demand. Our judgement is that it still has some ability to assist the transition the economy is making, and we regarded it as appropriate to provide that support. The forecasts published last week in the assume a lower path for interest rates and a lower exchange rate than both earlier forecasts and the ones the Board responded to at the February meeting. These are assumptions rather than forecasts or commitments to a course of action. It is worth noting that, despite concerns at various times about whether the exchange rate would adjust appropriately to our changing circumstances, it has been doing so over the period since we last met with the Committee. Against the US dollar it has fallen by around 17 per cent since our last hearing. The US dollar itself has been rising against all currencies, of course, so much of this movement is an American story rather than an Australian one. Against a basket of relevant currencies the Australian dollar has fallen by less, but the decline is still about 11 per cent since August. Further adjustment is probably going to occur. One other development since our last meeting with the Committee was the final report of the Financial System Inquiry. This was quite a wide-ranging report and there is now a further period of consultation. I simply note that the Inquiry did not find major problems in the financial system, but did make recommendations about capital, to enhance the resilience of the banking system, and about loss-absorbency more broadly in the context of resolution. These will be mostly in the province of APRA to consider. The Inquiry also made some observations about payments matters, generally supporting the steps the Payments System Board has taken since its inception in 1998, and pointing to some areas where further steps may be appropriate. The Payments System Board will be considering these matters at its meeting next week. We now await your questions.

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australia

Remarks to the American Chamber of Commerce in Australia (AMCHAM)

stevens

Thank you for the invitation to join you today. In an audience of business leaders exposed to the American and Australian business scenes, I might be expected to attempt some comparisons of the two economies. So I offer the following snapshot. American businesses and households seem to be getting more optimistic about the future. But Australian businesses and households seem to be getting less optimistic about the future. It would be an interesting lunch conversation to talk about how all those facts lead to the two differing conclusions about the future. Admittedly, the global backdrop in some respects is less supportive to Australia than it had been some years ago. Our terms of trade are falling. They have been doing so for about 3 1/2 years. It had always been understood that this would occur, even if we were not very accurate in predicting its timing (we predicted it way too early) or its extent: some key resource prices initially fell a little more slowly, but more recently a good deal more quickly, than either official or private consensus forecasts had assumed. Nonetheless, the actual event has been getting much attention. The various ramifications - declining mining investment, the effects on incomes and government revenues - are the subject of daily news. In some other respects, not a lot has changed lately. China continues to grow in size and importance and to open up. Much was made of China 'missing' its 2014 growth target, by one tenth of a percentage point. (Let us in Australia hope our target misses are all only of that size.) Much was also made of the lower target set for 2015, but this was always going to occur, and successive growth objectives are likely to get progressively lower over the years ahead. An economy as large as China is unlikely to sustain the sorts of growth rates seen in earlier years. No one grows at 10 per cent forever. Even growth a bit below this year's objective would still be a considerable impetus to global demand and output. That said, the outworking of some of the excesses of the earlier period of rapid growth, especially the period just after the financial crisis of 2008, remains a work in progress and a source of risk. But in other ways, one could argue that the global backdrop has improved. As I have noted, the US economy - still the world's largest and most innovative - has gained momentum over the past year, looking through the temporary ups and downs of the data. For all China's great importance to Australia these days, a healthy US economy should not be underestimated as a driver of business thinking and as a trend-setter for financial markets. In addition, the fall in oil prices, which is mostly the result of more oil being available than used to be the case, is mainly a bullish development for the global economy in the short term, problems for producer states notwithstanding. It is a bonus for American consumers certainly. It is expected that the Federal Reserve will, some time this year, lift the federal funds rate accelerator off the floor. If that happens there will no doubt be some disruption, as always, and more so as it will be the first Fed tightening for nine years and the ECB will be easing policy at the same time. So there is likely to be some turbulence in asset and foreign exchange markets. On the whole, though, I think we should regard the Fed's likely actions as a positive development. Fed policy is still likely to be quite expansionary for some time. The punch bowl isn't being taken away, its contents are just being made a little less potent. While that is going on our own economy continues its adjustment to the end of the investment phase of the 'mining boom'. The massive run-up in resources sector capital spending that was a natural response to earlier very high prices is reversing, causing a drag on demand. So we hope for other sources of demand to speed up to help make up the difference. Some of them are, though not as seamlessly as any of us would like. I've talked a lot about this before so I won't labour the point. It is a major transition. We can hope to assist it, and the Reserve Bank is doing that, and will continue to lend what support it can, within the limits of its powers and consistent with its mandate. The decline in the exchange rate is assisting the transition (as it assisted in absorbing the earlier phase of the mining boom). But we have always said we cannot hope to fine-tune this transition, however much we may wish otherwise. Looking back at the history of such episodes, of which there have been a few over the past century or more, if we come through this terms of trade event with neither a major outbreak of inflation in the upswing nor a major crash in the downswing, even if we have a period of sub-average growth in the process, we will have done far, far better than in any previous event of this kind, let alone one of this magnitude. I still think that is the most likely outcome. Even so, the lower terms of trade mean that, all other things equal, the path of future incomes is not as high as it might have looked a few years ago. Even allowing for the fact that we all knew, intellectually, that at least part of the boom was not permanent, there is a human tendency to project what we see now (good or bad) into the future. Eventually reality intrudes and we have to re-evaluate. That has happened countless times before and will again, no doubt. It means that attention needs to be given to the things that help our economy work to deliver what we need even with a lower terms of trade. These were the sorts of things that made a difference before the mining boom. They are not my field of expertise. I can simply observe that things such as: are likely to give us the best chance for the kind of prosperity we seek. Public policy will have its own contribution in fostering such an environment, but it is businesses (large and small) and individuals making their own choices that will ultimately deliver whatever success we are capable of.

r150421a_BOA

australia

The World Economy and Australia

stevens

Thank you to the American Australian Association for affording me the opportunity to speak again in New York. Thank you also to Goldman Sachs for hosting the event. There are about as many indicators of the world economy as there are people studying it. My remarks will be fairly high-level, and since we have just had the IMF meetings, it seems appropriate to begin with the picture they present. The Fund's latest publication estimates that output in the world economy grew by 3.4 per cent in 2014 (Graph 1). This is a bit shy of the long-run average of 3.7 per cent, and actually fractionally above the previous estimate in October. The projections are for a slight pick-up in 2015 and around average growth in 2016. These figures are broadly in line with the private sector consensus. Most of the recent growth has come from the emerging world. As a group, the emerging world grew by in 2014. China grew by about 7 1/2 per cent, more or less as the authorities intended. It will probably grow by a little less in 2015; the IMF is saying below 7 per cent. But given its size now, China growing at would still be a major contributor to global growth. Indeed, the current projections have China contributing about the same growth in global output in 2015 and 2016 as it did in recent years. Meanwhile, growth looks to have picked up in India but softened in some other emerging markets. In the major advanced economies, in contrast, growth has generally been below previous averages for quite a number of years. It has taken longer to recover than we had all hoped. There are, happily, some signs of improvement at present. Growth is slowly recovering in the euro area and has resumed in Japan. In the United States, notwithstanding some recent softer numbers, the economy looks to have pretty reasonable momentum. So it would appear that we are heading in the right direction. Unfortunately, that doesn't mean the legacy of the 2008 crisis is yet behind us. From the vantage point of most central banks, the world could hardly, in some respects, look more unusual. Policy rates in the major advanced jurisdictions have been near zero for six years now. In fact, official deposit rates in the euro area and some other European countries are now negative. As it turns out, the 'zero lower bound' wasn't actually at zero. Central bank balance sheets in the three large currency areas have expanded by a total of about US$5 1/2 trillion since 2007, and the ECB and Bank of Japan will add, between them, about another US$2 1/2 trillion to that over the next couple of years. That central banks have had to take such extraordinary measures speaks both to the severity of the crisis that these countries faced and the limited capacity of other policies to support growth. History tells us that recovering from a financial crisis is an especially long and painful process, and more so if other countries are in the same boat. The direct effect of this unprecedented monetary easing has been to lower whole yield curves to extraordinarily low levels, and that process is continuing. The most pronounced effects can be seen in Europe. If one were to invest in German government debt for any duration short of nine years, one would be paying the German government to take one's money. The same can be said for Swiss government debt. Even some corporate debt in Europe has traded at negative yields. It seems likely that these European developments are also affecting long-term interest rates in the United States. These ultra-easy monetary policies have helped along the process of balance sheet repair, bringing households and businesses closer to the point where they can start to spend and hire and invest again. And, it has to be observed, it has made fiscal constraints on governments much less binding than they would otherwise have been. Lower interest rates also increase the value of assets that can be used as collateral. Banks' willingness to supply credit is affected by their balance sheet's strength, of course, but it seems to be improving even in Europe at present. For larger businesses with access to capital markets, borrowing terms have probably never been more favourable. Such policies are, then, working through the channels available to them to support demand. But these channels are financial in nature. They don't directly create demand in the way that, for example, government fiscal actions do. They work on the incentives for private savers, borrowers and investors to alter their financial behaviour and, it is hoped in time, their spending behaviour. A striking feature of the global economy, according to World Bank and OECD data, is the low rate of capital investment spending by businesses. In fact, the rate of investment to GDP seems to have had a downward trend for a long time. One potential explanation is that there is a dearth of profitable investment opportunities. But another feature that catches one's eye is that, post-crisis, the earnings yield on listed companies seems to have remained where it has historically been for a long time, even as the return on safe assets has collapsed to be close to zero (Graph 2). This seems to imply that the equity risk premium observed has risen even as the risk-free rate has fallen and by about an offsetting amount. Perhaps this is partly explained by more sense of risk attached to future earnings, and/or a lower expected of future earnings. Or it might be explained simply by stickiness in the sorts of 'hurdle rates' that decision makers expect investments to clear. I cannot speak about US corporates, but this would seem to be consistent with the observation that we tend to hear from Australian liaison contacts that the hurdle rates of return that boards of directors apply to investment propositions have not shifted, despite the exceptionally low returns available on low-risk assets. The possibility that, , the risk premium being required by those who make decisions about real capital investment has risen by the same amount that the riskless rates affected by central banks have fallen may help to explain why we observe a pick-up in financial risk-taking, but considerably less effect, so far, on 'real economy' risk-taking. Whether this is best seen as a temporary increase in risk aversion, a genuine dearth of investment opportunities, evidence of monetary policy 'pushing on a string', a portent of secular stagnation, or just unusually long lags in the effects of policy, will probably be debated for some time yet. I don't pretend to know what that debate may conclude. In the meantime, we have to think about some of the vulnerabilities that may be associated with the build-up of financial risk-taking. This is one of the responsibilities of the Financial Stability Board, particularly (though not only) through its Standing Committee on Assessment of Vulnerabilities. Two factors stand out at present as combining to heighten fragility at some point. The first arises from the sheer extent and longevity of the search for yield. As I have noted, compensation in instruments for various risks is very skinny indeed. Investors in the long-term debt of most sovereigns in the major countries are receiving very little - if any - compensation for inflation and only minimal compensation for term. Some model-based decompositions of bond yields suggest that term premia on US long-term debt and some sovereign debt in the euro area are actually negative. Compensation for credit risk is also narrow in many debt markets. Moreover, because the search for yield is a global phenomenon, considerable amounts of capital have flowed across borders. There is some evidence to suggest that as emerging country bond markets have developed, particularly in Asia, more issuers have been able to raise funds in their local currencies. This leaves the foreign exchange risk associated with the capital flows more with the investor rather than a local bank or corporate, which is a good development. Nonetheless, we don't have full visibility of those risks and there has been a notable build-up of debt overall in some emerging markets. The other factor of importance is a set of structural changes in capital markets, where there are two key features worth noting. One is the expanding role of asset managers. The search for yield, and the general tendency since the crisis for some intermediation activity to migrate to the non-bank sector, has resulted in large inflows to asset managers since the crisis. Yet liquidity - the ability to shift significant quantities of assets in a short period without large price movements - has probably declined, which is the second of the structural changes worth noting. Certainly the willingness of banks and others to act as market-makers in the way they did in the past will have diminished considerably. Now, of course, to some extent this is a result of the changes to financial regulation which have aimed to improve the robustness of the financial system. We should be clear that it was intended that the cost of liquidity provision in markets be more fully borne by investors. Liquidity was under-priced prior to the crisis. Nonetheless, the question is whether end-investors truly appreciate that the availability of liquidity in the system has declined. Good asset managers have sufficient liquidity holdings to meet redemptions that may occur over any short time period and will also offer appropriate redemption terms and so pose only limited risks to the broader financial system. But the cost of holding the most liquid assets in a world of very low returns overall may pressure some asset managers to hold less genuine liquidity than they might otherwise. Meanwhile, the amount of client funds being managed is much larger than it was and we don't know how all those investors will behave in a more stressed environment, should one eventuate. A key concern the official sector has is that investors may be assuming a degree of liquidity that will not actually be available in a more stressed situation. Putting all that together, we find a world where the banking system is much safer, but in capital markets some valuations are stretched, credit spreads are compressed, there has been significant cross-border capital flow and liquidity may be less available than investors are assuming. That raises the risk that a sell-off, were it to occur, could be abrupt. What might trigger such an event? The usual trigger people have in mind is a rise in US interest rates. The US economy now looks strong enough for the Federal Reserve to consider increasing its policy rate later in the year. In itself, this should be welcomed. And it will have been very well telegraphed. Understandably, the Fed is proceeding with the utmost caution. But it will also have been over nine years since the Fed previously raised interest rates. Some market participants won't have lived through a Fed tightening cycle before. Hence, it would not be surprising to see some bumps along this road. A second trigger could come from slower growth in emerging markets. Growth has already weakened in some economies, several of which have been bruised by falling commodity prices. Capital that flowed into emerging markets could flow out again, perhaps when interest rates begin to rise in the United States. That would probably occur alongside an appreciating US dollar. So the distribution of credit risk and foreign currency risk will be of considerable importance. One can easily see why investors could become less forgiving of borrowers on a shaky footing, be they corporates or sovereigns. A complicating factor here is that the rise in US interest rates looks set to occur while the central banks of Japan and Europe are continuing an aggressive easing of monetary policy via balance sheet measures. The combined Japanese and European 'QE' will be very substantial. The extent to which such funds will flow across borders will depend on which sorts of investors are 'displaced' from their sovereign debt holdings and what their risk appetites are. To the extent that funds do flow across borders, the proportions in which they flow to emerging markets, as opposed to the United States, will also be important. So there is a fair bit that we don't know, but need to learn, about this environment. It will be important for the officials thinking about these and other risks to continue an effective dialogue with private market participants over the period ahead. These major global trends have certainly affected financial and economic conditions in Australia. We see the effects of the search for yield all around us. Short and long-term interest rates are at record lows, but are still attractive to some international investors. Foreign capital has been attracted not just to debt instruments but to physical assets. The demand for commercial property has been particularly strong and meant that prices have risen even as rental income has softened and the outlook for construction seems reasonably subdued. That raises some risks, which we discussed in our recent . We also noted the attention being given by APRA (Australian Prudential Regulation Authority) and ASIC (Australian Securities and Investments Commission) to risks in the housing market. APRA has announced benchmarks for a few aspects of banks' housing lending standards and both APRA and the Reserve Bank will be monitoring the effects of these measures carefully; at this stage, it is still too early to judge them. We can only say that over the past few months, the rate of growth of credit for housing has not picked up further. Overall, we think the Australian financial system is resilient to a range of potential shocks, be they from home or abroad. Banks' capital positions are sound and are being strengthened over time. They have little exposure to those economies that are under acute stress at present. Measures of asset quality - admittedly backward-looking ones - have been improving. But it is developments in the 'real' sector of the economy that, right at the minute, seem more in focus. The economy is continuing to adjust to the largest terms of trade episode it has faced in 150 years. As part of that adjustment, there has been a major expansion in the capital stock employed in the resources and energy sector, accomplished by exceptionally high rates of investment. These are now falling back quickly, exerting a major dampening effect on demand. There has been a major cycle in the exchange rate, which is still under way. There has been considerable change to the structure of the economy. This all happened as the major economies encountered the biggest financial crisis in several generations, with its very long-lasting after effects, and which also had an impact on Australian attitudes to spending and leverage. To say there have been some pretty powerful, and disparate, forces at work is something of an understatement, even for a central banker. At present, while growth in Australia's group of trading partners is about average, and is higher than the rate of growth for the world economy as a whole, the nature of that growth is shifting. The growth in Chinese demand for iron ore, for example, has weakened at the same time that supply has been greatly increased, much of it from Australia. Iron ore prices are therefore falling and contributing to a fall in Australia's terms of trade. As the terms of trade fall, and national income grows more slowly than it would have otherwise, adjustment is occurring in several ways: Macroeconomic policy is supporting the adjustment. On the fiscal front, the government has little choice but to accept the slower path of deficit reduction over the near term. But over the longer term, hard thinking still needs to occur about the persistent gap we are likely to see (under current policy settings) between the government's permanent income via taxes and its permanent spending on the provision of good and services. In the case of monetary policy, the Reserve Bank has been offering support to demand, consistent with its mandate as expressed by the medium-term inflation target. Relevant considerations of late include the fact that output is below conventional estimates of 'potential', aggregate demand still seems on the soft side as resources investment falls sharply, and unemployment is elevated and above most estimates of 'natural rates' or 'NAIRUs'. And inflation is forecast to be consistent with the 2-3 per cent target. So interest rates should be quite accommodative and the question of whether they should be reduced further has to be on the table. What complicates the situation is that these are not the only pertinent facts. A good deal of the effect of easier monetary policy comes via the housing sector - through higher prices, which increase perceived wealth and encourage higher construction, through higher spending on durables associated with new dwellings, and so on. These are not the only channels but, according to research, together they account for quite a bit of the direct effects of easier monetary policy. And they do appear to be working, thus far. Housing starts will reach high levels this year and wealth effects do appear to be helping consumption, which is rising faster than income. But household leverage starts from a high level, having risen a great deal in the 1990s and early 2000s. The extent to which further increases in leverage should be encouraged is not easily answered, but nor can it be conveniently side-stepped. Even if we chose to ignore it, monetary policy's to support demand by inducing households to bring forward spending that would otherwise be done in future might well turn out to be weaker than it used to be. For a start, households already did a lot of that in the past and, in any event, future income growth itself looks lower than it did a few years ago. Then there are dwelling prices, which, at a national level, have already risen considerably from their previous lows, at a time when income growth has been slowing. Popular commentary is, in my opinion, too focused on Sydney prices and pays too little attention to the more disparate trends among the other 80 per cent of Australia. That said, it is hard to escape the conclusion that Sydney prices - up by a third since 2012 - look rather exuberant. Credit conditions are only one of several factors at work here. But credit conditions very easy. So while the conduct of monetary policy can't allow these financial considerations to dominate the 'real economy' ones completely, nor can it simply ignore them. A balance has to be found. To this point, the balance that the Reserve Bank Board has struck has seen the policy rate held at what would once have been seen as extraordinarily low levels for quite a while now. The Board has, moreover, clearly signalled a willingness to lower it even further, should that be helpful in securing sustainable economic growth. The Board has been proceeding with a degree of caution that is appropriate in the circumstances. It also has, I would say, a realistic assessment of how much monetary policy can be expected to achieve in supporting the adjustment the economy needs to make. Any help in boosting sustainable growth from other policies would, of course, be welcome. In particular, things that could credibly be seen as lifting prospects for future income, and increasing confidence in those prospects, would give easy monetary policy a good deal more traction. In fact, that point generalises to the rest of the world. Across much of the world, too much weight is being put on monetary policy to try to achieve what it can't: a durable and sustainable increase in growth, in an environment where private leverage is already rather high or even too high. Monetary policy alone won't deliver that. This is probably a moment to recall the commitments we all made in the G20 meetings in Australia last year, as we agreed on the goal of an additional rise in global GDP of 2 per cent over five years. Those commitments were not actually about monetary policy; they were about other policies. It will be important this year, after one of the five years has passed, to see whether we are all making good on our various promises. More generally, actions which promote entrepreneurship, innovation, adaptation and skill-building, that reward 'real' risk-taking, while providing a stable macroeconomic environment and a well-functioning financial system, will best support our future wellbeing. Thank you.

r150428a_BOA

australia

Observations on the Financial System

stevens

Good morning and thank you to the for inviting me to speak here today. Your conference comes at an opportune time, since there are plenty of things to talk about. Global financial markets are still in the grip of a pervasive search for yield. Major regulatory reform proposals are still being designed and implemented at the global level. Meanwhile, technological change is continuing to offer new opportunities for businesses to serve customers and disrupting established ways of doing things. And, not least, the Financial System Inquiry released its Final Report late last year. You have a very extensive list of speakers over the next two days who will no doubt cover all this territory and more. So my remarks will be fairly general only. Ahead of next week's meeting of the Reserve Bank Board, I have no comments to offer today on monetary policy. Perhaps I might begin with a few remarks about the Financial System Inquiry. The Reserve Bank welcomes the Inquiry's Report. The Inquiry had a distinguished committee, a capable secretariat, and an effective and robust process of discussion and engagement. The Bank found its own engagement with the Committee very constructive. The Report is comprehensive and shows the Inquiry grappling with the big issues of our time. I hope the Chairman will not mind me saying that all Inquiries are, inevitably, shaped to some extent by the circumstances they face. The Campbell Inquiry came at a time when the weight of informed opinion had already shifted quite a way towards favouring deregulation. After a long period of experience with a highly regulated system, the limitations were, by the mid 1970s, increasingly apparent. So the push was towards a financial system where market forces dictated more of the terms of engagement. That deregulatory mindset helped prepare the ground for two of the most significant - and beneficial - changes our financial system has seen in modern times. Floating the exchange rate was one of them. The other was removing constraints on competition in the banking system. By the time the Wallis Inquiry came around in the mid 1990s the financial system had undergone significant change. There had been an influx of new banks. There had been a sharp run-up in credit, a boom in asset prices, a bust and a painful recession in the early 1990s. The importance of capital and supervision had been reinforced. But by the mid 1990s, developments in technology and the anticipated growth of capital markets loomed large and shaped the environment for that Inquiry. The importance of payments systems was much more on the radar screen. As you know, the Wallis recommendations transformed the regulatory architecture. APRA (Australian Prudential Regulation Authority) was created and took charge of bank supervision, a function previously performed by the Reserve Bank, and a new Payments System Board was created in the Bank with a mandate for efficiency and competition in the payments system as well as controlling risk and contributing to financial stability. ASIC (Australian Securities and Investments Commission) was given a stronger consumer protection mandate. That regulatory architecture continues today. There is no serious discussion about major change to it. Indeed, as has been noted before, the regulatory set-up and the Australian financial system more generally came through the most severe international financial crisis since the Great Depression very well. Not unscathed, not without some missteps or liquidity pressures and not without some credit losses. And not without some important supportive policy actions. But overall, we can certainly hold our heads up when the crisis narrative is told. At the same time, there are critical learnings for Australia from the experiences of those who had a worse time of it than us through the past seven years. We survived the crisis pretty well, but how do we avoid that leading to complacency? What do we have to do to protect against a future crisis? How should we respond to the wave of changes to global regulatory standards? Meanwhile, the technological frontier continues to move ahead quickly, even if in ways that Wallis could not foresee. And Australia's privately funded retirement income system - growing at the time of Wallis but by now amounting to about 100 per cent of GDP - could not be omitted from any comprehensive review of the system. This, then, was the backdrop when the Murray Committee set to work. The Inquiry has eschewed wholesale changes in favour of more incremental ones. I do not intend to offer a point by point response to all the recommendations. Let me touch on just a few themes. The first is enhancing the banking system's resilience. There are a few issues here, the most contentious of which is whether banks' capital ratios, which have already risen since the crisis, should be a little higher still. The Inquiry concluded that they should. There has been a lot of debate about just where current capital ratios for Australian banks stand in the international rankings. The reason there is so much debate is because such comparisons are difficult to make. There seems little doubt, though, that most supervisory authorities (and for that matter most banks) around the world have, since the crisis, revised their thinking on how much capital is needed and none of those revisions has been downward. So wherever we stood at a point in time, just to hold that place requires more capital. And it's likely to be demanded by the market. There's generally not much doubt about which way the world is moving. Of course, capital is not costless. If capital requirements become too onerous then the higher cost of borrowing could impinge on economic growth. But more capital brings the benefit of a more resilient system, one less prone to crisis and one more able to recover if a crisis does occur. Crises are infrequent, but very expensive. So there is a cost-benefit calculation to be done, or a trade-off to be struck - higher-cost intermediation, perhaps slightly reduced average economic growth in normal times, in return for the reduced probability, and impact, of deep downturns associated with financial crises. The Inquiry, weighing the costs and benefits, concluded that the benefits of moving further in the direction of resilience outweigh the rather small estimated costs. The second set of issues surround 'too-big-to-fail' institutions and their resolution. The Inquiry is to be commended for grappling with this. These issues are complex and even after substantial regulatory reform at the global level, there is still key work in progress. The stated aim of all that work is to get to a situation where, with the right tools and preparation, it would be possible to resolve a failing bank (or non-bank) of systemic importance, without disrupting the provision of its critical functions and without balance sheet support from the public sector. This is explicitly for globally systemic entities, but the Inquiry has, sensibly enough, seen the parallel issue for domestically systemic ones as worthy of discussion. Ending 'too-big-to-fail' is an ambitious and demanding objective. To achieve it, not only must systemic institutions hold higher equity capital buffers, but more tools to absorb losses are needed in the event the equity is depleted. Typically envisaged is a 'bail-in' of some kind, in which a wider group of creditors would effectively become equity holders, and who would share in the losses sustained by a failing entity. For this to work, there needs to be a market for the relevant securities that is genuinely independent of the deposit-taking sector - we can't have banks hold one another's bail-in debt. In a resolution, a host of operational complexities would also have to be sorted out. A resolution needs the support of foreign regulators if it is to be recognised across borders. It needs temporary stays on derivatives contracts so that counterparties don't scramble for collateral at the onset of resolution. And it needs to be structured and governed well enough to withstand potential legal challenges and sustain market confidence. A proposal for 'total loss-absorbing capacity', or TLAC, was announced at the G20 Summit in Brisbane last year. Consultations and impact assessments are under way, and an international standard on loss-absorbing capacity will be agreed by the G20 Summit in Antalya later this year; guidance on core policies to support cross-border recognition of resolution actions should be finalised shortly after. It is fair to say that in its main submission to the Inquiry, the Reserve Bank counselled caution as far as 'bail-in' and so on is concerned. We would still do so. The Inquiry also favours a cautious approach. Again, though, the world seems to be moving in this general direction. It isn't really going to be credible or prudent for Australia, with some large institutions that everyone can see are locally systemic, not to keep working on improvements to resolution arrangements. The third set of recommendations from the Inquiry I want to touch on are those related to the payments system. The Inquiry generally supported the steps the Payments System Board (PSB) has taken since its creation after Wallis, but raised a few areas where the Board could consider consulting on possible further steps. As it happens, these dovetail well with issues that the PSB has been considering for some time. The Reserve Bank has since announced a review of card payments regulation and released an Issues Paper in early March. Among other things, it contemplates the potential for changes to the regulation of card surcharges and interchange fees. Surcharging tends to be a 'hot button' issue with consumers and generated a large number of (largely identical) submissions to the Financial System Inquiry. But virtually all of the public's concern is directed at a couple of industries where surcharges appear to be well in excess of acceptance costs, at least for some transactions. The Bank considers that its decision to allow surcharging of card payments in 2002 has been a valuable reform. It allows merchants to signal to consumers that there are differences in the cost of payment methods used at the checkout. By helping to hold down the cost of payments to merchants, the right to surcharge can help to hold down the prices of goods and services more generally. The Bank made some incremental changes to the regulation of surcharging in 2013, but to date these have had a relatively limited effect on the cases of surcharging that most concern consumers. Our current review will consider ways we can retain the considerable benefits of allowing merchants to surcharge, while addressing concerns about excessive surcharges. One element of this might be, as the Financial System Inquiry suggests, to prevent surcharges for some payment methods, such as debit cards, if they were sufficiently low cost. This would mean that in most cases consumers would have better access to a payment method that is not surcharged, even when transacting online. Other options being considered are ways to make the permissible surcharge clearer, whether through establishing a fixed maximum or by establishing a more readily observable measure of acceptance costs. The capping of card interchange fees is also now a longstanding policy and, we think, a beneficial one. Nonetheless, it is important to ensure that it continues to meet its objectives. Caps were put in place in 2003 based on concerns that interchange fees in mature payment systems can distort payment choices and, perversely, be driven by competition between payment schemes. As suggested by the Inquiry, the Bank's review will consider whether the levels of the current caps remain appropriate. We know, for example, that lower caps have now been set in some other jurisdictions. But there are other elements of the current regime that also warrant consideration. For instance, while average interchange fees meet the regulated caps, the dispersion of interchange rates around the average has increased significantly over time. The practical effect of this is that there can be a difference of up to 180 basis points in the cost of the same card presented at different merchants. This problem is aggravated by the fact that merchants often have no way of determining which are the high-cost cards. Although the wide range of interchange fees is not unique to Australia, we would want to ensure so far as possible that the regulatory framework does not contribute to this trend or to declining transparency of individual card costs to merchants. The Bank's review will consider a range of options, including 'hard' caps on interchange fees and hybrid solutions, along with setting more frequent compliance points for caps. Options for improving the ability of merchants to respond to differing card costs will also be considered. While considering interchange fees, it is also appropriate to consider the circumstances of card systems that directly compete with the interchange-regulated schemes. This means, in particular, bank-issued cards that do not technically carry an interchange fee, but nonetheless are supported by payments to the issuer funded by merchant fees. More broadly, all the elements I have mentioned - interchange fees, transparency and surcharging - are interrelated, which means that there are potentially multiple paths to achieving similar outcomes. I encourage those with an interest to engage with the Bank in the review process in the period ahead. Turning away from the Financial System Inquiry to other matters, let me mention two. I said at the beginning that the 'search for yield' continues. There is a line of discussion that tackles this issue from a cyclical point of view, thinking about how the balance sheet measures taken by the major central banks are affecting markets, the extent and nature of cross-border spillovers, what happens when the US Federal Reserve starts to tighten policy at some point and so on. I've spoken about such things elsewhere and have nothing to add today. There is another conversation, however, that tends to take place at a lower volume, but which definitely needs to be had. That conversation is about what all this means for the retirement income system over the longer run. The key question is: how will an adequate flow of income be generated for the retired community in the future, in a world in which long-term nominal returns on low-risk assets are so low? This is a global question. Just about everywhere in the world the price of buying a given annual flow of future income has gone up a lot. Those seeking to make that purchase now - that is, those on the brink of leaving the workforce - are in a much worse position than those who made it a decade ago. They have to accept a lot more risk to generate the expected flow of future income they want. The problem must be acute in Europe, where sovereign yields in some countries are negative for significant durations. But it is also potentially a non-trivial issue in our own country. In a conference about wealth, this might be a worthy topic of discussion. And the final issue is misconduct. This has loomed larger for longer in many jurisdictions than we would have thought likely a few years ago. Investigations and prosecutions for alleged past misconduct are ongoing. It seems our own country has not been entirely immune from some of this. Without in any way wanting to pass judgement on any particular case, root causes seem to include distorted incentives coupled with an erosion of a culture that placed great store on acting in a trustworthy way. Finance depends on trust. In fact, in the end, it can depend on little else. Where trust has been damaged, repair has to be made. Both industry and the official community are working hard to try to clarify expected standards of behaviour. Various codes of practice are being developed, calculation methodologies are being refined, and In some cases regulation is being contemplated. Initiatives like the Banking and Finance Oath also can make a very worthwhile contribution, if enough people are prepared to sign up and exhibit the promised behaviour. In the end, though, you can't legislate for culture or character. Culture has to be nurtured, which is not a costless exercise. Character has to be developed and exemplified in behaviour. For all of us in the financial services and official sectors, this is a never-ending task. With those few remarks, I wish you a successful conference. Thank you.

r150610a_BOA

australia

Economic Conditions and Prospects: Creating the Upside

stevens

Thank you for the invitation to speak in Brisbane once again. The last time I spoke with this group, in July 2013, the economy was estimated to be growing at about . Two years on, the economy is growing at just shy of 2 1/2 per cent and underlying inflation is around , consistent with the target. In some respects, then, it might seem that not much has changed. In fact a number of important developments have occurred during that period, some as anticipated and some not. Overall, the fact that not much has changed is disappointing: the economy has not picked up speed as we had hoped. In this talk, I will make some observations about the global and domestic economies, and try to give some sense of what we have learned in the past couple of years. Two years ago, we judged Australia's trading partner group to be growing at about its average pace of around . It was expected that during 2014 and 2015 growth in this group would pick up a bit, to a pace a little above average. In fact, growth for our trading partners has at about 4 per cent and is expected to stay there over the next couple of years. To be sure, 4 per cent growth is faster than growth for the world economy as a whole, which is more like . It has been to Australia's advantage that we have a high exposure, for an advanced country, to the faster-growing Asian region. As an example, while the euro area is a significant trading partner for Australia, we were probably less affected than many countries in 2012 and 2013 when Europe lapsed back into recession. Two years ago, I noted that the economy of the euro area was still smaller than it was before the financial crisis. Regrettably, that remains true today. Europe is back on a growth path now, but it is still a fairly modest one, and it seems to require extraordinary settings of monetary policy to achieve even that. Growth has recently resumed in Japan after a dip in activity following the enactment of a tax increase last year. Japanese growth rates remain pretty modest, though since Japan has a declining population, they look better on a per capita basis. The full implementation of the so-called 'third arrow' of structural reform could be expected, if it occurs, to lift growth per head further over the long run. Growth is proceeding at a reasonable clip in the rest of Asia, though as I noted two years ago, in more than a few countries it has not been possible to restore the pre-crisis growth rates. And the growth that has been achieved has been accompanied in a number of cases by a sizeable increase in debt owed by households, firms or both. How big a vulnerability this will turn out to be under different financial conditions and/or lower growth we cannot yet know. While it has been to our advantage to have a lesser exposure to Europe than many other countries, the flipside is a much greater exposure to China. That means we will be more sensitive to fluctuations in China's performance than other countries. This is not a new point; I said as much about five years ago. But it is perhaps more concrete now, given that China's growth has slowed appreciably over the past few years. The moderation in 2014 was more or less as China's policymakers intended. The further moderation seen over the past six months or so may have been a little more than intended. Chinese policy has been responding to that outcome as you would expect: interest rates are declining, and some selected restraints on credit are being eased. Stepping back from the ebb and flow of short-run data, the big point is that China's policymakers are attempting two major transitions. One is towards more consumption-driven growth, as opposed to investment and export-led growth. This is necessary because a continental-sized economy such as China cannot rely on the rest of the world absorbing rapid growth in its output. The second, related transition is towards a more robust financial structure, which is necessary because the prevailing structure has too many risky aspects. Both these transitions are necessary, but both remain works in progress. How they will play out is unavoidably a source of uncertainty. What does seem fairly clear is that the pace of growth in demand for commodities like iron ore will be lower in future than in the past five years, even as supply continues to increase. Thus far much of the additional supply has been Australian ore, though it is apparent that at least some of the future increase in supply will be from other countries. Perhaps it is not surprising, then, that Australian discussion of the Chinese economy has been through the prism of the iron ore price - these days subject to daily monitoring. A few months ago, it almost seemed as though the price of iron ore might, in terms of attention given, eclipse that other price on which Australians focus with a passion, namely the price of a house. But of late house prices seem to have regained their pre-eminent place in our national psyche! Turning away from China, it is quite significant that there is a good deal more optimism now in the United States. The rate of unemployment has fallen considerably and growth in wages has begun to increase. There was a weak March quarter result for growth in output, which most observers attribute to temporary factors, though it remains to be seen just how robust the return to growth has been since. The significance of a healthier US economy is two-fold. One element is that the expectations of many business people around the world, including in Australia, still tend to take a cue from the tone of US business. The second is that, at some point, US monetary policy will begin to adjust to improved conditions. That will be a very gradual process, but at this stage, indications still seem to be that the US Federal Reserve will begin the process some time this year. It is reasonable to hope that this change in course can be accomplished without serious disruption to financial markets, but we cannot be certain of that. Countries receiving cross-border capital flows have generally sought to strengthen their economic and financial fundamentals since the 'taper tantrum' of mid 2013. The fact that the Fed has signalled as clearly as possible the way it thinks about these issues should also help reduce instability. On the other hand, 'guidance' is no guarantee of smooth sailing. Moreover, we stand today at a highly unusual juncture. We see a combination of remarkably low yields on financial assets, compressed risk premia and diverging outlooks for monetary policy across the major jurisdictions. It is a complex picture for both market participants and policymakers. Recently, we have seen some large and abrupt movements in currencies, commodity prices and even sovereign bond rates. While to some extent this is a normalisation after a period of unusually subdued volatility, these movements may also be signalling that a degree of underlying fragility has built up over the long period of 'search for yield'. Such dynamics bear watching. In Australia, recent growth in the economy has not been as strong as we want. Of course, what we are witnessing is not an economy heading along the course of a normal economic cycle, but a complex and rather lengthy adjustment both to the once-in-a-century cycle in our terms of trade and an earlier increase in household leverage. During the late 1990s and early 2000s, very confident households spent and borrowed more, and saved less, in the process extending their balance sheets. That process started to fade in about 2006 and then finished more abruptly when the financial crisis hit. But by then the run-up in resources prices was imparting a very large stimulus to the economy and allowed for solid growth to continue at a time when most other countries were still feeling the aftermath of the financial crisis. But now most of the capital spending that was needed to lift the output of the mining sector has been completed, at least for the production of iron ore. Some very large LNG projects are still underway, but as those projects and others draw to a close, the decline in mining investment that is already underway will continue (and perhaps accelerate). The latest edition of the Australian National Accounts, released last week, shows the picture. The quarterly growth figure was stronger than what had been embodied in our forecasts in the May , though that comes after a weaker-than-expected outcome in the previous quarter. Some of the strength resulted from unusually high export shipments of resources, which were less disrupted by weather conditions in the 'cyclone season' than has often been the case in the past. Indications are that this pace of growth wasn't repeated in the June quarter, when shipments of coal in particular were affected by weather disruptions on the east coast. Taking the results over the past four quarters, growth was 'below trend'. Export volume growth contributed strongly, while domestic final demand increased by a bit under 1 per cent, which is quite a weak result. Housing construction rose strongly, and consumer spending over the year rose by more than real household income (that is, the saving rate fell). Both these results owe a good deal to low interest rates and rising asset values. But other components of demand were weak. Business investment fell substantially, with mining investment falling quickly and, as best we can tell, non-mining capital spending also weak. Public final spending didn't grow at all. Public investment spending fell by 8 per cent over the past year. Overall, these outcomes are weaker than what, two years ago, we expected would be happening by now. Back then, the two-year-ahead forecast was for annual GDP growth to be in a range of 2 1/2 to 4 per cent by mid 2015. The width of that range reflected the normal size of error margins, coupled with the inevitable uncertainty about the timing of when some components of demand outside of mining might strengthen, and the judgement that if accommodative monetary policy really was held in place for several years (which was a key assumption behind those forecasts), activity could at some point start to pick up quite quickly. It will be three months before we get the national accounts data for the June quarter, but at this point, with three of the four quarters available for the year to June 2015, it would appear that the outcome will be either right at the bottom of the range predicted two years ago or, more likely, a bit below it. Of course, forecasts are hardly more than educated guesswork and two-year-ahead forecasts are even less reliable. That there are inevitably forecast errors is neither surprising nor new, and it is not any more concerning now than it always has been. This is far from the biggest forecast error I've seen over my three decades in this game. But it is nonetheless useful to see what we can learn from those errors. The following points are prominent: In summary, the economy has in several important respects followed a different track from the one expected a couple of years ago. That is partly because conditions in the world economy were different from what had been expected and partly because several domestic factors were different. Some in-built responses have been in evidence. For example the decline in the exchange rate, even if not by as much as we might have expected, has had the effect of supporting growth and keeping inflation from falling as much as it might have done. And, of course, monetary policy has also responded to the evolving situation, consistent with the Reserve Bank's mandate. These responses have had the effect of lessening the extent to which growth and inflation have differed from the outcomes expected two years ago, but haven't managed to eliminate those differences entirely, at least in the case of output growth. The slowing in wage growth in response to soft labour market conditions has also undoubtedly helped to hold employment up. In fact wage growth appears to be somewhat lower than previous relationships between wages and unemployment would suggest. This may be a sign of increased price flexibility in the labour market and could help to explain why employment recently has looked a little higher relative to estimated GDP than might have been expected. These hypotheses can be advanced only tentatively, though, until we have more data. Looking ahead, the most recent forecasts suggest that growth rates will be similar to those we have observed recently for a while yet. Residential investment will reach new highs over the period ahead. Household consumption is expected to record moderate growth. With national income growth reduced by a falling terms of trade, this requires a modest decline in the saving rate. It doesn't seem reasonable to expect much more from consumption growth than that. Resources sector investment has a good deal further to fall yet over the next two years. Other areas of investment seem very low and while I would have expected that by now these would have been showing signs of strengthening, the most recent indications are for, if anything, a weakening over the year ahead. Public final spending has not been growing and fiscal consolidation still has some way to run. Under the current macroeconomic conditions, it would seem inappropriate for governments to seek additional restraint here in the near term. Inflation is likely to remain low. Growth in labour costs is very low and some of the forces that were pushing up certain administered prices have started to reverse. So even if the exchange rate were to fall further, which in my view it needs to, we seem unlikely to have a problem with excessive inflation. Putting all that together, as things stand, the economy could do with some more demand growth over the next couple of years. Of course, these are forecasts. They might be wrong. In fact, they will be wrong, in some dimension or other. Our published material goes to some lengths to articulate a range of 'risks'. It is easy to think of 'downside' ones in the current mood of determined pessimism. But it is not entirely impossible to think of upside ones as well. A further fall in the exchange rate, which is assumed in the forecasts, would add both to growth and prices. If one thinks that such a decline at some point is likely, that constitutes an 'upside' risk. Of course, the list of countries that would prefer a lower exchange rate is a long one and we can't all have it. That being so, we might give some thought to trying to some upside risks to the growth outlook through policy initiatives. The Reserve Bank will remain attuned to what it can do, consistent with the various elements of its mandate - including price stability, full employment and financial stability. We remain open to the possibility of further policy easing, if that is, on balance, beneficial for sustainable growth. The temptation, of course, is to presume outcomes can be fine-tuned by policy settings and that we can simply dial up more or less demand in short order to avoid deviations from some ideal path. Reality is inevitably more messy than that and has not always been kind to such fine-tuning notions. As it is, some observers think monetary policy has done too little, while others think it already has done way too much. I think it has been about right for the circumstances. But the bigger point is that monetary policy alone can't deliver everything we need and expecting too much from it can lead, in time, to much bigger problems. Much of the effect of monetary policy comes through the spending, borrowing and saving decisions of households. There isn't much cause from research, or from current data, to expect a direct impact on business investment. But of all the three broad sectors - households, government and corporations - it is households that probably have the least scope to expand their balance sheets to drive spending. That's because they already did that a decade or more ago. Their debt burden, while being well serviced and with low arrears rates, is already high. It is for this reason that I have previously noted some reservations about how much monetary policy can be expected to do to boost growth with lower and lower interest rates. It is not that monetary policy is entirely powerless, but its marginal effect may be smaller, and the associated risks greater, the lower interest rates go from already very low levels. I think everyone can see that. If I am correct about this, it really is very important that other policies coalesce around a narrative for growth. In this regard, I think the Government is on the right track in not seeking to compensate for lower revenue growth by cutting spending further in the short run. Of course, some resolution of long-run budget trends is still going to be needed to sustain confidence and that will not be an easy conversation. Meanwhile, as often remarked, infrastructure spending has a role to play in sustaining growth and also in generating confidence. I am doubtful of our capacity to deploy this sort of spending as a short-term countercyclical device. The evidence of history is that it takes too long to start and then too long to stop. But it would be confidence-enhancing if there was an agreed story about a long-term pipeline of infrastructure projects, surrounded by appropriate governance on project selection, risk-sharing between public and private sectors at varying stages of production and ownership, and appropriate pricing for use of the finished product. The suppliers would feel it was worth their while to improve their offering if projects were not just one-offs. The financial sector would be attracted to the opportunities for financing and asset ownership. The real economy would benefit from the steady pipeline of construction work - as opposed to a boom and bust. It would also benefit from confidence about improved efficiency of logistics over time resulting from the better infrastructure. Amenity would be improved for millions of ordinary citizens in their daily lives. We could unleash large potential benefits that at present are not available because of congestion in our transportation networks. The impediments to this outcome are not financial. The funding would be available, with long term interest rates the lowest we have ever seen or are likely to. (And it is perfectly sensible for some public debt to be used to fund infrastructure that will earn a return. That is not the same as borrowing to pay pensions or public servants.) The impediments are in our decision-making processes and, it seems, in our inability to find political agreement on how to proceed. Physical infrastructure is, of course, only part of what we need. The confidence-enhancing narrative needs to extend to skills, education, technology, the ability and freedom to respond to incentives, the ability to adapt and the willingness to take on risk. It is in these areas too, where there are various initiatives in place or planned, but which often do not get enough attention, that we need to create a positive dynamic of confidence, innovation and investment. That is the upside we need to create.

r150630a_BOA

australia

The Changing Landscape of Central Banking

stevens

The landscape of central banking has changed a great deal in the three decades I have been involved in it, and especially since the financial crisis beginning in 2007. Some of the changes were made as a result of careful system design, in the light of long experience. Others, and arguably the more prominent ones, have come as a response to exceptional circumstances. These have been necessary, yet unsettling. And we don't really know where they will ultimately lead. In this talk I will reflect on some of these changes. Let me preface these reflections by saying that I am not casting criticisms towards other central banks or their policies. Indeed, my main point, to repeat, is that some central banks have found themselves doing extraordinary things because of the extraordinary circumstances to which they were required, by their mandates, to respond as best they could. Even among central banks that haven't quite had to do the extraordinary, many are operating outside their previous comfort zones and for the same reason. Ten years ago, it seemed that monetary policy debates had largely been settled. Had one asked about the goals of the central bank, the answer 'price stability' very quickly would have been given. In some countries, including my own, objectives about real economic activity and/or employment remained in legislation, and still do. In others, especially in the continental European tradition, price stability was the sole objective in law. But even in those countries where a 'dual mandate' was, and is, in operation, policymakers overwhelmingly would have acknowledged that real activity goals are about managing, to the extent possible, cyclical fluctuations around a potential output path. Monetary policy was not thought able, itself, directly to affect that potential path. This represented nothing more than the absorption of the fundamental insight of two centuries of monetary theory and experience: that monetary policy is, in the long run, about nominal magnitudes. To the extent that a monetary regime can reduce uncertainty about the general level of prices, and that that assists in resource allocation and in encouraging saving and investment, that will be monetary policy's contribution to average growth rates. By the mid to late 1980s, just about everyone accepted that, while the Phillips Curve might have a negative short-run slope, in the long run it was vertical. That consensus accepted that expectations about inflation matter for actual inflation over relevant time horizons. That meant that nominating some sort of numerical objective for inflation came to make sense. This was especially so after targeting measures of the stock of money, as an intermediate goal on the way to price stability, delivered less success than had been hoped. Explicit inflation targets also helped in another way. It had become widely accepted that the day-to-day conduct of monetary policy needed to be independent of the influence of governments. This was to avoid the temptation to seek a short-term stimulus to growth for political reasons, at the cost of a persistent rise in inflation. But in democracies, where central banks are creations of legislatures, there have to be limits to central banks' autonomy and devices for accountability. Correctly specified, an explicit inflation target with operational independence seemed to solve this problem. It would allow the central bank to give appropriate weight to output and employment, but would still anchor the price level in the long run and provide a metric to evaluate how well the central bank had used its independence. By the mid 1990s, then, the consensus seemed to be that the right regime was some sort of inflation target agreed between a government and the central bank (if not set out in legislation), operational independence for the central bank in pursuing the target, and a system of communication and accountability. Through the 1990s and the early 2000s, an increasing number of countries adopted some version of this approach. Even the Federal Reserve, for which the dual mandate is most strongly set down and defended, articulates a numerical description of price stability and describes it as a goal. There were still, of course, the financial stability goals that were the original of most central banks. It was generally accepted that the appropriate response in a liquidity panic would be to provide funds to solvent financial institutions, against collateral, at a rate related to but above the prevailing market rate. System-wide increases in demand for liquidity would be handled almost automatically via operations designed to keep the overnight rate at the target. Only in extraordinary cases would something more be required, and such events were expected to be very rare. For some years, then, the modus operandi of a developed country central bank involved setting a short-term interest rate and adjusting it incrementally in response to forecast deviations of inflation and/or output from the desired path. Occasionally, the central bank would move the policy rate more quickly in response to shocks thought likely to affect the outlook in a major way. Observed changes in asset values would be assessed in terms of their implications for the growth forecast. Rapid declines in asset values might evoke a monetary policy response if they were thought likely to have a significant economic effect. The results of this framework seemed to be good - we were living through the 'great moderation' after all. The actions were (relatively) uncontroversial and there was generally reasonable political support for the system. But then, unfortunately, things got more complicated. As we know, the materialisation of some of the risks that had built up in the financial system, followed by a financial crisis, deep recessions and slow recoveries, has meant that much more has been demanded of central banks in recent years, especially those in the major jurisdictions. This started when unusually large interventions were required to keep money markets functioning in Europe during the second half of 2007. Then, truly extraordinary actions were required in a number of jurisdictions following the failure of Lehman Brothers in September 2008. The complete breakdown of funding between intermediaries, the closure of important segments of the capital markets and the loss of public confidence in major financial institutions were more severe than any previous event over a number of decades. This required very forceful interventions by central banks, and by governments. A potential debt-default spiral had to be averted. Assets had to be liquefied. Private funding that had disappeared had to be replaced, in key instances, by central bank funding. And, not least, public confidence in deposit-taking institutions had to be restored, using guarantees and in some cases public injections of capital. This was not an idiosyncratic event; it was systemic. While the most acute problems were in the North Atlantic countries, the ramifications were global. Such actions, controversial as they were (and still are), were really the only course available to the decision-makers at the time. Lengthy retrospective critical evaluations, carried out in the (relatively) calm years afterwards, are the prerogative of historians, academics, journalists and legislatures. There is of course a lot of hindsight judgement in there, and in some cases not a little unfairness. The fact that they occur, though, marks the unusual territory that central banks and governments were forced to traverse. For this was more than just the injection of liquidity as a response to a brief panic. The threat to real economic activity was so dire that the stance of monetary policy had to be changed aggressively. Economic activity turned down very sharply, all around the world, in the closing months of 2008. Interest rates were slashed and in the major jurisdictions they quickly reached very low levels or, effectively, zero. This wasn't enough either to prevent many countries entering deep recessions or, subsequently, to generate reasonable recoveries. Hence, 'unconventional' measures were rolled out to try to provide additional stimulus. Central bank balance sheets, pre-crisis, were typically about 5-10 per cent of national GDP in size. (The Bank of Japan's was already larger than that, as a result of the use of balance sheet measures over the preceding decade.) They have since increased to around 25-30 per cent of GDP, with the Bank of Japan on a path that will take it to around 90 per cent. Balance sheet measures may have begun as direct interventions to stabilise the financial system, but are now long-running measures aimed at monetary policy goals. Monetary policy is being asked to return output to potential by boosting demand, after a severe demand downturn resulting in part from over-leverage. The problem here is that if leverage is too high, and needs to be reduced, monetary policy (by itself) may not be as effective at generating demand as people might wish. Twenty years ago, with a latent demand for more leverage-led spending, it wasn't hard to stimulate growth in demand with lower interest rates, at least not in the Anglosphere or the Nordic countries. It seems harder now. It is worth remembering that monetary policy doesn't directly create spending. What it does is alter a relative price. That has two significant effects. The first is that it redistributes income between savers and borrowers. In the wake of a financial crisis associated with over-leverage, monetary policy can, by lowering interest rates, lessen the burden on the indebted sectors by shifting the burden in part to the net holders of interest-earning assets. This will lessen the negative feedback from debt to spending, which, in turn, stops aggregate spending falling as much as it otherwise might do (even though the net asset holders will at some point start to reduce their spending if interest income continues to fall). The second effect is to alter the incentives faced by the private (and public) sectors in deciding whether to spend today or on some future day. But if people are less responsive to that because they are still highly leveraged, monetary policy is less powerful in the short term. Of course, this might just be temporary. Once the 'balance sheet repair' channel has been working for long enough for the repair to be largely complete, maybe people will respond with additional spending in the same way as they used to. In that case policy would still be effective, just with longer lags. On the other hand, if there has been a persistent shift in attitudes to debt, spending and saving, then monetary policy's weaker ability to generate short-term growth might just be part of the 'new normal'. So while it is beyond argument that central bank actions in the crisis headed off what could have been a catastrophe, it's another thing to think that monetary policy can easily restore enough demand to fully employ the economy's labour and capital doing what they were doing before the crisis. The evidence for effectiveness of such policies is strongest in the United States, but even there it has taken a long time for the recovery to gain momentum. If ultra-low interest rates and quantitative measures were powerful, they should have produced a lot more demand and presumably more inflation by now. Some critics of these policies thought, of course, that high inflation would, in fact, occur. They were wrong about that. If anything, inflation looks a bit too low globally despite the extent of monetary easing. Other critics would say that if the desired effects have been slow to emerge, that is only because the dosage was too small. Perhaps that's right. Or perhaps the evidence is telling us that, at whatever dosage, monetary policy can do only so much and that other tools have to be used as well. That is not to say that monetary authorities were wrong to implement such policies, only that they were perhaps bound to find their efforts of only relatively limited power. At any rate, it is still proving hard to generate demand. Financial risk-taking has increased, driven by the 'search for yield', but 'real economy' risk-taking is more difficult to find. Corporations sit on stockpiles of cash, in many cases apparently reluctant to accept lower returns on investment projects in spite of the lowest cost of debt funding ever seen. Capital is returned to shareholders, who are frequently faced with alternative options earning even less than the money would have earned in the corporation. At the same time, it is increasingly apparent that the ultra-low returns on offer on financial instruments are making it exceedingly difficult for the provision of retirement incomes. Although it now seems that the 'zero lower bound' for nominal interest rates wasn't actually zero, it is not clear that the recent negative rates implemented by a handful of central banks in Europe offer some new vista of policy effectiveness. The incidence of negative rates that society will accept may be somewhat narrow. Moreover, a recent speech by Jamie McAndrews outlines a number of respects in which negative interest rates, if attempted on a widespread basis over a long period, could in fact be very disruptive, and in ways not likely to be expansionary for growth. It hasn't helped matters that many governments feel they have insufficient scope for stimulus from the budgetary side. In the contemporary jargon, they lack 'fiscal space'. In some cases this is a result of poor fiscal discipline over a long period. In others it is more the result of the size of the debt build-up caused by the depth of the crisis itself. Whatever the backdrop, if the perceived limits to debt sustainability are close, then governments will tend to feel that fiscal stimulus today must be accompanied by a credible promise to reverse it tomorrow. This promise, if kept, would keep the debt trajectory largely as it was. But it also may negate the power of the policy to generate growth beyond a very short horizon. One has to have a lot of faith in the notion of temporary 'pump priming' to think otherwise. On the other hand, many would argue that since the track record in so many cases suggests that, once public borrowing starts, governments find it very hard to stop, perhaps that conservatism is for the best. Meanwhile, central banks' longstanding general concern for safeguarding financial stability has taken on more of an edge and is now less easily dissociated from monetary policy. There is still a tendency, as there was prior to the crisis, for financial stability and monetary policy work in central banks to be organised in separate silos. The monetary policy people think about output gaps and inflation, and the financial stability people think about asset prices and leverage and how to strengthen resilience. The current thinking is that regulatory tools should be deployed in response to concerns here. It certainly seems logical enough to ensure stronger capital standards and even to lean into the credit cycle with counter-cyclical tools where regulators have them. Yet this neat separation between financial stability and the central bank's other macroeconomic goals might just be a little too neat. I wonder whether it shouldn't leave us a little uneasy. For a start, experience of an earlier era of regulation counsels against putting a lot of faith in such measures. Not only that, but it is surely a lesson of the crisis that monetary policy and financial stability interact. Monetary policy works, after all, by altering financial prices and asset values. Lowering interest rates doesn't just conjure up demand through some process of immaculate conception. It works, when it works, at least partly by affecting risk-taking: by affecting borrowing and saving decisions. The central bank, by setting the rate of interest, is effectively setting the price of leverage. It's abundantly clear that leverage matters for financial stability. Few things matter more, actually. People have stopped short of saying that the goal of monetary policy should be changed from price stability to financial stability alone (though it is not impossible that a decade from now that will have changed). But they have more misgivings than they once might have had about attempts to meet inflation and/or unemployment mandates that ignore the financial implications of the interest rate settings thought necessary to reach those goals. Suppose a country faces an insufficiency of aggregate demand and below-target inflation, but can generate the demand needed to close the gap and push inflation up to target only by fostering a rise in private sector leverage. How aggressively should the central bank seek to increase demand and return inflation to target? The answer presumably depends on several considerations. Among them might be how well anchored inflation expectations are. The better anchored they are, the less risk of a damaging decline into very low or deflationary expectations. Surely another key consideration would be whether leverage has previously been low or high. If it is low, then some increase need not be particularly risky. On the other hand, if leverage is already high, perhaps as a result of an earlier run-up, and if the weakness of demand is in part a result of the private sector being cautious about further extensions of leverage, or even attempting to reduce its leverage, the central bank may face an unenviable set of choices. There is an intersection between the Phillips Curve world of output gaps and inflation targets, and the Irving Fisher/Hyman Minsky world of low frequency cycles in risk appetite and leverage. The financial sector isn't just an appendage to the 'real economy', passively responding to the course of output and prices. It is through the financial sector that monetary policy works to affect the economy. Sometimes, problems that have built up in the financial sector can have powerful effects on real economic outcomes that monetary policy might find impossible to offset. A sense of when and how that can happen is very important for monetary policy. So where does that leave us? The role of central banks has become much more prominent, and at the same time considerably more complex and potentially more controversial, than it was in the calmer days of the great moderation. More has been asked of central banks, under circumstances in which monetary policy might reach the limits of effectiveness, and yet at a time when it seems the ability of other macroeconomic policies to contribute to growth has lessened. A previous generation of central bankers, who fought lengthy battles to rid their respective countries of high inflation, are surely looking on in disbelief. Central banks' balance sheet actions have become dominant forces in a wider range of financial markets. Some would argue that the market's normal functions of pricing for risk have been distorted or overwhelmed by central bank actions. To those critics, the 'search for yield' is an artificial and dangerous phenomenon caused by central bank interventions. Central banks would counter that they had little choice but to pursue these actions and that, in any event, there are likely to have been some real factors at work in holding down real interest rates. Either way, some central banks seem likely to be large players in markets for quite some years. The manner and pace of eventual normalisation of balance sheets will surely, at some point, become a major challenge for private participants. Nor is it just in their transactions that central banks have become very conspicuous. In their efforts to add power to their easy monetary policy stances, central banks have sought to offer 'guidance' on their future behaviour. They have taken pains to spell out the sorts of conditions under which they would adjust policy and even given some sense of the likely pace. The forthcoming 'lift-off' by the Federal Reserve, when it happens, will surely be the most telegraphed monetary policy adjustment in history. That is all very sensible. Words matter as much as actions. The problem is that a central bank cannot realistically state how it will respond to all possible future states of the world. And in any event, many market participants, commentators, journalists and so on are not that interested in the nuance and conditionality that usually surround central bankers' careful utterances. They simply want to know what will happen and when. They will distil things down into a simple story, fitting the central bank into one pigeonhole or another. Allow me an analogy. In a remote part of Western Australia, construction of the Australian and New Zealand part of the Square Kilometre Array project is to take place. It is part of an international project, headquartered in Manchester. As the name suggests, the idea is to have multiple radio telescopes over a large area, increasing the effective size of the receiver antennae. This array will, it is said, be able to detect the faintest energy emanating from distant stars - billions of light years from the earth. Reading about that, one can't help but think of the financial markets. Countless market and media antennae are trained on the sound of the central bank voice, trying to discern and amplify signals out of all the static around, even when the central bank has no new signal to send, and static is all there is. The lesson that recovery from a downturn associated with a period of financial excesses almost always proves to be a slow one has been learned once again. Central banks have to do what they can to speed up that process. Together with governments, they can and did avert a catastrophic contraction. They can and have run an extended period of easy money, including by being innovative with their own balance sheets. In all likelihood, very accommodative policies will continue for quite a while. During that period, central banks will have little choice but to rely in part on regulatory tools to try to contain potential financial excesses, without convincing evidence of the power of such tools. But they will also have to learn to live, I suspect, without the earlier neat distinction between monetary policy and financial stability policy. In the end, of course, central bank policies can't restore the situation . Whatever adjustments economies needed to make, and may still need to make, in respect of financial and/or economic structure from their pre-crisis situation, cannot be avoided. Those adjustments are ongoing. I am optimistic enough to think that, in due course, they will have advanced sufficiently such that stronger growth, accompanied by less extreme central bank policy settings, could be anticipated. Needless to say, the more other policies, outside of the central bank's ambit, can contribute to that, the better. That was the point of the pro-growth commitments the G20 Leaders made in Brisbane in November 2014. It may be quite some time, though, before the central banking modus operandi that we had prior to the crisis is seen again.

r150722a_BOA

australia

stevens

Thank you for coming out once again to support the Anika Foundation. As a result of your generosity in past years, the Foundation is continuing to expand its activities, as you have heard from earlier presentations. The very efficient logistics for today were again provided by The Australian Business Economists. I also thank Macquarie Group for its financial support of today's event. I will organise today's remarks under four headings: Until recently, we were living, at a global level, through a period of remarkably low volatility and skinny pricing for risk. There was bound to be some set of events with the potential to change that. Once again, some of them have been in Europe. After some months, difficult discussions between the Greek Government and its European partners reached an impasse and Greece was, as a result, unable to make a scheduled repayment to the IMF. The ensuing few weeks, during which the Greek authorities had no choice but to curtail access to the banking system, have been extremely difficult and surely quite damaging for the Greek economy. There has been progress towards a solution in recent days, though a huge amount of work remains ahead to put the Greek economy, and the whole European project, onto a stable footing. To date, though, the financial spillovers from the Greek situation have not been large. Spreads to German sovereign yields observed for debt issued by the governments of Spain, Portugal and Italy remain quite contained. At this stage, we do not see a market response that signals serious doubts about the ability of those countries to remain in the euro area. There could be little doubt about the willingness of their European partners and European institutions to support these countries in the event that market conditions took a serious turn for the worse - as they might have done, and still might, had/if 'Grexit' occurred. The likely direct economic spillovers to the rest of Europe also seem fairly contained, since Greece is quite a small economy. Of course, things remain fluid. An unexpected turn of events - of which there have been many over time - could change the assessment above. Broader financial and economic impacts might be longer in coming and harder to predict. There are also important geo-strategic elements to the situation, which is one reason why nations outside Europe are taking such an interest. For our part, all we can do is watch and see what eventuates. Meanwhile, and of arguably greater relevance in our part of the world, China's economy and financial system are going through a period of adjustment and uncertainty. Recently there have been some quite spectacular developments in the equity market. A rapid run-up in share prices - which more than doubled in the space of a year, far beyond any plausible prospective improvement in company earnings - turned to a slump in mid June to early July. Share prices remain well above their level of a year ago, but the speculative nature of the run-up, and the part played by an increase in leverage, has understandably made everyone a little nervous. The Chinese authorities have acted forcefully with some very wide-ranging interventions to stabilise the situation. The effect this will have on the Chinese economy is not clear, but may prove to be relatively small. Share prices have stabilised in recent days and authorities have been making financial conditions more accommodative. Households' direct exposure to equity prices is relatively small, notwithstanding their large share of turnover. In addition, the rise in share prices was probably too short-lived for there to have been much in the way of positive wealth effects on spending. Other leveraged entities, such as banks and brokers, have shown little obvious sign of stress resulting from the developments in equity markets. It seems, on the basis of information available at present, that developments in the Chinese property markets and the broader financial sector are likely to be more important for the outlook. The economy had been showing signs of slowing, of course, in the first part of this year. But policies have been responding to this, and some of the recent economic data suggest they have been having a positive effect. Lastly on the international front, the likelihood still seems to be that US interest rates will begin to rise before the end of this year. This change, when it comes, will have been very well telegraphed. That being said, long-term yields in the United States and elsewhere are still very low, and risk premia compressed, albeit not so much as they were. Some turbulence may well occur as a result not of the first increase in US rates, but of investors trying to assess how soon subsequent increases might occur. But sooner or later we have to see a start to the process of adjusting these financial prices and I would expect Australian financial markets to be able to take all that in their stride. The Australian economy has been growing, but at a pace a bit below what we have traditionally thought of as average, as it adjusts to some pretty large changes in circumstances. The story of the phases of the 'mining boom' is well known. Commodity prices rose massively and have since declined (though some prices remain pretty high compared with longer-run history). Investment spending followed suit - first it rose by about 5 to 6 percentage points of GDP, and now it is on its way back down. Finally, shipments of resources picked up, as the new capacity created by the investment became available. As an aside, unlike the situation posited some years ago in the United States, and notwithstanding the growth of services, the physical weight of Australia's GDP has probably increased over the past decade. For iron ore and coal, annual tonnages being shipped from Australian mines have increased by more than half a billion tonnes since 2004. Growth in domestic demand, in contrast, is fairly subdued. Over the latest year for which we have data (to March 2015), final domestic spending rose by a bit under 1 per cent, as the fall in resources sector capital spending accelerated. Capital spending by other businesses has been weak too, while public demand was roughly unchanged over that year. The weakness in those areas is juxtaposed, as you know, with changing household behaviour. After a lengthy period during which consumer spending growth ran ahead of income growth, and leverage (measured as the ratio of debt to income) almost trebled, households changed course some time ago. To be sure, the rate of saving from current income has declined a little over the past couple of years, which is what is expected at a time of very low interest rates and positive wealth effects resulting from rising asset values. But it remains significantly higher than it was a decade ago. The types of saving rates we see now are more likely to be 'normal' than those of a decade ago. Moreover, while some households (such as first home buyers or, perhaps increasingly the same thing, first home investors) are taking on more leverage, many others are reducing it. They are taking advantage of lower borrowing costs to repay mortgage debt ahead of the schedule in their debt contracts. Despite the lowest interest rates that any current borrower has ever seen, the pace of lending to households remains moderate. This is not a credit crunch - lenders are willing to lend and competition to do so is strong. Indeed, the prudential supervisor has been minded recently to issue some timely warnings about the need to maintain sound lending standards. Rather, the story is that households are being more prudent about debt and are holding more liquid assets. One measure of this is the size of 'offset account' balances - bank deposits held to offset mortgage debt. These now amount to about $90 billion. When the housing credit data are adjusted for the increase in offset account balances, the rate of growth over the past year is put at about 6 per cent, as opposed to over 7 per cent as published. This may mean that the effect of easy monetary policy is to be somewhat lessened, at least for a time. Taking a medium-term perspective, though, the general strengthening of the balance sheet among many formerly more-indebted households has to be seen as a good thing. In the interim, the somewhat more restrained attitude to debt and spending by households, combined with a similar attitude by the government sector, has meant that there has not been quite enough domestic demand to achieve full employment, in the face of the fall in business investment. That is why we have felt that, on balance, a somewhat lower exchange rate was likely to be a part of the necessary adjustment. That adjustment seems to be occurring, with relatively little disruption, and is having an expansionary effect. Growth in services trade for example is picking up. The 'net export contribution' of services trade over the past year, of around 1/2 percentage point of GDP, is about the same as the contribution from iron ore exports over that period. It is worth noting that business conditions as measured in surveys have tended to improve overall, outside the mining sector, over the past year or so. At the same time, the state of the labour market, while still somewhat subdued, appears to be better than we had expected three or six months ago. Employment growth has picked up noticeably, and hours worked have also increased. The rate of unemployment is unchanged from a year ago, whereas we had been thinking it might be a little higher than this by now, since growth in real GDP has been, according to the available statistics, below trend. Candidate explanations for this better-than-expected set of labour market outcomes include the following: Some or all of the above possibilities may be at work. Time will tell which ones, but a few observations may be worthwhile at this point. First, the economy is making the adjustments required, even if it is a bit slower than we would ideally have liked. Second, if the slow growth of wages has in fact been a significant saver of jobs, that would appear to indicate a degree of labour market flexibility in operation. Third, to the extent that the data are hinting that our assumptions about trend growth may need to be revisited, that will be worth some discussion. It need not be the case that per capita growth would be any lower, if the lower growth simply reflects slower population growth. So there may be few implications for living standards as measured by income per head. But if there are assumptions about absolute growth rates embedded in business or fiscal strategies, or retirement income plans, they would need to be re-examined. I suspect this will turn out to be an important discussion: what is Australia's potential economic growth rate, per head, and why? And what do we want it to be? And, of course, what do we need to do to achieve our desired outcome? I return to that theme - securing prosperity - shortly. But first, a few words about stability. One of the features of much regular discussion of macroeconomic policy, and monetary policy in particular, is that people tend to adopt a rather short time-frame. Everyone watches high-frequency data and adjusts expectations about what policy should or will do accordingly. Policymakers are expected to respond to events and to deviations of economic performance from what had been anticipated. The number of surveys and obscure indicators seen as conveying information has continued to grow, as has the number of commentators to talk about them. To some extent this is perhaps a natural outworking of richer, more complex societies possessing more information and analytical resources, the 24/7 operation of financial markets and a competitive media searching for content. And to a point, it is perfectly reasonable to expect policy to be adjusted in response to relevant information about how things in the economy are tracking relative to policy objectives. The risk, however, is that this process can lead to a mindset in which policymakers end up responding to quite short-term phenomena, using instruments that take quite some time to have their full effect, including effects that might actually turn out to be adverse. This is relevant to our situation. A period of somewhat disappointing, even if hardly disastrous, economic growth outcomes, and inflation that has been well contained, has seen interest rates decline to very low levels. The question of whether they might be reduced further remains, as I have said before, on the table. But in answering that question, it is not quite good enough simply to say that evidence of continuing softness should necessarily result in further cuts in rates, without considering the longer-term risks involved. Monetary policy works partly by prompting risk-taking behaviour. In some ways that is good: in some respects, there has not been enough risk-taking behaviour. But the risk-taking behaviour most responsive to monetary policy is of the financial type. To a point, that is probably a pre-requisite for the 'real economy' risk-taking that we most want. But beyond a certain point, it can be dangerous. Deciding when such a point has been reached is, unavoidably, a highly judgemental process. And that is after the event, let alone beforehand. My judgement would be that policy settings that fostered a return to the sort of upward trend in household leverage we saw up to 2006 would have a high likelihood, some time down the track, of being judged to have gone too far. That is not the case at present, given the current rates of credit growth and so on. But the point is simply that in meeting the challenge of securing growth in the near term, the stability of economic performance can't be dismissed as a consideration. A balance has to be found. I note that the Board's post-meeting statements routinely refer to seeking a stance of policy that will 'most effectively foster growth and inflation consistent with the target' (emphasis added). The adjective 'sustainable' is used deliberately and financial sustainability is very definitely one of the things we have in mind. The transition in growth is not perfectly smooth, but our economy has, in my judgement, coped remarkably well through a lengthy period of very large shocks in a difficult world. Despite the doom and gloom and fulminations over the airwaves, in newspapers and in cyberspace, business confidence has risen in recent months. One day last week as I was preparing these remarks, newspapers carried stories that personal insolvencies are the lowest for more than a decade. On the same day we could read that income inequality in Australia, as measured in the most detailed survey available, has not, in fact, increased, contrary to the impression so often given. Perhaps we might be allowed to conclude that we have been meeting some of our challenges, thus far, with outcomes that, while not perfect, are not too bad. So there are reasons to feel more confidence in our future than we often seem to. The question to be asking is how we build on the broadly successful record we have in order to secure prosperity in the future. In this context, it is likely that questions about potential growth, in per head terms, will become even more prominent. This is partly because of the well-known implications of the lower terms of trade for income per head (i.e. it grows more slowly than output per head). It is partly about demographics, also a well-known issue. Ageing will lower the proportion of people working and hence, other things equal, output and income per head in the country. We all know these things at an intellectual level. But unless we think our wants, including for publicly provided services, will grow more slowly, which I doubt, the very practical imperative will increasingly be to secure sources of growth. And it is increasingly clear to people that the kind of sustained growth in mind here won't be the result of the manipulation of interest rates or year-to-year government fiscal settings. Demand management policies play an important role, but they have their limitations. Raising the economy's potential isn't just some esoteric concern for economists, or at least it shouldn't be. Our collective ability to deliver social policy outcomes, to enjoy the benefits of a 'good society', or at a more basic level to provide public services and even to defend ourselves, ultimately rests on a productive economy. Many problems, including distributional ones, are easier to deal with if incomes are rising steadily, less so if they are stagnant. Let's be clear that this is not 'growth at any price'. Wealthy countries tend to have cleaner air, cleaner water, better health and education systems, and more demanding standards for environmental protection, employee safety and leave entitlements. They can afford to devote resources to such things because their business sector is so productive. They tend also to have higher wages - not because they decree wages shall be high but because well-educated, skilled workforces working with a lot of capital and modern technology are more productive. The poorest peoples usually have far less in the way of such things. If we care about wellbeing in the broadest sense, we should care about things that affect potential output per head. Our citizens certainly care about the results. They don't frame the question as being about per capita real GDP or productivity per hour and they care about more than just 'narrow' outcomes for economic statistics. Many would be concerned to reduce our environmental footprint. They would not wish to sacrifice civilising aspects of our society and culture, including many that result from government intervention. But nor will they accept a future in which they are marginalised in the global village because of unwillingness to adapt or to invest, or because of a failure to foster a growth economy. There is a lot of talk at present about 'reform'. I would suggest that the case for 'reform' needs to be presented as a positive narrative for economic growth. We all know that competitive markets, investment in education, skills and infrastructure, and adaptability, are key parts of that growth narrative. These reforms matter because of the gains to incomes resulting from better allocative efficiency. But they also, ideally, would support entrepreneurship and innovation - 'risk-taking' by another name and of the kind we want. Measuring 'entrepreneurship' is not straightforward and various studies have somewhat differing results. At the risk of oversimplifying, one might say that Australians hold our own in the entrepreneurship stakes, but since we don't generally score at the top in such surveys, there must be scope to improve. That too can be part of the growth narrative - the narrative of how we build on the success enjoyed to date and secure an even more prosperous future. Thank you again for your attention, and for your support of the Anika Foundation. I hope to see you again in another year for a new round of challenges.

r150826a_BOA

australia

stevens

Thank you for the invitation to take part in this very important discussion. It is pleasing to see so many influential people coming together for a discussion about the country's economic future. In a sense, I am really an observer here, because the things you need to grapple with today are mostly outside my remit. Australia's monetary system is still - I trust - well supported by all the key stakeholders here. It has helped to deliver good outcomes. Our financial sector is robust and stable. But a stable monetary standard and a strong financial system, while necessary conditions for prosperity, are not sufficient ones. More is needed - and that's why you are here. Your topic is 'reform' in the broad. It's a term that will be used frequently over the next few hours. What does it mean? Often it is presented through the lens of allocative efficiency, otherwise known as productivity. And this is very important. Ideally, production and demand each face and respond to, without distortion or impediment, underlying relative costs. Those relative costs are given by the state of human and physical capital, technology, natural resource endowments and so on. Generally, economists think optimal allocative efficiency is achieved by removing barriers to competition in markets - be they tariffs, subsidies, protectionist devices, unnecessary regulation - and allowing relative prices to allocate productive resources. For most products, competitive markets will deliver the greatest choice at the lowest price to informed consumers. Granted, there are various exceptions to the generalisation above. Where markets are 'natural monopolies' or externalities exist, for example, regulation is called for. Good outcomes won't occur if consumers are not well informed. And so on. Nonetheless, I would venture that the biggest gains to prosperity over the past 25 years have come from more competition. (Aside, that is, from gains from the terms of trade, about which we can do nothing and which usually don't keep coming). Competition lowers prices and costs. It promotes the drive to do better, which spurs innovation. Minimising distortions due to the tax system also has a role in enhancing allocative efficiency. These things remain important. You should talk about them today. The 'to do list' remains substantial. In arguing the case for reform, though, the way the discussion is framed matters. I would like to suggest that 'reform' is a term which excites the intellectual elites and the various interest groups (including those who feel they have something to lose from reform) but doesn't do much to excite the general public. And getting buy-in from them is ultimately critical. To be sure, they have to be led. But they have to be convinced too. I submit that the general public is much more likely to grasp, intuitively, a conversation about growth. Growth in jobs, in incomes, in their standard of living, wealth and prosperity. Better allocative efficiency, if we could secure it, would doubtless add to growth. That growth is worth having. But the story is also about how to secure more dynamic effects: increasing the resources available to be deployed in economic activities of various kinds; fostering conditions under which innovation and genuine risk-taking flourish. In that regard, how to minimise adverse effects on work effort, enterprise, capital accumulation and innovation, due to tax or other factors, would be a worthwhile question - accepting, as a condition, that there is an amount of revenue the government must raise to fund the provision of services only the government can supply. Minimising those adverse effects means a larger economy; more income; more revenue and so on. In parallel, there is no avoiding the need to have the right labour market arrangements. The question is how to have suitable rules that offer basic fairness, but with minimum adverse effects on enterprise, employment, and the scope for free agents to come together in ways that mutually suit them - and that grow the economy. Whether we have that balance right is a question you might address. Growth is important. And for a while now, there has not been quite enough growth. There has growth, and more than in many countries. But, recent labour market outcomes notwithstanding, not as much as we ought to be capable of. Growth rates have mostly started with a '2' for a while now - despite the lowest interest rates in our lifetimes, banks able and willing to lend and measures of consumer and business confidence generally about average (notwithstanding what we keep reading in the media). This may be simply a feature of the post-financial crisis world - the need for balance sheet repair. It may be about changing demographics. It be that potential growth is a bit lower than we used to think - though I don't think we can know whether that is so at present. But whatever the factors at work, we are unavoidably and inexorably being led to the question: how do we get more growth? The fiscal policy debate, usually framed as 'when will we get back to surplus?' is actually about: how do we get more growth? Other discussions, so often framed as about 'fairness' - that is income distribution - might be better framed as: how do we grow the pie? That isn't because distribution doesn't matter. It's because distributional issues surely get easier with growth but much, much harder in its absence. Reasonable people get this. They also know, intuitively, that the kind of growth we want won't be delivered just by central bank adjustments to interest rates or short-term fiscal initiatives that bring forward demand from next year, only to have to give it back then. They are looking for more sustainable sources of growth. They want to see more genuine dynamism in the economy and to feel more confidence about their own future income. So in your deliberations today, a key question worth asking is: how do we generate more growth? Not temporary, flash-in-the-pan growth, but sustainable growth. How do we craft a credible, confidence-enhancing, narrative about growth? That's actually what 'reform' is about: making things work better for higher income and wellbeing. If there are some things of substance that you could agree on, it would be a step forward. Present here in the room you have the intellectual resources, the stakeholders, the leadership and the communication capabilities. In short, you have the ingredients. Over to you.